The American Consumer Is Fighting the Fed

The Great American Shopping Spree Continues

What if the Federal Reserve declared a restrictive monetary policy and no one heard it?

Fed officials have been busy these past few weeks arguing that the stance of monetary policy is now likely restrictive enough to bring inflation back down to its two percent target. The  data, however, do not show many signs that the economy is being restricted.

Retail sales came in much stronger than expected for the month of September. What’s more, there were upward revisions to July and August, so the American shopping spree has been going on stronger for longer. The core control figure, which goes into the calculation of gross domestic product, was revised up by a tenth for each month. As a result, it increased at a seasonally adjusted annualized rate of 6.4 percent in the third quarter.

The strong September sales figures likely include some borrowing from future holiday sales. As we have extensively chronicled over the past two years, households are doing holiday shopping earlier than in the pre-pandemic era, boosting late summer sales figures. Yet even with that in mind, the September sales numbers would seem to set the stage for a strong handoff into the fourth quarter.

It was not just sales that surprised to the upside on Tuesday. Business inventories rose 0.4 percent in August, and the July figure was revised up to show growth after the initial estimate of no change. This is an indicator that businesses are stocking up on products in anticipation of strong sales.

Whenever inventories grow, there are always those who will worry that they could be growing for a bad reason: businesses overstocking and finding insufficient demand to purchase the products. This doesn’t seem to be the case in the recent data. The sales-to-inventory ratio of 1.37 is exactly the long-term average, which indicates that stockrooms are not filling up much faster than the shop shelves are clearing.

Industrial production for August was supposed to be flat for the month, and manufacturing output was forecast to decline. Instead, both grew in the month. Manufacturing output put in a very impressive 0.4 percent reading. (Admittedly, both month-to-month figures were flattered by downward revisions of prior months.)

Growth Is Getting Upgraded All Over the Place

The Wall Street banks are scrambling to upwardly revise their forecast of third-quarter GDP. J.P. Morgan‘s North American economic research team on Tuesday marked up their forecast from a seasonally adjusted annualized rate of 3.5 percent growth to 4.3 percent for the third quarter.  Goldman Sachs said its tracking estimate rose to four percent from 3.7 percent.

The Atlanta Fed’s GDPNow model was dismissed or even mocked as being way too bullish on third-quarter growth when it started indicating a rate above five percent. Many analysts blithely assumed that this would have to come down to three percent or lower. On Tuesday, it rose to 5.4 percent from 5.1 percent.

To understand why this is troubling, let’s recall the conventional story of how monetary policy is thought to work. The Federal Reserve decides it needs to bring down inflation or ward off future inflation, so it raises its overnight interest rate target and sends its officials out on a forward communication strategy meant to complement the rate hike by convincing the market to move longer rates upward as well. After some sort of lag, higher rates push down employment and economic output. With a bit more lag, this leads to lower consumer demand because incomes drop due to higher unemployment, and savings rise as households become more cautious. Wages stop rising, and eventually prices stop rising too.

Do Our Inflation Models Have It All Wrong?

Look at what has happened over the past two years. The Fed started hiking rates at the end of the first quarter of 2022 after communicating that a hiking cycle was coming a few months earlier. Real GDP contacted slightly in the first and second quarter of 2022 but not for reasons easily attributable to higher interest rate hikes. But by the third quarter, the economy was growing like gangbusters, and growth continued at an above-trend pace in the fourth quarter.

The consensus view was that the restrictive stance of monetary policy would likely bite in the first and second quarter of 2023, throwing the economy into a mild recession. S&P Global, for instance, forecast the economy would grow just 0.2 percent for the full year.

“We expect the Fed to cut rates in late 2023 as its soft landing turns into a hard one with prices softening on weak demand,” S&P Global explained.

Instead, the economy continued to grow above the Federal Reserve’s estimate of 1.8 percent potential growth in both the first and second quarters. Now it appears to be growing at an incredibly fast pace.

What’s more, unemployment has shown no signs of rising significantly after the Fed started hiking rates. In fact, the labor market seems not to have paid any heed to interest rates at all. Consumer spending has done the same.

Fed officials have frequently stated that they think their hikes from earlier this year and even last year are still working their way through the economy. The lags have gotten very long, for some reason. This is a bit hard to justify in theory because long-term inflation expectations (thought by the Fed to have a big influence on future inflation) have remained anchored. What’s making the lags, well, so laggy?

Another difficult question arises: even though demand for labor and consumer spending have remained high and economic growth has accelerated, inflation came down a lot. Keep in mind that under the conventional narrative, inflation is supposed to come down after the labor market and consumer spending soften. In the past two years, inflation came down first and Fed officials are now telling us that labor markets and demand will soften next.

The Fed seems oblivious to this. Fed officials have repeatedly claimed that their rate hikes and balance sheet reductions are responsible for bringing inflation down from the multi-decade highs. And it is this victory that gives them confidence inflation will keep coming down.

So, what’s going on here? What we appear to be discovering is that our understanding of inflation is far more flawed than previously thought. One possibility that is consistent with the data is that inflation might not come down with a lag after Fed hikes but in anticipation of Fed hikes. If that’s so, the Fed should be very, very careful about sending the message that there will be no more rate hikes.

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