The US economy has picked up over the past month. The latest consumer price index inflation report showed signs of cooling. From jobs data to retail sales, growth indicators are holding up. All of this could point to a safe path for the Federal Reserve to ease rate hikes, normalize the economy, and keep the US from hitting an economic skid.
But this good news doesn’t mean the U.S. economy is still out of the woods. From inflation to consumer spending, there are clear signs that the economy is still at risk of slipping into recession.
cool but not cool
In the past few weeks, signs that very high inflation was easing were the most high-profile and most anticipated changes. Several inflation indicators improved, including 0% month-on-month price change. It looks like a breakthrough, but it’s too early to ring the bell.
Even with these traditional indicators improving, the underlying inflation indicators are still heating up. For example, consider the median CPI for the Cleveland Fed. It attempts to measure “average” inflation by looking at the price change of the median item in a basket of commodities tracked by the CPI. As the Cleveland Fed noted in its survey of new indicators, the indicator is of particular interest because “the median CPI provides a better signal of underlying inflation trends than more closely monitored inflation indicators. to provide. So while Core CPI, a traditional measure that excludes volatile food and energy costs, rose just 3.8% in July, the Cleveland Fed’s measure rose 6.5% in July, down from the past three-month average. increased by 7.6%. This is not an acceptable level of inflation to declare the problem solved.
Wage growth is another sign that the US fight against high inflation is far from over. The Atlanta Fed’s median wage growth tracker was 6.3% in July and averaged 6.7% over the past three months. Wage growth could drive broader inflation if it grows much faster than firms’ productivity. Given productivity, the Atlanta Fed’s indicator should be closer to 3.5-4%. Americans’ expectations of inflation over the next 12 months have fallen slightly, but remain at 6.2%. “This points to an upside risk to inflation as workers negotiate higher wages that businesses can pass on to consumers through price increases,” said a San Francisco Fed researcher on the forecast.
In short, there are compelling reasons why we expect inflation to remain solid over the next few quarters, even with significant price cuts on a handful of high-profile products.
Consumer stumbling block
Any discussion of the strength of the US economy must begin with the consumer. American consumers enjoy many benefits, including low unemployment, accumulated savings, and strong household balance sheets. Consumption held up despite a decline in gross domestic product in the first half of 2022. That said, the economic outlook is a change in margins, where consumer power is weakening. A few points stand out.
- Private domestic demand — the portion of GDP attributed to demand from U.S. consumers and businesses, less the impact of international trade, business inventories, and government spending — cooled in the first half of the year. This is a key indicator that economists use to predict employment growth. Strong private demand has prompted consumers to signal that labor market conditions are strong but momentum is slowing. A rise in the unemployment rate seems inevitable despite the impressive July employment data. Initial weekly unemployment claims are on the rise, and layoff announcements are spreading beyond the tech sector, with companies like Walmart and Wayfair announcing job cuts. In fact, a survey of US companies by accounting firm PwC found that about half of respondents said they were planning layoffs.
- A slowdown in private demand occurs despite a surge in the amount of time employees spend at work. This means that corporate revenue growth is slowing, even as the amount of money employees have to pay rises rapidly. This points to lower labor productivity and lower profit margins. Companies will inevitably seek to protect their profits through a combination of slowing hiring and cutting pay.
- Spending increased in the first half of the year despite a slowdown in income. This means that the increase in consumer spending in the first half of the year was solely due to the use of savings. It cannot continue indefinitely. Even if people’s incomes were moderated somewhat by lower gas prices, it’s quite possible that households would use it to replenish their cash buffers rather than go out and spend.
I don’t like to bet against the US consumer, but when inflation risks rise and the labor market is likely to slow down, it’s hard to back US consumers.
The pain of the housing market
Another warning sign for the economy is flashing from a dormant housing market. Rising mortgage rates have dampened demand for housing. Pending home sales and signed contracts for existing properties are collapsing, which means that close rates will drop significantly in the coming months.
With demand faltering, builders will have to focus on clearing the huge backlog of homes they’ve sold but haven’t finished building, rather than starting new homes. Not surprisingly, home completions (completed homes) increased, but home construction starts (homes under construction) slowed. This gap will continue to shrink and the number of units under construction will decrease.
Fed Chairman Jerome Powell talks about housing market reset. While this shakeout is clearly underway, it is far from complete. The number of people planning to buy a home in the next six months has fallen to its lowest level since February 2013, according to Conference Board data.
companies do not want to invest
Non-residential business capex (where companies spend money on equipment and software upgrades) is also unlikely to be a growth engine if the consumer and housing markets are unlikely to provide the impetus for a strong economic recovery. For one thing, as GDP growth expectations weaken and growth prospects weaken, business investment tends to slow (and vice versa). We can already see that companies are becoming more cautious with their spending. The regional survey of six-month capex intentions looks south. And the tech industry, which has accounted for most of the growth in real non-residential capital spending over the past two years, has been hit hard by the stock market slump amid rising interest rates. It’s also the industry most responsible for the recent rise in layoffs.
Globally, the signs are getting worse. Europe is in recession, but China’s zero COVID policy is holding back growth in the region. With no incentive for businesses to invest to meet demand elsewhere, businesses may suspend spending plans until the outlook clears.
And what about the Fed? Is a slowdown in rate hikes, or a turnaround to cut rates to support the economy imminent? I think it’s unlikely. First of all, Fed officials have been very vocal in recent weeks about their plans to continue raising rates. In his highly anticipated speech at the Fed’s annual meeting in Jackson Hole, Wyoming, on Friday, Powell even warned of “some pain.” And even slowing the pace of rate hikes, which has yet to be decided, is not the same as cutting rates. Importantly, government officials are reluctant to change policy immediately. Releasing anti-inflationary policies prematurely when inflation is still high raises inflation expectations and increases the risk of higher inflation becoming entrenched in the economy.
If you want to know how concerned the economic slowdown is, it’s worth watching the stock market. Equity price movements can be summarized into three factors: interest rates, actual and expected returns, and risk premiums. The strong performance of most equities in July and August could be largely attributed to lower interest rates as investors assumed the Fed would ease. However, there are no signs that the Fed will end rate hikes or that inflation will come down. That’s why Fed Chair Powell’s speech contributed to Friday’s big sell-off. Add in the fact that the economy will continue to slow, putting downward pressure on corporate profits, and it sets the stage for another stock market selloff.
Over the past two months, the economy has started to pick up. But as Americans return from their summer vacations, a recession, or even a recession, is likely to become a reality this fall and winter.
Neil Dutta is Head of Economics at Renaissance Macro Research.