Category: Macroeconomics

Another Mixed Inflation Report

Fed Chair Jerome Powell and Fed Vice-Chair Philip Jefferson this summer at the Fed conference in Jackson Hole, Wyoming. (Photo from the AP via the Washington Post.)

This morning, the Bureau of Labor Statistics (BLS) released its report on the consumer price index (CPI) for September. (The full report can be found here.) The report was consistent with other recent data showing that inflation has declined markedly from its summer 2022 highs, but appears, at least for now, to be stuck in the 3 percent to 4 percent range—well above the Fed’s 2 percent inflation target. 

The report indicated that the CPI rose by 0.4 percent in September, which was down from 0.6 percent in August. Measured by the percentage change from the same month in the previous year, the inflation rate was 3.7 percent, the same as in August. Core CPI, which excludes the prices of food and energy, increased by 4.1 percent in September, down from 4.4 percent in August. The following figure shows inflation since 2015 measured by CPI and core CPI.

Reporters Gabriel Rubin and Nick Timiraos, writing in the Wall Street Journal summarized the prevailing interpretation of this report:

“The latest inflation data highlight the risk that without a further slowdown in the economy, inflation might settle around 3%—well below the alarming rates that prompted a series of rapid Federal Reserve rate increases last year but still above the 2% inflation rate that the central bank has set as its target.”

As we discuss in this blog post, some economists and policymakers have argued that the Fed should now declare victory over the high inflation rates of 2022 and accept a 3 percent inflation rate as consistent with Congress’s mandate that the Fed achieve price stability. It seems unlikely that the Fed will follow that course, however. Fed Chair Jerome Powell ruled it out in a speech in August: “It is the Fed’s job to bring inflation down to our 2 percent goal, and we will do so.”

To achieve its goal of bringing inflation back to its 2 percent targer, it seems likely that economic growth in the United States will have to slow, thereby reducing upward pressure on wages and prices. Will this slowing require another increase in the Federal Open Market Committe’s target range for the federal funds rate, which is currently 5.25 to 5.50 percent? The following figure shows changes in the upper bound for the FOMC’s target range since 2015.

Several members of the FOMC have raised the possibility that financial markets may have already effectively achieved the same degree of policy tightening that would result from raising the target for the federal funds rate. The interest rate on the 10-year Treasury note has been steadily increasing as shown in the following figure. The 10-year Treasury note plays an important role in the financial system, influencing interest rates on mortgages and corporate bonds. In fact, the main way in which monetary policy works is for the FOMC’s increases or decreases in its target for the federal funds rate to result in increases or decreases in long-run interest rates. Higher long-run interest rates typically result in a decline in spending by consumrs on new housing and by businesses on new equipment, factories computers, and software.

Federal Reserve Bank of Dallas President Lorie Logan, who serves on the FOMC, noted in a speech that “If long-term interest rates remain elevated … there may be less need to raise the fed funds rate.” Similarly, Fed Vice-Chair Philip Jefferson stated in a speech that: “I will remain cognizant of the tightening in financial conditions through higher bond yields and will keep that in mind as I assess the future path of policy.”

The FOMC has two more meetings scheduled for 2023: One on October 31-November 1 and one on December 12-13. The following figure from the web site of the Federal Reserve Bank of Atlanta shows financial market expectations of the FOMC’s target range for the federal funds rate in December. According to this estimate, financial markets assign a 35 percent probability to the FOMC raising its target for the federal funds rate by 0.25 or more. Following the release of the CPI report, that probability declined from about 38 percent. That change reflects the general expectation that the report didn’t substantially affect the likelihood of the FOMC raising its target for the federal funds rate again by the end of the year.

Solved Problem: How Do You Calculate GDP?

Supports: Macroeconomics, Chapter 8, Economics, Chapter 18, and Essentials of Economics, Chapter 12.

In a report, a consulting firm claimed that wealth is a better measure of the financial health of an economy than is GDP. They made the following argument:

“GDP counts items multiple times. For instance, if someone is paid USD 100 for a product/service and they then pay someone else that same USD 100 for another product/service, that adds USD 200 to a country’s GDP, despite the fact that only USD 100 was produced at the start.”

Briefly explain whether you agree with the consulting firm’s argument.

