The Big Idea

Sacrifice ratio lite

| September 22, 2023

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Economists use “sacrifice ratio” to describe how much growth an economy needs to give up to get an increment of disinflation. The FOMC’s latest round of economic and policy projections show that officials expect a sacrifice ratio much lower than they previously thought. In effect, policymakers now appear to believe that inflation can come under control with little or no economic pain at all.  While no one would object to such a happy circumstance, I am dubious that the US economy can be so fortunate. If it sounds too good to be true, it probably is.

Braced for pain

Federal Reserve officials have been warning for some time that getting inflation back to 2% would likely require some pain for the economy.  Some officials have gone so far as to indicate that they were willing to spark a recession if that is what it would require to drive inflation down. Chair Powell has always been optimistic that the job could be done with a soft landing rather than an outright downturn.  At Wednesday’s press conference, he repeated a sentence that he has used perhaps dozens of times over the past 18 months: “Reducing inflation is likely to require a period of below-trend growth and some softening of labor market conditions.”

The prior round of FOMC economic projections released in June clearly showed this. The median forecast called for 1.0% real GDP growth in 2023 and 1.1% in 2024, below the FOMC’s estimate of the long-run trend at 1.8%.  Similarly, the unemployment rate was projected to rise to 4.1% by the end of this year, 4.5% by the end of 2024, and to hold at that 4.5% level through the end of 2025. Those levels compare to the FOMC’s assessment that full employment is consistent with a 4.0% unemployment rate.

That June economic forecast could be thought of as a soft landing: a period of below-trend growth and of modest slack in the labor market, but not enough weakness to yield an outright contraction of real activity and thus a recession.

No pain, same gain

The updated FOMC economic projections released on Wednesday suggest that the committee now believes that it can get inflation back to 2% with virtually no economic pain.  Forecasts for real GDP growth in 2023 and 2024 were revised upward to 2.1% and 1.5%, respectively. Growth is now expected to average 1.8% this year and next, exactly in line with the FOMC’s assessment of trend.  The economy is currently viewed as operating above its potential, that is, product and service markets are imbalanced with demand outpacing supply.  In popular jargon, the economy is overheated.  In June, the Fed prescribed a 2-year period of sub-trend growth to bring markets back into balance.  Now, evidently, the Fed believes that the economy can operate above its potential indefinitely.

Similarly, the latest FOMC projections of the unemployment rate are 3.8% for late-2023, and 4.1% for late-2024 and late-2025.  Relative to the FOMC’s assessment that 4.0% is the long-run full employment level, this means that the labor market is forecast to run at essentially full employment indefinitely.

Chair Powell provided additional color on this view at Wednesday’s press conference.  He noted that “we’ve seen now meaningful rebalancing in the labor market without an increase in unemployment, and that’s because we’re seeing that rebalancing in other places.  In, for example, job openings and in the jobs worker gap.”  In other words, the Fed appears to believe that it can skim all of the froth in the labor market off without creating a significant rise in the unemployment rate.  Rather, as the labor market cools, job openings will fall until demand and supply of workers is in perfect balance without any rise in unemployment.

This is a wonderful story, and there is no doubt that a good deal of the rebalancing achieved so far has come in this manner.  However, judging by the entirety of labor market data, including the rock-bottom level of initial claims, the fact that labor force participation already appears to be about as high as it can sustainably go, and the extremely aggressive demands of unions in a series of industries so far this year, I struggle to believe that wage gains are going to recede back to a pace consistent with 2% inflation without creating at least a modest amount of labor market slack. It is worth noting that average hourly earnings year-to-date are still rising at better than a 4% annualized rate, and the ECI and Atlanta Fed wage tracker gauges, while also decelerating, are running significantly higher than that.

In any case, the most striking aspect of the new FOMC economic projections is that the sharply stronger growth and labor market estimates were accompanied by unchanged inflation forecasts for 2024 and 2025.  It would appear that the FOMC saw the economic data for the last three months, when growth outperformed expectations while inflation came in softer than forecast and concluded that this happy combination will continue indefinitely.

I will not repeat here all of the detailed analysis of the inflation data that I have laid out in CPI and PCE deflator recaps in recent months, but drawing broad conclusions based on the last three months’ data seems dicey.  The bulk of the recent slowdown in core inflation has come in the most volatile categories.  In particular, used vehicle prices and airfares accounted for much of the softness.  However, the wholesale auction data on used vehicle prices have already turned higher, signaling a swing in the CPI component before the end of the year (and that’s before any fallout from the UAW strike), and airfares are likely to follow jet fuel prices higher in the months ahead as well.

It is striking that the FOMC has, in the parlance of economists, revised down the assessment of the sacrifice ratio to essentially zero.  Everyone looking to lose 10 or 20 pounds should take note.  Apparently, “no pain, no gain” is no longer operative.

Another sacrifice ratio

There is another relationship similar to the “sacrifice ratio” for which the latest FOMC projections signal a massive recalculation, the potency of monetary policy.

You may remember that at the beginning of 2022, a few months before liftoff, the prevailing view in the financial markets was that the Fed would not be able to raise its policy rate above 2% without causing a severe recession.  Similarly, at that time, the FOMC dot projections had the funds rate remaining below the committee’s median assessment of long-run neutrality, 2.50%, through the end of 2024.

Of course, that view of the sensitivity of the economy to higher interest rates proved woefully inaccurate.  As things stand, the Fed has hiked rates above 5% and expects to keep them there through the end of 2024.  Moreover, the median dots for 2024, 2025, and 2026 in Wednesday’s new projections are all above the median assessment of neutrality, which is still 2.50%.  So, monetary policy is already restrictive, a point that Powell emphasized multiple times at his press conference Wednesday, and is forecast to remain so for more than three years.

How does that translate economically?  The restrictiveness of policy is said by Powell and the FOMC to be the force driving inflation down to 2%.  And yet, that extraordinary stretch of tight monetary policy merely generates trend real GDP growth and allows the labor market to tread water at full employment.

The Fed’s unrealistically optimistic economic outlook not only points to a decoupling of inflation from the economy and the labor market but also suggests that an extended period of very tight monetary policy would merely keep the economy from overheating further.  Think of the image of a motor vehicle traveling downhill where the driver has to stand on the brake just to prevent an accelerating speed (I did some driving in Colorado this summer, so I experienced this dynamic first hand).

This analogy is actually a good one, though it may not be the one that the Fed has in mind.  The lingering effects of pandemic-era fiscal stimulus and labor shortages have exerted powerful tailwinds for the economy this year.  I do not believe that Fed policy has entirely lost its sting.  Rather, the Fed has needed to apply the brakes pretty hard just to prevent the economy from accelerating further due to non-monetary stimulative forces.  If those tailwinds were to dissipate suddenly, which I do not expect, then the current monetary policy setting would likely slow the economy down pretty quickly.  In any case, circling back to where we started, Chair Powell has told us that we actually need to slow the car and the economy down to prevent the engine from overheating, but the committee is now forecasting instead that the car will coast along at its current speed for three years.

At the risk of overreaching on this analogy, I would conclude by predicting that if the FOMC is right about the growth and unemployment forecasts for 2023 and 2024, then Chair Powell and company are going to have to hit the brakes harder.  I am quite confident that if the FOMC’s median projections for real GDP and unemployment are realized, then inflation will be higher than Fed officials are forecasting and that more rate hikes will be required as well as a later beginning to rate cuts.  My own policy forecast is broadly similar to the FOMC’s, but only because I expect the economy to trace out something close to the FOMC’s June projections rather than September’s estimates.

Stephen Stanley
stephen.stanley@santander.us
1 (203) 428-2556

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