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Surprisingly Strong CPI Report

Photo courtesy of Lena Buonanno.

As we’ve discussed in several blog posts (for instance, here and here), recent macro data have been consistent with the Federal Reserve being close to achieving a soft landing. The Fed’s increases in its target for the federal funds rate have slowed the growth of aggregate demand sufficiently to bring inflation closer to the Fed’s 2 percent target, but haven’t, to this point, slowed the growth of aggregate demand so much that the U.S. economy has been pushed into a recession.

By January 2024, many investors in financial markets and some economists were expecting that at its meeting on March 19-20, the Fed’s Federal Open Market Committee would be cutting its target for the federal funds. However, members of the committee—notably, Chair Jerome Powell—have been cautious about assuming prematurely that inflation had, in fact, been brought under control. In fact, in his press conference on January 31, following the committee’s most recent meeting, Powell made clear that the committee was unlikely to reduce its target for the federal funds rate at its March meeting. Powell noted that “inflation is still too high, ongoing progress in bringing it down is not assured, and the path forward is uncertain.”

Powell’s caution seemed justified when, on February 2, the Bureau of Labor Statistics (BLS) released its most recent “Employment Situation Report” (discussed in this post). The report’s data on growth in employment and growth in wages, as measured by the change in average hourly earnings, might be indicating that aggregate demand is growing too rapidly for inflation to continue to decline.

The BLS’s release today (February 13) of its report on the consumer price index (CPI) (found here) for January provided additional evidence that the Fed may not yet have put inflation on a firm path back to its 2 percent target. The average forecast of economists surveyed before the release of the report was that the increase in the version of the CPI that includes the prices of all goods and services in the market basket—often called headline inflation—would be 2.9 percent. (We discuss how the BLS constructs the CPI in Macroeconomics, Chapter 9, Section 19.4, Economics, Chapter 19, Section 19.4, and Essentials of Economics, Chapter 3, Section 13.4.) As the following figure shows, headline inflation for January was higher than expected at 3.1 percent (measured by the percentage change from the same month in the previous year), while core inflation—which excludes the prices of food and energy—was 3.9 percent. Headline inflation was lower than in December 2023, while core inflation was almost unchanged.

Although the values for January might seem consistent with a gradual decline in inflation, that conclusion may be misleading. Headline inflation in January 2023 had been surprisingly high at 6.4 percent. Hence, the comparision between the value of the CPI in January 2024 with the value in January 2023 may be making the annual CPI inflation rate seem artificially low. If we look at the 1-month inflation rate for headline and core inflation—that is the annual inflation rate calculated by compounding the current month’s rate over an entire year—the values are more concerning, as indicated in the following figure. Headline CPI inflation is 3.7 percent and core CPI inflation is 4.8 percent.

Even more concerning is the path of inflation in the prices of services. Chair Powell has emphasized that as supply chain problems have gradually been resolved, inflation in the prices of goods has been rapidly declining. But inflaion in services hasn’t declined nearly as much. Last summer he stated the point this way:

“Part of the reason for the modest decline of nonhousing services inflation so far is that many of these services were less affected by global supply chain bottlenecks and are generally thought to be less interest sensitive than other sectors such as housing or durable goods. Production of these services is also relatively labor intensive, and the labor market remains tight. Given the size of this sector, some further progress here will be essential to restoring price stability.”

The following figure shows the 1-month inflation rate in services prices. The figure shows that inflation in services has been above 4 percent in every month since July 2023. Inflation in services was a very high 8.7 percent in January. Clearly such large increases in the prices of services aren’t consistent with the Fed meeting its 2 percent inflation target.

How should we interpret the latest CPI report? First, it’s worth bearing in mind that a single month’s report shouldn’t be relied on too heavily. There can be a lot of volatility in the data month-to-month. For instance, inflation in the prices of services jumped from 4.7 percent in December to 8.7 percent in January. It seems unlikely that inflation in the prices of services will continue to be over 8 percent.

Second, housing prices are a large component of service prices and housing prices can be difficult to measure accurately. Notably, the BLS includes in its measure the implicit rental price that someone who owns his or her own home pays. The BLS calculates that implict rental price by asking consumers who own their own homes the following question: “If someone were to rent your home today, how much do you think it would rent for monthly, unfurnished and without utilities?” (The BLS discusses how it measures the price of housing services here.) In practice, it may be difficult for consumers to accurately answer the question if very few houses similar to theirs are currently for rent in their neighborhood.

