Summary
The strike against the Big Three US automakers by the UAW and the Fed’s stating that it will be tighter for longer, perhaps pushing rates even higher this year – with financial markets apparently believing the message – were all bad news items in the past month. Moreover, it was a terrible month for financial assets, with big drops in broad equity indices and bond prices. (At least the economy sidestepped a hit from a federal government shutdown, for now.) Despite the bad news, real GDP growth for the third quarter is expected to be strong (with the Atlanta Fed’s GDPNow looking for 4.9 percent annualized). Moreover, the job market remains solid – hardly any sign of a slowdown, let alone a recession. Soft landing? Maybe, but most inflation measures remain around double the Fed’s long-term 2.0 percent goal. We still think that the cumulative impact of significant Fed tightening since early last year will be increasingly visible in the economic and financial data as 2023 winds down – and even more so as 2024 begins.
Economic Activity
Although weekly unemployment claims remain extremely low, and even fell during September, most other measures suggest that the job market is slowing. It is far from slow, however, with nonfarm payroll growth still well in excess of long-run demographic trends and with the number of open positions significantly above the number of unemployed persons (although this is moving closer to balance). The September employment report was released after this commentary was finished, but we anticipate that the figures showed that nonfarm payrolls grew at a modestly slower rate. But the key figure in the report may be the labor force participation rate (LFPR). As we noted last month, the LFPR jumped in August to the highest level since the Covid downturn began. Additional increases would be positive for the economy, and the LFPR remains 1.5 percentage points below the level seen at the start of 2020, so there is room for further increases. A growing labor force would allow for a faster pace of job growth and perhaps a modest rise in the unemployment rate, as workers new to the labor force typically take some time to find a job.
The biggest part of the US economy, consumer spending, appears to be slowing. When adjusted for inflation, personal consumption expenditures (PCE) rose only slightly in August. The monthly data can be volatile, of course, and the slowdown in August may have been an adjustment to a surge in spending in the prior month. But payment card data past the mid-point of September show a decided slowing in card usage. While weekly data is even more volatile than monthly, this could be an early sign of slowing spending. Light vehicle sales dipped to the slowest pace since March in August, and it is likely that sales slowed somewhat further in September, as the autoworker’s strike began in the middle of the month. Most of those sales will not be lost forever but simply delayed. When those foregone auto sales will occur depends on when the strike ends, how quickly retailers can get units to sell, and the state of the consumer at that time. The personal saving rate fell to the lowest level of the year in August. At 3.9 percent, it is below the 5.5-7.0 percent decade-long range over most of the past 50 years – but it is above the 2.7-3.4 percent range for the final 10 months of last year. This suggests that consumers can dip into savings to keep spending going, but significantly higher interest rates than a year ago will make it more difficult for consumers to borrow to do the same. Auto loan rates, for example, are at the highest level in at least 18 years.
Higher interest rates are having a continuing and increasingly negative impact on housing activity. Survey data from Freddie Mac show that average 30-year fixed-rate mortgage (FRM) rates climbed above 7.3 percent in late-September, the highest level since late 2000. Not only does this increase make housing less affordable for buyers, but the large number of existing homeowners with mortgages originated in the 2001-02 period have rates increasingly well below current rates. As a result, the number of existing homes for sale remains near record lows, and home sales have moved steadily lower since early this year. The latest survey data suggest that even-weaker home sales are on the horizon, with NAR’s pending home sales index dropping to an all-time low in August (equal to the bottom seen during the Covid downturn), presaging a significant drop in reported existing sales in September. Additionally, the present home sales component of the NAHB Housing Market Index fell in September to the lowest level since March.
According to survey data from the Institute for Supply Management (ISM), manufacturing continued to contract through August while services expanded modestly (September data were not yet available as this was written). This story has been unchanged for nearly a year, and the September surveys are likely to show the same. The Small Business Optimism Index from the National Federation of Independent Business (NFIB) has also told a basically unchanged story for more than the past year, with figures moving around an average level that is historically low, but without worsening further.