Solving the Problem

Step 1:  Review the chapter material. This problem is about how GDP is calculated, so you may want to review Macroeconomics, Chapter 8, Section 8.1, “Gross Domestic Product Measures Total Production” (Economics, Chapter 18, Section 8.1 and Essentials of Economics, Chapter 12, Section 12.1)

Step 2: Answer the question by explaining whether the consulting firm has correctly explained how the Bureau of Economic Analysis calculates GDP. The consulting firm has given an incorrect explanation of how GDP is calculated, so you should disagree with the firm’s argument. The definition of GDP in the chapter is: “The market value of all final goods and services produced in a country during a period of time.” The quoted excerpt is incorrect in claiming that GDP counts items multiple times. In terms of the example, if you pay $100 for a (very nice!) haircut at a hair salon and the owner of the hair salon uses that $100 to buy groceries, both transactions should be included in GDP because they represent $200 worth of production—a $100 haircut and $100 worth of groceries. Only buying and selling of used goods or of intermediate goods is excluded from GDP. In other words, contrary to the firm’s claim, when the Bureau of Economic Analysis calculates GDP, it doesn’t “count items multiple times.”

H/T Wojtek Kopczuk on X.

Surprisingly Strong Jobs Report

Photo from Lena Buonanno

When the Bureau of Labor Statistics’ Employment Situation report is released on the first Friday of each month economists and policymakers—notably including the members of the Federal Reserve’s Federal Open Market Committee (FOMC)—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 indicator of the current state of the labor market. The most recent report showed a surprisingly strong net increase of 336,000 jobs during September. (The report can be found here.)

According to a survey by the Wall Street Journal, economists had been expecting an net increase in jobs of only 170,000. The larger than expected increase indicated that the economy might be expanding more rapidly than had been thought, raising the possibility that the FOMC might increase its target for the federal funds rate at least once more before the end of the year.

To meet increases in the growth of the U.S. working-age population, the economy needs to increase the total jobs available by approximately 80,000 jobs per month. A net increase of more than four times that amount may be an indication of an overheated job market. As always, one difficulty with drawing that conclusion is determing how many more people might be pulled into the labor market by a strong demand for workers. An increase in labor supply can potentially satisify an increase in labor demand without leading to an acceleration in wage growth and price inflation.

The following figure shows the employment-to-population ratio for workers ages 25 to 54—so-called prime-age workers—for the period since 1985. In September 2023, the ratio was 80.8 perccent, down slightly from 80.9 percent in August, but above the levels reached in early 2020 just before the effects of the Covid–19 pandemic were felt in the United States. The ratio was still below the record high of 81.9 percent reached in April 2000. The population of prime-age workers is about 128 million. So, if the employment-population ratio were to return to its 2000 peak, potentially another 1.3 million prime-age workers might enter the labor market. The likelihood of that happening, however, is difficult to gauge.

A couple of other points about the September employment report. First, it’s worth keeping in mind that the results from the establishment survey are subject to often substantial revisisons. The figure below shows the revisions the BLS has released as of October to their preliminary estimates for each month of 2023. In three of these eight months the revisions so far have been greater than 100,000 jobs. As we discuss in Macroeconomics, Chapter 9, Section 9.1 (Economics, Chapter 19, Section 19.1 and Essentials of Economics, Chapter 13, Section 13.1), the revisions that the BLS makes to its employment estimates are likely to be particularly large when the economy is about to enter a period of significantly lower or higher growth. So, the large revisions to the preliminary employment estimates in most months of 2023 may indicate that the surprisingly large preliminary estimate of a 336,000 increase in net employment will be revised lower in coming months.

Finally, data in the employment report provides some evidence of a slowing in wage growth, despite the sharp increase in employment. The following figure shows wage inflation as measured by the percentage increase in average hourly earnings (AHE) from the same month in the previous year. The increase in September was 4.2 percent, continuing a generally downward trend since March 2022, although still somewhat above wage inflation during the pre-2020 period.

As the following figure shows, September growth in average hourly earnings measured as a compound annual growth rate was 2.5 percent, which—if sustained—would be consistent with a rate of price inflation in the range of the Fed’s 2 percent target.  (The figure shows only the months since January 2021 to avoid obscuring the values for recent months by including the very large monthly increases and decrease during 2020.)

