Paul Diggle

Hello and welcome to Macro Bytes the economics and politics podcast from abrdn. My name is Paul Diggle, Chief Economist at abrdn.

 

Luke Bartholomew

And I'm Luke Bartholomew, Senior Economist at abrdn.

 

Paul Diggle

And today we are talking about the US economy and some of the crucial debates in macro markets at the moment, things like the drivers of benign disinflation over the past year in the US whether this can continue, whether the last mile, bringing inflation back to the 2% target is going to prove the hardest, the risks of a repeat of the 1970s experience of inflation pressures reemerging and whether the market should be worried both about inflation dynamics, but also the size of US deficit and debt.

 

So, we're delighted to be joined by abrdn Deputy Chief Economist, James McCann to talk about all these issues. Welcome, James.

 

James McCann

Thank you very much for having me.

 

Paul Diggle

So, James 2024 started in markets with a lot of optimism about the remarkable progress the US economy, the Fed, had made on bringing inflation down, annualising the run rates of sequential PCE inflation over three, six-month time horizons seemed to suggest the job had basically been done. And at one point, the financial markets were very confident in rate cuts beginning from March, but that narrative has taken a bit of a battering in recent weeks. Can you talk us through the latest inflation numbers in the US and what they might be saying about the last mile of lowering inflation?

 

James McCann

Absolutely, and I think it's probably worth just providing a very quick introduction for those who aren't avid followers of US inflation data about the different measures that the Fed looks at and focuses on. The classic measure of inflation, of course, is CPI inflation. That's what economists talk about most commonly, a basket of goods and services and a measurement of prices across those, the Fed looks very closely at something called PCE inflation, which is very similar in many ways. It's a basket of, of prices across a range of goods and services as well. The difference is the survey method, it asks businesses what price they receive, rather than consumers as what price they pay. And then secondly, it has a number of different compositional methodological differences. So, it's a broader measure and incorporates a larger range of goods and services that consumers buy. It has different weights as well within it based on that difference in scope. And then there's some more technical aspects about how the index is calculated that I won't get into. But having just provided that little bit of context, you're absolutely right, that PCE measure, which of course is the Fed’s target in the six months over the second half of last year that had fallen to 1.9% annualised. So, basically at even a tiny bit below the Fed’s target in core terms that is, so remarkable progress.  Core CPI had fallen too but not by quite as much, so core CPI at the end of last year six month annualised was running at 3.3. Still well down, but not as impressively.

 

The bad news I suppose for the Fed is that core CPI is continuing to come in hot in early 2024. We saw the headline numbers beat expectations, and the breakdown of it was relatively unfavourable. So, despite another large declining core goods prices, we saw pretty hot core services prices. And we can map across some of their core CPI information into the PCE information and that tells us that actually core PCE in January is almost certain to accelerate to above-target consistent rates. Now, this is just one month, but it's a bit of a knock in that disinflation narrative and maybe tells the markets that the path lower inflation, that the last mile of inflation will be a little bit bumpier than they might have hoped for.

 

Paul Diggle

And there are obviously a lot of moving parts in the inflation numbers, but particularly in those core services numbers, some of the subcomponents that markets are really lasered in on are rents, medical costs, and then more broadly, how wages feed into inflation. Could you talk a little bit about what those moving parts are doing?

 

James McCann

Absolutely, and we've long been expecting in the market has long been expecting rental inflation to start to moderate, it's been running a very, very high rate, and it has been slowing to some extent. But when we look at other indicators of rents, private sector indicators of rents, they're very clearly cooled the housing market itself so house prices themselves have cooled, and there's been expectation that will feed into the core CPI and the core PCE rental dynamics. That's not yet coming through and I think again that core CPI showed very, very, very, very strong owners’ equivalent rent. So that's an unusual component. It's one where you ask people who own their own homes, how much they'd have to rent them for.