Third, the Fed uses the personal consumption expenditures (PCE) price index, not the CPI, to gauge whether it is achieving its 2 percent inflation target. The Bureau of Economic Analysis (BEA) includes the prices of more goods and services in the PCE than the BLS includes in the CPI and measures housing services using a different approach than that used by the BLS. Although inflation as measured by changes in the CPI and as measured by changes in the PCE move roughly together over long periods, the two measures can differ significantly over a period of a few months. The difference between the two inflation measures is another reason not to rely too heavily on a single month’s CPI data.

Despite these points, investors on Wall Street clearly interpreted the CPI report as bad news. Investors have been expecting that the Fed will soon cut its target for the federal funds rate, which should lead to declines in other key interest rates. If inflation continues to run well above the Fed’s 2 percent target, it seems likely that the Fed will keep its federal funds target at its current level for longer, thereby slowing the growth of aggregate demand and raising the risk of a recession later this year. Accordingly, the Dow Jones Industrial Average declined by more than 500 points today (February 13) and the interest rate on the 10-year Treasury note rose above 4.3 percent.

The FOMC has more than a month before its next meeting to consider the implications of the latest CPI report and the additional macro data that will be released in the meantime.

Is It Spring Yet?

The Economics of Apple’s Vision Pro

Photo from apple.com.

On Friday, February 2, Apple released Vision Pro, its long-awaited, much discussed virtual reality (VR) headset. The Vision Pro headset allows users to experience either VR, in which the user sees only virtual objects, as for instance when the user sees only images from a video game; or augmented reality (AR), in which the user sees virtual objects, such as icon apps or web pages superimposed on the real world (as in the two photos below). Apple refers to people using the headsets as being engaged in “spatial computing” and sometimes refers to the headsets as “face computers.”

Photo from Apple via the Wall Street Journal.

Photo from Apple via the Wall Street Journal.

Vision Pro has a price of $3,499, which can increase to more than $4,000 when including the cost of the insert necessary for anyone who wears prescription eyeglasses or contact lenses and who chooses to buy additional storage capacity. The price is much higher than Meta’s Quest Pro VR headset (shown in the photo below), which has a price of $999.

Photo from meta.com.

In this post, we can briefly discuss some of the economic issues raised by the Vision Pro. First, why would Apple charge such a high price? In her review of the Vision Pro in the Wall Street Journal, Joanna Stern, the site’s personal technology writer, speculated that: “You’re probably not going to buy the $3,500 Apple Vision Pro. Unless you’re an app developer or an Apple die-hard ….”

There are several reasons why Apple may believe that a price of $3,499 is profit maximizing. But we should bear in mind that pricing any new product is difficult because firms lack good data on the demand curve and are unsure how consumers will respond to changes in price. In our new ninth edition of Economics and Microeconomics, in Chapter 6 on price elasticity we discuss how Elon Musk and managers at Tesla experimented with the cutting the price of the Model 3 car as they attempted to discover the effect on price changes on the quantity demanded. Managers at Apple are in similar situation of lacking good data on how many headsets they are likely to sell at $3,499.

If Apple lacks good data on how consumers are likely to respond to different prices, why pick a price four times as high as Meta is charging for its Quest Pro VR headsets?

First, Apple expects to be able to clearly differentiate its headset from Meta’s headset. If consumers considered the two headsets to be close substitutes, the large price difference would make it unlikely that Apple would sell many headsets. Apple has several marketing advantages over Meta that make it likely that Apple can convince many consumers that the Meta headset is not a close substitute for the Vision Pro:

Apple has a history of selling popular electronic products, such as the iPhone, iPad, Air Pods, and the Apple Watch. It also owns the most popular app store. Apple has succeeded in seamlessly integrating these electronic products with each other and with use of the app store. As a result, a significant number of consumers have a strong preference for Apple products over competitors. Meta has a much more limited history of selling popular electronic products. For instance, it doesn’t produce its own smartphone.
Apple has an extensive network of retail stores inside and outside of the United States. The stores have been successful in giving consumers a chance to try a new electronic product before buying it and to receive help at the stores’ Genius Bars with setting up the device or dealing with any later problems. Meta operates few retail stores, relying instead on selling through other retailers, such as Best Buy, or through its online site. For some consumers Meta’s approach is less desirable than Apple’s.

Second, as we discuss in Economics and Microeconomics, Chapter 15, Section 15.5, charging a high price for a new electronic product is common, partly because doing so allows firms to price discriminate across time. With this strategy, firms charge a higher price for a product when it is first introduced and a lower price later. Some consumers are early adopters who will pay a high price to be among the first to own certain new products. Early adopers are a particularly large segment of buyers of Apple products, with long lines often forming at Apple stores on the days when a new product is released. That firms price discriminate over time helps explain why products such as Blu-ray players and 4K televisions sold for very high prices when they were first introduced. After the demand of the early adopters was satisfied, the companies reduced prices to attract more price-sensitive customers. For example, the price of Blu-ray players dropped by 95 percent within five years of their introduction. Similarly, we can expect that Apple will cut the price of Vision Pro significantly over time.

