Summary
Leading indicators of recession continue to worsen, as do many financial/credit metrics, but the economy stubbornly refuses to decline. How long can this discrepancy persist, and which set of indicators (current or leading) will eventually prove to be a more accurate reflection of what will occur? Inflation remains well above the Federal Reserve’s long-term goal, suggesting still more tightening ahead. Even if the end of tightening is near, outright easing by the Fed seems unlikely as long as inflation is much too high. And it may already be too late to escape at least a modest downturn. (Late-breaking development: First Republic Bank has become the second biggest bank failure in US history. It was taken over by the FDIC and its assets sold to JPMorgan Chase).
Economic Activity
The latest job market data indicate still-tight conditions, although growth continues to slowly trend lower. Nonfarm payrolls (NFP) rose by 236,000 for March, with the U-3 unemployment rate slipping back to a historically low 3.5 percent. While the March NFP gain was the slowest since the end of 2020, it was about equal to the 10-year median gain and above the median gains for 11+ years, suggesting no significant concerns. Moreover, the unemployment rate has remained around its 50-year low despite an increase in the labor force participation rate to the highest level since the start of the Covid downturn. Benchmark revisions to weekly unemployment claims showed a modestly higher level than the pre-revision data as well as a slight uptrend, but the level of claims remains low and the recent uptrend is still so small that there is no suggestion of a significant weakening of the job market.
First-quarter real GDP growth was reported as slowing to an annualized gain of 1.1 percent, but on a four-quarter trend basis (a better measure given the volatility of quarterly GDP) growth edged higher to 1.6 percent. Not great, but clearly not recessionary. We continue to view the final sales to private domestic purchases component of GDP (core GDP) as a better measure of underlying growth than the overall figure. This approach removes trade and inventories, which tend to be extremely volatile, as well as government, as a better way to measure the trend in private spending. This measure showed an acceleration to 2.9 percent, the fastest annualized growth in nearly two years. But, as with overall GDP, the four-quarter growth rate is a better measure of trend, and this was up by only 1.1 percent – slow, but still not recessionary.
A bigger concern, however, is that the biggest boost to core GDP growth came from a 3.7 percent jump in personal consumption expenditures. While this pace is unsustainable in its own right, it came from a surge in January spending. Monthly data showed that real consumer spending declined in both February and March, a significant slowing in this key component of economic growth.
Business activity continues to be mixed. The manufacturing sector remains in retreat, according to the Institute for Supply Management (ISM) survey. This survey has been below 50 (indicating contraction) for five consecutive months, and the March level was the lowest since the end of the Covid downturn. Other survey data confirm this weakness in manufacturing. The manufacturing component of industrial production, for example, has stalled for more than the past year. The service sector continues to expand, with the ISM survey for services at 51.2 for March, but this figure was getting closer to the contraction level of 50. The NFIB Small Business Optimism Index continued its uneven path lower for March, closing in on the lowest levels for a decade. Two key categories in the overall index slipped further, with “plans to increase employment” at the lowest level since the end of the Covid recession and “now a good time to expand” at the lowest level since 2009. On the radar is a significant tightening of bank lending standards for businesses, according to the Fed’s Senior Loan Officer Survey. And most impacts from the banking problems are yet to be reflected in that data. If there is a significant pullback in lending by banks, that could be the change that pushes the economy into recession.
Housing activity was mixed over the past month. New home sales jumped by nearly 10 percent for March to the highest annualized pace in a year. But housing starts and existing home sales both edged a bit lower for the month. Still, with a solid job market, lower mortgage rates, and positive demographics, the housing market has little risk of falling sharply. Moreover, a continued lack of homes for sale (especially existing homes) is holding up national home prices. Mortgage rates jumped in the first half of March but then fell over the second half of the month and remained lower for April. Lower rates will help to keep housing demand from falling sharply (and may allow for some modest increases). But perhaps offsetting this positive for buyers is a continued tightening of mortgage credit.