 

So, it tends to be a little bit more slow to update because people aren't tracking the housing market as closely. But the concern is that people have baked in that rental inflation will slow and we do think it will slow. But again, an example of a little bit more bumpiness, that's perhaps taking a little bit longer to feed through. And then there's concern about medical care services. That's a really important part of PCE inflation, the partial data, also from the PPI report, that's another inflation measure to throw into the mix that was released last week for January, that measures inflation one step earlier in the chain. So, the prices that producers, wholesalers received for their goods and services, that indicated that medical care services was inflation was going to come in relatively hot in January too, the core CPI doesn't pick that up as thoroughly. That's one of the differences in the scope measures there. So, some lingering concerns that you'll maybe get a bit more on medical care services as well. Another aspect of that service is inflation proving difficult. And really for the Fed they look at the headline inflation, they look at core inflation, they don't want to get too distracted by some of these exclusion measures. But the fear for them might be I suppose, that they're getting a lot of good news on goods prices and that's covering up some of the strength and services prices, which is okay, because they look at the basket as a whole or at least large portions of the baskets, their fear might be of that goods price disinflation, deflation starts to evaporate, then actually inflation might be running too hot. You mentioned wages there, I think, you know, one light at the end of the tunnel is that wage measures are clearly moderating. So, if they look at that, as a forward-looking indicator of where these core prices might move, then that's an encouraging sign that domestically generated inflation is cooling. But yeah, I think the main message is just a reminder that some of this process might be nonlinear might be bumpy, might be not as smooth and quick as the market had been hoping for.

 

Paul Diggle

And perhaps some of that concern on the if the goods disinflation kind of dries up a little bit that feeds in or interrelates with events in the Red Sea as well, yeah, a lot of the favourable unwinding post-pandemic supply chain disruptions, some of that has reversed a little bit, we think it's more of a European than a US issue but I suppose that's also a lingering concern that might be in the mix.

 

Luke Bartholomew

So, just to pick up on this last mile phrase that we've mentioned a few times now, because I guess that was a phrase that's been introduced into the discourse by policymakers. It's a mantra that they've been repeating quite a lot, the idea being that there might be something particularly difficult about the last mile of squeezing inflation out of the system and I guess the idea of the rhetoric is that central banks will be willing to travel this last mile, regardless of how difficult it might be. But I'm sort of wondering where they got the idea that the last mile might be so difficult, James, I mean, notwithstanding some of the bumpiness that you described there, I don't think it's intrinsically obvious that say, getting inflation from 3 to 2%, should be that much more difficult from getting it from, say, 4 to 3%. So A) where this idea comes from and B) the fact that central banks have been so keen to keep on reinforcing this last mile, it could be difficult but we'll travel it message does that tell us something about their reaction functions and willingness to perhaps commit the policy error of keeping policy too tight for too long to ensure inflation doesn't pick up and therefore cause a recession rather than the policy error of maybe taking their foot off the brakes too early and allowing inflation to pick up again?

 

James McCann

Yeah, I think these are really important and good, good questions, in terms of that, you know, is the last mile of inflation harder – the IMF, another important part of the policy community have been banging this drum, I suppose you could argue that some of the early yards of disinflation, were maybe easier based on global supply chains figuring themselves out, energy price inflation starting to come out of the system and the associated knock-on effects of that sort of broader goods price dynamic and it could be the case it's the services aspect that is stickier that's harder to shake out requires more disruption. That that could be one plausible argument. I would say, US labour market has looked to be cooling in a relatively benign manner. And as we mentioned, those wage costs have come down, you know, much more easily than I had anticipated. I had thought that that would require more of a shakeout in the labour market to see that to see that moderation. So, you know, I think there's a strong degree of policy consensus around it or certainly a significant fear around it. And not I’m certain it will turn out to be the case but certainly there seems to be a degree of conservatism among central banks in that direction, thinking about the motivation for that and the relative risks. This is something that chair Powell talks about a lot, that risks are now finely balanced for the FOMC, between seeing inflation continue to surprise above target versus doing too much to undermine the US growth and labour market environment. Perhaps from the Fed’s perspective, it's not seeing many red alarms, red lights on the latter, so it feels it has the room to go and, and be really careful about this last leg of inflation, when it sees initial claims at extremely low-levels, when it sees payroll growth coming in at robust rates, it feels maybe it has the luxury to be a bit more cautious around the last mile of inflation and hold policy tighter for a little longer. Time will tell if that turns out to be a policy mistake, it's not impossible that the data turn on them and they feel that they missed a window here, but from the best information that's available to them at the moment, maybe they think there's a degree of time, you know, more broadly, maybe they feel a degree of humility, having had issues with their inflation forecasting, like many of us over the over recent years, and they don't want to take anything for granted. And maybe an element of conservatism too around inflation risks, and, you know, a disproportionate fear of that relative to their mandate. That's maybe more speculative. But yeah, I think it's an important question and I think the interesting thing is, how would the Fed react if you were to start to see some more red lights going off on the growth front? You know, how would that caution on the last mile change? How would they balance that? I think that's quite an interesting question.