Third, because Apple is initially producing a relatively small number of units, it is likely experiencing a high average cost of producing the Vision Pro. The production of the components of the headset and the final assembly are likely to be subject to large economies of scale. (We discuss economies of scale in Economics and Microeconomics, Chapter 11, Section 11.6.) Apple hasn’t released information on how many units of the headset it intends to produce during 2024, but estimates are that it will be fewer than 400,000 and perhaps as few as 180,000. (Estimates can be found here, here, and here.) Compare that number to the 235 million iPhones Apple sold during 2023. We would expect as Apple’s suppliers increase their production runs, the average cost of production will decline as Apple moves down its long-run average cost curve. As a result, over time Apple is likely to cut the price.

In addition, when producing a new good, firms often experience learning as managers better understand the most efficient way to produce and assemble the new good. For example, the best method of assembling iPhones may not be the best method of assembling headsets, but this fact may only become clear after assembling several thousand headsets. Apple is likely to experience a learning curve with the average cost of producing headsets declining as the total number of headsets produced increases. While economies of scale involve a movement down a static long-run average cost curve, learning results in the long-run average cost curve shifting down. This second reason why Apple’s average cost of producing headsets will decline contributes to the liklihood that Apple will cut the price of the Vision Pro over time.

Finally, we can discuss a key factor that will determine how successful Apple is in selling headsets. In Chapter 11 of the new ninth edition of Economics and Microeconomics, we have a new Apply the Concept, “Mark Zuckerberg … Alone in the Metaverse?” In that feature, we note that Meta CEO Mark Zuckerberg has invested heavily in the metaverse, a word that typically means software programs that allow people to access either AR or VR images and information. Zuckerberg believed so strongly in the importance of the metaverse that he changed the name of the company from Facebook to Meta. The metaverse, which is accessed using headsets likes Meta’s Quest Pro or Apple’s Vision Pro, is subject to large network externalities—the usefulness of the headsets increases with the number of consumers who use them. The network externalities arise because many software applications, such as Meta’s Horizon World, depend on interactions among users and so are not very useful when there aren’t many users.

Meta hasn’t sold as many headsets as they expected because they have had difficulty attracting enough users to make their existing software useful and the failure to have enough users has reduced the incentive for other firms to develop apps for Meta’s headsets. Initially, some reviewers made similar comments about Apple’s Vision Pro. For instance, even though streaming films in 3D is one of the uses that Apple promotes, some streaming services, including Netflix and YouTube, have not yet released apps for Vision Pro. Some important business related apps, such as FaceTime and Zoom, aren’t yet available. There are also currently no workout apps. As one reviewer put it “there are few great apps” for Vision Pro. Another reviewer wondered whether the lack of compelling software and apps might result in the Vision Pro headset suffering the fate of “every headset I test [which] ends up in my closet collecting dust.”

So, a key to the success of the Vision Pro will be the ability of Apple to attract enough users to exploit the network externalities that exist with VR/AR headsets. If successful, the Vision Pro may represent an important development in the transition to spatial computing.

A Sign of the (Digital) Times

An issue of the American Economic Review celebrating the 100th anniversary of the journal in 2011.

The American Economic Association (AEA) was founded in 1885 and is the leading organization of business and academic economists in the United States. It first began publishing the American Economic Review (AER) in 1911. The AER remains the leading academic economic journal in the United States. Like most other academic journals, in recent years the AER has been available in both digital format and in paper copies mailed to subscribers. In January 2024, the AEA announced that the paper version of the journal will soon end:

“The AEA will phase out print journals over the next year by no longer offering print subscriptions for members and institutional subscribers as of February 1. Existing print subscriptions for members and institutions will be honored through January 2025 but will be unable to be renewed.”

The transition of the AER from a paper-only to a digital-only format has been a long one, strecthing over three decades. The tranisition began in the 1990s when the development of the internet made electronic publishing feasible. An important step in making academic journals available electronically was the establishment by William Bowen of the Mellon Foundation of JSTOR in 1994. JSTOR was intended to make electronic versions of back issues of academic journals available inexpensively to libraries and other institutions.

