ABOUT THE AUTHOR
A member of Putnam's Fixed Income team since 2007, Onsel Gulbiten analyzes macroeconomic issues, including inflation, interest rates, and policy developments.
- Cyclical factors, economic imbalances, and rising government debt may contribute to keeping inflation at 3.0%–3.5%.
- It is highly doubtful that the Fed can maintain its hawkish inflation rhetoric when weak labor market data eventually arrives.
- As the arithmetic of U.S. debt deteriorates, the private sector will likely demand a higher premium for holding Treasuries.
Inflation has been coming down since its peak in the summer of 2022. Because the U.S. has so far avoided a recession, soft-landing hopes have risen along with the decline in inflation. Even the Federal Reserve itself joined the bandwagon. The soft-landing view, a scenario in which inflation goes back to the Fed’s 2% target sustainably without a recession, might gather more momentum if a recession is not in sight. But there are cyclical and structural factors indicating inflation may not fall to 2% without a recession. By reviewing these factors, it becomes clear why an extended period of sticky inflation stabilizing at around 3.0%–3.5% is more likely during the Fed’s long pause, when the lagged impact of the Fed’s tightening continues to take effect.
Jobs, wages, and spending contribute to making inflation sticky
The U.S. labor market is tight. The unemployment rate is at historical lows. The overall labor force participation might look low, but this is mostly reflecting demographic changes. The prime-age labor force participation rate has risen to levels last seen at the beginning of this century. And people continue to come to the labor force. The uptick in the unemployment rate in the past couple of months has been due to increased labor force participation, not job losses. A labor market tightness indicator — the JOLTS job openings rate — has been declining but is still high. A job openings rate of 2.5% can likely bring inflation toward 2%. A drop from the current job openings rate of 5.8% to 2.5% needs to come from the demand side, as there is a limit to labor supply.
The uptick in the unemployment rate in the past couple of months has been due to increased labor force participation, not job losses.
While a large decline in labor demand is possible as the normalization of economic activity post-Covid comes to an end, when labor supply is constrained, any extra demand for labor is likely to come with higher wages and, hence, inflation. The labor strikes making headlines more frequently of late are not a coincidence.
There is a growing argument that excess savings — estimated relative to pre-Covid savings or saving rate trends — have been waning, and so we are returning to pre-Covid dynamics. However, household consumption has always been a function of income — primarily labor income — and wealth. While narrowly defined excess savings might be declining, the overall household wealth is still very high because asset prices are high. Asset markets went through a period of volatility when the Fed started tightening in the first half of 2022 but gained back most of the losses afterward. Housing activity slowed significantly, but home prices just flatlined; they did not decline. Remember that during the housing bubble of the early 2000s, households did not have “excess savings” but saved less and, hence, maintained their elevated level of spending because their perceptions of wealth were high.
Focus on decline in “excess savings” ignores household wealth in real estate and equities
Composition of U.S. household assets (as % of disposable income)
Sources: Federal Reserve, BEA. Data as of 6/30/23.
In today’s inflated wealth environment, the saving rate can stay low for longer, keeping the willingness to spend high — until a recession arrives. The willingness to spend comes with the willingness to pay, keeping inflationary pressures alive. A tight labor market along with strong consumption can be considered the cyclical reasons that can make inflation sticky as it falls toward 3%, but these factors are also the consequences of economic imbalances.
Inflation can help correct the imbalance of wealth and income
Historically, there has been a stable relationship between income and wealth, that is, aggregate capital. If there is too much wealth (capital) relative to incomes, it means there is unproductive capital in the economy. Investment and capital stock decline or do not grow as much as incomes, bringing the capital-to-income ratio down. If, on the other hand, the stock of wealth is too low with respect to incomes, the returns to capital rise, investment increases, and the capital/wealth-to-income ratio moves up.
Unprofitable firms are likely to fail, and some of the expected returns on investments will not be realized.
Today, the aggregate wealth is high relative to personal incomes, even though this ratio might be off its highest level. That is, there may be unprofitable companies and investments that were made with high return expectations; unprofitable firms are likely to fail, and some of the expected returns on investments will not be realized. Real estate, new technologies, or government debt might be among those investments made with high return expectations. Recessions typically correct imbalances as unprofitable companies and investments go under.
