The big economic story for Q3 was the long-anticipated commencement of easing by the FOMC. Contrary to popular opinion, it was not overdue. In this writer’s opinion, the magnitude of the cut – 50bp – was entirely unjustified by the prevailing data; indeed, one could debate whether a rate cut was necessary at all. With output growth at 3%, payroll gains accelerating, unemployment well below the historical average, and inflation still stubbornly above the Fed’s target, an argument could be made for holding rates steady.
By easing 50bp in the face of those data points, Chairman Powell capitulated to market pressure, exposing his dovish tendencies. Worse, he gave credence to those critics who believe that making such a move so close to the Presidential election was political. While such suspicions are the stuff of conspiracy theory, the Powell Fed has called into question the long-respected perception of the central bank’s independence.
Labor Market
The focus leading into the September rate cut was on the labor market, and the move was followed by the September jobs report, which saw a larger-than-expected payroll gain, a dip in the jobless rate, and a pickup in hourly earnings.
Non-farm payrolls grew by 254,000 in September. We would be remiss to not point out that the trend over the last year has been large upside surprises in the initial payrolls release, only to be followed by large downward revisions in the subsequent month, so don’t be surprised if the September gain is slashed next month. Payroll gains over the last six months have averaged only 167k per month, compared with an average gain of 240k over the previous six months. However, gains have accelerated from 118k in June through the September print. (Note that we still contend that job “gains” are actually recoveries from the covid shutdown, as the labor force remains some 4.2 million jobs shy of equilibrium when factoring in normal growth had the economy not been shut down.)
The jobless rate fell in September to 4.1% from 4.2% in August and 4.3% in July. However, it was 4.0% in May, and 3.4% in April 2023. Still, 4.1% is a historically low rate of unemployment. Chairman Powell has not stated a defined “full employment” rate, but his predecessor did, and her full employment threshold was 5.0%. The jobless rate has only been at or below that level 39% of the time historically since 1948, and the average unemployment rate since then is 5.7%.
Average hourly earnings rose 0.4% in September, for an annual gain of 4.0%, the highest rate since May. That translates to an inflation-adjusted gain of 1.4%, which helps explain why so many households are struggling, especially in light of compound inflation.
One other show of relative strength in the labor market was the increase in job openings in August, from 7.7M to just over 8M. At the same time, initial jobless claims have trended lower since late July, as have ongoing filings for unemployment insurance.
These numbers augur for a slowing of the pace of monetary accommodation, so we would expect the Fed to cut rates by only 25bp at each of the two remaining FOMC meetings in 2024. However, based on the data, we only expected a 25bp rate cut in September, so there is a chance that this dovish Fed will once again cave to market pressure and capitulate to a larger cut if the market clamors for one.
Housing
The S&P CoreLogic Case-Shiller 20-City Composite Home Price Index (HPI) rose in July for an 18th consecutive month, and is up 5.9% year-over-year. That rate of increase, however, is the lowest since last November, and July’s monthly gain was just 0.3%. Sixteen of the 20 markets in the Composite Index posted increases for July, the fewest since January, with San Francisco, Tampa, Dallas and Seattle experiencing monthly declines. In addition, Denver’s increase was just 0.03%. San Francisco fared the worst, with a 0.42% decrease for the month.
The strongest market in July was Las Vegas, with a 0.88% gain for the month. Year-over-year, Las Vegas is second only to New York with a gain of 8.2% to New York’s 8.7% increase. Los Angeles and San Diego home prices are both up 7.2%. The weakest market on a year-over-year basis is Portland, where home prices are up just 0.8%.
Some markets appear to be at bubble levels, with more than half the cities in the Composite Index at record levels. However, only New York, Las Vegas, and the southern California markets are at year-over-year levels that are notably above trend, and the pace of the annual increase in the overall index has been slowing for six months, with the current year-over-year increase in the Composite Index below the long-term average. Thus, we see limited risk of a sharp correction.