Typically, at the end of a year, libraries would send the issues of academic journals published during that year to be bound into volumes. The libraries would then put the volumes on library shelves making them available to faculty, students, and researchers. University libraries that subscribed to large numbers of academic journals found that over time they were devoting more and more space to shelving bound volumes of academic journals. Many libraries began storing the volumes off site in warehouses, making the volumes less accessible to faculty and students. JSTOR made it possible for libraries to store back issues of journals electronically rather than physically. Many academic societies, like the AEA, were happy to allow JSTOR to make electronic copies of the back issues of their journals. Although academic societies often fund their activities in part from subscriptions to their journals, the societies earned little or no revenue from back issues of their journals.

During the 1990s, the AEA and other academic societies began to make current issues of some journals available on CD-ROMs as more factulty began to use personal computers that had those drives available. Many faculty—including Glenn and Tony!—found the CD-ROM versions of journal issues a little awkward and time consuming to use. CD-Roms never became an important way of distributing journal issues to subscribers. (This article published in 1997 by Hal Varian, who was then at the University of California, Berkeley and is now the chief economist at Google, provides an interesting discuss of the AEA’s first steps toward transitioning its journals to electronic formats.)

By the 2000s, the AEA was offering subscribers to the AER the choice of electronic-only subscriptions—with issues available for download on the AEA’s website—or electronic access along with print copies at a higher annual price. This model was one widely used by non-academic magazines and newspapers. As the number of subscribers receiving print copies of the AER dwindled, the leadership of the AEA eventually decided to eliminate print copies, as indicated in the announcement quoted at the beginning of this post.

For better or worse, in most fields, print copies of academic journals seem to be well on their way to extinction.

Surprisingly Strong Jobs Report

Photo courtesy of Lena Buonanno.

This morning of Friday, February 2, the Bureau of Labor Statistics (BLS) issued its “Employment Situation Report” for January 2024. Economists and policymakers—notably including the members of the Fed’s Federal Open Market Committee (FOMC)—typically focus on the change in total nonfarm payroll employment as recorded in the establishment, or payroll, survey. That number gives what is generally considered to be the best gauge of the current state of the labor market.

Economists surveyed in the past few days by business news outlets had expected that growth in payroll employment would slow to an increase of between 180,000 and 190,000 from the increase in December, which the BLS had an initially estimated as 216,00. (For examples of employment forecasts, see here and here.) Instead, the report indicated that net employment had increased by 353,000—nearly twice the expected amount. (The full report can be found here.)

In this previous blog post on the December employment report, we noted that although the net increase in employment in that month was still well above the increase of 70,000 to 100,000 new jobs needed to keep up with population growth, employment increases had slowed significantly in the second half of 2023 when compared with the first.

That slowing trend in employment growth did not persist in the latest monthly report. In addition, to the strong January increase of 353,000 jobs, the November 2023 estimate was revised upward from 173,000 jobs to 182,000 jobs, and the December estimate was substantially revised from 216,000 to 333,000. As the following figure from the report shows, the net increase in jobs now appears to have trended upward during the last three months of 2023.

Economists surveyed were also expecting that the unemployment rate—calculated by the BLS from data gathered in the household survey—would increase slightly to 3.8 percent. Instead, it remained constant at 3.7 percent. As the following figure shows, the unemployment rate has been remarkably stable for more than two years and has been below 4.0 percent each month since December 2021. The members of the FOMC expect that the unemployment rate during 2024 will be 4.1 percent, a forcast that will be correct only if the demand for labor declines significantly over the rest of the year.

The “Employment Situation Report” also presents data on wages, as measured by average hourly earnings. The growth rate of average hourly earnings, measured as the percentage change from the same month in the previous year, had been slowly declining from March 2022 to October 2023, but has trended upward during the past few months. The growth of average hourly earnings in January 2024 was 4.5 percent, which represents a rise in firms’ labor costs that is likely too high to be consistent with the Fed succeeding in hitting its goal of 2 percent inflation. (Keep in mind, though, as we note in this blog post, changes in average hourly earnings have shortcomings as a measure of changes in the costs of labor to businesses.)

Taken together, the data in today’s “Employment Situation Report” indicate that the U.S. labor market remains very strong. One implication is that the FOMC will almost certainly not cut its target for the federal funds rate at its next meeting on March 19-20. As Fed Chair Jerome Powell noted in a statement to reporters after the FOMC earlier this week: “The Committee does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2 percent. We will continue to make our decisions meeting by meeting.” (A transcript of Powell’s press conference can be found here.) Today’s employment report indicates that conditions in the labor market may not be consistent with a further decline in price inflation.

It’s worth keeping several things in mind when interpreting today’s report.

