Viewpoint
January 10, 2025 | 14:57
January 10, 2025
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Bracing for Inflation and Financial Turbulence |
| Happy New Year to all! We are now just days away from Trump’s Inauguration, but the economic and financial fireworks have already begun. Trump’s latest press conference was chock-full of threats against Canada, Panama, Greenland, and Denmark. He finished up with a notice that “all hell will break out in the Middle East if the hostages aren’t released” before he takes office. While U.S. and global financial markets still largely see this rhetoric as posturing for negotiations, uncertainty and anxiety are starting to creep in. |
| For now, the labor market continues to perform well above expectations with net new job creation accelerating to 256k in December and the jobless rate dropping back down to 4.1%. Average hourly earnings growth did cool to 3.9%, but the Fed will likely want to see more moderation on this front before it eases again. Moreover, December’s inflation data are not expected to provide any real assurances to the Fed or financial markets that we are truly on a sustainable moderating inflation path, especially if tariffs start flying in less than two weeks. CPI prices are expected to increase another 0.3% in December, bringing the year-on-year rate back up to 2.9% from a low of 2.4% in September. Core CPI inflation is expected to remain at a robust 3.3%. Large increases in the December ISM Prices Paid Indexes for both services and manufacturers point to an even larger acceleration in core producer price inflation to 3.8% from 3.4% in November (Chart 1). The services prices paid index hit its highest level in nearly two years last month. In three of the past four years, we have seen an acceleration of consumer inflation in the first quarter. With new tariffs looming, this does not bode well for inflation trends. The financial markets abhor uncertainty, but President-elect Trump appears to thrive on it. A U.S. trade policy uncertainty index was 13.5 times above its long-run average in December, its highest level since the first Trump Administration and the third-highest since the index was created in 1985 (Chart 2). The U.S. equity market failed to launch a year-end Santa Claus rally with the S&P 500 slipping 2.7% in December even as it managed to hold on to a robust 24% gain for the year. However, one can’t help but feel that the risks are tilted toward a tougher start to 2025. As if on cue, the 10-year Treasury note hit its highest level since 2023, increasing more than 100 basis points since September’s low. We have warned about this possibility for a while now, speculating that the Trump election honeymoon may be short-lived for financial markets. The Minutes from the December FOMC meeting revealed that potential changes in tariff and immigration policies from the incoming Administration are already shifting the calculations of several Fed officials. Some FOMC members saw merit in keeping rates unchanged and most saw policy as now significantly less restrictive. Almost all saw increased upside risks to inflation. Longer-term real Treasury yields are galloping higher in response (Chart 3). Fed funds futures are now fully pricing in only two quarter-point rate cuts over the next two years. That’s light years from market expectations back on September 19 when eight quarter-point rate cuts by March of 2026 were fully priced in. 2025 has just started, and I’m already dizzy from all the policy uncertainty and change in investors’ interest rate expectations. Now, where did I put that Tylenol? |
The Fed and Tariffs |
| The Minutes from the December 17-18 FOMC meeting (released this week) noted that: “All participants judged that uncertainty about the scope, timing, and economic effects of potential changes in policies affecting foreign trade and immigration was elevated.” Although “a number of participants indicated that they incorporated placeholder assumptions to one degree or another into their projections”, most policymakers did not. The Fed staff also made “preliminary placeholder assumptions about potential policy changes” in their baseline forecast. Along with incorporating recent data and compared to the previous baseline for 2025, this resulted in “slightly slower” real GDP growth and no improvement in inflation “as the effects of the staff’s placeholder trade policy assumptions held inflation up”. The assumptions and forecast details weren’t published, but it’s likely that U.S. tariff increases, and foreign retaliation, were the dominant policy shocks. For FOMC participants, the concern is how these affect economic growth and inflation, and thus the appropriate path for monetary policy. U.S. tariff increases contribute to one-time increases in prices faced by U.S. consumers and businesses. The degree to which they ultimately jump will be determined by the availability of domestic and other (non-tariffed) foreign substitute goods, how readily supply chains can adapt, and how strong demand is to begin with. Any increase in