The Atlanta Fed’s GDPNow is looking for nearly 6.0 percent annualized third-quarter real GDP growth. Is the coast clear of recession (for now), or is this the last gasp of strength? Cogent arguments can be made for either course, but we still think that the latter is more likely than the former. Having said that, we (and many others) underestimated the stimulus that would come from expansionary fiscal policy, especially last year’s poorly named Inflation Reduction Act. Moreover, monetary policy works with long and variable lags – not to mention that policy didn’t really become contractionary until only a few months ago, when the inflation-adjusted federal funds rate finally turned positive. Moreover, the job market is cooling (even if it’s not yet actually cool), consumers are rapidly spending down their savings, and Fed tightening can be seen with tighter bank lending standards and increasing loan delinquencies. While the GDPNow figure is an accounting tool, not a forecast, early data for the third quarter are showing a pickup in many of the components that go into GDP; so, while we may expect a downturn, it’s not here yet – the long-expected recession may not actually arrive until the first half of next year. In the meantime, the Fed won’t be easing policy (it may even tighten a bit further); but long-term rates may anticipate easing and start to move lower – especially if inflation continues to decelerate.
Most measures show that the job market is slowing. With nonfarm payroll gains of 187,000 for August and significant downward revisions to the prior two months, the three-month average increase of 150,000 is the slowest since the immediate aftermath of the Covid recession. Still, this is about double the pace of job gains that we would expect to see if the economy was at “full employment” with real GDP growth at trend. So, there is room for further slowing without the economy slipping into recession. The U-3 unemployment rate for August jumped to 3.8 percent, the highest since February 2022, but still a very low figure historically. Positively, this rise in the unemployment rate came not from a drop in employment but from a rise in the labor force participation rate (LFPR). When more people enter the labor force in a particular month, they tend not to get jobs immediately – pushing the unemployment rate higher (at least temporarily). At 62.8 percent, the LFPR is up to the highest level since just before Covid hit. Did the rise come from volatility in the relatively small Household Survey, or from a longer-lasting behavioral change? Hopefully, the latter – but we will know for sure as additional data are released in coming months. The ongoing low unemployment rate in the face of slower job gains illustrates the lack of workers in the economy. The Job Openings and Labor Turnover Survey (JOLTS) for July showed that the downward trend in job openings, ongoing for more than two years, continued – bringing the number of open positions down to the lowest level since early 2021. Moreover, the ratio of job openings to the number of unemployed workers fell to 1.51 for the month, the lowest since September 2021. The ratio remains historically high, showing that there are still a lot more jobs than workers available to fill them, but the job market is clearly not as tight now as it has been. Additionally, the quits rate dropped to the lowest level since September 2020. Workers tend not to quit when they are increasingly uncertain about finding a new job. But while the labor market has cooled, it’s not yet cold – with the 12-month growth rate in average hourly earnings having stabilized this year at around 4.3-4.4 percent, compensation for civilian workers still well above the average growth rate of the past 30 years, and a few large union salary settlements. Demand for workers still exceeds supply, but by less and the job market is moving closer to balance.
Consumer spending continues at a solid pace, with the broadest measure of consumer spending, personal consumption expenditures (PCE), increasing by 0.8 percent for July and by 0.6 percent when adjusted for inflation. Ongoing job/wage increases are helping to boost consumer spending, along with (but to a lesser extent) increases in household wealth from higher equity and house prices. Increasingly, however, consumers are spending by dipping into savings, with the saving rate down to 3.5 percent – well below the average of the past 10 (or 20, or 30, etc.) years. As long as the job market continues to expand with wages moving higher, households will still have the wherewithal to spend. But unless households take more out of savings (how low can the saving rate go?), the growth in consumer spending will slow. Another route for households to keep the rapid pace of spending going would be to increase borrowing; but with interest rates at the highest levels in more than a generation and banks tightening lending standards, this path seems limited.
Housing data tend to be reported with a lag, suggesting that the recent rise in mortgage rates to the highest levels since 2001 is not yet reflected in the sales data. Indeed, new home sales rose in July to the highest level since early 2022, while pending home sales (existing sales that are reported at contract signing as are new sales) rose (modestly) in July for the first time since February. More contemporaneous measures of housing activity show that home sales likely fell, perhaps by a lot, in August. The MBA’s weekly survey of purchase mortgage applications dropped by 8.7 percent last month to the lowest level since 1995. Additionally, the NAHB’s Housing Market Index fell in August to the lowest level in five months, with the forward-looking “traffic of prospective buyers” component down by 15 percent. The lack of supply of existing homes continues to support prices, even as demand declines. Since the data began in 1982, only January and February of last year had fewer than July’s seasonally-adjusted figure. The lack of homes for sale and far tougher underwriting criteria over the past 15 years suggest that even if the economy turns down later this year or next year, big declines in house prices are unlikely. This is not 2008. Homebuilders continue to try to offset the lack of existing homes for sale, with single-family housing starts up by 6.7 percent in July; but given constraints on new construction (zoning restrictions, lack of workers, high price of land, etc.), it would be impossible for new builds to fully close the gap. And given the sharp rise in mortgage rates and the subsequent likely drop in housing demand, that’s probably a positive. This is not 2002-2005, when a glut of homes was built in response to skyrocketing demand for owner-occupied homes stemming from far too easy credit conditions (especially for home buyers).