The payroll employment data and the data on average hourly earnings are subject to substantial revisions. This fact was shown in today’s report by the large upward revision in net employment creation in December, as noted earlier in this post.
A related point: The data reported in this post are all seasonally adjusted, which means that the BLS has revised the raw (non-seasonally adjusted) data to take into account normal fluctuations due to seasonal factors. In particular, employment typically increases substantially during November and December in advance of the holiday season and then declines in January. The BLS attempts to take into account this pattern so that it reports data that show changes in employment during these months holding constant the normal seasonal changes. So, for instance, the raw (non-seasonally adjusted) data show a decrease in payroll employment during January of 2,635,000 as opposed to the seasonally adjusted increase of 353,000. Over time, the BLS revises these seasonal adjustment factors, thereby also revising the seasonally adjusted data. In other words, the BLS’s initial estimates of changes in payroll employment for these months at the end of one year and the beginning of the next should be treated with particular caution.
The establishment survey data on average weekly hours worked show a slow decline since November 2023. Typically, a decline in hours worked is an indication of a weakening labor market rather than the strong labor market indicated by the increase in employment. But as the following figure shows, the data on average weekly hours are noisy in that the fluctuations are relatively large, as are the revisons the BLS makes to these data over time.

4. In contrast to today’s jobs report, other labor market data seem to indicate that the demand for labor is slowing. For instance, quit rates—or the number of people voluntarily leaving their jobs as a percentage of the total number of people employed—have been declining. As shown in the following figure, the quit rate peaked at 3.0 percent in November 2021 and March 2022, and has declined to 2.2 percent in December 2023—a rate lower than just before the beginning of the Covid–19 pandemic.

Similarly, as the following figure shows, the number of job openings per unemployed person has declined from a high of 2.0 in March 2022 to 1.4 in December 2023. This value is still somewhat higher than just before the beginning of the Covid–19 pandemic.

To summarize, recent data on conditions in the labor market have been somewhat mixed. The strong increases in net employment and in average hourly earnings in recent months are in contrast with declining average number of hours worked, a declining quit rate, and a falling number of job openings per unemployed person. Taken together, these data make it likely that the FOMC will be in no hurry to cut its target for the federal funds rate. As a result, long-term interest rates are also likely to remain high in the coming months. The following figure from the Wall Street Journal provides a striking illustration of the effect of today’s jobs report on the bond market, as the interest rate on the 10-year Treasury note rose above 4.0 percent for the first time in more than a month. The interest rate on the 10-year Treasury note plays an important role in the financial system, influencing interest rates on mortgages and corporate bonds.

FOMC Meeting: Steady as She Goes

Federal Reserve Chair Jerome Powell (Photo from the New York Times.)

This afternoon, Wednesday, January 31, the Federal Reserve’s Federal Open Market Committee (FOMC) held the first of its eight scheduled meetings during 2024. As we noted in a recent post, macroeconomic data have been indicating that the Fed is close to achieving its goal of bringing the U.S. economy in for a soft landing—reducing inflation down to the Fed’s 2 percent target without pushing the economy into a recession. But as we also noted in that post, it was unlikely that at this meeting Fed Chair Jerome Powell and the other members of the FOMC would declare victory in their fight to reduce inflation from the high levels it reached during 2022.

In fact, in Powell’s press conference following the meeting, when asked directly by a reporter whether he believed that the economy had made a safe landing, Powell said that he wasn’t yet willing to draw that conclusion. Accordingly, the committee kept its target range for the federal funds rate unchanged at 5.25 percent to 5.50 percent. This was the fifth meeting in a row at which the FOMC had left the target unchanged. Although some policy analysts expect that the FOMC might reduce its federal funds rate target at its next meeting in March, the committee’s policy statement made that seem unlikely:

“In considering any adjustments to the target range for the federal funds rate, the Committee will carefully assess incoming data, the evolving outlook, and the balance of risks. The Committee does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2 percent.”

Powell reinforced the point during his press conference by stating it was unlikely that the committee would cut the target rate at the next meeting. He noted that:

“The economy has surprised forecasters in many ways since the pandemic, and ongoing progress toward our 2 percent inflation objective is not assured. The economic outlook is uncertain, and we remain highly attentive to inflation risks. We are prepared to maintain the current target range for the federal funds rate for longer, if appropriate.”

Powell highlighted a couple of areas of potential concern. The Fed gauges its progress towards achieving its 2 percent inflation goal using the percentage change in the personal consumption expenditures (PCE) price index. As we noted in a recent post, PCE inflation has declined from a high of 7.1 percent in June 2022 to 2.9 percent in December 2023. But Powell noted that PCE inflation in goods has followed a different path from PCE inflation in services, as the following figure shows.