 

Luke Bartholomew

So, perhaps just to add a little bit more speculation as to what could be behind the Central Bank's view on the balance of risks that perhaps one risk that they're alert to is being judged by economic history in much the same way as Arthur Burns and the Fed of the 1970s was haunted by this experience of letting inflation seemingly get out of control in that decade. And, you know, there was a chart going around for a while, perhaps a bit of a chart crime, but a chart nonetheless showing the 1970s inflation experience and overlaying our recent one and what the 1970s decade of high inflation describing it in that way sort of loses is that really what happened is inflation went up, it went down and then went back up again, as the shocks came through. And perhaps it's sort of this concern about reliving that kind of experience of seeming like you've won the battle, only then to see inflation pick up again that's haunting central banks as well.

 

Paul Diggle

Yeah, much better in their mind to be to be Paul Volcker than Arthur Burns. But that said, James, you obviously highlight that the growth aid has remained very resilient, even as inflation has come down a lot. So, you're not having to do what Volcker did and impose a very weak growth environment recession to bring down inflation. Actually, what seems to have occurred is a big positive supply-side shock in the US economy.  That's the organising principle that economists call the combination of strong growth and lower inflation. But what specifically has driven supply-side improvements in the US?

 

James McCann

There have been a number of as you see them in a number of favourable tailwinds coming in at the same time, the most, I suppose, immediate of those was an unblocking of global supply chains that allowed that the goods sector to kick back into gear, so to speak, I don't think that was an enormous positive tailwind, but it was something important to note. I think that the real impetus, though, has come more through the labour market. We've seen labour supply increase very noticeably over the over the last 12 months or so driven by a combination of strong immigration flows, immigration was significantly held up during the pandemic by all the restrictions on movement and delays in visa processing, etc. And those who have improved those backlogs have started to come through and immigration has rebounded very, very smartly. And then similarly, for those in the US labour market, more are participating, or at least those in the US more are participating in the labour market. We've seen the prime participation rate rise to multi-decade highs. And that of course, was following a multi-year shock after the pandemic where people left the labour force for various reasons, be it childcare, be it concerns over public safety and health, etc. So, that sort of positive tailwind has been quite important in helping cool the labour market without that need for very significant demand destruction on the labour demand side. I think another dynamic that's been important too, has been productivity is improved very, very noticeably. So, productivity accelerated at the end of last year to 2.6% in year-on-year terms. To put that into context, productivity numbers get thrown around during recessions. So, we should exclude that, you know, but excluding those dynamics, that's the strongest we've seen since the early 2000s. And of course, that was a stronger productivity era compared to the sort of post-GFC environment where productivity was very subdued.

 

So, I think some final shakeout us on the pandemic hangovers and scars has been quite important in driving that. And again, productivity is important, because it means that even if wage costs are running at high levels, it's not as impactful for firms' bottom lines, they can absorb more of that without having to cut their margins or having to push it on to put higher prices on to consumers. So, you know, there have been a few, a few positive supply shocks, and they've been probably more powerful than we had expected, certainly 12 months ago. And I think they've really helped facilitate this combination of strong growth and slowing inflation.

