Summary
Unless the bottom suddenly drops out of the economy, it’s difficult to see a recession starting before the end of this year. There’s simply not enough time, and there’s too much momentum. Not only has economic activity not slowed, many of the key figures (employment, GDP) accelerated in the last month/quarter. Moreover, the strike against the Big Three US automakers by the UAW is just about over, and that should help boost production over the remainder of this year (although perhaps at the cost of higher inflation in coming years as wage/benefit pressures find an outlet in prices). But not everything was positive. Geopolitical risk surged with the conflict in Gaza (and the increasing chances of a broader conflict in the region). It was another terrible month for financial assets. And Fed tightening (with the resulting rise in interest rates) over the past 19 months is doing what it’s supposed to do: reducing interest-sensitive consumer and business borrowing and increasing delinquencies and defaults. With the Federal Reserve on hold for now (perhaps not tightening again in the near term and certainly not easing unless a recession occurs), financial pressures will continue. As a result, there should be signs of slowing economic activity as the year winds down and especially in early 2024. Recession odds remain elevated for next year, but this “Energizer Bunny” of expansions continues. At least for now.
Economic Activity
Perhaps the best measure of contemporaneous economic activity, the monthly change in nonfarm payroll employment, unexpectedly jumped in September. The increase of 336,000 was the largest since January, and it was accompanied by upward revisions to the prior two months. While strong job gains are a positive indicator for the health of the economy, September’s surge was well above the less than 100,000 increase that is estimated to be sustainable (i.e., growth that would keep the unemployment rate stable given current demographics). With the unemployment rate already historically low at 3.8 percent, a significant pickup in hiring could boost inflation – something that the Fed is likely to be concerned about. As we have noted previously, however, the labor force participation rate (LFPR) remains about 1.5 percentage points below its pre-Covid level, so there may be some room for faster non-inflationary job gains. But given worsening demographics today, mostly from the aging of the Baby Boom cohort, many of whom have retired already or are transitioning into retirement, the LFPR may be above its long-term trend. In the absence of retired Baby Boomers moving back into the active labor force, it will be difficult for the LFPR to rise much more, at least without a significant increase in compensation to attract those retirees. This hurdle, in turn, suggests that further above-trend job growth is likely to be inflationary.
The solid job gains have enabled consumers to continue spending, even as excess savings have been diminished and higher interest rates have made borrowing more expensive. Real personal consumption expenditures (PCE) climbed at an annualized pace of 4.7 percent in September, boosting the 12-month trend rate up to nearly 2.4 percent. With PCE constituting the largest part of the US economy (about 70 percent of all spending), it would be difficult for the overall economy to slow significantly without some cooling on the part of consumers. Higher interest rates appear not to have had much of an impact on auto sales yet, but auto loan rates rose in late October to the highest level in more than two decades (at 7.7 percent). While perhaps not yet slowing demand, these higher rates are having a negative impact on the ability of at least some buyers to make payments. Fitch recently noted that 60-day delinquency rates for subprime borrowers in September (at 6.1 percent) surpassed the previous peak seen in October 1996. Additionally, delinquency rates on credit cards rose in the second quarter to the highest level since 2012. With the personal saving rate dropping to a low 3.4 percent in September, higher interest rates may start to have a bigger negative impact on PCE soon.
Housing activity has been severely impacted by higher financing costs. The weekly mortgage rate survey from Freddie Mac showed a further increase to nearly 7.8 percent in late October for 30-year fixed-rate mortgages (FRMs), the highest level since October 2000. The MBA’s mortgage applications index (for purchases plus refinancings) dropped in mid-October to the lowest level since May 1995. Despite high mortgage rates and low affordability, new home sales rose in September to the highest level in more than 18 months. This series tends to be one of the most heavily revised, so perhaps this September surge will be lessened when the initial October data are released next month. Or perhaps homebuilders are offering enough incentives to buyers to offset higher mortgage rates. Either way, this strong level of sales is unlikely to be sustained. The NAHB’s Housing Market Index dropped to the lowest level since January in October, as did the next six-month-sales-expectations component. Unlike new sales, existing home sales dropped in September to the lowest level since October 2010 – a combination of reduced demand and lack of homes for sale. Both the low demand and lack of supply stem primarily from the same source: higher mortgage rates.
According to survey data from the Institute for Supply Management (ISM), manufacturing activity slowed for the 12th consecutive month in October and dropped even further below the breakeven level of 50 percent (at 46.7 percent). Importantly, the new orders and employment indices fell at a faster clip, while prices paid fell but not as quickly. The October data for services were not yet available when this report was written, but the sector is expected to show another modest gain. The Small Business Optimism Index from the National Federation of Independent Business (NFIB) has been little changed for more than the past year, with figures moving around an average level that is historically low, but without worsening further (or improving).