Inflation during 2022 was much greater in the prices of goods than in the prices of services, reflecting the fact that supply chain disruptions caused by the pandemic had a greater effect on goods than on services. Inflation in goods has been less than 1 percent every month since June 2023 and has been negative in three of those months. Inflation in services peaked in February 2023 at 6.0 percent and has been declining since, but was still 3.9 percent in December. Powell noted that the very low rates of inflation in the prices of goods probably aren’t sustainable. If inflation in the prices of goods increases, the Fed may have difficulty achieving its 2 percent inflation target unless inflation in the prices of services slows.

Powell also noted that the most recent data on the employment cost index (ECI) had been released the morning of the meeting. The ECI is compiled by the Bureau of Labor Statistics and is published quarterly. It measures the cost to employers per employee hour worked. The BLS publishes data that includes only wages and salaries and data that includes, in addition to wages and salaries, non-wage benefits—such as contributions to retirement accounts or health insurance—that firms pay workers. The figure below shows the percentage change from the same month in the previous year for the ECI including just wages and salaries (blue line) and for the ECI including all compensation (red line). Although ECI inflation has declined significantly from its peak in he second quarter of 2022, in the fourth quarter of 2023, both measures of ECI inflation were above 4 percent. Wages increasing at that pace may not be consistent with a 2 percent rate of price inflation.

Powell’s tone at his news conference (which can be watched here) was one of cautious optimism. He and the other committee members expect to be able to cut the target for the federal funds rate later this year but remain on guard for any indications that the inflation rate is increasing again.

Has the Federal Reserve Achieved a Soft Landing?

The Federal Reserve building in Washington, DC. (Photo from the New York Times.)

Since inflation began to increase rapidly in the late spring of 2021, the key macroeconomic question has been whether the Fed would be able to achieve a soft landing—pushing inflation back to its 2 percent target without causing a recession. The majority of the members of the Fed’s Federal Open Market Committee (FOMC) believed that increases in inflation during 2021 were largely caused by problems with supply chains resulting from the effects of the Covid–19 pandemic.

These committee members believed that once supply chains returned to normal, the increase in he inflation rate would prove to have been transitory—meaning that the inflation rate would decline without the need for the FOMC to pursue a contractionary monetary by substantially raising its target range for the federal funds rate. Accordingly, the FOMC left its target range unchanged at 0 to 0.25 percent until March 2022. As the following figure shows, by that time the inflation rate had increased to 6.9 percent, the highest it had been since January 1982. (Note that the figure shows inflation as measured by the percentage change from the same month in the previous year in the personal consumption expenditures (PCE) price index. Inflation as measured by the PCE is the gauge the Fed uses to determine whether it is achieving its goal of 2 percent inflation.)

By the time inflation reached its peak in mid-2022, many economists believed that the FOMC’s decision to delay increasing the federal funds rate until March 2022 had made it unlikely that the Fed could return inflation to 2 percent without causing a recession. But the latest macroeconomic data indicate that—contrary to that expectation—the Fed does appear to have come very close to achieving a soft landing. On January 26, the Bureau of Economic Analysis (BEA) released data on the PCE for December 2023. The following figure shows for the period since 2015, inflation as measured by the percentage change in the PCE from the same month in the previous year (the blue line) and as measured by the percentage change in the core PCE, which excludes the prices of food and energy (the red line).

The figure shows that PCE inflation continued its decline, falling slightly in December to 2.6 percent. Core PCE inflation also declined in December to 2.9 percent from 3.2 percent in November. Note that both measures remained somewhat above the Fed’s inflation target of 2 percent.

If we look at the 1-month inflation rate—that is the annual inflation rate calculated by compounding the current month’s rate over an entire year—inflation is closer to Fed’s target, as the following figure shows. The 1-month PCE inflation rate has moved somewhat erratically, but has generally trended down since mid-2022. In December, PCE inflation increased from from –0.8 percent in November (which acutally indicates that deflation occurred that month) to 2.0 percent in December. The 1-month core PCE inflation rate has moved less erratically, also trending down since mid-2022. In December, the 1-month core PCE inflation increased from 0.8 percent in November to 2.1 percent in December. In other words, the December reading on inflation indicates that inflation is very close to the Fed’s target.

The following figure shows for each quarter since the beginning of 2015, the growth rate of real GDP measured as the percentage change from the same quarter in the previous year. The figure indicates that although real GDP growth dropped to below 1 percent in the fourth quarter of 2022, the growth rate rose during each quarter of 2023. The growth rate of 3.1 percent in the fourth quarter of 2023 remained well above the FOMC’s 1.8 percent estimate of long-run economic growth. (The average of the members of the FOMC’s estimates of the long-run growth rate of real GDP can be found here.) To this point, there is no indication from the GDP data that the U.S. economy is in danger of experiencing a recession in the near future.

