Viewpoint
January 17, 2025 | 14:17
January 17, 2025
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Inflation Progress, But… |
| Heading into a possible tariff storm, the downward trend in inflation has slowed and maybe even stalled. The yearly increase in core PCE prices, the Fed’s preferred guide, was 2.8% in November, unchanged from the year-to-date average. It’s somewhat comforting that core prices are running a little slower at around 2½% on a shorter-term basis, and this trend likely continued in December given that core CPI prices rose an annualized 2.7% in the month and PCE inflation usually runs a bit slower due to substitution effects. But the moderating trend in core CPI inflation has settled in the low 3s on both a short-term and yearly basis (Chart 1). Furthermore, the Cleveland Fed’s two measures of underlying inflation—trimmed-mean and weighted-median CPI—were both tracking north of 3% on a 1-, 3-, 6- and 12-month basis in December. The stalling in disinflation likely reflects some recent firmness in the labor market, with the jobless rate edging lower, as well as robust consumer spending. While base effects should help lower the yearly inflation rate this year, progress may only be sustained if consumer spending cools somewhat. That, in fact, is our base-case forecast, which underlines our view that inflation will grind down slowly this year, before settling back to the target next year. We are encouraged by some other price reports this week. The National Federation of Independent Business survey found that, despite a record increase in economic optimism since the election, the percentage of small businesses raising prices or planning to do so rose only slightly in the final two months of last year. The Fed’s Beige Book also reported that prices were increasing “modestly overall, with growth rates ranging from flat to moderate”. Still, some businesses are worried about “the potential for higher tariffs to contribute to price increases”. |
| Whether tariffs lead to a one-time adjustment in prices or more persistent pressure will, in part, depend on labor market conditions. Some evidence (quits rate, unemployment duration) suggests the job market has loosened a bit, though perhaps not enough to achieve the inflation goal. To the extent that tariffs weaken the economy and increase joblessness, their upward push on inflation should be transitory, as noted by Fed Governor Waller. But much will depend on the size and breadth of tariffs and, importantly, whether businesses and workers expect multiple rounds, in which case price- and wage-setting behavior would likely unfold in ways that add stickiness to inflation. Moreover, tariffs could reverse the deflationary trend in goods prices, at a time when services prices are still running too hot for price stability. |
Beyond tariffs, another source of inflation uncertainty stems from the thrust of fiscal policy, which will largely depend on the mix of tax and spending cuts (as Michael discusses below). The increased inflation angst is one reason bond yields have risen since the election. |
The Fiscal Handoff |
| On January 20, the Trump Administration will get the keys to drive America’s trade, immigration, fiscal, and regulatory policies once again. In a January 8 meeting with Senate Republicans, the President-elect indicated that he had already penned about 100 executive orders to get things done quickly, particularly on the tariffs and border security files (according to the Wall Street Journal). Congress has constitutional authority over taxing and spending, and the President must invoke various emergency and trade remedy provisions to go it alone on tariffs. This week, the Treasury released its December accounts, describing what the new Administration and GOP-led Congress are inheriting. The 12-month trailing budget deficit was $2.0 trillion with $4.9 trillion of receipts and $6.9 trillion of outlays. The shortfall represents a hefty 6.9% of GDP. The total public debt (at December-end) was $36.1 trillion (123% of GDP). The Congressional Budget Office (CBO) now projects that the deficit will improve to less than $1.7 trillion by fiscal 2027 (ending September). This is based on current law which includes the expiry of the 2017 tax cuts by January 1, 2026 (note: the corporate tax rate reduction was permanent). The hit to disposable personal income would be enough to cause the economy to contract, which is why this is not going to happen. The new Administration and Republicans in Congress have vowed to make these cuts permanent (even the Democrats favor making some expiring cuts permanent). The CBO estimates the 10-year deficit impact of full extension at $4.0 trillion. And, there were also campaign promises to lower corporate and personal taxes even more (estimates put the total 10-year deficit impact topping $10 trillion). Hence, the quest for offsetting spending cuts and other revenue sources. Already circulating in Congress (they