The shape of the yield curve and the Conference Board’s Index of Leading Economic Indicators (LEI), both of which have been extremely accurate predictors of business-cycle turning points, continue to point to a recession in the near term. Monetary policy, despite having tightened for more than a year, finally actually became tight in May when the real federal funds rate turned positive for the first time since late 2019. It took longer than usual for tighter monetary policy to become tight in this cycle because of the exceptional degree of Fed easing during and after the Covid downturn through a combination of a zero-interest-rate policy and significant quantitative easing. With mortgage demand plummeting and business demand for commercial and industrial (C&I) loans shrinking (helped by tighter lending standards), the impact of tighter monetary policy is becoming more evident. The LEI has declined for 18 consecutive months; and with the current value of the index 7.8 percent below year-earlier levels, it is clearly indicating a recession is coming.
Inflation and the Federal Reserve
The 12-month trend rate for the overall price index for personal consumption expenditures (PCE) has edged higher over the past three months after having trended lower since the middle of 2022. And at 3.4 percent in September, it remains well above the Fed’s long-term goal of 2.0 percent. But the trend rate for the core PCE price index (removing the volatile food and energy components) has continued to trend lower, down to 3.7 percent in September. Additionally, the “super core” trend inflation rate (the total less food, energy, and housing) fell in September to its lowest level since April 2021 at 3.0 percent. Other measures of the central tendency of PCE inflation also continue to move lower. The Dallas Fed’s trimmed mean PCE inflation rate, for example, dipped to 3.9 percent in September, the lowest trend rate since the start of last year. All of these inflation measures (and most others, besides) have slowed considerably since their peak (mostly in 2022), but almost all remain above the Fed’s goal.
The Federal Open Market Committee (FOMC) concluded its most recent meeting on November 1 and reported that it made no changes to the stance of monetary policy, continuing the recent pace of quantitative tightening and keeping the federal funds rate unchanged. The FOMC’s policy statement noted that inflation was still elevated and that the economy looked stronger, suggesting that the Fed still has a tightening bias. Note that this doesn’t mean that the Fed will tighten in the near term, only that the members may feel that it is more likely that they would tighten rather than ease as long as economic conditions don’t change significantly. But it is clear that the Fed remains data-dependent and will consider especially (1) what will happen to economic growth (will the job market show less or more excess demand?) and (2) will inflation continue to move lower (especially the super core measure).
Financial Markets
October was another terrible, horrible, no good, very bad month for financial markets. Prices on long-term Treasury securities dropped sharply again and the 10-year note yield flirted with 5.0 percent. Meanwhile, broad equity averages briefly fell into correction territory. The list of financial market concerns is a long one: excessive inflation, possible additional Fed tightening (or at least higher rates for longer), increasing federal budget deficits bringing ever-larger supplies of new Treasury issuance, rising geopolitical concerns (Ukraine, Gaza, etc.), a possible near-term recession, and the specter of a federal government shutdown (yes, again) on November 17.
The yield on 10-year Treasury notes ended October at 4.93 percent, down a tad from the monthly high of 4.98 percent but up from 4.69 percent at the start of the month. Yields have not been this high since mid-2007. The yield on the 2-year Treasury note finished at 5.08 percent, a small decline from the start of October. Financial market participants often use the 2-year-to-10-year interest rate spread as a proxy for the shape of the yield curve. The 2-year yield has been above the 10-year since the middle of 2022, an inversion that suggests a coming recession, peaking at a difference of nearly 110 basis points in July. With the spread now down to about 10 basis points, the yield curve is significantly less inverted. It turns out, however, that while an inverted yield curve has been an excellent predictor of recessions, the yield curve typically flattens significantly in the period immediately before recessions begin. But that flattening usually occurs as the Fed eases monetary policy before a downturn in the economy starts, bringing short-term rates down by more than long-term rates. What does it mean when the flattening occurs because long-term rates rise relative to short-term rates? This is a very unusual circumstance, so it’s not clear what the current flattening portends.
It was a bad month for equity markets, as well. From the end of September to the end of October, the S&P 500 Index fell by 2.1 percent. From the start of the year, this index is still up by 7.7 percent. But from the peak earlier this year to the trough last week, the index was down by 10.1 percent – just above the 10.0 percent decline that defines a market correction. But that correction lasted for only one day. The Dow Jones Industrial Average fell by just over 1.0 percent last month, and it is down by 1.7 percent so far this year. The tech-heavy NASDAQ Composite dropped by 6.4 percent in October, but it still up by a whopping 21.6 percent this year. Finally, the small-cap Russell 2000 Index dropped by 6.1 percent over last month and by 7.3 percent thus far this year.
David W. Berson, Ph.D.
Chief US Economist
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