How the Fed’s Softer Tone Could Hurt Its Fight Against Inflation
Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.
In the early days of the Federal Reserve’s rate hiking cycle, we noted that in addition to rate hikes and quantitative tightening, Federal Reserve Chairman Jerome Powell was using his statements to tighten economic conditions. At the time, we argued that Powell’s forceful tone on the need to rein in inflation served as a warning to businesses and consumers that higher rates were on their way and would remain until the battle against price increase was largely won. By telegraphing the Fed’s intent, we believed chair Powell was attempting to slow the economy by managing expectations of future growth. Put simply, if consumers and businesses believed challenging times were ahead, they would spend less, and the economy would slow to a more sustainable pace without the Fed having to cause a recession. We are revisiting the concept of the Fed’s bully pulpit as a monetary tool in light of the reactions consumers and the markets are having to Powell’s recent comments indicating the Fed may be able to cut rates and a soft landing is a real possibility.
In mid-December the Fed released forecasts from the Federal Open Markets Committee (FOMC) that implied three rate cuts in 2024. The projection was widely viewed as a signal the Fed was satisfied that inflation was well on its way to being in the rearview mirror and that the economy would emerge unscathed from the rate hikes that began in 2022. Since then, equities have surged, with the S&P 500 hitting a new all-time high last week, and consumers have become decidedly optimistic about the economy going forward.
Indeed, consumer sentiment jumped to 78.8 in January, up 9.1 points from December’s final reading of 69.7, according to the latest consumer sentiment survey released by the University of Michigan. The preliminary readings come on the heels of December’s surge in expectations and leave the measure at its highest level since July 2021. The spike in optimism was nurtured by Fed comments about the potential for rate cuts in 2024 as 38 percent of respondents expect interest rates to fall in the coming year, up from 26 percent in December. The spike in expectations for rate cuts has been exceeded only during periods when the economy was either entering a recession or on its way out of contraction. Rising expectations of rate cuts amid Powell’s comments are likely also influencing overall optimism. For example, there was a 27 percent increase in the short-term outlook for business conditions. Consumers also expect higher incomes in 2024, with respondents expecting a median 2.8 percent rise in household income, which marks the highest level since 2006. This is where our concern lies. Strong wage growth and renewed economic optimism could prevent inflation from receding from current levels. e survey also shows that
The good news is results from the survey also show that inflation expectations continue to edge lower, with respondents expecting prices to rise 2.9 percent in the coming year, down from December’s reading of 3.1 percent. The current reading marks the lowest level since December 2020 and is now in the 2.3 to 3.0 percent range seen during the two years preceding the onset of COVID. Long-term inflation expectations also declined, coming in at 2.8 percent, down 0.1 percent from December’s final measure.
While the Fed views anchored inflation expectations as important in preventing inflation from becoming embedded in the economy as it was from 1966–1982, the general surge in optimism may create a challenge in the Fed’s effort to bring inflation sustainably down to its 2 percent target. That’s because consumer expectations are a double-edged sword. So, while Powell sought to tighten economic conditions through the expectations channel in 2022, his comments and the FOMC’s projections may have the unintended result of loosening conditions and fueling a rise in growth, which could reignite inflationary pressures.
Somewhat quietly, market expectations of inflation in the coming years have surged during the past few weeks. The five-year, five year forward inflation breakeven rate—a measure watched by the Fed—reached a low in late December of 2.13 percent but has since risen to 2.42 percent as of last Friday. This rate reflects market expectations of the average expected inflation over the five-year period that begins five years in the future. While the rate remains within striking distance of the Fed’s stated inflation target, it is clearly moving in the wrong direction. We believe that with the disinflationary process stalling, the job market still tight, and wage growth remaining elevated, any loosening of financial conditions that occurs due to improving expectations resulting from the Fed’s softened stance could force the FOMC to keep rates higher for longer, which we believe increases the odds of a recession in 2024.
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Data out last week suggests that conventional wisdom may be underestimating challenges facing the economy going forward.
Consumer spending moves higher: The latest retail sales numbers from the U.S. Census Bureau show overall retail sales in December grew 0.6 percent, doubling November’s pace of 0.3 percent. The latest data shows retail sales are up 5.6 percent on a year-over-year basis. For the full year, retail sales increased 3.2 percent. Growth was widespread, with nine of the 13 categories seeing increases. While sales figures are not adjusted for the effects of inflation, the latest numbers show that December’s surge in sales far outpaced price increases.
Beige book hints at potential easing in the job market: The latest release of the Federal Reserve’s Beige Book, which provides real-time anecdotal assessments of business conditions across the country, showed that the pace of economic growth was unchanged in the majority of the 12 Federal Reserve Districts from the prior reading. Consistent with retail data out last week, holiday shoppers provided an economic boost, with the majority of districts reporting sales meeting expectations and three districts noting that sales exceeded expectations. While retail sales provided a boost to the economy, manufacturing activity declined in most districts.
Given our belief that the tight labor market and elevated wage growth are threats to the disinflationary process, it was noteworthy that while most districts reported little change in employment levels, nearly all respondents reported one or more signs of a cooling labor market. Additionally, while the majority of districts described wage growth as moderate or modest, many respondents expected wage growth to decline over the next year.