The two indicators that we think give the best guidance for economic growth continue to suggest that the current expansion will end soon. The Conference Board’s Index of Leading Economic Indicators (LEI) has declined for 12 consecutive months, and February’s 12-month change of -7.8 percent is at depressed levels that have always preceded recessions. Additionally, the yield curve continues to be inverted, with long-term rates below short-term rates. When this inversion is both sustained enough and deep enough, recessions almost always follow – and both of these qualifications have probably been met. But the entire yield curve is not yet inverted, and this has been a key metric in recession predictions stemming from the yield curve. Still, most studies use the spread between rates on 10-year and 3-month Treasury securities and this spread shows the steepest inversion since 1981. The lead time between when these leading indicators began flashing red and recession start dates has varied considerably. For the LEI, the average and median are both around 5 months, but range between 0 months and 16 months (data back to the December 1969 recession). For the yield curve (over the same period) the average lead time is 9.5 months, with the median at 8 months (ranging between 5 and 16 months). The LEI is indicating that a recession may be overdue, while the yield curve suggests that the economy is edging close to the precipice but may not be there quite yet.
Inflation and the Federal Reserve
Inflation continued to be elevated in March and, importantly, remained well above the Fed’s long-term goal of 2.0 percent. The personal consumption expenditure (PCE) price index is a much broader measure of inflation than the more commonly viewed Consumer Price Index (CPI), but its breadth is in large part why the Fed views it as a better measure of inflation. The PCE price index rose by only 0.1 percent for March, the slowest pace in 8 months, with the 12-month trend rate dropping by nearly a percentage point to 4.2 percent – the slowest in 22 months. The news was not as good for the core PCE price index (removing the volatile food and energy components). While the monthly gain slowed to 0.3 percent, its trend rate slipped only slightly to 4.6 percent. Fed Chair Jay Powell recently noted the importance of services less shelter as perhaps the best measure of underlying price pressures. This measure of underlying inflation edged down for March as well, but with the trend rate slipping only to 4.4 percent. All of these inflation measures are well below their 2021-22 peaks and are moving in the right direction, but they are not yet close to the Fed’s 2.0 percent goal.
The slowing in underlying inflation and banking sector disruptions will probably not keep the Fed from tightening monetary policy again at its May 2-3 FOMC meeting. The level of inflation is still a bit more than twice the Fed’s goal, with tight labor markets and continued economic growth; thus, financial markets expect another 25 basis point (BPS) tightening move – with the CME reporting an 86 percent probability of this result. This would bring the target range for the federal funds rate up to 5.00-5.25 percent, the highest since September 2007. This would also mean that the real federal funds rate (using the 12-month change in the PCE price index as the relevant inflation rate) would move further into positive territory – an additional sign that monetary policy has become contractionary. Still, in March this measure of the real fed funds rate was only +0.4 percent, not much above zero and so not very restrictive.
Financial Markets
Another month, another failed bank. This time it is First Republic Bank, as deposit withdrawals over the month made continuation of the institution untenable. This is unlikely to change the Fed’s decision on monetary policy later this week; but combined with Fed Vice Chair Michael Barr’s report on the prior failures of Silicon Valley and Signature Banks, it may move the Fed toward a somewhat different regulatory framework going forward. For now, the Fed will rely on the new Bank Term Funding Program (BTFP) and the shifting of all deposits – as seen with First Republic, Silicon Valley, and Signature banks – rather than those below the FDIC insurance limit of $250,000 to other institutions to reduce the odds of a more systemic banking problem. Whether that will be enough, however, remains to be seen.
Unlike the initial market reaction to the failures of banks in March, financial markets reacted with a yawn to the First Republic news, with the CBOE Market Volatility Index (VIX) dropping to its lowest level since November 2021 at the end of April. Longer-term Treasury yields were also little affected by this event, with 10-year yields at the end of April little changed from the end of March, at 3.44 percent. No sign of a flight to safety here. There has also been little impact from the banking system problems on US equity markets. Large-cap measures were up for the month, with the S&P 500 Index up by 1.5 percent, the Dow Industrials up by 2.5 percent, and the NASDAQ Composite up by only a tad. Mid- and small-cap measures fell modestly over the month. As with fixed-income, no sign of a problem here.
Financial markets appear to be increasingly concerned about the debt limit and the lack of meaningful progress in extending it. While yields on mid- and long-dated Treasury securities have been stable over the past month, yields on short-dated securities have risen, showing some concerns over the next several months. No one knows what will happen with the debt ceiling (hopefully no breach will occur), but short-term fixed-income markets are expressing some discomfort.
David W. Berson, Ph.D.
Chief US Economist
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