And speaking of indicators that are continuing to tell the same story, both the yield curve and the Conference Board’s Index of Leading Economic Indicators (LEI) continue to point to a recession in the near term (whenever that is). Monetary policy, despite having tightened for more than a year, finally became actually 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. We continue to view the usual leading indicators of recession (the yield curve and the LEI) as being accurate predictors, although not as timely in the current period.
Inflation and the Federal Reserve
There are lots of inflation measures, but there are three that the Federal Reserve concentrates on (although it looks at all of them): the overall PCE price index, the core PCE price index, and the “super core” PCE price index (services excluding energy and housing). On a one-month basis, the overall PCE jumped by 0.39 percent in August as energy prices spiked. The core PCE (with energy and food removed) rose by only 0.14 percent – the slowest pace since late 2020. Finally, the super core PCE also increased by 0.14 percent. The Fed can’t control energy prices, and the two measures that it has reasonable long-run control over both slowed to annualized growth rates of 1.7 percent in the most recent month. But monthly prices can be volatile, and that’s why the Fed also looks closely at the 12-month trend rates. The trend rate for the overall PCE edged higher to 3.48 percent; the core PCE slowed to 3.88 percent on a trend basis (the slowest since mid-2021); while the trend rate for the super core PCE moved lower to 4.43 percent (tied with May as the slowest since August 2021). What should we make of these inflation readings, and – more importantly – what is the Fed likely to make of them?
The Federal Open Market Committee (FOMC) did not have the August PCE data at its September meeting, but it’s unlikely that having the data would have made a significant difference. The Survey of Economic Projections (SEP, the projections of the individual FOMC members) had small significant differences from the June SEP. Most importantly, the FOMC now looks for faster economic growth this year and a bit less inflation – with an expectation of one additional tightening move this year (unchanged from the June SEP). But, most importantly, the FOMC now expects the year-end 2024 and 2025 federal funds rate to be 50 basis points higher than it did in June, even with its inflation forecast little changed. The Fed expects real GDP growth to slow to around trend over the next two years, with lower inflation (finally moving to the long-run goal in 2026). The gradual easing of inflation will allow the Fed to ease monetary policy starting next year and continuing into 2026, but with the level of rates higher than expected in June.
This is a reasonable forecast if the economy really does enter a soft landing, with trend economic growth and inflation moving meaningfully toward the Fed’s goal. But what happens if inflation stays hotter (probably with stronger economic growth)? Or if the economy falls into recession next year (as we expect)? In the first alternative, the Fed would certainly continue to tighten monetary policy next year – probably by enough to cause a more serious recession later next year (or in 2025). If the economy falls into recession late this year or early next year, then inflation would move lower faster and sooner than assumed in the September SEP – and the Fed would ease policy sooner and more aggressively than in the September SEP. A modest recession would not require the Fed to bring policy rates back to zero percent or to start quantitative easing again, but the path of rates would be lower than in the SEP. At this point, that’s our baseline view.
Financial Markets
It was a bad month for financial markets in September, with the Fed stating that it would stay tighter for longer, the ongoing reverberations of Fitch’s downgrade of US Treasury debt in August, and concerns that a government shutdown would result in additional downgrades (as suggested by Moody’s). Moreover, the federal government debt situation appears likely to worsen without limit in coming decades.
The yield on 10-year Treasury debt climbed to 4.60 percent in late September (and was a tick below this as the month ended), the highest level since mid-2007. Over the course of the month, the yield rose by 50 basis points. Shorter-term Treasury yields also increased, but by less, allowing the yield curve to flatten. In May, the spread between the 3-month and 10-year Treasury notes was nearly 200 bps, but at the end of September it had dropped to under 100 bps – still a substantial inversion.
Equity markets had a bad month, as well. From the end of August to the end of September, the S&P 500 Index fell by 4.9 percent, roughly to the lowest level since early June. It is now up by 11.7 percent thus far in 2023 (and by 19.6 percent from a year ago despite the drop over the past month). The Dow Jones Industrial Average fell by 3.5 percent last month (but is up by 1.1 percent this year), while the NASDAQ Composite dropped by 5.8 percent in September (but has still spiked by 26.3 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 5.4 and 6.2 percent, respectively, for September (and with a gain of 3.0 and a decline of 0.5 percent for the year).
David W. Berson, Ph.D.
Chief US Economist
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