began working on January 3) is a proposal to cut mandatory spending by up to $5.7 trillion over the decade. Mandatory outlays include things like social security, Medicare, Medicaid, and a host of programs for individuals, families, and businesses. Politicians, historically, have had a tough time cutting these items, but they must be cut to make a big dent in total spending. As noted above, the government spends roughly $7 trillion each year with defense outlays, non-defense discretionary spending, and interest payments all coming in around $1 trillion. Mandatory spending is a massive $4 trillion. Already, there has been some pushback within the GOP. And recall, the Republicans hold a very slim majority in the House with 219 seats versus 215 for the Democrats and one vacancy. Treasury’s latest accounts also show the 12-month tally for ‘customs duties’ at $79 billion, with the new Administration touting this as a significant new revenue source. For the 12 months ending November, goods imports were $3.2 trillion. A 10% universal tariff would generate almost $325 billion (20% would garner more than $645 billion) for the new ‘External Revenue Agency’, other things equal. But among retaliatory tariffs, eroded purchasing power due to higher prices, along with production and job losses, the net revenue take would be noticeably less. But even shaved 10-year totals are attractive to some to fund domestic tax cuts. Still, the price tag also includes dampened productivity growth, potentially faster inflation, and higher interest rates. But the quest for new revenue could trump these too. |
Is the Fed Really That Restrictive? |
| I have a question, and I am sure some folks at the Federal Reserve do too. Is monetary policy restrictive enough? I hear Fed officials and macroeconomists repeating “restrictive monetary policy” like a mantra. But, in the December FOMC press conference, Jay Powell let it slip that the policy stance is now significantly less restrictive. Was the September pivot to cut rates premature, and are we setting ourselves up for a reversal down the road? It has been nearly three years since the Fed embarked on one of its most aggressive monetary tightening campaigns to tame overheated demand and curtail runaway inflation. Then last September, believing it was closing in on the end zone of its inflation goal and seeing troubling signs of labor market slackening, it began to pivot to a less restrictive monetary policy stance, cutting the fed funds rate by 100 basis points over the last three FOMC meetings of 2024. |
| The problem is that there isn’t a lot of evidence, at the moment, that restrictive monetary policy is significantly holding back anyone or much of anything in the United States. Take retail sales for example. It’s telling that the top two sales growth categories over the past year are durable goods that are supposed to be the most sensitive and vulnerable to rising interest rates. Auto dealers and furniture stores both clocked in at a jaw dropping 8.4% growth rate in December (Chart 1). No doubt, hurricane replacement had something to do with this stellar growth, but it certainly doesn’t scream ‘I surrender, the weight of increasing interest rates is too much for me to bear’! Indeed, even the retail sales control group (which excludes motor vehicles, gasoline, building materials, and food service sales, and is a good proxy for consumer spending in the GDP report) has been extremely robust, jumping at a 16.4% annualized pace in September, when the Fed made a bigger-than-normal 50 basis point rate cut, then accelerating again in November to a 5.0% annualized pace, and closing out December at a stout 8.4% (Chart 2). In fact, the sales numbers have been so good, we believe real consumer spending Q4/Q4 in 2024 could match 2023’s pace of 3.0%. On a year-over-year basis, 2024 real consumer spending growth of 2.7% could exceed the 2023 pace of 2.5%. Consumers didn’t even break a sweat despite two years of so-called highly restrictive monetary policy. Waiting for the consumer spending slowdown has been a bit like waiting for Godot. |
The phantom labor market recession that many saw in the rising jobless rate last summer has also largely vanished. The Sahm Rule recession indicator is no longer being triggered, and job growth perked back up in recent months. Even average hourly earnings growth has re-accelerated in Q4. One can also argue that overall financial conditions aren’t all that tight. The S&P 500 just put in back-to-back years of 20%+ returns under this supposedly “highly restrictive” monetary regime. Except for the housing market, spotting the negative impact from restrictive monetary policy has been difficult. If a consumer spending slowdown doesn’t show up soon, the Fed may have to be on hold longer than it currently thinks. We now believe the Fed will delay its next rate cut until June before it will have enough clarity to see if monetary policy has truly been restrictive enough. |