Inflation and the Two Speed Economy

Michael Normyle – Nasdaq’s US Economist joins IBKR’s Andrew Wilkinson and Jeff Praissman to discuss the current state of the economy and how manufacturing and services are pulling it in two different directions.

Contact Information:

Email:  Michael.Normyle@nasdaq.com

Web:   www.nasdaq.com

Note: Any performance figures mentioned in this podcast are as of the date of recording (July 17, 2023).

Summary – IBKR Podcasts Ep. 96

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Jeff Praissman

Hi everyone, welcome to IBKR Podcasts, I’m your host, Jeff Praissman, along with Andrew Wilkinson. In this podcast, we’re going to discuss the two-speed economy we’ve been seeing with manufacturing contracting and services expanding and the much larger size of the service sector has been able to keep the overall economy afloat. It’s our pleasure to welcome back to the IBKR Podcast, Michael Normyle, Nasdaq’s US economist. Welcome Michael, thank you for joining us.

Michael Normyle

Thanks for having me.

Andrew Wilkinson

So Michael, in today’s episode, we’re going to talk about a particular type of indicator known as a diffusion index and I just wanted to take a moment to explain to the audience what that is. The purpose of a diffusion index is to add context to a particular data series such that we can portray relative traction. The beauty here of a diffusion index is in its design. The survey asks respondents to tell us whether they are operating at the same speed as in the prior month or whether they are operating at either a faster or slower pace. Any diffusion index runs from 0 to 100, and so the watershed here is a reading of 50, which indicates the same level as the prior period. Readings above 50 therefore indicate expansion while sub-50 index readings indicate contraction. And while the overall index has a composite reading, it’s comprised of a series of individual component readings, and I know that you’re going to go into these later on. Two of the most prominent diffusion indexes are the Manufacturing Purchasers Managers Index and the Services Purchasing Managers Index. First of all, can you give each one of those a sense of relative importance and then can you tell us why the manufacturing index often gets the most press coverage and then what is it currently telling us?

Michael Normyle

Sure. Well, I think in relative terms maybe it should be that services gets the most attention just because that’s the biggest part of the economy. But like you said, it’s really manufacturing that gets the most attention for the PMI. I’m going to keep it easy and just say PMI. You know, the manufacturing has the longest history. The Services PMI is relatively new as well so maybe that could be part of just that kind of legacy reliance and therefore also if you’re looking at it as something that influences the market, for example, then you have a lot more history to work with the Manufacturing PMI compared to the Services PMI.

Andrew Wilkinson

Can you give us the relative sense of the contribution of manufacturing to GDP and compare that to the contribution of the services sector to GDP.

Michael Normyle

So, like you’re saying, manufacturing used to be 28% of value added to GDP at its peak, but that was in 1952. So in 2021, it’s down to 11% and as manufacturing has declined in importance, we’ve seen services increase and so in 2021, services was actually 77% of the value added to GDP and you see similar kind of shifts if you were looking at employment for example as well where there used to be much more people employed in the manufacturing sector. Now of course services is the dominant sector that people work in.

Andrew Wilkinson

OK. So, tell us where we are right now with the health of the manufacturing sector?

Michael Normyle

Well, it’s not looking great if you’re looking at the PMI. So, of course there’s multiple Manufacturing PMIs, but the one that we talked about earlier with the longest history, that’s the Manufacturing PMI from the Institute for Supply Management or ISM as people call it. But there are also other ones from S&P Global and the Regional Federal Reserve banks also have their own. But to focus on ISMs, its latest reading is 46 and as you mentioned, under 50 means that the sector is contracting and so it’s actually been trending lower since March of 2021 and it’s been below 50 for the last eight months. So, manufacturing has been contracting according to the PMI for the last eight months and really why that peak was so long ago, that has to deal with the pandemic experience. That was around where vaccines had rolled out and people kind of could get back a little bit more to their normal lives. And so that’s where we started to see people transitioning from spending more on goods to more on services. And so it was kind of a downtrend from there and now it’s been to the point where the sector is actually contracting.

Andrew Wilkinson

OK, so now on the flip side, the services sector, how’s that doing relative to that fifty line, that contraction expansion?