As we note in this blog post, the employment cost index (ECI), published quarterly by the BLS, measures the cost to employers per employee hour worked and can be a better measure than AHE of the labor costs employers face. The first figure shows the percentage change in ECI from the same quarter in the previous year. The second figure shows the compound annual growth rate of the ECI. Both measures show a general downward trend in the growth of labor costs, although the measures are somewhat dated because the most recent values are for the second quarter of 2023.

Ultimately, the key question is one we’ve considered in previous blog posts (most recently here) and podcasts (most recently here): Will the Fed be able to achieve a soft landing by bringing inflation down to its 2 percent target without triggering a recession? The September jobs report can be interpreted as increasing the probability of a soft landing if the slowing in wage growth is emphasized but decreasing the probability if the Fed decides that the strong employment growth is real—that is, the September increase is not likely to be revised sharply lower in coming months—and requires additional increases in the target for the federal funds rate. It’s worth mentioning, of course, that factors over which the Fed has no control, such as a federal government shutdown, rising oil prices, or uncertainty resulting from the attack on Israel by Hamas, will also affect the likelihood of a soft landing.

The Fed Throws Wall Street a Curveball

A trader on the New York Stock Exchange listtening to Fed Chair Jerome Powell (from Reuters via the New York Times)

Accounting for movements in the market prices of stocks and bonds is not an exact exercise. Accounts in the Wall Street Journal and on other business web sites often attribute movements in stock and bond prices to the Fed having acted in a way that investors didn’t expect. 

The decision by the Fed’s Federal Open Market Committee (FOMC) at its meeting on September 20-21, 2023 to hold its target for the federal funds rate constant at a range of 5.25 percent to 5.50 percent wasn’t a surprise. Fed Chair Jerome Powell had signaled during his press conference on July 26 following the FOMC’s previous meeting that the FOMC was likely to pause further increases in the federal funds rate target. (A transcript of Powell’s July 26 press conference can be found here.)

In advance of the September meeting, some other members of the FOMC had also signaled that the committee was unlikely to increase its target. For instance, an article in the Wall Street Journal quoted Susan Collins, president of the Federal Reserve Bank of Boston, as stating that: “The risk of inflation staying higher for longer must now be weighed against the risk that an overly restrictive stance of monetary policy will lead to a greater slowdown than is needed to restore price stability.” And in a speech in August, Raphael Bostic, president of the Federal Reserve Bank of Atlanta, explained his position on future rate increases: “Based on current dynamics in the macroeconomy, I feel policy is appropriately restrictive. I think we should be cautious and patient and let the restrictive policy continue to influence the economy, lest we risk tightening too much and inflicting unnecessary economic pain.”

Although it wasn’t a surprise that the FOMCdecided to hold its target for the federal funds rate constant, after the decision was announced, stock and bond prices declined. The following figure shows the S&P 500 index of stock prices. The index declined 2.8 percent from September 19—the day before the FOMC meeting—to September 22—two days after the meeting. (We discuss indexes of stock prices in Macroeconomics, Chapter 6, Section 6.2; Economics, Chapter 8, Section 8.2; and Essentials of Economics, Chapter 8, Section 8.2.)

We see a similar pattern in the bond market. Recall that when the price of bonds declines in the bond market, the interest rates—or yields—on the bonds increase. As the following figure shows, the interest rate on the 10-year Treasury note rose from 4.37 percent on September 19 to 4.49 percent on September 21. The 10-year Treasury note plays an important role in the financial system, influencing interest rates on mortgages and corporate bonds. So, the yield on the 10-year Treasury note increasing from 3.3 percent in the spring of 2023 to 4.5 percent following the FOMC meeting has the effect of increasing long-term interest rates throughout the U.S. economy.

What explains the movements in the prices of stocks and bonds following the September FOMC meeting? Investors seem to have been surprised by: 1) what Chair Powell had to say in his news conference following the meeting; and 2) the committee members’ Summary of Economic Projections (SEP), which was released after the meeting.

Powell’s remarks were interpreted as indicating that the FOMC was likely to increase its target for the federal funds rate at least once more in 2023 and was unlikely to cut its target before late 2024. For instance, in response to a question Powell said: “We need policy to be restrictive so that we can get inflation down to target. Okay. And we’re going to need that to remain to be the case for some time.” Investors often disagree in their interpretations of what a Fed chair says. Fed chairs don’t act unilaterally because the 12 voting members of the FOMC decide on the target for the federal funds rate. So chairs tend to speak cautiously about future policy. Still, their seemed to be a consensus among investors that Powell was indicating that Fed policy would be more restrictive (or contractionary) than had been anticipated prior to the meeting.

