Two of the Federal Reserve’s closely watched gauges for prices and labor costs released on Friday reaffirmed expectations that the central bank will begin raising interest rates in March as the Fed moves to tame inflation.
The personal consumption expenditures deflator, the Fed’s official indicator for inflation, advanced by 0.1 percentage points to 5.8% on a year-over-year basis. The core PCE deflator, which excludes energy and food, was also up by 0.2 percentage points to 4.9% on the month. Both were the highest in nearly four decades.
At the same time, the employment cost index, another key indicator for the Fed in setting monetary policy, continued to grow at a multi-decade high rate in the fourth quarter last year, up by 1%.
The index is different from other wage growth measures because it is based on the Bureau of Labor Statistics’ survey of both private and public employers and includes not only on wages but also health insurance, retirement packages and other benefits.
While supply bottlenecks remain a problem for inflation, labor costs receive most of the Fed’s attention because wage-push inflation can quickly get out of control.
In the current tight labor market, with widespread labor shortages and a low unemployment rate, the Fed cannot rely on the “sticky wage” norm—which is the key argument in favor for short-run fiscal and monetary policies. Businesses have been flexible with job benefits while offering multiple pay jumps since last year to retain their workers.
While such a wage-price spiral remains distant, the Fed’s clear signal for multiple rate hikes followed by a balance sheet run-off in the second half of the year is an important step to keep inflation expectations anchored.
More important, what has been lost in the coverage of the Fed’s meeting this week is its notable shift in its inflation target to above 2% for “some time,” according to its statement released on Wednesday.
The Fed’s reasoning was that after years of inflation being under 2% between the financial crisis and the pandemic, it is “appropriate monetary policy” to adjust the target so that in the longer run inflation will average out to be 2% annually.
All of that is also necessary to set the stage for a soft landing of the economy, which has been running hot.
Personal spending and income
In the same report with the PCE deflator, personal spending in December fell by 0.6% and, after adjusting for inflation, by 1% on the month. The pullback in spending was in line with earlier data on retail sales and anecdotal evidence from the Fed’s Beige Book as omicron’s surge was to blame.
We expect spending to continue to decline in January as the number of cases and hospitalizations reached all-time highs in mid-January. That spread of the virus will, in turn, most likely slow down the monthly increase in prices, similar to what happened in August and September with the delta variant.
Personal income in December ticked up by 0.3%, driven largely by wage gains for the third monthly increase in a row. But December was also the last month that advance child-tax credit payments were sent to American parents, potentially dragging income in January.
The savings rate advanced to 7.9% on the month from 7.2%, remaining close to the pre-pandemic average, likely because of the pullback in spending.
But with the pandemic-era fiscal and monetary policies fading, the unprecedented amount of excess savings that has been accumulated since the pandemic began will continue to be one of the main reasons for growth to stay near 4% this year based on our forecast.
The takeaway
After a historically profitable year, there seems to be enough room for businesses to absorb rising labor costs while keeping prices stable to prevent a wage-price spiral scenario, which will become inevitable as demand continues to moderate.
And in the big picture, even with four rate hikes this year, the financial conditions—real interest rates in particular—would still be highly accommodative given the current level of inflation.
