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Inflation is falling, the economy is doing well, and the Fed is in no rush
Wednesday’s FOMC meeting is going to be pretty boring. No one is expecting a rate cut, and everyone thinks the Fed will open the door to cutting rates in September.
A rate cut in September is certainly possible if the next Consumer Price Index and Personal Consumption Expenditures (PCE) inflation rates fall below the Fed’s 2% target. But that is by no means a certainty, and it shouldn’t be. Given current interest rates, and growth looks strong and stable, there is little risk the Fed will keep cutting rates for much longer.
Wall Street and many other observers are nervous about the economy and worried the Fed will make some changes. Unhedged thinks they need to calm down a bit.
Let’s look at the numbers.
inflation
US inflation is almost at the Fed’s target. Core CPI (Unhedged’s preferred measure) was notably lower in June, increasing 1% month over month, with a three-month average just under 2%. The Fed’s preferred inflation measure, the Personal Consumption Expenditures Price Index, was in line but still below, rising slightly above expectations at 2.6% annual growth, the same as in May. But the pattern is similar. Things don’t need to get better, just that the trend continues.
employment
Those who think interest rates should start being cut now are primarily concerned about rising unemployment.
The headline unemployment rate hit a two-year high of 4.1%. Though historically low, the increase was large enough to nearly trigger the therm rule, a recession indicator that suggests a recession could begin when the three-month moving average unemployment rate rises 0.5 percentage points above its 12-month low. The measure reached 0.43 percentage points in June.
But Claudia Thurm, who created the rules, said she doubts the current figures indicate an imminent recession.
We’re not necessarily on the brink of a recession right now, but the likelihood of a recession within six months is increasing. … What complicates this is that the supply of labor is expanding, and immigration is a factor. Immigration makes it harder to measure the labor market. And it could take time. [some migrants] It takes longer to find a job, so the unemployment rate is expected to fall again. [once they do]The speed and scale of immigration has been so rapid that it has made employment statistics difficult to interpret.
This cycle is strange. You have to remember that unemployment is very low, around 4%. It’s hard to imagine anything terrible happening to the economy when so many people have jobs.
Survey data
Recent GDP numbers and early releases from the Atlanta Fed’s GDP Now Monitor suggest that overall growth is solid and probably above trend. Still, nervous types are getting nervous about ambiguous survey data.
The June ISM manufacturing and services surveys both pointed to a decline in economic activity, with the services economic activity sub-index dropping an unexpected 12% into contraction territory. Manufacturing activity has contracted for three consecutive months and is accelerating its pace. The employment composition of both surveys is shrinking.
However, the Fed is particularly focused on inflation in the non-housing services sector and is unlikely to be lulled into a frenzy by the one-month ISM reading, which has been in expansionary mode for 16 of the past 18 months. Price sub-indexes are also still expanding for both the manufacturing and services sectors.
Are consumers becoming more responsive?
“The American Consumer Shows Signs of Decline” was the headline of a Financial Times article over the weekend, which cited weakening consumer sentiment surveys, weak outlooks for consumer goods makers such as Whirlpool, Lamb Weston and UPS, and reports of price cuts at retail chains.
All of these points are true, and all are important. But these tightenings look more like a normalization after a period of post-pandemic “revenge spending” than a sign of broader household savings. And the weakness coincides with areas that look very strong.
The University of Michigan’s latest consumer confidence survey results were indeed weak. But since the pandemic hit, such numbers have become harder to interpret. Over the past two years, the trend has been upward, but it has also become more volatile, with higher highs and lower lows. The latest results don’t seem to break that pattern.
One of Michigan’s main sub-surveys asks consumers if now is a good time to buy big household items like appliances. Here, the trend is clearly trending downward. Is this a sign of weakness to come?
But the swings in sentiment aren’t showing up in the spending numbers. Real personal consumption expenditure growth has continued to trend at about 2.5% per year. Private data shows spending has slowed slightly, but is still growing at a healthy clip. Below is a graph of spending across Visa’s U.S. network:
When we discussed Lamb Weston last week, we noted slowing restaurant traffic and a price war among fast-food chains that’s reflected in the National Restaurant Association’s performance index, which is shrinking.
This is surprising, but may be more a natural reaction to the extraordinary restaurant boom of 2022 and 2023 than a sign of macroeconomic weakness. If air traffic is trending like this, we’re not seeing a general consumer pullback.
Despite some disappointing reports from companies in recent weeks, second-quarter earnings were generally pretty strong, with S&P 500 companies reporting total revenue growth of 5 percent and profits up by almost 10 percent, according to FactSet.
A bad quarter for UPS would normally be a bad omen, given that the company’s fortunes are often tied to those of the broader economy, but the company’s problems have more to do with costs than demand. U.S. package volume trends have been improving for the past year or so, with package volumes increasing in the second quarter for the first time in nine quarters.
Some companies, such as Lamb Weston, are facing severe pricing pressure, but that’s not the case for all. Coca-Cola’s U.S. business grew 10% in the quarter, but most of that was due to pricing. Some home improvement companies, such as Whirlpool, are struggling, but not all of them. Paint retailer Sherwin-Williams had a strong quarter, with higher sales and prices. Branded consumer goods companies such as Colgate and Unilever reported strong results. Colgate cut some prices, but sales volumes surged.
finance condition
In choosing both its communications and monetary policy strategies, the Fed needs to consider the impact of financial conditions on growth. While rising interest rates are clearly pressuring certain sectors such as housing and construction, financial conditions remain accommodative overall. Equities are within a few percentage points of their all-time highs. Credit spreads are tight. Implied volatility is low. The economy as a whole does not appear to be financially constrained.
Summary
The Fed does not seem in danger of making the classic mistake of keeping interest rates too high for too long. The economy is still in remarkably good shape, with more strengths than weaknesses. Unemployment is low and businesses are thriving. The Fed can afford to wait a little longer, perhaps longer than September, until inflation is firmly under control.
(Armstrong and Leiter)
Good read
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