Implications:  One month is not a trend.  While headlines will herald the decline in both consumer prices and producer prices in July, don’t pop any champagne bottles.  As with the June report, a large swing in energy prices (which declined 9.0% in July) was the dominant force behind the monthly move in July.  If you strip out the typically volatile food (+1.0% in July) and energy categories, “core” prices continued to rise in July, up 0.2%.  And even with the July report showing a decline for the first time since April 2020, the producer prices are up a whopping 9.8% over the past year, and core prices are up 7.6%.  It’s important to understand that, even if producer prices peaked on a year-ago basis back in March, it will not be a swift return to the Fed’s target of 2% annual inflation.  We expect the path back toward normal will be far stickier than most anticipate as the massive surge in the M2 measure of money continues to wend itself through the economy.  Looking at the details of today’s report show that core prices were led higher by trade services (margins received by wholesalers), which rose 0.3% in July, as well as costs for transportation and warehousing services (+0.4%).  Some of the largest price declines came further back in the supply chain, as prices for processed and unprocessed goods for intermediate demand fell 2.3% and 12.4%, respectively.  That said, prices for these categories remain up 17.4% and 27.5% in the past year.  In short, the inflation trend continues to run well above the Fed’s target, and we believe they will have to raise rates higher – and for longer – than markets anticipate.  In other news this morning, initial unemployment claims rose 14,000 last week to 262,000. Meanwhile, continuing claims rose 8,000 to 1.428 million. These numbers suggest continued job growth in August but not as fast as in the first seven months of the year.

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Implications:  Is the inflation scare over?  Not by a long shot.  Today’s downside surprise to July consumer prices was the mirror-image of June’s surprise to the upside, both of which were driven by the volatile energy sector.  Consumer prices were unchanged in July, muted by a 4.6% decline in energy, which followed a 7.5% energy price spike in June.  Excluding energy, consumer prices were up 0.4% in July.  The decline in energy prices for the month drove the year-ago comparison for the headline index down to 8.5% (versus 9.1% in June).  When you look at inflation on a year-ago comparison basis, it probably peaked back in June at 9.1%, but that doesn’t mean inflation is no longer a major problem.  In the past two months –  taking the surge in June as well as the unchanged overall price level in July – consumer prices are up at an 8.1% annual rate.  That is no different than the 8.1% annualized increase in April and May, before the spike and then decline in energy prices.  Looking at the details of today’s report, food prices – the other typically volatile category – was a different story from energy,  posting its seventh consecutive monthly gain of at least 0.9%, on the back of higher costs for all six major grocery-store food groups.  Stripping out food and energy, “core” prices rose 0.3% in July, leaving the year-ago comparison unchanged at 5.9%.  Digging into the core data shows persistent inflation pressures that were partially offset by a string of smaller category declines.  Housing rents (for both actual tenants and the rental value of owner-occupied homes) continued to increase at an outsized pace in July, rising 0.6%.  Notably, in the past two months, rental prices for actual tenants have posted the two largest monthly increases since 1987.  Rents have been a key driver for inflation in 2022, and should continue to do so in 2023-24 because they make up more than 30% of the overall CPI and still have a long way to go to catch up to home prices, which skyrocketed during COVID.  Other core categories to increase in July were prices for motor vehicle insurance (+1.3%), new vehicles (+0.6%), and hospital services (+0.5%).  Meanwhile, several categories that have risen sharply in prior months cooled in July, including prices for airline fares (-7.8%), hotels (-3.2%), and used vehicles (-0.4%).  The best news in today’s report was real earnings increasing 0.5%, its first monthly increase in ten months.  But take this with a grain of salt, as real earnings are down 3.0% in the last year, and we expect them, at very best, to remain roughly flat in the year ahead. Since February 2020 (pre-COVID), consumer prices are up at a 5.6% annual rate and core prices are up at a 4.2% rate.  How did we get here?  By forcing an economy to shutdown while simultaneously injecting an unprecedented amount of fiscal and monetary stimulus.  Inflation has been – and always is – a monetary phenomenon.  To get inflation back down to 2.0%, the Fed needs to focus less on hiking interest rates and more on getting the growth in the money supply under consistent control.