 

Paul Diggle

Yeah, and I think it's interesting to ask why the US had those positive supply shocks in abundance. But by contrast, the likes of the UK, the Eurozone didn't. They have seen inflation moderate quite significantly, but at the same time growth has moderated and indeed slipped into recession in the UK and bumping around zero in the Eurozone. And those economies did get some of those positive supply shocks, particularly the global ones you talked about James, lower commodity prices, supply chain improvements. They also to some extent, got this, what economists would call the inward shift of the Beveridge curve, which is basically an improved job matching function, the labour market, matching up people in unemployment with job vacancies. But it just seems like the US got those things to a much larger extent.  For example, the US didn't have to deal with the large run-up in commodity prices triggered by obviously the Russian invasion of Ukraine. But I think the productivity performance must be the really big difference maker, as you highlight. And I wonder why that is? I mean, is it because the US is at the technological frontier? So early benefits of AI have already been felt in the US economy? Is that a legacy of Biden-era policies like the Chips Act, the Inflation Reduction Act, raising R&D investment? Is it a legacy of labour market policies during the pandemic, which encouraged labour hoarding in Europe, but perhaps, created destruction in the US? I mean, any thoughts on why the US got this tailwind to such a greater extent?

 

James McCann

Yeah, if we compare the trend in productivity, what this recovery has done has been put you right back on your pre-pandemic trend, and I think that's the stark contrast and you look at other developed economies and some emerging economies too, they're still languishing well below that trend. I think my instinct then is to think that some of the pandemic responses while you have by no means perfect, maybe have helped weather sort of that shock or correct that hangover, see the US through that hangover, whereas other economies maybe haven't got there. So, you know, as you said, maybe pointing to aspects of the labour and product market responses, the combination of very, very strong demand side stimulus, which arguably had its downside in a period of higher inflation, but maybe prevented some of that supply damage through the pandemic from becoming more permanent? You know, these are, these are things I might speculate on, I probably would flag at the moment where speculation will probably take many years before people fully figure out what was at the root of this. You know, I think the AI one is, is really interesting. If I think forward about can the US maintain this level of this rate of productivity growth and I think you are having now probably, given that you've returned back to your pre-pandemic trend having to become more optimistic on the run rate of future productivity growth. So, you'd have to draw in a hope or expectation that AI is unlocking, you know, faster productivity labour output across the economy. You know, possibly, normally we tend to see as you know, I think you folks have spoken in this podcast before we normally tend to see the benefits of this type of technological revolution take longer to materialise, but it's not impossible and keep your mind open to that, certainly, because the supply side has probably been the area of the economy that surprised us most in the last 12 to 18 months.

 

Luke Bartholomew

So, looking forward then James and outside of productivity, I mean, are there potential avenues for the supply side improvements to continue or is this run its course I mean, it seems to me for example, that the Beveridge curve as Paul described it, this reflecting the efficiency of labour market matching, having moved back to its pre-pandemic levels, is there really scope for that to continue to improve?  Or global supply chains that have subsequently and unsnagged after the COVID disruptions. If anything, now they might be going in the wrong direction due to the Red Sea. So, you know, from what was a huge tailwind last year, these positive supply development, I mean, is it possible that they could be turning into headwinds, even for this year and beyond?

 

James McCann

I certainly think it's possible that some of them have run their course. And I think you've outlined a couple there, you know, absolutely on the global supply chain dynamic towards the second half of last year, measures that try and capture all aspects of that freight costs, commodity prices, etc., they were showing that the supply chains were functioning and back to normal. And as you say, if anything the risk has moved to further disruption based on disruptions in the Middle East. So, I think that's, that's one which is certainly run its course, I think the efficiency of the labour market as measured by the Beveridge curve, unless we assume, you know, an even more efficient labour market than before the pandemic, which feels like maybe a little bit of a stretch, then that's something that's run its course, I think the participation rate has probably peaked. And even, there's actually evidence of that starting to struggle a little bit and come off its highs. You know, we know the US has demographic challenges. So, an ageing population is consistent with a structural decline in the participation rate. So, I think that's one too that has probably run its course, but more open-minded on the population growth and immigration dynamic, it's possible that it has further legs to run and, and that's something that could provide a bit of support to, and maybe on the productivity side, not impossible that you get a few more quarters of strong productivity growth. But if I wrap these things all up, I'd probably come with the conclusion that much of the supply-side dividend or recovery is probably behind us, that would be my best conclusion.

