Would a September Rate Cut Be Enough for the Economy?

Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.

Equities rose during a holiday-shortened week as investors balanced more signs of a slowing economy and some cooling of the labor market against optimism that the Federal Reserve may cut rates at its September meeting. While the headline number from the Bureau of Labor Statistics Nonfarm payroll report showed still-strong job growth, details within the data (along with other economic releases last week) add to the emerging picture of an economy that is beginning to slow.

To be sure, the 206,000 new jobs reported in last Friday’s Nonfarm report modestly beat Wall Street expectations of 190,000; however, details of the report, including revisions to last month’s initial estimates, suggest that the economy may be losing more of its luster. Of the new jobs created, 82,400 were in health care and social assistance, and 70,000 government positions were added—with 65,000 of these at the state and local level. These three areas aren’t driven by economic growth. Temporary help services—a leading indicator of the broader labor market—fell by 48,900. This is a timely measure because employers typically let go of temporary workers before cutting permanent staff. Further, estimates of the number of new positions added in April and May were revised downward by 57,000 and 54,000, respectively. In another potential sign that the employment market is weakening, the pace of wage growth moderated in June. Hourly pay for production and nonsupervisory workers grew 0.3 percent in June, down from May’s pace of 0.4. On a year-over-year basis, wages for nonsupervisory production workers are up 4 percent—still above the 3 to 3.5 percent level the Fed believes is consistent with its target of sustainable 2 percent inflation.

The other employment measure from the Bureau of Labor Statistics (BLS), the Household report, shows that the unemployment rate unexpectedly rose 0.1 percent in June and stands at 4.1 percent, the highest level since November 2021 and 0.7 percent from the low of 3.4 percent in January 2023. The latest unemployment reading shows the economy is inching toward triggering the so-called Sahm rule (regular readers of our commentaries may recall this rule, developed by former Federal Reserve Economist Claudia Sahm). According to the rule, since 1960, every time the three-month moving average unemployment rate rose by 0.5 percent or more from the previous three-month moving average low, a recession followed. The current rate is now 0.43 percent higher than the low, meaning less than a 0.1 percent increase would put the rise at the threshold.

The relatively muted employment data raised hopes among investors that the Fed would cut rates in September. Certainly, signs that the strain in the labor market is starting to ease (along with a slowdown in the pace of wage growth) are likely to be seen by members of the Federal Open Market Committee as tailwinds in its fight to bring inflation down to target. Additionally, should progress on the pace of inflation captured in last month’s Personal Consumption Expenditures and Consumer Price Index readings persist, it’s possible that the Fed may conclude a rate cut in September is warranted. Unfortunately, a 25-basis-point reduction at that time may not be the magic elixir some investors are seeking. Recall that prior to the beginning of the past four recessions, the Fed began cutting rates. Unfortunately, the cuts came after the economic slowdown had already gained momentum. That’s because weakening demand and slowing economic growth are what typically drive a slowdown in price pressures and easing tightness of the labor market. Indeed, as we have detailed over the past several months, various forward-looking and real-time measures of the economy suggest that growth is fading. While there have been occasional data points that offer glimmers of hope that the economy continues to defy the weight of elevated rates, the overall trend has been downward. In fact, as we discuss later in this commentary, last week’s data showed more of the same.

While the thought of a slowing economy and a potential recession can be concerning, it is important to remember that they are a natural part of every economic cycle and set the stage for the next growth phase. Fortunately, with the slow unwinding of inflation over the past two years, the Fed should have more room to cut rates, which we believe will shorten the length and severity of a potential recession and help contain the slowdown.

Wall Street wrap

Manufacturing continues to contract: The latest headline reading from the Institute for Supply Management (ISM) shows activity continues to slow, with June’s measure at 48.5, down 0.2 from May’s reading. The latest reading marks the 19th time in the past 20 months that the reading has been in contractionary territory. (A reading of 50 or above signals expansion.) Readings for new orders came in at 49.3, up 3.9 points from May but still at a contractionary level. Order backlogs slid further into contraction territory, with the June reading declining to 41.7—down from May’s 42.4 level.

Despite weakening in the manufacturing industry, materials prices continued to rise, but at a slower pace. The latest reading for input prices was 52.1, down from May’s reading of 57. Three of the six largest industries reported higher costs. The latest reading marks the sixth consecutive month of rising prices, after eight consecutive months of decreases. Goods prices have been the driving force in the disinflationary process as price increases shifted to the services sector. While input price growth moderated during the month, should costs continue to expand, we may see inflation on this side of the economy perk up, which could put additional upward pressure on inflation overall.