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Implications:  Productivity continued to decline in the second quarter, with labor costs surging and rising inflation remaining a key headwind for workers’ purchasing power.  The 4.6% annualized decline in productivity in Q2 came as output declined while hours worked rose, both combining to reduce output per hour. Productivity is down 2.5% from a year ago, but stands 1.4% above the level in the fourth quarter of 2019 pre-COVID.  Although “real” (inflation-adjusted) compensation per hour fell at a 4.4% annualized rate in Q2, that doesn’t mean workers are being paid less.  In fact, wages have been rising, they just haven’t been able to keep up with the high inflation.  This is likely to remain an ongoing issue in the coming quarters, as inflation remains elevated while the rehiring of lower-paid workers puts downward pressure on the average amount paid per hour.  On the manufacturing front, productivity rose at a 5.5% annualized rate as output rose while hours fell. We expect hours and output will rise in the quarters ahead as the labor force continues to heal, supply-chain issues improve, and the Fed continues to tighten monetary policy but is not yet tight.  Productivity growth historically can be very volatile from quarter to quarter, and the policy reactions due to the pandemic have only added to further volatility.  It will take many more quarters or even years to clearly settle out how much the trend has changed in light of COVID and related policies, but the early read is that the growth potential of the economy is weaker than it was pre-COVID.  That’s what we get for shutting down the economy during COVID and ramping up regulation. Another law that boosts government spending and taxes won’t help.

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With the Senate having passed a budget plan yesterday with only Democratic votes as well as a tie broken by Vice President Harris, it is only a matter of time before President Biden signs the first significant tax hike since the “Fiscal Cliff” tax hike in early 2013.  What’s important to keep in mind is that it could have been worse…much, much worse.  

President Biden originally set out to raise the top tax rate on regular income to 39.6%.  That didn’t happen.  Biden wanted to raise the top tax rate on long-term capital gains and dividends to 39.6% (versus a current 20%).  That didn’t happen.  He wanted to get rid of the step-up basis at death.  Nope.  He wanted to raise the regular corporate tax rate to 28% (versus the current 21%) and tax “carried interest,” as well.  Again, no dice.

Compared to what the President sought, the tax hike we’re soon getting is a shadow of its former self.  But that doesn’t mean it’s good for the economy.  The three most prominent sources of more government revenue will be a new 15% minimum tax on the book profits of large publicly-traded companies, beefed-up IRS enforcement against the middle class, and a new 1% tax on stock buybacks.      

Although these changes are not, all by themselves, going to throw the economy into a recession (monetary policy eventually getting tight should generate a recession all by itself!), that doesn’t mean the tax changes are good ideas.

Take the new 15% minimum tax on companies.  Essentially, Congress is outsourcing tax policy to FASB, the Financial Accounting Standards Board, which is a private organization that develops accounting standards.  Meanwhile, companies that might be affected by this tax will find ways to avoid it, for example, by reorganizing so tax deductions are taken by more profitable spin-offs that are going to pay taxes above the minimum anyhow.  

The 1% tax on stock buybacks is another new and bizarre policy change.  The theory is that companies should be using that money for business investment, not buybacks.   But if a company is generating more cash flow than it can effectively invest, then a buyback is better than just having the money sit in the corporate treasury, where bad managers might use it for empire building, unprofitable investments or even to boost their own pay.

Moreover, many of the political advocates for a buyback tax claim they want fewer large companies dominating markets.  But slowing buybacks means big incumbent companies have more of a reason to simply keep cash on their own books, instead of distributing it to shareholders who can then, if they want, invest more in newer upstart companies.

The good news is that, just like with the 15% minimum tax, companies can adjust their behavior to avoid the new tax on buybacks, for example, by raising dividends.  This is also why Congress is probably over-estimating the revenue the new law is going to generate.

