The Street Gets Inflation Threat Backwards
Barry Ritholtz
02/09/06 - 04:02 PM EST
In my opinion, the majority of economists, strategists and financial media -- the full "punditocracy" -- are
exactly wrong on inflation. Indeed, I am hard pressed to think of another item of such grave economic consequence that most of the Street has so backwards.
The problem is, they are looking for inflation in all the wrong places. The inflation (
ex-inflation) crowd has managed to ignore robust price increases across a variety of goods and services. Yet somehow they seem to have found inflation in the one part of the economy where there is almost none: wages.
One only had to see the market reaction to last week's data on non-farm payrolls, hourly wages and unemployment rate to realize how much the Street has gotten its panties in a bunch.
The
Federal Reserve is acutely sensitive to wage pressure -- much more so than to the commodity price increases we have seen over the past five years. Maybe that's why the
FOMC quietly
announced that the upcoming meeting, previously planned for March 28, has been expanded to two days. It will now begin on March 27. (I'm sure the extra day isn't for more time to welcome aboard Ben Bernanke.)
If the Fed falls prey to the erroneous interpretation of wages and jobs, we could see a tightening cycle that goes far beyond what many on Wall Street currently expect. And that would bode extremely poorly for market prospects, both this year and next.
Recent Inflationary History
Recall the 2001-02 period. The economy was essentially a flat line. Tax cuts hadn't helped, spending down the surplus was of no avail, nor was the war in Afghanistan all that stimulative. The Fed had seen the Japanese debacle and was in no mood for a decade or more of zero growth. With Bernanke providing the intellectual rationale, it made a concerted effort to "reflate" the economy by cranking up money supply and radically dropping rates to half-century lows.
The prime risk of artificially reflating any economy is inflation. And that is precisely what has followed this Fed orchestrated "reflation." With the exception of wages, prices for just about everything else have risen, as detailed
here and reflected in the Reuters/Jefferies CRB Index.
| CRB 6 years |
 |
Except, of course, wages. They are flat to slightly higher over the past five years. In real (i.e., inflation-adjusted) terms, they are actually negative.
Wrong Way Corrigan
Part of the reason the majority is wrong about inflation owes to the fixation on core CPI. Removing a volatile component from a single month is sensible when an event gives cause.
A perfect example: Hurricanes Katrina and Rita distorted the data for a few months. That would have been a perfectly valid excuse to report the core rate ex-energy, because of the short-lived reaction to events in the Gulf.
However, one has to wonder just what is going on the brains of those who insist on ignoring the situation when the volatility is in but one direction. With the the CRB index trending upward for 51 consecutive months, the ongoing reporting of inflation
ex-inflation is nothing short of idiocy.
I suspect the other source of error is laziness. Many people read the headlines but do not delve into the (boring) details beneath. So let's review the recent data trilogy and see if we can determine whether wage inflation is real or imagined.
Unemployment Rate
Anytime there is a large and unexpected shift in the unemployment rate, it behooves us to look more closely at the data. The recent drop to a 4.7% unemployment rate did not disappoint.
What we find is not a sudden -- and inflationary -- upsurge in hiring; rather, it was instead more of the a drop in the labor participation rate. As the Bureau of Labor Statistics (BLS)
reported, while the overall population grew in January, the civilian labor force itself got smaller.
With his permission, I used the terrifically instructive charts from a recent commentary by Northern Trust's Paul Kasriel, and then annotated them.
| Participation Rate Unemployment Rate |
 |
Kasriel notes:
There has never been an expansion cycle in the past 45 years in which the participation rate (those actually in the labor force as a percent of those that could be in the labor force) trended lower save for the current one. Had the labor participation rate risen in a normal cyclical fashion, today's unemployment rate would be considerably higher
Further, benchmark revisions to the population controls to the household survey by the Census Bureau may have also had an inadvertent impact of lowering the unemployment rate. Note that this is not an actual measure but an accounting adjustment. (See
this for more details.)
The weak labor participation rate should put the Fed's mind at ease as to the slack in the labor market reason: There's plenty of it.
Non-Farm Payrolls
Non-farm payrolls (NFP) gave the Street yet another way to misread inflation.
While January's NFP number was far below consensus, it was misunderstood in several ways:
The three-month average of 229,000 is misleading. Why? Recall that the hurricanes altered NFP data in September and October. The BLS repeatedly noted that reporting the data of displaced/relocated personnel was going to be problematic. To the bureau's credit, it eventually managed to track down most of the relocated workers; hence the upwards revisions. Hence, the revised three-month average is revealing of little, other than that many displaced Gulf/New Orleans employees have settled into new jobs.
With NFP a negative 8,000 in September and a plus 56,000 in October, that makes the five-month average 147,000. When job creation barely keeps up with population growth, it's hardly inflationary.
January is one of those months when the seasonal adjustments have an enormous impact. This happens every year, as the temporary holiday workers finish their stints. But it points out that the 193,000 payroll figure, which some are fearing as a sign of inflation, needs to be taken with a grain of salt.
Measured in
actual job gains (i.e., not seasonally adjusted), the economy lost 2.625 million jobs from December to January.
Year-over-year payroll growth appears to be peaking, as this chart shows. Kasriel notes that "year-over-year nonfarm payroll growth appears to be peaking out around 1.6% -- lower than any other cyclical peak in the past 45 years."
| All Employees Total Nonfarm |
 |
Wage Inflation
We know that wage inflation is Public Enemy No. 1 for the Fed. Do the most recent data give it cause to act pre-emptively? Hardly.
January hourly wages rose 7 cents per hour -- that's a 3.3% increase. As you can see from the constant-dollar CES chart below, wages dove in late 2005 after the hurricanes hit. They have since snapped back to pre-hurricane levels. But they are hardly trending upwards.
 |
| Source: CES |
The most recent wage increase is very likely the result of the mix of new construction jobs -- especially in the Gulf region. That's hardly emblematic of surging wage pressure.
Looking at wage improvements since 1965, we are coming off the lowest annual improvement levels in half a century. In fact, the recent wage gains are weaker than even the lows in 1986-87 period.
| CES Average Hourly Earnings |
 |
In the 1970s, wages rose at a 6% to 8% annual level. Coming from below 2% annual gains, and still far below 4%, is hardly cause for concern.
Reap What You Sow
The Fed's reflation has succeeded all too well. The prices of homes, food, energy and all manner of commodities have been moving higher for several years now. Wall Street has mostly ignored this kind of inflation.
Income, on the other hand, has been fairly stagnant. I'm hard pressed to recall any union negotiating victory in recent years. Globalization and outsourcing have kept wage pressures extremely low.
I expect the economy to slow in 2006, and to possibly enter a recession in 2007. If the Fed erroneously misreads the most recent data as proof of a too-strong economy and a tight labor market, it risks turning a bad, but manageable, situation into a disaster.
