Beige Book: Inflation Not Transitory

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Beige Book: Inflation Not Transitory

Early last month, we warned about the change in tone in the Fed’s Beige Book Reports, with the September edition saying there was a “downshift” in US economic activity over the summer. That was spot on, as captured by the Atlanta Fed GDPNow model’s dramatic downward trend for Q3 US economic growth since August. Just yesterday, the model posted its lowest Q3 estimate yet at only 0.5 percent, and that’s with nearly complete data for last quarter except for just one more update on the 27th.

The Beige Book’s predictive findings are why we review it when it is out 8 times a year, as it offers “on-the-ground” insights from the Fed’s regional contacts. This detailed qualitative color is especially important given the unique economic challenges created by the pandemic, and why Chair Powell is a vocal proponent of this report. With that, we always start our review with an update on hot button issues we measure by tracking how many mentions they receive in each edition of the Beige Book:

Virus-related terms: 30 mentions of the virus in this month’s report, up from 25 in September, 9 in July, 13 in June and 24 in April.

Vaccine: 10 references of “vaccine/vaccination/vaccinated” versus 3 in September, 5 in July, 13 in June, 20 in April and 29 in March.

Rising/elevated prices or price pressures: 13 citations here compared to 12 in September, 9 in July, 12 in June, 11 in April, 8 in March and 3 in January.

Supply disruptions/supply chain disruptions: 26 mentions versus 29 in September, 17 in July, 17 in June, 15 in April and 15 in March.

Labor shortage/s: 25 references versus 26 in September, 22 in July, 12 in June, 3 in April and 3 in March.

The trends in references to these terms continue to highlight the issues slowing down the US economy: 1) rising concerns about the virus and less attention on vaccines versus earlier this year, 2) increasing inflationary pressures, and 3) elevated attention on challenges related to labor shortages and supply chain disruptions.

As for our main takeaways from the latest Beige Book, three points:

#1: Most Fed districts reported that “economic activity grew at a modest to moderate rate” over the last six weeks, but “several” still said the “pace of growth slowed this period.” The main culprits echo our word count analysis, with the US economy constrained by supply disruptions, labor shortages and uncertainty about virus variants. Here are some examples:

  • Although most districts noted “positive growth in consumer spending”, auto sales pulled back due to low inventories and increasing prices.
  • Travel and tourism activity was mixed, depending on the cadence of virus cases and the seasonal impact of back to school. Business and international travel also continued to lag domestic leisure travel.
  • Residential real estate activity was “unchanged or slowed slightly but the market remained healthy, overall”. Demand is still robust, but some headwinds included low inventories, upward pricing pressures and the typical seasonal slowdown around this time of year.

Looking ahead, the Fed’s regional contacts still have positive near-term outlooks, but “some districts noted increased uncertainty and more cautious optimism than in previous months”. We thought Philadelphia summed up the current troubled economic environment best: “According to contacts in manufacturing, construction, and finance, there is too much uncertainty and too little labor to pursue capital expansions that might address the product scarcity and high prices resulting from the supply chain disruptions.”

#2: Employment “increased at a modest to moderate rate in recent weeks” but was constrained by a low labor supply especially for transportation and technology businesses. Retail, hospitality, and manufacturing firms even reduced hours or pulled back production due to the lack of workers. Businesses continued to struggle with high turnover as “workers left for other jobs or retired”, while child-care problems and vaccine mandates also posed challenges. For example, Richmond said employers worried federally mandated vaccines could make their labor challenges worse. Cleveland also said “the expiration of supplemental unemployment insurance benefits and a return to school did little to alleviate worker shortages.”

To help combat these labor issues, firms further leaned on automation and increased wages to attract and retain employees. Other incentives: “signing and retention bonuses, flexible work schedules, or increased vacation time.” As a result, most districts characterized wage growth as “robust” versus “strong” in the last report.

#3: Inflation took a meaningful turn higher with most districts reporting “significantly elevated prices”. Increasing demand for goods and raw materials drove input costs higher across a slew of industries. Major reasons for price pressures: scarce products from supply disruptions, commodity shortages, and transportation and labor limitations. For example, an apparel business in Boston resorted to transporting product more expensively by air due to ramping shipping costs and delays. Notable price increases occurred for steel, freight, and electronic components.

On the plus side, strong demand enabled many businesses to raise selling prices to pass costs onto consumers. Going forward, inflation expectations were mixed between some thinking prices will stay high or keep rising while others forecast moderation over the next year.

Bottom line: even with a slowing US economy from labor shortages and supply disruptions, the American consumer remains strong which is contributing to more structural rather than transitory wage and price pressures. Chair Powell has already started walking back his characterization of inflation as “transitory”, and this latest report affirms that approach. That’s in large part why the Fed Funds Futures market continues to raise its odds for rate hikes next year. The default expectation is for two rate increases in 2022 with odds at 35 pct, up from just 14 pct a month ago.