As it pertains directly to inflation, half of all districts reported price growth, with two describing the pace as moderate. Despite rising prices, profit margins were squeezed as “increased consumer price sensitivity had forced retailers to narrow their profit margins and to push back in turn on their suppliers’ efforts to raise prices,” according to the report. Should profit margins continue to face pressures, businesses may turn to cutting payrolls to protect further erosion of margins.
Manufacturing production remains weak: Industrial production edged up 0.1 percent in December but declined at a 3.1 percent annualized rate during the fourth quarter, according to the latest data from the Federal Reserve. Manufacturing (the largest component of industrial production) also rose 0.1 percent for the month but declined 2.2 percent annualized for the quarter. Durable goods manufacturing fell 0.4 percent in December but was offset by a 0.6 percent gain for nondurable products. The latest report is consistent with other measures of manufacturing we follow and suggests that a rebound in that side of the economy has yet to materialize.
Existing home sales decline: The National Association of Realtors (NAR) reported that existing home sales in the U.S. declined 1 percent in December to a seasonally adjusted annual rate of 3.78 million units. On a year-over-year basis, sales of existing units are down 6.2 percent. On an annual basis, existing home sales slumped to the lowest level since 1995.
The inventory of unsold homes was 1 million units, down 11.5 percent from November. Despite the decline in sales, the median price for existing homes reached $382,600 in December, which is 4.4 percent higher than year-ago levels. Despite the lackluster finish to the year, NAR Chief Economist Lawerence Yun believes December marked a trough for the market. “The latest month’s sales look to be the bottom before inevitably turning higher in the new year,” Yun said in a statement accompanying the report. “Mortgage rates are meaningfully lower compared to just two months ago, and more inventory is expected to appear on the market in upcoming months.”
Should the existing market pick up due to lower interest rates, it could lead to higher home prices in the future and a reversal of easing shelter prices consumers saw throughout much of 2023.
Similar to existing home sales, new construction slowed to close out 2023. The latest housing starts data from the U.S. Census Bureau shows residential starts declined 4.3 percent in December from the prior month to a 1.46 million annualized rate. However, on a year-over-year basis, starts were up 7.6 percent from December 2022. Single-family housing starts fell 8.6 percent from November’s revised pace to a seasonally adjusted annualized rate of 1.03 million units. Meanwhile, multi-family starts were 417,000, up 7.5 percent from November’s revised pace of 388,000.
While starts were down in December, permits rose 1.9 percent from November to 1.495 million. Single-family permits edged 1.7 percent higher than the prior month to 977,000; multi-family permits tumbled by 11 percent for the month and are now down 18.8 percent year over year.
Home builders feeling more optimistic: Thanks to a pullback in interest rates, optimism among home builders improved last month. The latest sentiment reading from the National Association of Home Builders came in at 44, up seven points from December’s reading. While still below 50, the latest reading marks the second consecutive month of an uptick in optimism. However, to combat the impact of higher interest rates, 62 percent of respondents reported offering some sort of incentive to entice buyers, with 31 percent reporting they cut prices on new homes. The average price reduction was 6 percent, unchanged from December, according to the survey.
Continuing jobless claims ease: Weekly initial jobless claims numbered 187,000, a decrease of 16,000 from last week’s upwardly revised figure and the lowest level since late September 2022. The four-week rolling average of new jobless claims came in at 203,250. Continuing claims (those people remaining on unemployment benefits) were at 1.806 million, a decrease of 26,000 from the previous week. The four-week moving average for continuing claims declined slightly to 1.848 million, down 13,750 from last week’s upwardly revised figure.
The week ahead
Monday: The Conference Board’s latest Leading Economic Index Survey for December will be out mid-morning. For months, these reports have suggested the U.S. economy may be on the cusp of or in a recession. We will be scrutinizing the data for any indications of a change in the pace of the slowdown.
Wednesday: We’ll get an update on the health of manufacturing and services in the U.S. when S&P Global releases its Flash Purchasing Manufacturers Index reports for January. Activity in manufacturing weakened last month and remains at contractionary levels, while the services side has shown continued resilience. We will be watching for signs to determine whether the services sector is seeing erosion of strength as the cumulative effects of rate hikes continue to work their way through the economy. We’ll also be looking at demand for employment in both industries.
Thursday: We get our first estimate of fourth-quarter GDP. Wall Street estimates project growth to come in at 2.0 percent quarter over quarter annualized.
The Chicago Federal Reserve Bank releases its national activity index. The report provides a look at economic activity across the country as well as related inflationary pressures, and we will be watching for signs of slowing economic growth.
The U.S. Census Bureau will release data on new home sales for December. Last week’s Home Builders Index from the National Association of Home Builders showed that optimism among builders has risen as interest rates have retreated from recent highs, and we’ll be looking at this data to assess the impact on the behavior of buyers of new properties.
Initial and continuing jobless claims will be announced before the market opens. Initial filings fell last week, and the four-week rolling average of continuing claims also eased. We will continue to monitor this report for signs of changes in the strength of the employment picture.
Data on durable goods orders for December will be released to start the day. We’ll be watching for signs that businesses are continuing to pull back spending in light of economic uncertainty.
Friday: The December Personal Consumption Expenditures price index from the U.S. Commerce Department will be out before the opening bell. This is the preferred measure of inflation used by the Federal Reserve when making rate hike decisions.
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