the broad price level lifts the published inflation rate and erodes the purchasing power of households and firms, thus reducing real consumer spending and business investment. Productivity also suffers as production shifts to less efficient firms and there’s less incentive to innovate owing to less global competition. U.S. exports would also be reduced owing to retaliatory tariffs. Given this weakened economic backdrop, the Fed’s policy dilemma is how to respond to the initial increase in inflation. In the press conference, Powell (and a reporter) referred to a staff report from September 2018 that made the case that the Fed should “see through” the inflation impact and focus instead on the negative growth consequences. The report said that “the desirability of this strategy depends on firmly anchored inflation expectations and the passthrough of cost shocks into inflation being relatively short lived”. If these conditions didn’t hold, e.g. “the tariff hike leads workers to raise their wage demands or firms to raise their markups”, then the alternative strategy would be to raise policy rates and risk a recession to restore price stability. In 2018, it’s unclear to what extent policymakers heeded the staff’s advice. Amid the tit-for-tat tariff wars and updrift in PCE inflation, the Fed was raising policy rates. They hit their cyclical peak in December (2.25%-to-2.50%). A potential issue for the Fed this time is that we’ve come off an episode in which inflation surged to four-decade highs, and inflation expectations, wage demands and firms’ pricing behaviors could be more sensitive to tariff hikes. This would be at a time when disinflation appears to have stalled, and the economy and labor market are still relatively strong. Some Fed officials are confident the inflation process will stay in check. In a speech this week, Governor Waller said: “If, as I expect, tariffs do not have a significant or persistent effect on inflation, they are unlikely to affect my view of appropriate monetary policy.” We suspect other policymakers aren’t as confident, and we look for even more Fed caution as it contemplates further rate cuts. |
Is the Fed Successfully Waging War on Inflation? |
| Federal Reserve Board staff recently compiled a wage metric that should provide a more accurate read on wage inflation than any single measure. The new series combines information across eleven industries from the employment cost index, Atlanta Fed Wage Tracker, average hourly earnings, and a constructed series based on ADP data. The methodology derives the ‘common component’ that best captures underlying wage growth in each industry and then aggregates across the various series. This removes the ‘noise’ that often plagues individual wage measures due to measurement error, special factors, or job shifts between industries with different pay scales. The new wage series is an important development because it will help the Fed better monitor a key source of inflation pressure—wage growth stemming from tightness in labor markets. Stable, low wage growth tells the Fed that labor market conditions are balanced with the unemployment rate close to its long-run neutral level (a concept that can only be inferred, not measured). This would mean the Fed is on track to achieve the dual mandate of maximum employment and price stability. Instead, if wage growth is high and rising due to worker shortages, then the mandate is at risk. The good news for the Fed (and investors) is that this new measure suggests wage growth has returned to pre-pandemic levels, falling to 2.8% y/y in 2024Q3 from a cycle-high 5.8% in 2022. That’s actually a little below the 2019 average, with wage growth slowing sharply in some industries, such as leisure and hospitality, though remaining higher in education and health care. The new measure may seem at odds with the trend in other metrics, such as the ECI and the Wage Tracker, which, though falling, are still about one percentage point above 2019 levels. However, it accords with reports from the Fed’s Beige Book that wages are rising only moderately, and is consistent with signs of loosening in the labor market, such as a declining quits rate and a rising duration of joblessness, notwithstanding the downtick in December’s jobless rate. This could explain why Powell believes the labor market is no longer a source of upward price pressure and that further loosening would be undesired. Milder wage growth is one reason the Fed expects inflation to make further gradual progress toward the target and is planning to ease policy further. It now has a credible single measure of wage inflation, which could come in handy if tariff walls go up. As Michael notes in his Thought, the Fed would normally see through a tariff-led spike in prices and ease policy to cushion the economy. But its hands could be tied if workers receive higher wages as compensation for less spending power, adding stickiness to inflation. The new wage measure should help reduce the chance of a policy error in an especially uncertain time for policymakers. |