We’re also highly skeptical the federal government will hit its revenue projections for the next fiscal year and beyond.  This year there’s been a surge in tax revenue, a side-effect of all that temporary COVID-related stimulus in 2020-21, creating a feedback loop of borrowing, printing, and spending that also created illusory tax receipts.  As a result, the budget deficit in the past twelve months is actually slightly smaller than it was in the twelve months prior to COVID.  But, as the economy slows, and the artificial stimulus wears off, revenue growth will slow, and, when a recession eventually hits, could easily turn negative. 

The bottom line is that this budget deal will raise spending and tax rates over the next decade, and this is bad for the economy’s long-term growth potential.  But we’ve had much larger tax hikes in the past and survived.  Yes, we’re headed for a recession, but investors should be much more worried about how tight monetary policy needs to get, not the current tax hike.         

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist 

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Implications:  No sign of a recession in the labor market.  Just the opposite: the job market was very strong in July.  Nonfarm payrolls rose 528,000 for the month, easily beating not only the consensus expected 250,000 but also the forecast from every economics group.  It’s taken 29 months, but nonfarm payrolls are finally higher than they were pre-COVID.  The service sector continues to lead the way, with the fastest gains for education & health, leisure & hospitality, and professional & business services.  However, manufacturing payrolls rose 30,000 in July, the fifteenth consecutive monthly gain.  Meanwhile, the unemployment rate has finally returned to the pre-COVID low of 3.5%.  The decline in the unemployment rate versus June was due to a combination of a 179,000 gain in civilian employment (an alternative measure of jobs that includes small-business start-ups) as well as a 63,000 decline in the labor force.  That dip in the labor force shows the report was not 100% pure good news.  Another problem is that although wages are rising they are not keeping pace with inflation.  Average hourly earnings rose 0.5% in July and are up 5.2% versus a year ago, which would be good news if inflation were where it was pre-COVID.  However, the CPI was probably up 8.8% in July versus a year ago, so “real” (inflation-adjusted) wages are falling even as nominal wage growth is solid.  Total hours worked rose 0.4% in July and are up 4.1% in the past year.  The key to keep in mind is that although the US is not in a recession yet, this doesn’t mean the US won’t fall into one sometime in the next couple of years.  Overly loose monetary policy has generated an inflation problem that’s worse than any we’ve had in four decades.  Although the Federal Reserve has raised short-term rates to 2.375%, it still isn’t focused on consistently limiting the growth of the M2 measure of money, which was the ultimate source of the problem.  In turn, this means, the Fed is likely to keep raising short-term rates and do so more than the markets currently expect.  Eventually the Fed needs to get tight to bring down inflation and, with a lag, that tightness will cause a recession.  But that recession hasn’t started already and is unlikely to start this year.          

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Implications:   The trade deficit in goods and services came in at $79.6 billion in June, as exports rose while imports declined, continuing to narrow the deficit from March’s record $107.7 billion print.  Trade was a major detractor from first quarter GDP growth; imports grew rapidly as companies aggressively built up inventories due to fragile supply chains and what looked like to them unwavering demand from the US consumer. The massive and artificial government stimulus in the US, both fiscal and monetary, and the slow reopening of the economy over the past few years changed consumers spending habits to focus more on goods consumption than services. That has now reversed and consumers have shifted back towards services and less on goods leaving many companies with excess inventories.  This means we could continue to see imports slow over the next few months.  At the same time, international demand has been on the rise, and that was reflected in solid export activity again in June.  We like to follow the total volume of trade (imports plus exports), which signals how much businesses and consumers interact across the US border. That measure grew by $3.3 billion in June, is up a robust 21.2% versus a year ago, and sits at a record high. Unfortunately, these massive numbers are driven not only by more demand for goods and services, but also higher prices as inflation has soared.  In addition, Russia’s invasion of Ukraine, and COVID restrictions in China may affect trade patterns for some time.   Supply-chain problems are still a big issue as ports remain overwhelmed in the US, and the tragic war in Ukraine is only adding to the problem.  For example, the ports of Los Angeles and Long Beach currently have 20 container ships waiting to be unloaded.  Although this is near recovery lows, it’s well above the 0 - 1 normal level experienced pre-COVID.  Also notable in today’s report, the dollar value of US petroleum exports again exceeded US petroleum imports for the fourth consecutive month.  It’s too early to say for sure, but this is an encouraging sign that the US is getting back to where it was in 2020 when it was a net petroleum exporter.  In other news this morning, initial unemployment claims rose 6,000 last week to 260,000. Meanwhile, continuing claims increased 48,000 to 1.416 million.  We are forecasting that nonfarm payrolls rose 230,000 in July, a slowdown from the more rapid pace on the first half of the year.  