The FOMC releases the SEP four times per year. The most recent SEP before the September meeting was from the June meeting. The table below shows the median of the projections, or forecasts, of key economic variables made by the members of the FOMC at the June meeting. Note the second row from the bottom, which shows members’ median forecast of the federal funds rate.

The following table shows the median values of members’ forecast at the September meeting. Look again at the next to last row. The members’ forecast of the federal funds rate at the end of 2023 was unchanged. But their forecasts for the federal funds rate at the end of 2024 and 2025 were both 0.50 percent higher.

Why were members of the FOMC signaling that they expected to hold their target for the federal funds rate higher for a longer period? The other economic projections in the tables provide a clue. In September, the members expected that real GDP growth would be higher and the unemployment rate would be lower than they had expected in June. Stronger economic growth and a tighter labor market seemed likely to require them to maintain a contractionary monetary policy for a longer period if the inflation rate was to return to their 2.0 percent target. Note that the members didn’t expect that the inflation rate would return to their target until 2026.

9/16/23 Podcast – Authors Glenn Hubbard & Tony O’Brien discuss inflation, the current status of a soft-landing, and the green economy.

Join authors Glenn Hubbard & Tony O’Brien as they discuss the economic landscape of inflation, soft-landings, and the green economy. This conversation occurred on Saturday, 9/16/23, prior to the FOMC meeting on September 19th-20th.

Inflation, Disinflation, Deflation, and Consumers’ Perceptions of Inflation

Inflation has declined, although many consumers are skeptical. What explains consumer skepticism? First we can look at what’s happened to inflation in the period since the beginning of 2015. The figure below shows inflation measured as the percentage change in the consumer price index (CPI) from the same month in the previous year. We show both so-called headline inflation, which includes the prices of all goods and services in the index, and core inflation, which excludes energy and food prices. Because energy and food prices can be volatile, most economists believe that the core inflation provides a better indication of underlying inflation. 

Both measures show inflation following a similar path. The inflation rate begins increasing rapidly in the spring of 2021, reaches a peak in the summer of 2022, and declines from there. Headline CPI peaks at 8.9 percent in June 2022 and declines to 3.7 percent in August 2023. Core inflation reaches a peak of 6.6 percent in September 2022 and declines to 4.4 percent in August 2022.

As we discuss in Macroeconomics, Chapter 15, Section 15.5 (Economics, Chapter 25, Section 25.5, and Essentials of Economics, Chapter 17, Section 17.5), the Fed’s inflation target is stated in terms of the personal consumption expenditure (PCE) price index, not the CPI. The PCE includes the prices of all the goods and services included in the consumption component of GDP. Because the PCE includes the prices of more goods and services than does the CPI, it’s a broader measure of inflation. The following figure shows inflation as measured by the PCE and by the core PCE, which excludes energy and food prices.

Inflation measured using the PCE or the core PCE shows the same pattern as inflation measured using the CPI: A sharp increase in inflation in the spring of 2021, a peak in the summer of 2022, and a decline thereafter.

Although it has yet to return to the Fed’s 2 percent target, the inflation rate has clearly fallen substantially during the past year. Yet surveys of consumers show that majorities are unconvinced that inflation has been declining. A Pew Research Center poll from June found that 65 percent of respondents believe that inflation is “a very big problem,” with another 27 percent believing that inflation is “a moderately big problem.” A Gallup poll from earlier in the year found that 67 percent of respondents thought that inflation would go up, while only 29 percent thought it would go down. Perhaps not too surprisingly, another Gallup poll found that only 4 percent of respondents had a “great deal” of confidence in Federal Reserve Chair Jerome Powell, with another 32 percent having a “fair amount” of confidence. Fifty-four percent had either “only a little” confidence in Powell or “almost none.”

There are a couple of reasons why most consumers might believe that the Fed is doing worse in its fight against inflation than the data indicate. First, few people follow the data releases as carefully as economists do. As a result, there can be a lag between developments in the economy—such as declining inflation—and when most people realize that the development has occurred.