 

Paul Diggle

Why don't we pivot to the demand side of the economy, because among many other tailwinds one for the US economy last year was fiscal policy. Can you give us a sense, James, of the size and source of fiscal expansion in the US last year?

 

James McCann

Yeah, there was a hidden fiscal expansion last year, partly because there's no sort of major new legislation passed and partly because it was obscured by changes around the accounting on student debt practices. But if we sort of try and cut through those factors and look at the numbers, then we think the deficit broadly doubled from around 3.8% of GDP, which is large already to around 7.5%, which is very, very large, especially outside of outside of a recession.

 

There are a few things behind that one is relatively supportive government outlays passed during the final sort of throes of a fully unified Democrat government, there were some lingering effects from the big pieces of Biden legislation passed earlier in his term, as you mentioned, the Chips Act, the Inflation Reduction Act, the Bipartisan Infrastructure Investment Act too. So that was all quite helpful. And then there were some quirks too. So, things around the timing of receipts, markets doing very poorly last year, and the effect that there has on income tax filings around capital gains, etc., we don't think that they're hugely consequential. But if we think about that, 3 to 4% points of GDP widening and the deficit and try and map that into growth implications direct government spending and investment, we think that probably added around 1 percentage point to GDP growth last year. So that's probably taking up around a third of aggregate US growth. If we try and map some of those policies in infrastructure investments, the manufacturer of semiconductor chips, plants, the investment that's been facilitated and supported by tax credits in the Inflation Reduction Act, you know structures investment in the US was 15% year-on-year, which in an environment of very high-interest rates is clearly an outlier, we probably attribute that almost entirely to those fiscal imperatives that added around 0.4 percentage points to growth. So, you can pretty quickly get a very sizable direct government contribution to the economy, which, you know, undoubtedly provided pretty significant support.

 

Paul Diggle

And it's worth underlining quite how unusual a deficit of that size at this point in the business cycle is I mean, it was sub 4% unemployment at practically full unemployment, and then having a further fiscal tailwind is unusual, another way of saying that is that the structural budget deficit is very large. But that tailwind might turn to a bit of a headwind in 2024 right, James? And what sort of tightening in fiscal policy are we talking about?

 

James McCann

Yeah, I've pencilled in, it's always difficult to forecast, I pencilled in a 2 percentage point of GDP tightening in the deficit. So that's a drop in the deficit from that 7.5% to around 5.5%. You know, again, that headline number is really large and you'd expect that to the normal times that would be a meaningful fiscal headwind. I think there are one or two of those temporary factors which will unwind again, the timing of receipts just shifts into a different fiscal year, and that will benefit it. I think capital gains will be stronger given the market environment we had, so that an additional form of income tax receipts as well. So, once they figure themselves out, we look at the fundamental changes. Government expenditures are definitely going to be tighter I think, the Fiscal Responsibility Act pencilled in around 60 billion cuts to non-discretionary defence spending, there's risks of shutdowns and further cuts to that if Congress can't reach agreement, so a little bit less on the government expenditure side, you know, in our forecasts, we've got that 1 percentage point of GDP growth contribution from government has to shrink to probably around half a percentage point. So not an outright headwind but much weaker contribution from the government side. And then the structures investment side too, I think that's going to be very difficult to repeat the type of growth that we got last year from that channel, even if structures investment remains at these levels, that implies very significant investment in that sector. So, we think that will dry up as well. So, you can quite easily pencil in lesser, a smaller contribution from the government angle of around 1 percentage point or 0.5 to 1 percentage point of GDP. So, I think that will be, you know, certainly a less helpful tailwind to the economy this year.

