Jacquelyn Martin/AP Photo
Federal Reserve Chair Jerome Powell speaks during a news conference on Wednesday at the Federal Reserve Board in Washington.
On Wednesday, Federal Reserve Chair Jerome Powell announced that the central bank will raise its target interest rate once again, though this time by only one-quarter of a percentage point to 4.5–4.75 percent. That’s the smallest rate hike since last March, after numerous increases of three-quarters of a point.
Powell’s main justification for continuing to hike has been a focus on “core” services other than housing. While overall inflation has slowed markedly over the last six months, this particular metric has remained stubbornly high.
Powell has focused on this metric because it provides the best window into what he sees as the major engine of inflation, which is the cost of labor. “Because wages make up the largest cost in delivering these services, the labor market holds the key to understanding inflation in this category,” he said in a November speech. “In the labor market, demand for workers far exceeds the supply of available workers, and nominal wages have been growing at a pace well above what would be consistent with 2 percent inflation over time. Thus, another condition we are looking for is the restoration of balance between supply and demand in the labor market.”
In other words, rather than the spending of workers, capitalists, and everyone else causing price increases—the “demand-pull” theory—it’s the shortage of workers across the economy causing inflation by raising costs for business, or the “cost-push” theory. If you take it out of the bloodless language of Fed-speak, it means that to beat inflation, we need high unemployment and a recession.
But this is a mistake. Not only is there little reason to grant top priority to this peculiar metric, but doing so also leaves out two major sources of price pressure that will likely be exhausted this year: drawing down of pandemic savings and home equity withdrawals. Conversely, if the Fed keeps tightening long enough to cause unemployment to rise, it is highly likely that it will continue to rise far longer than the Fed seems to think.
As far as potential problems with core services minus housing, Alex Williams has a technical breakdown at Employ America. In brief, the metric contains a lot of compensation data that is highly suspect or opaque, as well as other data from services that are vulnerable to price increases caused by goods shortages. Plus, a quarter of the index is composed of a grab bag of random industries that arguably are unrepresentative. One shouldn’t privilege such a dubious figure over all others, even when it comes to measuring labor costs. That’s especially true when the other leading indicators are pointing in the opposite direction, showing prices and wages moderating.
More fundamentally, there is no reason to privilege cost-push dynamics above alternatives. Certainly cost-push effects can happen, and have happened over the last year. But they are not the only factor driving developments in prices, given that any modern economy is a dynamic and highly complex thing.
For instance, one can easily tell a story in which demand-pull pressure leads to cost-push, or vice versa—imagine a store that can’t keep its shelves stocked offering higher wages to add more shifts, forcing neighboring stores to raise their wages, and thus their prices, to compensate. One needs a holistic view with many different sources of data, and to always be ready to revise one’s views to fit with the most recent evidence. As Skanda Amarnath argues at Employ America, demand-focused data is both more timely and more accurate.
There is no reason to privilege cost-push dynamics above alternatives.
In particular, two major sources of spending will likely slow markedly this year: pandemic savings and mortgage equity withdrawals. Recall that in 2020, the savings rate soared to its highest rate in history, as most people stayed at home to avoid being infected while getting stimulus checks and, if they were laid off, “super-dole” unemployment payments. The rate reached 33 percent in April 2020, and remained above the previous record high for an entire year afterward (aside from a few months in 1975).
But those benefits were limited—Americans haven’t seen a stimulus check since spring 2021, and enhanced unemployment cut off shortly thereafter. As Matthew Klein writes at The Overshoot, the savings rate has since fallen to historically low levels, as people spend down their pandemic savings. About half of it is gone—accounting for something like a trillion dollars last year—and at current rates, the other half will be gone by the end of 2023.
Meanwhile, as Bill McBride calculates, home equity withdrawals finally went above zero in late 2020, as home values soared that year and homeowners sought to borrow against their increased wealth. They increased to several hundred billion dollars in 2022, but appear to be leveling off, as rising interest rates have markedly cooled off the housing market. Nobody is going to refinance with mortgage rates this high, and taking out home equity is costly at this moment as well.
Homeowners still have quite a large equity cushion, but given how leery most people seem to be of obtaining home equity loans after the housing crisis—the amount of lending over the last two years was not even close to the heights of the mid-2000s—and relatively high interest rates, it seems likely that this source of credit will remain mostly untapped over the medium term.
That means something like a trillion and a half dollars of spending that will taper off this year—a considerable amount even in a $26 trillion economy, and one that will undoubtedly put downward pressure on prices.
Finally, there is relative risk to consider. As economist J.W. Mason points out, there are many times in the past in which inflation was high and then dropped afterward. Price movements are generally pretty chaotic. But there is not one instance in American history where unemployment rose by one percentage point and then came back down again. In every case, it rose some more, usually by several points at least—surely because rising unemployment creates a negative feedback loop of less spending leading to more layoffs. (This is known as the Sahm rule, after former Federal Reserve and White House economist Claudia Sahm.)
Now, I’ve got nothing against digging into the guts of every data set to see what might be lurking in obscure corners of the economy—on the contrary, that’s a smart practice. But this is one of the best economies for workers in American history, and it would be tragic indeed to see it crash unnecessarily, because of myopic obsession with one particular metric. As MSNBC’s Chris Hayes says, “Land the plane, Jerome.”
