The economy will weigh down Democrats' midterm prospects

As this November’s midterm congressional elections approach, the economy isn’t likely to improve too much.

The
Federal Reserve
has a dual mandate: full employment and low contained
inflation,
currently defined as 2%. But while the economy is operating at full employment, inflation is out of control. Irresponsible fiscal and monetary stimulus have combined to cause an embedded core inflation rate of something above 4%. The Fed will keep raising its rates aggressively. I anticipate a 50-basis-point rate hike at the September meeting. After September, its policy will depend on the data. What does that mean?

Well, the most important data points will be on wage inflation and the state of the employment market. Right now,
wages
are running up over 5% year on year. But trend productivity growth is only 1-1.5%. The spread between wage growth and trend productivity is too high — indeed, it is inflationary. In order to bring down wage inflation, the Fed must engineer slack in the employment market. Put another way, the unemployment rate must increase.

Let’s focus closer on inflation.

The Personal Consumption Expenditures Price Index, the Fed’s preferred measure of inflation, is running at a
7.7%
annual rate, well above the 2% inflation target. And so-called “core inflation,” stripping out food and energy, is running at an annualized rate of
4.8%
. Importantly, other inflation measures that strip out volatile components of the price index (such as
trimmed-mean
and
median
) have all increased. Arguably, core inflation is accelerating, not decelerating.

Inflation is embedded in price growth, which is fueling wage growth that is in turn fueling price growth. The economy is experiencing a wage-price spiral. Wages account for 70% of the input costs for the economy.

Wages are driving inflation. Private wages and salaries grew at a 5.7% annual rate in the first half of the year. Subtracting trend productivity of 1-1.5% gives us an underlying inflation rate of something just over 4%.

Equally important, unit labor costs are soaring. Unit labor costs, a measure of worker compensation and productivity, increased at a 10.8% pace in the second quarter from the prior quarter. Productivity data are volatile, but productivity in the United States is experiencing its sharpest drop in 74 years. The Fed will keep tightening aggressively until there are clear signs that wages are falling and productivity is rising.

In the meantime, households are increasingly experiencing financial distress due to the spread between wages and inflation. Wages are rising at a 5% plus rate, but inflation is running up over 7%. Households are being especially squeezed due to rising energy and food prices. Gasoline prices have dropped by about a dollar a gallon, but the average price of gasoline across the country remains 80 cents a gallon above levels from a year ago.

Food prices are
also very elevated
. The food-at-home (grocery store or supermarket food purchases) consumer price index increased 1.0% from May 2022 to June 2022 and was 12.2% higher than June 2021. The food-away-from-home (restaurant purchases) consumer price index increased 0.9% in June 2022 and was 7.7% higher than in June 2021.

This poses a problem for Democrats. As the midterm elections approach, the economy will be decelerating, unemployment will be rising, and inflation will be too high. Dissatisfaction with the economy is the highest since 2008. Moreover,
only 37%
of U.S. residents approve of the job President Joe Biden is doing, while 62% disapprove. On Biden’s handling of inflation, the numbers are even worse. Only 29% approve, while 69% disapprove.

James Rogan is a former foreign service officer who later worked in finance and law for 30 years. He writes 
a daily note
 on finance and the economy, politics, sociology, and criminal justice.

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