 

Paul Diggle

Of course, much depends on politics here. So, there's both a bill currently going through Congress that could change that fiscal picture a little bit. And, of course, an election later this year, which everything could change again.

 

James McCann

That's right, Congress is struggling to get anything done. But has made some progress, at least on around 110 billion worth of child tax credits and corporation tax cuts, which feels odd, given the size of the deficit that we spoke about where you sit in the current business cycle, and the ability to do your basic fiscal homework around passing a budget, etc., raising the debt ceiling, all of that has been has been challenging. At the moment, we're not convinced that that will, that that will get through. But if it does get through, then that would probably mean you'd get around another half percentage point maybe a little bit less boost from the fiscal side to grow to be filling up that that loss growth that we spoke about, for this year. And yes, then looking into 2025, we will have a new president, and well, maybe, and we'll have a new Congress. And, you know, I think that will be really important in determining where the policy goes and where the deficit goes into the next the next term.

 

Luke Bartholomew

Also, looking to that longer-term horizon change there and as you say, sometimes it's lack of willingness in Congress to do the fiscal homework and the sense in which the deficit is already very large for this point in the cycle and maybe both parties have commitments that would see it, increase post the election. I mean, there have been these concerns about a lack of political will to get a grip on the deficit and so and so the long-term path of debt, but I mean, how much real worry, really is this in the rating agencies, several of them have downgraded US government debt. Most recently, Fitch last summer to basically no effect. I mean, US interest costs have risen, but that's largely a function of, policy interest rates, there was a bit of a concern at the back end of last year about maybe rising term premia, which could reflect some concerns about government borrowing, but those have largely fizzled out. So, you know, is this really a genuine concern? I mean, is it possible that there is something of a fiscal crisis or is that concern misplaced?

 

James McCann

I think there's a genuine concern, I think a fiscal crisis in reasonable time horizons feels like more of a tail risk than something that should be really high up the sort of priority or the focus. But I think the public finances do look to be on for the very long-term and unsustainable footing. And we see that, Paul mentioned earlier, that structural deficit or structural gap between spending and receipts, you know, that really needs corrective action and as you say, that just doesn't seem to be the political will to address that either through less spending or higher taxes. If anything, the political winds just continue to push towards a reduction in the tax burden, or increases in spending, depending on which party you're listening to. And even when power was shared, the easiest course of direction seems to be some combination of those where both sides win through those channels.

 

So, I think there's concerns that the US will continue to run sizable, sizable deficits. I think there's concerns to reasonable ones, that the interest expense, the interest burden on the current debt is becoming more challenging to finance, and we see that rise above 3 percentage points of GDP each year, that's the highest it's been since the 1980s. So certainly, you've got this combination of very high, we call it primary deficits, which excludes the interest cost, and then high-interest costs makes for significant overall deficit. So, our forecasts, consistent with the CBO, another fiscal watchdogs, says the US debt just continues on its current path to drift higher. You know, what would really be necessary, though, for that to escalate into a crisis will be here for markets to get very upset at that and stop financing that at current interest rates, so to permanently charge the US government significantly higher to finance that very large deficit, when we run those types of simulations, we could see the US debt burden rise from something between 110 to 120% of GDP under our current forecast to close to 150% of GDP over the next decade, which would be a very significant leg up, you know, absent any corrective action. The good news for the US is it has this exorbitant privilege that there's a huge structural demand in the global economy for US Treasuries for dollar-denominated assets. And that seems to be, you know, keeping a lid on and providing it with room to be fiscally irresponsible in a way that a lot of economies don't have that benefit. So, I think the US in some ways, because of the role it plays in the global economy is getting away with a really poorly managed and probably unsustainable fiscal policy. I just don't think that they'll get called on that, at least in the next sort of 10 years or so we probably should think about that as a tail risk and something to monitor as opposed to something to be really focused on around our base case.

 

Luke Bartholomew

All right, well, I think that is all we have time for this week. So as ever, please do let me remind you to like and subscribe, wherever it is that you prefer to get your podcasts. And all that remains is for me to thank James, for joining us this week, and to thank you all for listening. So, thanks very much and speak again soon.