Paradoxically, though inflation is falling fast, the Federal Reserve’s job to bring inflation down to its 2% target is not getting easier. In some ways, the real inflation fight is only beginning.
Last Friday, the Bureau of Labor Statistics released the personal income data series, which includes inflation as measured by the personal consumption expenditure price index, the Federal Reserve’s preferred inflation metric. The income data and inflation data were good. They were in line with market expectations. Personal income increased 0.4%, disposable personal income increased 0.4%, and personal consumption expenditures increased 0.1%.
In addition, the personal consumption expenditure price index, PCE, increased 0.1%. Excluding food and energy, the so-called core PCE price index increased 0.2%. The Federal Reserve focuses on the core PCE. On a three-month annualized basis, core PCE was up 3.6% in November, the smallest increase in almost two years. The inflation news is good but not good enough.
Now the real fight begins.
What makes the Federal Reserve’s job so difficult is wage inflation in the services sector. Wages account for almost 70% of the cost of doing business in the services sector. The services sector accounts for 80% of total economic activity and employs 80% of labor. Spending on core services, excluding residential housing and energy, remains healthy. In November spending on services rose 0.3%, almost 4% on an annualized basis. The outlook for services spending remains positive. Labor is now enjoying real wage increases. Disposable personal income in November was up 0.4%. The PCE price index was up 0.1%. The Atlanta Federal Reserve’s Wage Tracker shows wage inflation rising at 6%. Labor is seeing real wage growth of over 2%.
Moreover, households are benefiting from falling gasoline and diesel prices and next month, Social Security beneficiaries will receive their annual cost of living adjustment. The cost of living adjustment will be 8.7%. Seventy million people will see an 8.7% increase in their monthly social security benefits. Households still have substantial excess savings. The economy is resilient. Finally, the fiscal 2023 omnibus appropriations bill will put upward pressure on inflation. The legislation raises non-defense spending by 8% and defense spending by 10% next year, well above current core inflation of 3.6% on a three-month annualized basis.
Only the residential housing market is in recession. Real wage increases will encourage consumers to keep spending. Consumer confidence is rebounding as inflation falls, especially gasoline inflation. The labor market remains resilient. Jobless claims remain low, while job openings remain high relative to the number of unemployed workers. Demand for labor exceeds supply, and wage pressure remains elevated.
From here it is all about wage inflation. Businesses must cover costs and will raise prices to cover the costs of higher wages. If wages are increasing at 6% and productivity per worker is rising at 1.5%, then everything else being equal, businesses will raise prices by 4.5%, well above the Federal Reserve’s 2% target. Neither the market nor businesses will tolerate margin erosion. The next meeting of the Federal Open Market Committee, FOMC, is Feb. 1, 2023. It is an open question whether the FOMC will raise interest rates by 0.25% or 0.5% but one thing is clear, interest rates will go higher. Wage inflation is too high. It must be stopped. The longer wage inflation persists, the more difficult it is to reduce. The inflation fight is just beginning.
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James Rogan is a former U.S. foreign service officer who later worked in finance and law for 30 years. He writes a daily note on finance and the economy, politics, sociology, and criminal justice.