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The ISM Non-Manufacturing index increased to 56.7 in July, easily beating the consensus expected 53.5.  (Levels above 50 signal expansion; levels below signal contraction.)

The major measures of activity moved mostly higher in July, and nearly all stand above 50, signaling growth. The business activity index rose to 59.9 from 56.1, while the new orders index also increased to 59.9 from 55.6. The employment index rose to 49.1 from 47.4, while the supplier deliveries index fell to 57.8 from 61.9.

The prices paid index declined to 72.3 in July from 80.1 in June.  

Implications:  The service sector accelerated in July, with the ISM Services index easily beating consensus expectations.  With intense scrutiny of every data point on the strength of businesses and consumers, today’s surprise to the upside combats concerns that the US economy is already in (or teetering on the edge of) a recession.  We believe the service sector will lead the US economy higher in 2022, as consumers shift their spending habits away from goods and toward the still-reopening service sector.  The details of today’s report proved to be very positive.  Business activity and new orders, the two most forward-looking pieces of the report, both rose to 59.9.  Contrasting this with Monday’s ISM Manufacturing report shows the shift in consumer spending.  Keep in mind that data on inflation-adjusted consumer spending shows that the actual amount of goods being purchased has been falling since early 2021.  However, inflation-adjusted spending on services has continued to expand at a healthy pace as consumption preferences return to “normal.”  In other details in today’s report, supplier deliveries dropped over four percentage points and now sits at the lowest level since the beginning of 2021, signaling fewer bottlenecks.  On the hiring side, the employment index rose to 49.1 in July from 47.4 in June.  Despite remaining in contraction territory, the primary issue for the labor market remains a lack of supply, not demand.  Survey respondents continue to cite difficulties finding qualified applicants, while the demand for talent remains robust.  Finally, the highest reading for any category continues to come from the prices index, but it posted the largest monthly decline in more than five years.  While this is welcome news, prices are continuing to rise in the service sector, and at a historically fast pace, with 16 industries reported paying higher prices in July.  That said, were it not for inflationary headwinds, lingering supply-chain disruptions, material and labor shortages – all stemming from the poor pandemic-related policy decisions made in the last two years – the service sector would be doing even better.  In other recent news, data out yesterday showed that car and light truck sales rose 2.6% in July to a 13.3 million annual rate.  Supply constraints continue to be the key impediment to auto sales, largely related to a lack of computer chips needed for production.  The end of that problem is not here, but it’s closer.  Look for it to ease as we move deeper into the second half of 2022, resulting in a somewhat faster pace of sales.