Home price gains continue to be driven by a lack of supply, which in turn is a function of mortgage rates. However, the average 30-year fixed rate has fallen by more than 100bp since last October, and by more than 50bp since August, as the market began to price in a rate cut (and the 50bp cut that the Fed implemented was widely anticipated, or at least hoped for, by the markets). As the Fed continues to ease, as they surely will, mortgage rates should fall further, which will gradually release supply as some homeowners become more willing to sell their homes and take on another mortgage at rates they see as more affordable.
Consumption
There is a bifurcation among U.S. consumers as a result of compound inflation. While the current rate of inflation has been receding, prices overall are about 20% higher than they were at the beginning of 2021. This has pressured consumers at the lower end of the economic spectrum, leading to lower discretionary spending among their ranks. We see this in the earnings struggles of discount retailers such as Dollar General.
At the same time, overall personal consumption expenditures continue to increase. Real personal consumption expenditures year-over-year as of August were up 2.9%, roughly the same pace as over the prior three months, and higher than the pace of the first four months of the year, but less than during the 2023 holiday season. Discretionary spending at the higher end of the economic spectrum, such as on international travel, remains relatively strong. Retail sales are up 2.0% year-over-year, just off the pace of a year ago.
However, consumer sentiment is flagging. The University of Michigan’s Consumer Sentiment Index ticked up in August, but remains about ten points below where it was in March, and is below the lowest level reached during the pandemic. And a number of retailers have issued warnings for lower earnings over the next several quarters. The expectation is that consumption will decline overall throughout 2025 unless the Fed is able to engineer a soft landing through monetary accommodation.
Inflation
As a reminder, the Fed’s inflation target is a reading of 2.0% year-over-year on its preferred inflation gauge, the Personal Consumption Expenditures (PCE) price deflator. That indicator stands at 2.7% as of August, having increased by a tick from July. So not only is it not at or below the Fed’s target, it’s moving in the wrong direction for the Fed to be aggressively cutting interest rates.
Other price indicators are similarly sticky. Headline CPI is up 2.6% as of August. And while the Producer Price Index (PPI), a measure of inflation in the pipeline, is up only 1.1% year-over-year, it was negative from the end of 2022 through last August and again in October through January and May and June. The latest reading is the second-highest since November 2022.
There are also a couple of wild cards that could push prices higher. One is the combination of Hurricanes Helene and Milton, which will result in an increase in demand for building supplies, vehicles, appliances, and other items destroyed in those storms, as well as the potential for stimulus in the form of aid to those affected. The other is the dockworkers’ strike that was recently delayed until January 15, which could have serious inflationary implications. These events may argue for the Fed to temper its accommodative stance; it remains to be seen whether Powell and company have the discipline to adhere to the price stability component of their dual mandate, or whether they continue to acquiesce to market whims.
The Election
Another wild card in terms of the economic outlook is the Presidential election. There is probably at least a coin-flip likelihood of a recession ensuing in 2025, regardless of who is in the White House come January 2025. History would suggest that the economy would likely fare better under former President Trump than under Vice-President Harris, though little is known for certain of her economic policy positions; this presumption is based solely on the data using her current administration’s policies as a proxy.
A number of concerns have been raised over various tax proposals that have been floated, particularly the tax on unrealized capital gains. It should be noted that any tax proposal must be approved by Congress, and that particular proposal is highly unlikely to ever see the light of day. This also highlights the importance of down-ticket races on the economic outlook in terms of control of the legislature.
Conclusion
We believe that there is a moderate risk of recession in 2025 as economic growth continues to slow under the burden of compound inflation, unless the Fed is able to engineer a soft landing. It is this writer’s opinion that the likelihood of that scenario is threatened by the central bank’s overly aggressive accommodation in the face of market pressure, rather than adhering to its data-dependent monetary discipline in its efforts to stabilize prices. It would not be surprising for inflationary pressures to re-emerge, forcing the Fed to either abandon accommodation or risk falling behind the fight against inflation, as it did in 2021. The result of that would likely be stagflation.
In the interim, expect rates to continue to fall, which should result in an easing of tight housing inventories and a pickup in mortgage lending activity. We don’t anticipate much relief for credit card borrowers, however, who remain burdened by higher prices.
There is still uncertainty related to several wild cards; namely, the severe weather events in the Southeastern U.S., the postponed dockworkers’ strike, and, most notably, the forthcoming election.
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