Blogs review: U.S. inflation and growth
What’s at stake: Most discussions over the past few weeks on the blogosphere have centered around whether the U.S. economy is, eventually, gaining enough pace to generate an uptick in inflation. While Q1 GDP was drastically revised down, other indicators suggest that the economy is indeed heating up.
Is inflation about to pick up?
Real Time Economics writes that minutes from the Federal Reserve’s June meeting suggest there is a growing gap between officials who believe U.S. inflation could remain too low for the Fed’s comfort and those who believe a spike in consumer prices could be closer than forecasters think. Some policy makers “expressed concern about the persistence of below-trend inflation,” the minutes said. Indeed, a couple even suggested the central bank might have to let unemployment fall below its long-term normal rate in order to ensure inflation moves back toward the 2% target. That sentiment was far from unanimous, however. “Some others expected a faster pickup in inflation or saw upside risks to inflation expectations because they anticipated a more rapid decline in economic slack.”
Joe Weisenthal writes that it’s becoming conventional wisdom that the economy is heating up for real this time. After numerous false starts and disappointments since the financial crisis, it appears we’ve kicked into a higher gear. Deutsche Bank economist Torsten Slok make for a good overview of the case that inflation is coming. First, capacity utilization is high. Meanwhile, surveys show that businesses are finding it harder and harder to fill job openings. Third because companies are having a harder time finding employees, they’re indicating that salary increases are coming.
Calculated Risk writes that for most of the ’90s there was a huge “gap” between capacity utilization and CPI. There were periods when capacity utilization was higher than now – and inflation lower. As an example, capacity utilization was close to 83% in 1998, and YoY inflation averaged 1.5%. So I don’t think the first graph presented by Deutsche Bank is convincing that inflation is “right around the corner”. Also note that the last two other pieces of information are from a small survey and also not convincing.
Ryan Avent writes that there are two ways one can reconcile the view that inflation is going to remain low with what appears to be happening in labor markets. One possibility is that both markets and the Fed have it wrong (or that markets have it wrong because the Fed has it wrong). It could be the case that there is more inflationary pressure in the economy than markets anticipate, and that either the Fed will have to act faster to check that pressure or will reveal that it is in fact happy to accept a rate of inflation a bit faster than anything America experienced over the past two decades. The other possibility is that tightening labor markets simply aren’t going to exert much inflationary pressure on the economy. In the 2000s, nominal wage growth reached 4.5% amid rising commodity prices, yet core inflation never reached 2.5%. In the 1990s wage growth reached 5%, yet core inflation declined steadily. It may simply be the case that we aren’t appreciating just how many margins there are along which labor markets have room to adjust.
Tim Duy writes that the Fed has consistently predicted higher inflation, and consistently been surprised that that inflation has not yet arrived despite rapidly falling unemployment rates. If you are betting on inflation over the medium-term, you are essentially betting that the Fed will not do what it has done since Federal Reserve Chair Paul Volker – tighten policy in the face of credible inflationary pressures. Over the last twenty years (mean core-PCE inflation: 1.7%; mean core-CPI inflation: 2.2%.), core measures of inflation have more often than not been at or below the upper range of the Fed’s error band, especially for core-PCE inflation. And this included periods in which the US economy was at times substantially outperforming the current environment no less.
What to make of the downward GDP revision in Q1
Stephen Cecchetti and Kermit Schoenholtz write that growth from the fourth quarter of 2013 to the first quarter of 2014, originally thought to have been about +0.1% in April, was revised last week to –2.9%. News reports varied between shock and concern. Was the anemic recovery over? Or, was it just that this winter was especially harsh? Kevin Drum writes that there are two way to look at this. The glass-half-full view is: Whew! That huge GDP drop in Q1 really was a bit of a blip, not an omen of a coming recession. The economy isn’t setting records or anything, but it’s back on track. The glass-half-empty view is: Yikes! If the dismal Q1 number had really been a blip, perhaps caused by bad weather, we’d expect to see makeup growth in Q2. It’s just horrible news if it turns out that during a “recovery” we can experience a massive drop in GDP and then do nothing to make up for it over the next quarter.
Gavyn Davies writes that if confirmed in future releases, this would be the weakest quarter for US real GDP outside a recession since the Second World War. The markets largely ignored this piece of news because investors still seem convinced that the first quarter was hit by a series of temporary shocks to GDP. The extreme weather was clearly the main such shock (a point confirmed with micro data by Atif Mian and Amir Sufi), but there was also an outsized downward revision to the official estimate of consumers’ expenditure on health services. Another reason why the markets are ignoring any recession risk in the US is that the GDP data are at odds with many other sources of information on the underlying growth rate in the American economy, including the improving employment data, buoyant business surveys, and robust manufacturing and durable goods reports.
Stephen Cecchetti and Kermit Schoenholtz point to two factors that deserve deserve special attention: (1) the statistical noise created by seasonality; and (2) the propensity to revise GDP many years after the period being measured.
Seasonality in GDP is enormous. The chart below shows that the seasonal adjustments swamp the small changes in the adjusted growth rates. If you looked only at unadjusted data, you could say that the U.S. economy goes through a depression in the first quarter of every year, as the level of output plunges on average by 18 percent! When the seasonal factor is large and variable, as it is in the first quarter of every year in the United States, it is heroic to draw inferences from a percentage point here or there.
Stephen Cecchetti and Kermit Schoenholtz write that revisions can also be quite big. Prior to last week’s release of revised first-quarter data, the biggest revision on record was only 2.5 percentage points. So, a 3-percentage point revision only three months after the quarter ended is enormous. Nevertheless, further large revisions may still lie ahead! Statistically, the revisions to economic growth for quarter t between the t+3-month estimate (which we just received last week for the first quarter) to the t+10-year estimate (which will not be available for nearly a decade) have ranged from minus 6 percentage points to plus 7 percentage points over the past 40 years, with a standard deviation of about 2 percentage points.