Beware the Wage-Price Spiral

Peter's Economy and Market Wrap, Week Ending July 14, 2023

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“Don’t fight the tape” and its more modern-day equivalent “the trend is your friend” are familiar Wall Street cliches that perhaps best capture the market’s present bullish mood.  Indeed, this week all major US indices hit 15-month highs. 

The propellant for this latest move was seemingly good news on the inflation front.  Both the Consumer Price Index (CPI) and Producer Price Index (PPI) beat expectations with lower inflation numbers than estimated, and the Wall Street spin machine used this news to argue that the Fed need not raise interest rates at its next meeting. 

Following this news, bond yields fell, and stock prices rose; and the big bet now is on a “soft landing” that will accommodate the bulls.  This hoped-for soft landing will, according to the bullish calls, result in a continued decline in inflation without a rise in the unemployment rate.

Fair enough, but let’s first take a deeper look at this week’s actual inflation news.  The CPI still has the core inflation rate, which excludes food and energy, more than twice the Federal Reserve’s 2% target at 4.8%.  If we assume the Fed won’t start lowering rates until the core hits 2%, it is unlikely that will happen for many, many more months even if the current downward trend continues.

In the meantime, the Fed’s higher interest rates will remain high.  They will boost people’s adjustable-rate mortgages, increase the cost of one’s credit card debt, and gouge small businesses that have to refinance debt.  Plus, as they teach at business schools, the higher the interest rate, the fewer the capital projects “pencil” and the less investment is made.  And do note here that the rate for a 30-year fixed rate mortgage is over 7%.

As a second quite related issue, the current downward trend in core inflation may well not continue.  My big concern here is the kind of wage-price spiral we witnessed in the stagflation of the 1970s.

This spiral started with a “price inflation” shock that eroded the real wages of workers.  Remember here that real wages equal the actual paycheck minus inflation; and for roughly 3/4s of the time Joe Biden has been president, real wages have fallen.

So when real wages fall, workers then demand compensatory wage hikes.  This is the other shoe dropping on the wage-price spiral.

In a very tight labor market such as we are witnessing, workers are likely to have enough bargaining power to get these compensatory wage hikes.   In addition, the US is facing a likely labor strike at UPS by the Teamsters while there is trouble also afoot at Amazon.  The end game may be both more supply chain disruptions and a spike in wages that will feed into a wage-price spiral.

Of course, as this wage-price spiral unfolds, core inflation is unlikely to fall further – and more likely to start rising again!  So we will keep our eyes on this over the next six months!

A third potential fly in the soft-landing ointment has to do with the forecast of very tough times ahead for the commercial real estate industry.  In a post-pandemic world where remote work has hit major cities like a neutron bomb, many analysts see a collapse in a commercial real estate market plagued by historically high vacancy rates that will spill over into a banking crisis.  Inevitably, any such crisis will tighten credit.

Fourth, there is the excess savings problem that must be addressed.  The problem here is that there isn’t any excess savings anymore.

During the pandemic, savings rates ballooned as people couldn’t spend their money freely on things like travel and entertainment.  Meanwhile, lucrative government programs stuffed cash in the pockets of many Americans.

Once, however, the economy opened back up, Americans began using their excess savings to spend like drunken sailors – and frankly, it’s been a heck of a party.  According to the Federal Reserve, however, excess savings will be gone by the end of the year.  This, in combination with a fall in real wages and income, means far less purchasing power; and the key macro point here is that consumption accounts for more than 2/3rds of growth in the GDP growth equation. 

Look, therefore, for consumption to weaken and growth to slow as consumers are tapped out and real wage growth remains slow to negative.

In closing, it was indeed a very good week for the bulls.  From a purely technical trading perspective, the market trend is clearly up; and on this technical signal alone, US markets, along with markets around the world, are likely to see more green than red days, at least for a while. 

That said, I remain wary and see lower risk generating income in short term treasuries than rolling the stock dice. My only major stock holding is an exchange-traded fund for India, symbol IFN; I see India in a secular upswing because of favorable demographics – more about this in a future missive.

In the meantime, watch your back and protect your job and wealth.  Peter Navarro.  Out.