Inflation’s ‘Upside Risks’ on the Rise Due to Strong US Economy

The Evolving Economic Landscape of 2023: Implications for Inflation and Policy

As we move further into 2023, the economic narrative continues to revolve around the dual dynamics of taming inflation and experiencing robust economic growth in the United States. Despite the current environment of the highest interest rates in over two decades, this unique coexistence persists.

However, as we approach 2024, a resilient and unexpectedly strong consumer sector may alter the narrative, potentially introducing more favorable inflation news and influencing Federal Reserve Chair Jerome Powell’s framing of the Fed’s ongoing battle against inflation. Powell is set to deliver a crucial speech in Jackson Hole, Wyoming, on Friday.

Shruti Mishra, a Bank of America US and global economist, suggests that Powell’s tone at Jackson Hole may lean less toward balance than the July Federal Open Market Committee (FOMC) minutes, as recent data increases the risk of a resurgence in inflation.

The recent economic data indicates that consumer spending remained robust in July, suggesting that the third quarter is on track to record the fastest economic growth since the fourth quarter of 2021. This resilience in consumer spending may introduce upside risks to inflation.

Citi economist Veronica Clark emphasizes the potential for upward pressure on goods prices as demand for goods increases, accompanied by rising commodity prices and signs of inventory peaking. The ongoing correction of supply chain issues may also be reaching its limits, contributing to a more complex inflationary landscape.

The July increase of 0.7% in retail sales, including a notable 10.3% surge in nonstore retailer sales compared to the previous year, underscores consumers’ continued willingness to spend. Economists at Citi believe that heightened goods consumption could elevate the risk of inflation resurgence.

However, a nuanced story emerges beneath the surface of headline inflation’s recent decline. While July’s Consumer Price Index (CPI) showed a 0.2% month-on-month increase in headline inflation, the same trend was observed in “core PCE,” which excludes volatile elements such as food and energy.

Jefferies US economist Thomas Simons argues that this may not present the full picture. He points out that healthcare services and airfare have been particularly volatile in the post-pandemic economy. Excluding these components, Simons introduces an alternative metric called “super duper core service inflation,” which grew at a rate of 0.7% in June, the highest month-over-month increase since February.

While the current disinflationary trend in the economy is encouraging, Simons cautions against premature celebration. He believes that continued pressure in the “super duper core measure of inflation” will motivate the Fed to maintain high interest rates and adopt a hawkish policy stance.

Gregory Daco, chief economist at EY-Parthenon, notes that if stickiness in inflation, as highlighted by Simons, plays out and month-over-month inflation rebounds, 2023 could end with higher inflation than it currently exhibits.

The post-pandemic labor market, while no longer booming, is witnessing substantial wage growth. Wages are increasing at an annual rate of 4.4%, outpacing the headline inflation rate of 3%. This implies that “real” wages, adjusted for inflation, have turned positive for the first time since March 2021.

A recent New York Fed study reveals that the average wage workers are willing to leave a job for has reached an all-time high of $78,645, marking an 8% increase compared to the previous year.

Persistent wage growth raises concerns about ongoing pressure on core service inflation. Thomas Simons suggests that significant relief in these prices may not materialize until the labor market experiences more slack, which is not expected to happen in the near term.

Federal Reserve Chair Jerome Powell has acknowledged the importance of wage dynamics, emphasizing the need for wages to rise in a manner consistent with the Fed’s 2% inflation target. While Powell maintains that the labor market remains “very tight,” he has also noted signs of a “better balance” emerging in the US labor market, emphasizing the importance of labor market conditions in addressing inflation concerns.

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