Probably more important, though, is the fact that most people think of inflation as meaning “high prices” rather than “increasing prices.” Over the past year the U.S. economy has experienced disinflation—a decline in the inflation rate. But as long as the inflation rate is positive, the price level continues to increase. Only deflation—a declining price level—would lead to prices actually falling. And an inflation rate of 3 percent to 4 percent, although considerably lower than the rates in mid-2022, is still significantly higher than the inflation rates of 2 percent or below that prevailed during most of the time since 2008.

Although, core CPI and core PCE exclude energy and food prices, many consumers judge the state of inflation by what’s happening to gasoline prices and the price of food in supermarkets. These are products that consumers buy frequently, so they are particularly aware of their prices. The figure below shows the component of the CPI that represents the prices of food consumers buy in groceries or supermarkets and prepare at home. The price of food rose rapidly beginning in the spring of 2021. Althought increases in food prices leveled off beginning in early 2023, they were still about 24 percent higher than before the pandemic.

There is a similar story with respect to gasoline prices. Although the average price of gasoline in August 2023 at $3.84 per gallon is well below its peak of nearly $5.00 per gallon in June 2022, it is still well above average gasoline prices in the years leading up to the pandemic.

Finally, the figure below shows that while percentage increases in rent are below their peak, they are still well above the increases before and immediately after the recession of 2020. (Note that rents as included in the CPI include all rents, not just rental agreements that were entered into that month. Because many rental agreements, particularly for apartments in urban areas, are for one year or more, in any given month, rents as measured in the CPI may not accurately reflect what is currently happening in rental housing markets.)

Because consumers continue to pay prices that are much higher than the prices they were paying prior to the pandemic, many consider inflation to still be a problem. Which is to say, consumers appear to frequently equate inflation with high prices, even when the inflation rate has markedly declined and prices are increasing more slowly than they were.

Solved Problem: The Mexican “Super Peso”

A food market in Mexico. (Photo from mexperience.com)

Supports: Macroeconomics, Chapter 18, Economics, Chapter 28, and Essentials of Economics, Chapter 19.

In September 2023, an article in the Los Angeles Times discussed the effects on Mexico of the “’super-peso,’ as the Mexican currency has been dubbed since steadily gaining 18% on the dollar during the last 12 months.” The article focused on the effects of the rising value of the peso on people in Mexico who receive U.S. dollars from relatives and friends working in the United States. Many of the people who receive these payments rely on them to buy basic necessities, such as food and clothing. An article in the Wall Street Journal on the effects of the rising value of the peso noted that: “The peso’s strength has helped curtail inflation ….” 

  1. Briefly explain what the Los Angeles Times article means by the peso “gaining” on the U.S. dollar? Does the peso gaining on the dollar mean that someone exchanging dollars for pesos would receive more pesos or fewer pesos? 
  2. As a result of the rising value of the peso would people in Mexico receiving dollar payments from relatives in the United States be better off or worse off? Briefly explain. 
  3. Why would the increasing strength of the peso reduce the inflation rate in Mexico?
  4. The Los Angeles Times article also noted that: “The Bank of Mexico’s benchmark interest rate of 11.25% is more than double the U.S. Federal Reserve target …” Does this fact have anything to do with the increase in the value of the peso in exchange for the dollar? Briefly explain. 

Solving the Problem

Step 1:  Review the chapter material. This problem is about the effect of fluctuations in the exchange rate and the relationship between interest rates and exchange rates, so you may want to review Macroeconomics, Chapter 18, Section 8.2, “The Foreign Exchange Market and Exchange Rates,” or the corresponding sections in Economics, Chapter 28 or Essentials of Economics, Chapter 19.

Step 2: Answer part a. by explaining what it means for the peso to be “gaining” on the U.S. dollar. The peso gaining on the dollar means that someone can exchange fewer pesos to receive a dollar. Or, alternatively, someone exchanging dollars for pesos will receive fewer pesos. 

Step 3: Answer part b. by explaining why people in Mexico receiving dollar payments from relatives in the United States will be worse off because of the rising value of the peso. People living in Mexico needs pesos to buy food and clothing from Mexican stores. Because people will receive fewer pesos in exchange for the dollars they receive from relatives in the United States, these people will have been made worse off by the rising value of the peso. 