The high wealth-to-income ratio has corrected in the past through recession
U.S. household net worth to personal income ratio and U.S. saving rate (%)
Sources: Federal Reserve, BEA, NBER. Data as of 7/31/23.
However, there is another way to resolve imbalances: Inflation can gradually bring the wealth-to-income ratio down if household wealth increases at a slower pace than personal incomes. That is, rather than wealth declining as it does in recessions, incomes rise at a faster pace and correct imbalances over time.
Another way to resolve imbalances is for incomes to rise faster than household wealth.
If the labor market is structurally tight, labor income can keep pace with rising consumer prices or grow at a faster pace. Along with high (but not necessarily rising) interest rates, profit margins slowly decline. Since earnings do not increase as rapidly as labor income, equities, which are intrinsically linked to corporate earnings, and bonds, which may not fully reflect the high inflation environment, do not rise as much as labor income. Therefore, inflation can gradually correct the imbalance between wealth and income.
Inflation mitigates the problem of rising government debt
The largest imbalance in the economy is perhaps in the public sector. The government debt-to-GDP ratio has surged in the past 15 years, but there has not been any serious attempt to address the issue. When there is no willingness to raise taxes or cut spending to bring the debt ratio to sustainable levels, inflation tax becomes the optimal policy. While keeping the private sector “inflation expectations” below the actual inflation and/or making use of the government’s price-setting advantage in some sectors, inflation quietly transfers wealth from the private to the public sector. That is, when direct taxation is not feasible, an inflation tax becomes the second-best policy option.
Inflation mitigates the problem of rising government debt
U.S. debt (% of GDP) and inflation (%)
Sources: U.S. Treasury, BLS, Federal Reserve, Putnam calculations. Data as of 8/31/23.
There are cyclical and structural reasons pointing to sticky inflation, but there is also a Fed fighting inflation. After more than doubling its balance sheet just a few years ago, the Fed raised rates quickly and started QT (quantitative tightening). In September, the Fed said one more rate hike is possible and quick rate cuts are not likely. The Fed may talk tough when asset prices are at the highs and unemployment is at the lows. But the Fed cares. Its mandate includes employment. It is highly doubtful that the Fed can maintain its hawkish rhetoric when weak labor market data eventually arrives. Since the beginning of this rapid tightening cycle, every weak-looking data or development tilted the FOMC members in a dovish direction until the data proved that the economy is actually strong.
It is highly doubtful that the Fed can maintain its hawkish rhetoric when weak labor market data eventually arrives.
The Fed has already said that rates are at restrictive levels, which might be true, and prefers waiting a bit longer for inflation to fall rather than accelerating rate hikes to kill it off quickly. As the job gains lose momentum, which is inevitable, the Fed is likely to get even more cautious and is unlikely to go “the last mile.” The Fed does not want to cause a recession. Inflation at around 3% is more palatable to the public than a recession.
One might still argue that Fed Chair Powell wears Paul Volcker’s hat and can kill off inflation via a recession. However, Powell is facing those above-mentioned structural issues that Volcker did not face. When Volcker took charge at the Fed in 1979, the U.S. economy did not have major imbalances, the population was young and growing, government debt was at the lows of the century, and the Fed did not have a large balance sheet. Volcker’s rate hikes did not and could not cause a debt crisis.
Inflation stabilizing at around 3.0%–3.5% is more tolerable than a debt crisis.
Today, U.S. government debt is high, and the Fed’s balance sheet is large. Since the 2008 global financial crisis, as U.S. debt has grown, the Fed’s balance sheet has increased, keeping interest rates low and debt sustainability concerns out of sight. With QT now underway while U.S. debt continues to expand, debt arithmetic will further deteriorate. This is already increasing the premium the private sector demands for holding Treasuries and increases the risk of disfunction in the Treasury market or a related market. Financial stability is as important as price stability for the Fed; the Fed is always the lender of last resort. The Fed will have to make a choice between financial instability, or debt crisis, and inflation. Inflation stabilizing at around 3.0%–3.5% is more tolerable than a debt crisis, which, in the end, brings a significant increase in taxes and/or cuts in government spending.
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