Michael Normyle

Right, services it’s doing better. The latest reading was 53.9 and both of these are for the June value, but services has also been trending lower. Of course, you know we’re coming out of a period after the pandemic where people had a lot of money to spend so the economy was doing very well. So, it was kind of a sugar high almost for the economy a bit. So, services has been trending lower from that point since November 2021, so that’s a bit of a later peak date for services, but it stayed above 50 essentially. And so that means, of course, that the sector has been expanding and so, like I said, the latest value is almost 54. So, it’s staying well above that 50 divider line.

Andrew Wilkinson

So just to explain then the fixation with the manufacturing side.

Michael Normyle

Well, I think that goes down to the fact that even though manufacturing has become smaller and smaller part of the economy, it’s still much more volatile as a sector. So it can still have a have a … it can be the tail that wags the dog at times for the economy. So even though services is less volatile and much larger, just having that 10 plus percent of the economy that can swing from a strong expansion to a more severe contraction in a relatively short period of time can do a lot for the overall economy status.

Jeff Praissman

How does the shift away from manufacturing towards services potentially affect the effectiveness of monetary policy?

Michael Normyle

Well, it really gets down to the fact that monetary policy is something that’s transmitted through rates and as manufacturing is a much more capital-intensive sector. So if you want to start a new manufacturing company, you need a factory, you need equipment, inventory workers, etcetera and so all that capital is expensive so you’re very likely going to require financing. And so therefore, what rates are doing is very impactful for manufacturing as a sector, making it very rate sensitive. But for services it’s a lot less capital intensive like you could start a one-person consulting firm with a phone and a computer, right? So, it’s much less capital intensive and therefore less rate sensitive. And so, as services have become the dominant sector in the economy, that blunts the impact of rate hikes on the overall economy.

Andrew Wilkinson

Mike, what other factors might affect the speed at which traditional monetary policy is or isn’t working?

Michael Normyle

Well, one of them that is perhaps not as well-known and it differs also across countries, is home ownership. And so, there’s a couple of different factors at play there which is the share of people who own their homes outright, and the prevalence of fixed rate mortgages. So, over the last decade you’ve seen a rising share of people in bigger economies that own their home outright. So that’s a bigger share of people who are not impacted by rate hikes passing through to mortgage rates. And then in the US, the OECD data shows that the share of households with a mortgage has dropped from 44% in 2010 to 40% in 2020. So, that brings us to the other issue with the impact of monetary policy being fixed rate mortgages, and then the US adjustable-rate mortgages are less than 4% of outstanding mortgages. So only people with new mortgages are really being impacted by the rate hike cycle over the last year and a half and that’s because if the bulk of mortgages are adjustable rate, then rate hikes lead to higher rates for all mortgages, not just new mortgages. And so that means a bigger share of income is going to go to interest payments and that reduces disposable income and cools demand. There’s actually recent work from the San Francisco Fed that showed that if all households in the US had their mortgage debt adjusted to the current rate that would make interest payments as a percent of income double from where they are currently. So that just goes to show how impactful having more adjustable-rate mortgages, which are much more popular outside the US, is as a factor for monetary policy and its effectiveness. But in the US, since it’s so many fixed rate mortgages, that really shuts off that transmission channel.

Okay, so another factor is the tight labor markets that we’ve seen recently and the issue there being that companies are not responding to rate hikes in kind of the “normal way.” In the past, rate hikes, they hurt companies a couple ways. They cool the economy so that hurts demand for goods and services. They also increased the cost of capital, so that hurts margins. And so, with lower demand and tighter margins, companies might look to layoffs to align the size of the workforce with demand and help maintain those margins in the process.

Now though, we’re seeing labor hoarding where companies remember how difficult it’s been to hire in recent years so they’re reluctant to lay people off, and that’s keeping labor supply tight and then that helps to hold wage growth and inflation higher. And so, instead of layoffs, we’ve seen companies instead reducing hours worked and so that’s really an unusual kind of dynamic typically. Another factor is the neutral rate and that could potentially be higher than people think. So the neutral rate, it’s the rate at which monetary policy is neither boosting nor slowing the economy, and so there’s some research out of Vanguard suggesting that it could be higher than people think and so that would mean that monetary policy right now isn’t as tight as the Fed might think it is. But the trouble is that there’s no real way to observe what the neutral rate is in practice, so it’s a bit of an imperfect estimate. And then lastly, another factor could be quantitative easing and that’s just because quantitative easing created a buildup of reserves at banks and so U.S. banks are parking $3 trillion in reserves at the Fed. So, they don’t really need cash and so that might be why especially the larger banks have been pretty slow to increase the rates that they offer on deposits. And again, that’s the case where that removes the incentive for people keeping their money there to save it instead of spend it.