The labor market also shows few signs of a recession, as indicated by the following figure, which shows the unemployment rate in the months since January 2015. The unemployment rate has remained below 4 percent in each month since December 2021. The unemployment rate was 3.7 percent in December 2023, below the FOMC’s projection of a long-run unemployment rate of 4.1 percent.

The FOMC’s next meeting is on Tuesday and Wednesday of this week (February 1-2). Should we expect that at that meeting Fed Chair Jerome Powell will declare that the Fed has succeeded in achieving a soft landing? That seems unlikely. Powell and the other members of the committee have made clear that they will be cautious in interpreting the most recent macroeconomic data. With the growth rate of real GDP remaining above its long run trend and the unemployment rate remaining below most estimates of the natural rate of unemployment, there is still the potential that aggregate demand will increase at a rate that might cause the inflation rate to once again rise.

In a speech at the Brookings Institution on January 16, Fed Governor Christopher Waller echoed what appear to be the views of most members of the FOMC:

“Time will tell whether inflation can be sustained on its recent path and allow us to conclude that we have achieved the FOMC’s price-stability goal. Time will tell if this can happen while the labor market still performs above expectations. The data we have received the last few months is allowing the Committee to consider cutting the policy rate in 2024. However, concerns about the sustainability of these data trends requires changes in the path of policy to be carefully calibrated and not rushed. In the end, I am feeling more confident that the economy can continue along its current trajectory.”

At his press conference on February 1, following the FOMC meeting, Chair Powell will likely provide more insight into the committee’s current thinking.

Solved Problem: The Houthis and the Price Elasticity of Demand for Shipping

Map from the Wall Street Journal.

Supports: Microeconomics and Economics Chapter 6, Section 6.2 and Esstentials of Economics, Chapter 7, Section 7.6.

The Houthis, a rebel group based in Yemen, have been attacking shipping in the Red Sea, which freighters sail through after exiting the Suez Canal. About 30 percent of global shipping travels through the Suez Canal. An article in the Financial Times noted that maritime insurance firms have increased their charges for insuring freight passing through the Suez Canal by about $6,000 per container.” The article also noted that: “Freight demand is price inelastic in the short run and transport isn’t a big part of overall costs.” And that “the average container holds about $100,000 worth of goods wholesale, which will be sold at destination for $300,000.”

Is there a connection between the observation that freight demand is price inelastic and the observation that the charge for transporting goods isn’t a large fraction of the price of the goods shipped by container? Briefly explain.
The article notes that the main alternative to transporting freight by ship is to transport it by air, but if only 1 percent of freight sent by ship were to be sent by air instead, all the available flight capacity would be filled. Does this fact also have relevance to explaining the price inelasticity of demand for transporting freight by ship? Briefly explain.

Solving the Problem

Step 1: Review the chapter material. This problem is about the determinants of the price elasticity of demand, so you may want to review Microeconomics and Economics, Chapter 6, Section 6.2 (Essentials of Economics, Chapter 7, Section 7.6), “The Determinants of the Price Elasticity of Demand and Total Revenue.”

Step 2: Answer part a. by explaining why the small fraction that transportation is of the total price of the goods in a container of freight makes it more likely that the demand for shipping is price inelastic in the short run. This section of the chapter notes that goods and services that are only a small fraction of a consumer’s budget tend to have less elastic demand than do goods and services that are a large faction. In this case, the consumer is a firm shipping freight. Because the $6,000 increase per container in the cost of shipping freight makes up only 2 percent of the dollar amount the freight can be sold for, shippers are likely not to significantly reduce the quantity of shipping services they demand. Note, though, that the article refers to the price elasticity of freight demand “in the short run.” It’s possible that over a longer period of time the market for transporting freight by ship may adjust by, for instance, firms offering to ship freight by air increasing their capacity and lowering their prices. In that case, the price elasticity of demand for transporting freight by ship will be higher in the long run than in the short tun.

Step 3: Answer part b. by explaining whether the limited amount of available capacity for sending freight by air may help explain why the demand for sending freight by ship is price inelastic. This section of the chapter notes that the most important determinant of the price elasticity of demand for a good or service is the availability of close substitutes. That there is only a small amount of unused capacity to transport goods by air indicates that transporting goods by air is not a close substitute for transporting goods by sea. Therefore, we would expect that this factor contributes to the demand for transporting goods by sea being price inelastic in the short run.