Step 4: Answer part c. by explaining why the increasing strength of the peso will reduce inflation in Mexico. A country’s inflation rate includes the prices of imported goods as well as the prices of domestically produced goods.  A stronger peso means that fewer pesos are needed to buy the same quantity of a foreign currency, which reduces the peso price of imports from that country. For example, a stronger peso reduces the number of pesos Mexican consumers pay to buy $10 worth of cucumbers imported from the United States. Falling prices of imported goods will reduce the inflation rate in Mexico. 

Step 5: Answer part d. by explaining why higher interest rates in Mexico relative to interest rates in the United States will increase the value of the peso in exchange for the U.S. dollar. If interest rates in Mexico rise relative to interest rates in the United States, Mexican financial assets, such as Mexican government bonds, will be more desirable, causing investors to increase their demand for the pesos they need to buy Mexican financial assets. The resulting shift to the right in the demand curve for pesos will cause the equilibrium exchange rate between the peso and the dollar to increase. 

Sources:  Patrick J. McDonnell, “Mexico’s Peso Is Soaring. That’s Bad News for People Who Rely on Dollars Sent from the U.S.,” Los Angeles Times, September 5, 2023; and Anthony Harrup, “Mexico’s Peso Surges to Strongest Level Since 2015,” Wall Street Journal, July 13, 2023.

What Explains the Surprising Surge in the Federal Budget Deficit?

Figure from CBO’s monthly budget report.

During 2023, GDP and employment have continued to expand. Between the second quarter of 2022 and the second quarter of 2023, nominal GDP increased by 6.1 percent. From July 2022 to July 2023, total employment increased by 3.3 million as measured by the establishment (or payroll) survey and by 3.0 as measured by the household survey. (In this post, we discuss the differences between the employment measures in the two surveys.)

We would expect that with an expanding economy, federal tax revenues would rise and federal expenditures on unemployment insurance and other transfer programs would decline, reducing the federal budget deficit. (We discuss the effects of the business cycle on the federal budget deficit in Macroeconomics, Chapter 16, Section 16.6, Economics, Chapter 26, Section 26.6, and Essentials of Economics, Chapter 18, Section 18.6.) In fact, though, as the figure from the Congressional Budget Office (CBO) at the top of this post shows, the federal budget deficit actually increased substantially during 2023 in comparison with 2022. The federal budget deficit from the beginning of government’s fiscal year on October 1, 2022 through July 2023 was $1,617 billion, more than double the $726 billion deficit during the same period in fiscal 2022.

The following figure from an article in the Washington Post uses data from the Committee for a Responsible Federal Budget to illustrate changes in the federal budget deficit in recent years. The figure shows the sharp decline in the federal budget deficit in 2022 as the economic recovery from the Covid–19 pandemic increased federal tax receipts and reduced federal expenditures as emergency spending programs ended. Given the continuing economic recovery, the surge in the deficit during 2023 was unexpected.

As the following figure shows, using CBO data, federal receipts—mainly taxes—are 10 percent lower this year than last year, and federal outlays—including transfer payments—are 11 percent higher. For receipts to fall and outlays to increase during an economic expansion is very unusual. As an article in the Wall Street Journal put it: “Something strange is happening with the federal budget this year.”

Note: The values on the vertical axis are in billions of dollars.

The following figure shows a breakdown of the decline in federal receipts. While corporate taxes and payroll taxes (primarily used to fund the Social Security and Medicare systems) increased, personal income tax receipts fell by 20 percent, and “other receipts” fell by 37 percent. The decline in other receipts is largely the result of a decline in payments from the Federal Reserve to the U.S. Treasury from $99 billion in 2022 to $1 billion in 2023. As we discuss in Macroeconomics, Chapter 17, Section 17.4 (Economics, Chapter 27, Section 27.4), Congress intended the Federal Reserve to be independent of the rest of the government. Unlike other federal agencies and departments, the Fed is self-financing rather than being financed by Congressional appropriations. Typically, the Fed makes a profit because the interest it earns on its holdings of Treasury securities is more than the interest it pays banks on their reserve deposits. After paying its operating costs, the Fed pays the rest of its profit to the Treasury. But as the Fed increased its target for the federal funds rate beginning in March 2022, it also increased the interest rate it pays banks on their reserve deposits. Because most of the securities it holds pay low interest rates, the Fed has begun running a deficit, reducing the payments it makes to the Treasury.