Measures of business activity continue to be mixed. Although the Institute for Supply Management (ISM) manufacturing survey index rose a bit for August, it has been below 50 (indicating contraction) for nine consecutive months. Moreover, all 10 of the components of the index were also below 50. While manufacturing may be moribund, the larger service sector continues to expand. The ISM services index slipped modestly for July (August figures were not yet available when this report was written), but remained above the breakeven level of 50 (at 52.7, it’s not showing significant expansion). The Small Business Optimism Index from the National Federation of Independent Business (NFIB) climbed for a third consecutive month in July to a new high for the year, but it remains on the low side historically. Note that the advance figures for August’s NFIB Small Business Economic Trend Jobs Report confirmed the JOLTS data, with a drop in current job openings.
Current indicators continue to show economic expansion. In addition to the Atlanta Fed’s GDPNow, the Conference Board’s Index of Coincident Indicators rose solidly for July and is up to a record high – no signs of recession here. But leading indicators of recession continue to point toward a future downturn. The Conference Board’s Index of Leading Economic Indicators declined for a 16th consecutive month in July, with the 12-month change at a level (-7.5 percent) that has always preceded recessions. Additionally, the yield curve continues to be significantly inverted (although not over its entire length), with short-term rates generally above long-term rates. The yield spread between 3-month Treasury bills and 10-year Treasury notes continues to be more negative than at any time other than during the 1979-81 period. Recessions have always occurred when this spread has been as wide as it is today, although the long and variable lags of monetary policy changes make the timing of the likely downturn uncertain.
Inflation and the Federal Reserve
How much has inflation slowed since the peak, and is it still slowing? We can look at the 12-month growth rate for a longer-term trend view, the 3-month annualized growth rate for a shorter-term trend view, and the 1-month annualized growth rate for a current growth rate. Using the Fed’s preferred measure of inflation, the PCE price index, this is where we are:
The trends for total and core inflation are similar. Inflation has clearly slowed substantially, although it is still above the Fed’s long-term goal of 2.0 percent. When FOMC members discuss inflation, they usually refer to the 12-month trend in order to remove short-term “noise” in numbers. While the 12-month trend offsets some of the short-term fluctuations in the inflation data, it lags the other measures both when inflation is rising and when it is falling, as it is today. Should the Fed concentrate on a shorter-term measure of inflation in order to get a more up-to-date view of price changes, or should it instead emphasize a longer-term measure, which can never be as timely but is less affected by noisy data that may be offset in coming months? There is no unambiguously correct answer to that question, and the FOMC certainly looks at all of these inflation measures and more. But it appears that the 12-month trend rates are most important. And because these lag the shorter-term measures, they show a higher pace of inflation – and are farther away from the Fed’s goal.
Despite inflation’s being well above the Fed’s goal, still-tight (albeit looser) job markets, and above-trend economic growth, financial market participants expect no further tightening moves by the Fed this year. In fact, markets expect the Fed’s next policy move to be an easing – most likely next spring. Perhaps markets are looking more closely at shorter-term inflation measures than the FOMC is, with Fed Chair Jay Powell continuing to say that the Fed expects to stay tighter for longer.
There were no additional bank failures last month, and there was no change in Fed policy as August was not a month with a FOMC meeting. But August was the month with the key Kansas City Fed symposium at Jackson Hole, WY. While this event is typically not a venue primarily to discuss near-term policy, in his opening remarks Powell again emphasized that the Fed would be data dependent in its decision making and that the FOMC expected short-term rates (presumably the federal funds rate) to remain higher for longer. With no change in Fed policy expected in the near-term, shorter-term Treasury yields (out to about 3-years) were little changed over the month. But longer-term rates rose modestly in the month, with, for example, the 10-year Treasury note yield rising from 3.97 to 4.09 percent from the end of July to the end of August. But that relatively modest move hid a much larger rate rise and fall over the month. The 10-year yield jumped to 4.34 percent during the KC Fed symposium, helped higher by Powell’s comments, an earlier downgrade of US debt by Fitch, and an ongoing increased supply of Treasury debt as the budget deficit rises. Some weaker economic data over the last 10 days of August, coupled with monthly PCE inflation increases of only 0.2 percent, reduced the market’s odds of a Fed tightening this year and brought longer-term rates down. If trend inflation continues on a downward path and data on the economy indicate slower growth, then market expectations of a near-term Fed easing will rise, and long-term rates will drop further. Of course, if inflation remains stubbornly around current levels (or moves higher) and growth doesn’t slow, market expectations of Fed policy could change in the other direction – helping to boost longer-term rates. If our view of a modest recession next year is correct, then inflation should drop more sharply then, allowing the Fed to ease (perhaps aggressively), with interest rates across the yield curve dropping (and the yield curve eventually moving back to its normal upward-sloping shape).
Equity markets mirrored the movements in longer-term Treasury note prices over the month, moving down for most of the month before rallying toward month end (note that fixed-income prices and yields move in opposite directions). From the end of July to the end of August, the S&P 500 Index declined by a modest 1.8 percent (rallying from a drop of 3.3 percent intra-month). It is now up by 17.4 percent thus far in 2023 (and by 13.6 percent from a year ago). The Dow Jones Industrial Average fell by 2.4 percent last month (but is up by 4.8 percent this year), while the NASDAQ Composite slipped by 2.2 percent in August (but has surged by 34.1 percent so far this year). Mid- and small-cap averages moved similarly to the large caps (although the magnitudes of the declines were somewhat larger, as mid-size and smaller firms tend to be more interest-rate-sensitive), with declines of 3.0 and 4.3 percent, respectively, for August (and with gains of 8.9 and 6.0 percent for the year).
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