Jeff Praissman

And with this shift more from manufacturing to services, what are some of the potential risks to the economy that have become so reliant on the service sector while seeing manufacturing continuing to decrease?

Michael Normyle

In one sense, the risks aren’t too great because services is less volatile as a sector than manufacturing so until the last couple of recessions, services employment tended to hold up or even increase during post war recessions, while manufacturing always lost workers. But in the other sense, you have the risk that we’ve been dealing with the last few years and what companies are battling with currently and that’s the fragility of supply chains. And now when they’re disrupted, goods inflation can rise quickly and then that requires rate hikes from the central bank. So that’s why we see companies grappling with how to make their supply chains more resilient and the return to kind of large-scale industrial policy like the CHIPS Act to support domestic manufacturing.

Andrew Wilkinson

Mike, just talk a little bit about the transmission mechanism of monetary policy. When the Fed starts tightening interest rates, how long does that take to hit home and to restrict demand? And then what other ways can a central bank restrict activity if raising rates isn’t helping?

Michael Normyle

Well, Milton Friedman famously said that monetary policy operates with long and variable lags, so there’s not exactly a typical lag, but the kind of broad accepted ranges in the 12 to 18 months range but it also depends on the sector. So for instance, mortgage rates, they adjust very quickly to changes in monetary policy. So that means that the housing sector is impacted with a short lag and the same is true for asset prices, which also respond pretty much immediately to monetary policy changes but that’s not true for a lot of the economy. So, if you take a situation where there’s a long lag between placing an order and an item being delivered, for example, any policy changes that occur between those two periods won’t really be reflected in the kind of predetermined price. Or you can consider the banking sector, so when policy rates go up cost to borrow rises almost instantly, but then banks tend to be slower to raise the rates that they pay on deposits. And so that creates a lag between increasing rates, incentivizing saving over spending, even if the impact on borrowing is closer to immediate.

And so in terms of alternatives, we might be stuck with the best of imperfect options here. In the past, we’ve seen governments try price controls, which was the case last year in Europe in response to the war in Ukraine sharply increasing natural gas prices. But from an economic perspective, this is actually problematic because it deals with a supply problem by creating artificially low prices, which would increase demand, so it kind of incentivizes the wrong behavior. But that’s going to be hard to argue when it’s coming to people being able to afford to heat their homes. But as like a long-term type of approach to maintaining inflation it’s not the most viable. So, the best that we’ve seen banks do to try to speed things up lately has been forward guidance. So, before we used to know very little about what the Fed was planning until they did it. And in the last 10 to 15 years, we’ve seen them be more transparent about what they’re thinking, what their reaction function is and where they think rates are headed. So that can help get, you know, markets a bit ahead of where the Fed actually is by them laying out that path a bit more clearly.

Andrew Wilkinson

Would you say that the that the Fed probably thinks that they’ve got inflation under control at this point?

Michael Normyle

If they do, they’re not going to say it out loud. It seems to be the case. I think they were burned by the whole transitory fiasco in 2021 and they would rather overdo it than underdo it. So, I think the bias is much more towards overdoing it. So, I think even with the last inflation report being “so good” in a sense for the Fed, where core inflation fell more than markets had expected. You know, one report is not good enough for the Fed here so that’s why they’ve been — We still have markets expecting a hike in July and the Fed speak that we’ve gotten since the CPI report has done nothing to take that second rate hike that they’ve talked about off the table just yet. They’re still maintaining their data dependent stance.

Jeff Praissman

This is great. Once again, I’d like to thank our guest, Michael Normyle from Nasdaq for joining us at IBKR Podcasts. For more from Michael and Nasdaq, please go to our website under education to view previous Nasdaq webinars as well as our previous. I also want to remind everyone that they can find all our podcasts on our website under education, scroll down to IBKR Podcast or on YouTube, Spotify, Apple Music, Amazon Music PodBean, Google Podcast and Audible. Thank you for listening until next time we’re Andrew Wilkinson and Jeff Praissman with Interactive Brokers. Thank you.