Note: The values on the vertical axis are in billions of dollars.

The reasons for the sharp decline in individual income taxes are less clear. The decline was in the “nonwithheld category” of individual income taxes; federal income taxes withheld from worker paychecks increased. People who are self-employed or who receive substantial income from sources such as capital gains from selling stocks, make quarterly estimated income tax payments. It’s these types of personal income taxes that have been unexpectedly low. Accordingly, smaller capital gains may be one explanation for the shortfall in federal revenues, but a more complete explanation won’t be possible until more data become available later in the year.

The following figure shows the categories of federal outlays that have increased the most from 2022 to 2023. The largest increase is in spending on Social Security, Medicare, and Medicaid, with spending on Social Security alone increasing by $111 billion. This increase is due partly to an increase in the number of retired workers receiving benefits and partly to the sharp rise in inflation, because Social Security is indexed to changes in the consumer price index (CPI). Spending on Medicare increased by $66 billion or a surprisingly large 18 percent. Interest payments on the public debt (also called the federal government debt or the national debt) increased by $146 billion or 34 percent because interest rates on newly issued Treasury securities rose as nominal interest rates adjusted to the increase in inflation and because the public debt had increased significantly as a result of the large budget deficits of 2020 and 2021. The increase in spending by the Department of Education reflects the effects of the changes the Biden administration made to student loans eligible for the income-driven repayment plan. (We discuss the income-driven repayment plan for student loans in this blog post.)

Note: The values on the vertical axis are in billions of dollars.

The surge in federal government outlays occurred despite a $120 billion decline in refundable tax credits, largely due to the expiration of the expansion of the child tax credit Congress enacted during the pandemic, a $98 billion decline in Treasury payments to state and local governments to help offset the financial effects of the pandemic, and $59 billion decline in federal payments to hospitals and other medical facilities to offset increased costs due to the pandemic.

In this blog post from February, we discussed the challenges posed to Congress and the president by the CBO’s forecasts of rising federal budget deficits and corresponding increases in the federal government’s debt. The unexpected expansion in the size of the federal budget deficit for the current fiscal year significantly adds to the task of putting the federal government’s finances on a sound basis.

The Labor Market Continues to Cool  

As we discussed in this post, most recent data are consistent with the labor market having cooled, which should reduce upward pressure on wages and prices. On Friday morning, the Bureau of Labor Statistics (BLS) released its employment report for August 2023. (The report can be found here.) On balance, the data in the report are consistent with the labor market continuing to cool.

Data from the establishment survey showed an increase in payroll employment of 187,000, which is close to the increase of 170,000 economists surveyed by the Wall Street Journal had forecast. The following figure shows monthly changes in payroll employment since January 2021.

Although the month-to-month changes have been particularly volatile during this period as the U.S. economy recovered from the Covid–19 recession, the general trend in job creation has been downward. The following table shows average monthly increases in payroll employment for 2021, 2022, and 2023 through August. In the most recent three-month period, the average monthly increase in employment was 150,000.

PeriodAverage Monthly Increases in Employment
2021606,000
2022399,000
Jan.-Aug. 2023236,000

The BLS revised downward its previous estimates of employment increases in June and July by a combined 110,000. The changes to the estimate of the employment increase for June are particularly notable. As the following graph shows, on July 7, the BLS initially estimated the increase as 209,000. The BLS’s first revision on August 4, lowered the estimate to an increase of 187,000. The BLS’s second revision on September 1, lowered the estimate further to 105,000. In other words, the BLS now estimates that employment increased by only half as much in June as it initially reported. As we discuss in Macroeconomics, Chapter 9, Section 9.1 (Economics, Chapter 19, Section 19.1 and Essentials of Economics, Chapter 13, Section 13.1), the revisions that the BLS makes to its employment estimates are likely to be particularly large when the economy is about to enter a period of significantly lower or higher growth. So, the large revisions to the June employment estimate may indicate that during the summer economic growth slowed and labor market conditions eased.

Data from the household survey showed the unemployment rate increasing from 3.5 percent in July to 3.8 percent in August. The following figure shows that the unemployment rate has fluctuated in a narrow range since March 2022. Employment as estimated from the household survey increased by 222,000. The seeming paradox of the number of people employed and the unemployment rate both increasing is accounted for by the substantial 736,000 increase in the labor force.