The employment index declined 1.8 points in June from the prior month and fell back into contractionary territory at 49.3.

The report showed that businesses continue to take a cautious view of the economy going forward. “Demand remains subdued, as companies demonstrate an unwillingness to invest in capital and inventory due to current monetary policy and other conditions,” noted Tim Fiore, Chair of the ISM. The latest durable goods order released last month by the U.S. Census Bureau confirmed Fiore’s view, as it showed a drop in capital spending by companies. Business investment is generally seen as a contributor to future growth or increased productivity. As such, the lack of investment may point to slowing growth in the months ahead.

Services sector activity tumbles: ISM data for the services side of the economy showed that the sector slipped into contraction in June, with a headline reading for the sector coming in at 48.8, down five points from May’s reading of 53.8. This is the second time in three months that this measure has been in contractionary territory and only the third time in the past 49 months with a reading below 50. New orders dropped to 47.3 from May’s reading of 54.1. Along with contracting growth, demand for workers declined further, with the employment index coming in at 46.1, down from May’s reading of 47.1. The latest employment index reading marks the fifth time in the past seven months that both ISM’s manufacturing and services employment surveys have been in contractionary territory. Reflecting the uniqueness of the post-COVID economic period, it’s unusual to see contraction like this without seeing actual job losses. Prior to the onset of COVID in early 2020, if you go back to the start of monthly ISM services data in 1997, both services and manufacturing showed contraction (below 50) in 44 months. In all but three of those months there were private-sector job losses.

On the inflation front, the prices paid index in the survey eased modestly but is still in expansion territory at 56.3, down from 58.1 in May. Of 18 industries covered by the survey, 13 reported paying higher prices.

The generally downbeat tone of the report was underscored in comments by Steve Miller, Chair of ISM’s services business committee. “The decrease in the composite index in June is a result of notably lower business activity, a contraction in new orders for the second time since May 2020 and continued contraction in employment,” Miller said in a statement. “Survey respondents report that in general, business is flat or lower, and although inflation is easing, some commodities have significantly higher costs.”

When both the ISM services and manufacturing PMIs are in contractionary territory it indicates the economy is weakening.

Continuing jobless claims move higher: Weekly initial jobless claims were 238,000, up 4,000 from last week’s upwardly revised level. The four-week rolling average of new jobless claims came in at 238,500, up 2,250 from the previous week’s average.

Continuing claims (those people remaining on unemployment benefits) stand at 1.858 million, up 26,000 from the previous week’s revised total and now at the highest level since November 2021. Both of these are on an uptrend, and we are watching this measure closely as further evidence that the labor market is losing steam.

The week ahead

Monday: The Federal Reserve will release its latest look at the financial condition of consumers through its Consumer Credit report covering the month of May. Consumer credit card debt has risen in recent months as have the number of credit card and auto loans slipping into severe delinquency. We’ll be watching to see if consumers are continuing to add to their debt levels.

Tuesday: Fed Chair Jerome Powell heads to Capitol Hill to present his semiannual monetary policy report. We will be listening to his comments for indications of how he views the labor market, the pace of disinflation and the Fed’s expectations for interest rates for the remainder of the year.

The National Federation of Independent Businesses Small Business Optimism Index readings for June will be out prior to the opening bell. Recent readings have indicated that price pressures and the state of the labor market continue to weigh on small businesses, with many firms raising wages. We will watch for signs that suggest these challenges are easing.

Thursday: The Consumer Price Index report from the BLS will be the big report for the week. Recent data has shown the disinflationary process has stalled and may be reversing; we will be dissecting the data to see if the data suggests prices continue to ease or if last month’s better-than-expected data was a temporary blip.

Initial and continuing jobless claims will be out before the market opens. Continuing claims have been moving higher, and we’ll continue to monitor this report for signs of eroding strength of the employment picture.

Friday: The latest readings from the BLS on its Producer Price Index will offer a look at changes in costs for buyers of finished goods. It can provide insights into the direction of input costs faced by businesses and can indicate how prices may move at the consumer level in the future.

The University of Michigan will release its preliminary report on July consumer sentiment and inflation expectations. We will be watching to see if recent news of higher inflation and forecasts of higher rates for longer has affected consumers’ expectations.

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