Ed Koch, one of New York City’s most colorful Mayors (1978 to 1989) loved to stand in street corners and ask anyone that passed by, “How am I doing?”
Today, if the U.S. economy replaced Mayor Koch, the answer might be, “You’re doing great!” One of the most widely used forecasting tools when forecasting real GDP, is the Atlanta Fed GDP Now, tracker. Currently, it is forecasting a whopping 10.3% growth rate for Q2:2021! Compared to real GDP potential growth of approximately 1.8% -- such growth is insane and unsustainable as we begin to project economic activity into next year.
Evidence of robust growth is reflected by a monthly metric of U.S. Manufacturing activity, namely the ISM Index (released in early June) that rose to 61.2 in May. This reading greatly exceeds its neutral reading of 50. And while this high composite reading may be partially due to bottleneck supply-side pressures, virtually every other component included in the composite index is above 50 and flashing faster growth.
But since the manufacturing sector accounts for only 11% of the U.S. economy, we would be remiss if we ignored what was happening in the Service sector. That sector also remains robust with the ISM-Services reading jumping to 64.0 in May compared to a reading of 62.7 in the prior month.
Yet, what most investors are demanding to know at the moment is whether inflation is more likely to accelerate or decelerate from its current above-trend growth rate.
Stated another way, is the 3.1% (year-over-year) spike in Core PCE inflation measuring a broad array of consumer goods, excluding food and energy (targeted by the Federal Reserve at 2.0%) likely to remain high or slow in the coming months. Similarly, will the latest (year-over-year) Consumer Price Index (CPI) up 4.2% and 3.0% for the Core CPI slow from here. Additionally, will the latest (year-over-year) Producer Price Index (PPI) and core PPI which rose by 6.2% and 4.6%, respectively, continue to remain at such lofty levels.
In our latest research, (using all available data for both ISM surveys from 1997 to the present), we find that when the service sector is growing at a disproportionately faster pace relative to the manufacturing sector – we tend to experience longer-lasting periods of rising inflation pressures. This may occur because it’s easier to increase productivity in the manufacturing sector as economic activity expands while that may be less likely to occur in the Service sector. Rising productivity in the U.S. manufacturing sector may be able to dampen some of the upward price pressures observed in other parts of the economy.
This can be directly observed in our chart that reveals that when the average spread between both indices widened (e.g., 2003 to 2006), rising inflation pressures persisted for 2.8 years. In contrast, during periods when the spread was narrower at 1.6% (e.g., 2017 to 2018) inflation pressures were relatively short-lived!
Therefore, if investors want to predict whether the latest spike in inflation pressures is likely to be short-lived or long-lasting, all they should do is focus on the spread between the ISM Service Sector and ISM Manufacturing Index. A wider spread, led by stronger Service Sector activity tends to be associated with longer periods of rising inflation while a narrower spread may suggest shorter-duration inflation pressures lie ahead!
The current spread between both ISM Surveys from Jan. 2021 to May 2021 is averaging about 3.8% which happens to be narrower than the periods associated with long bouts of inflation in our sample. This strongly implies that the Federal Reserve may not be far off in assuming the strong price pressures we are observing are more likely to be transitory and apt to ease next year!