Finally, as the first of the following figures shows, measured as the percentage change from the same month in the previous year, the increase in average hourly earnings (AHE) remained in its recent range of between 4.25 and 4.50 percent. That rate is down from its peak in mid-2022 but still above the rate of increase in 2019, before the pandemic. But, as the second figure shows, if we look at the compound rate of increase in AHE—that is the rate at which AHE would increase for the year if the current rate of monthly increase persisted over the following 11 months—we can see a significant cooling in the rate at which wages are increasing.

As a reminder, AHE are the wages and salaries per hour worked that private, nonfarm businesses pay workers. AHE don’t include the value of benefits that firms provide workers, such as contributions to 401(k) retirement accounts or health insurance. As an economy-wide average they suffer from a composition effect during periods in which employment either increases or decreases substantially because the mix of high-wage and low-wage workers may change. AHE are also subject to significant revisions. Therefore, short-range changes in AHE can sometimes be misleading indicators of the state of the labor market.

Data Indicate Continued Labor Market Easing

A job fair in Albuquerque, New Mexico earlier this year. (Photo from Zuma Press via the Wall Street Journal.)

In his speech at the Kansas City Fed’s Jackson Hole, Wyoming symposium, Fed Chair Jerome Powell noted that: “Getting inflation back down to 2 percent is expected to require a period of below-trend economic growth as well as some softening in labor market conditions.” To this point, there isn’t much indication that the U.S. economy is experiencing slower economic growth. The Atlanta Fed’s widely followed GDPNow forecast has real GDP increasing at a rapid 5.3 percent during the third quarter of 2023.

But the labor market does appear to be softening. The most familiar measure of the state of the labor market is the unemployment rate. As the following figure shows, the unemployment rate remains very low.

But, as we noted in this earlier post, an alternative way of gauging the strength of the labor market is to look at the ratio of the number of job openings to the number of unemployed workers. The Bureau of Labor Statistics (BLS) defines a job opening as a full-time or part-time job that a firm is advertising and that will start within 30 days. The higher the ratio of job openings to unemployed workers, the more difficulty firms have in filling jobs, and the tighter the labor market is. As indicated by the earlier quote from Powell, the Fed is concerned that in a very tight labor market, wages will increase more rapidly, which will likely lead firms to increase prices. The following figure shows that in July the ratio of job openings to unemployed workers has declined from the very high level of around 2.0 that was reached in several months between March 2022 and December 2022. The July 2023 value of 1.5, though, was still well above the level of 1.2 that prevailed from mid-2018 to February 2022, just before the beginning of the Covid–19 pandemic. These data indicate that labor market conditions continue to ease, although they remain tighter than they were just before the pandemic.

The following figure shows movements in the quit rate. The BLS calculates job quit rates by dividing the number of people quitting jobs by total employment. When the labor market is tight and competition among firms for workers is high, workers are more likely to quit to take another job that may be offering higher wages. The quit rate in July 2023 had fallen to 2.3 percent of total employment from a high of 3.0 percent, reached in both November 2021 and April 2022. The quit rate was back to its value just before the pandemic. The quit rate data are consistent with easing conditions in the labor market. (The data on job openings and quits are from the BLS report Job Openings and Labor Turnover—July 2023—the JOLTS report—released on August 29. The report can be found here.)

In his Jackson Hole speech, Powell noted that: “Labor supply has improved, driven by stronger participation among workers aged 25 to 54 and by an increase in immigration back toward pre-pandemic levels.” The following figure shows the employment-population ratio for people aged 25 to to 54—so-called prime-age workers. In July 2023, 80.9 percent of people in this age group were employed, actually above the ratio of 80.5 percent just before the pandemic. This increase in labor supply is another indication that the labor market disruptions caused by the pandemic has continued to ease, allowing for an increase in labor supply.

Taken together, these data indicate that labor market conditions are easing, likely reducing upward pressure on wages, and aiding the continuing decline in the inflation rate towards the Fed’s 2 percent target. Unless the data for August show an acceleration in inflation or a tightening of labor market conditions—which is certainly possible given what appears to be a strong expansion of real GDP during the third quarter—at its September meeting the Federal Open Market Committee is likely to keep its target for the federal funds rate unchanged.