Another Middling Inflation Report

Photo courtsey of Lena Buonanno.

On the morning of January 11, 2024, the Bureau of Labor Statistics released its report on changes in consumer prices during December 2023. The report indicated that over the period from December 2022 to December 2023, the Consumer Price Index (CPI) increased by 3.4 percent (often referred to as year-over-year inflation). “Core” CPI, which excludes prices for food and energy, increased by 3.9 percent. The following figure shows the year-over-year inflation rate since Januar 2015, as measured using the CPI and core CPI.

This report was consistent with other recent reports on the CPI and on the personal consumption expenditures (PCE) price index—the measure the Fed uses to gauge whether it is achieving its target of 2 percent annual inflation—in showing that inflation has declined substantially from its peak in mid-2022 but is still above the Fed’s target.

We get a similar result if we look at the 1-month inflation rate—that is the annual inflation rate calculated by compounding the current month’s rate over an entire year—as the following figure shows. The 1-month CPI inflation rate has moved erratically but has generally trended down. The 1-month core CPi inflation rate has moved less erratically, making the downward trend since mid-2022 clearer.

The headline on the Wall Street Journal article discussing this BLS report was: “Inflation Edged Up in December After Rapid Cooling Most of 2023.” The headline reflected the reaction of Wall Street investors who had hoped that the report would unambiguously show further slowing in inflation.

Overall, the report was middling: It didn’t show a significant acceleration in inflation at the end of 2023 but neither did it show a signficant slowing of inflation. At its next meeting on January 30-31, the Fed’s Federal Open Market Committee (FOMC) is expected to keep its target for the federal funds rate unchanged. There doesn’t appear to be anything in this inflation report that would be likely to affect the committee’s decision.

Information, Stock Prices, and Boeing

Agents from the National Transportation Safety Board inspect a piece of the Boeing jetliner found in a backyard in Portland, Oregon. (Photo from the AP via the New York Times.)

What causes movements in stock prices? As we explain in Economics and Microeconomics, Chapter 8, Section 8.2 (Macroeconomics, Essentials of Economics, and Money, Banking, and the Financial System, Chapter 6, Section 6.2): “Shares of stock represent claims on the profits of the firms that issue them. As the fortunes of the firms change and they earn more or less profit, the prices of the stock the firms have issued should also change.”

We also note that: “Many Wall Street investment professionals expend a great deal of effort gathering all possible information about the future profitability of firms, hoping to buy the stocks that are most likely to rise in the future. As a result of the actions of these professional investors, all of the information about a firm that is available on news and financial websites, cable TV business shows, and online discussion sites like X and Reddit is already reflected in the firm’s stock price.” As a consequence, the price of a firm’s stock will change only as a result of new information about the future profitability of the firm issuing the stock.

During the course of a typical week, the new information that becomes available about a large company, like Apple or General Motors, is likely to indicate only minor changes in the future profitability of the firm. Therefore, we wouldn’t expect that the firm’s stock price would change very much. Sometimes, though, investors receive important new information that causes them to significantly revise their expectations of the future profitability of a firm. That’s what happened to Boeing, the jetliner manufacturer, on Friday, January 5. An Alaska Air Boeing 737 Max 9 was taking off from Portland International Airport when a piece of the plane blew out. (A Wall Street Journal article gives the details of the incident.)

The accident caused some industry observers to question whether Boeing’s quality control during manufacturing had deficiencies that might lead to other problems being discovered on the firm’s jetliners. Boeing was particularly at risk of having its quality control methods questioned because in 2019 two slightly different models of the 737 Max airliner had crashed, causing the planes to be grounded for almost two years.

The effect of the Alaska Air incident on Boeing’s stock price can be seen in the following figure, reproduced from the Wall Street Journal. On Friday, January 5 at 4 pm eastern time—the time at which trading on the New York Stock Exchange (NYSE) closes for the day—the price of Boeing’s stock was $249.00 per share. The accident took place at around 7:40 pm eastern time, so it occurred after the close of trading on the NYSE. When trading on the NYSE resumed at 9:30 am on Monday, January 8, Boeing’s stock price had declined to $227.79 per share. The size of the drop in price indicated that investors believed that the Portland accident would have a significantly negative affect on Boeing’s future profitability. Boeing’s profits could fall if the accident leads airlines to reduce their future purchases of 737 Max airliners or if Boeing’s costs rise significantly as a result of making repairs on Max airliners currently in servide or as a result of having to spend more on quality control measures when manufacturing the planes.

The effect of the Portland accident on Boeing’s stock price is an example of the efficiency of the stock market in processing information about a firm’s future profitability.