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Implications:  The manufacturing sector continued to expand in July, though at a slightly slower pace, with eleven of eighteen industries reporting growth.  The current slowdown in manufacturing activity is characterized by supply-chain issues and a weakening in demand due to the ongoing shift in consumer preferences away from goods and toward services.  Respondent comments in July highlighted shortages of key inputs, but also a drop in the pace of new orders due to fears of a recession and some customers reporting high inventory levels.  The result was the new orders index falling to 48.0 in July, dipping further into contraction territory and hitting the lowest reading since the early days of the COVID pandemic.  Keep in mind that data on inflation-adjusted consumer spending shows that the actual amount of goods being purchased has been falling since early 2021. However, inflation-adjusted spending on services has continued to expand at a healthy pace as consumption preferences return to “normal.”  While the softening of new orders is a negative sign for future manufacturing activity, it should also give US factories time to catch up on all the existing orders they already have in the pipeline.  For example, the production index remained in expansion territory at 53.5 in July, signaling factories still have plenty to do.  Fewer new orders and more production on existing orders also seems to be easing pressure on supply chains, with the order backlog index falling to 51.3 in July, the lowest in over two years.  The supplier deliveries index also signaled progress, falling for the third month in a row and hitting the lowest reading in more than two years as well.  Though the employment index remained (barely) in contraction territory at 49.9 in July, the survey comments indicate this doesn’t seem to be due to softening orders, with an overwhelming majority of respondents stating that their companies are still hiring.  Finally, the best news in today’s report came from the prices index, which posted the largest monthly drop since 2010, a signal that inflation pressures might have peaked.  In other news this morning, construction spending declined 1.1% in June, with large drops in home building easily offsetting small gains in water and communication infrastructure.

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The Federal Reserve raised short-term interest rates by three-quarters of a percentage point (75 basis points) on Wednesday.  The day before, the Fed had released M2 money supply data for June and it fell slightly, the second decline in three months.  At his press conference after the rate hike, Fed Chairman Jerome Powell was vague about the Fed’s future intentions on rates, but was not asked one single question about the money supply.

For now, with the federal funds rate at 2.375%, the futures market is leaning toward a rate hike of 50 bps in September.  The Fed has apparently abandoned “forward guidance” partly because it has already pushed rates close to what many Fed members said is “neutral.”

Meanwhile, the 10-year Treasury yield has fallen from north of 3.4% to under 2.7% suggesting the market thinks the Fed will either slow down rate hikes, or maybe even cut them next year.  Unless, inflation falls precipitously, this makes no sense.  “Core” PCE inflation is closing in on 5% and a “neutral” interest rate should be at least that high, or higher.  The Fed has never managed policy under its new abundant reserve system with inflation rising this fast.  No one, even the Fed, knows exactly how rate hikes will affect the economy under this new system. (See MMO)

Many think the economy is in recession already, because of two consecutive quarters of declining real GDP.  But this is a simplified definition.  Go to NBER.Org to see the actual definition of recession.  A broad array of spending, income, production and jobs data rose in the first six months of 2022.  GDP is not a great real-time measure of overall economic activity for many reasons.  Jerome Powell does not think the US is in recession, and neither do we.  What we do know is that inflation is still extremely high and the only way to get it down and keep it down is by slowing money growth.

And that does look like it’s happening.  So far this year, M2 is up at only a 1.7% annual rate, after climbing at an 18.4% annual rate in 2020-21.  By contrast, M2 grew at a 6.2% annual rate in the ten years leading up to COVID.

Slow growth (or even slight declines) in M2 is good news.  The problem is that the Fed never talks about M2 and the press never seems to ask.  Moreover, slower growth in M2 may be tied to a surge in tax payments – when a taxpayer writes a check to the government, the bank deposits in M2 fall.  Data on deposits at banks back this up.  However, banks have trillions in excess reserves and total loans and leases are growing at double digit rates.  At this point, it is not clear that the new policy regime can persistently slow M2.  Will higher rates stop the growth of loans?  This looks to be happening in mortgages, but it appears to be demand-driven, not supply-driven.   

The bottom line is that the Fed seems determined to bring inflation down but thinks raising short-term interest rates, all by itself, can do the job effectively, even at the same time that it is willing to hike more gradually when inflation is well above the level of rates.  This is not a recipe for confidence in the Fed.  Expect rates to peak higher than the market now expects and keep watching M2.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist 

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The table and charts in the Recovery Tracker track high frequency data, which are published either weekly or daily. With states reopening their economies and widespread distribution of COVID-19 vaccines, these indicators show continued improvement in economic activity. It won't improve in a straight line, but the trend should remain positive over the coming months and quarters. The charts in the Recovery Tracker highlight where the high frequency data indicators were from 2019 to 2022.

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