The labor market continues to move into better balance, with an improvement in labor supply accompanying a gradual cooling in demand. In addition, while the bulk of excess household savings have now been drawn down, real income growth is helping to sustain spending. On the corporate side, the earnings recession of the past year is beginning to recede, and S&P500 earnings are forecast to return to modest growth over the next twelve months. [1]
Figure 1: Real Income and Spending
Source: Bureau of Economic Analysis, MacKay Shields
News on the inflation front has also been positive. Over the past three months, the core Consumer Price Index (which excludes food and energy) has risen at just a 2.4 percent annualized rate, down from 5.1 and 4.1 percent at the end of the first and second quarters, respectively. The healing of the supply side of the global economy has tamped down on core goods inflation this year, while core services inflation has also moderated. Importantly from the Fed’s perspective, service price disinflation has been evident not just in housing, but in a number of discretionary service categories including airfare, recreation and dining out.
Despite progress on the inflation side of its mandate, policy makers have signaled that strength in the economy runs the risk of delaying the return of inflation to their two percent objective. Hence in the latest economic projections, the median FOMC participant not only still anticipates an additional rate hike before year end, but now sees just 50 basis points of rate cuts next year, down from 100 in the previous projection round in June. At the time of writing, this “higher for longer” signaling has resulted in tighter of financial conditions, with long-term Treasury yields rising sharply, the dollar strengthening, and the S&P500 returning to levels last seen in June.
These developments illustrate the dilemma facing policy makers. Inflation has clearly moderated but continued strength in the economy could jeopardize further progress, forestalling a pivot to less restrictive policy. Keeping policy tight for an extended period in turn risks a more significant economic slowdown and too-sharp an increase in unemployment.
This dilemma will play out against a backdrop of growing economic challenges. First, the cooling of the labor market is not occurring without some pain. Permanent job losses have been growing at a rate typically encountered before economic contractions. Bank lending standards remain tight, and not surprisingly, so does loan growth. And while many businesses and households locked in low interest rates in 2020 and 2021, today’s high rates will increasingly bite as debt comes due, eroding balance sheet health. It also remains to be seen if the rise in real wage growth can continue. Corporate margins are already under pressure as top-line revenue growth remains tepid and labor and non-labor costs are moderating only slowly. These developments could result in a more meaningful slowing in labor demand if businesses seek to defend margins. Finally, a number of unique circumstances will weigh on growth in the near term. The resumption of student loan payments along with higher gasoline prices will serve as a restraint on spending for many households. And a prolonged United Auto Workers strike, as well as a potential government shutdown, also pose slight headwinds to the economy’s momentum.
Figure 2: Unemployment due to Permanent Job Loss
Source: Bureau of Labor Statistics, MacKay Shields. Shading represents NBER recessions
The end of interest rate cycles always pose challenges, requiring agility from both policy-makers and investors. The current cycle has at least two additional challenges, and how they evolve has a direct bearing on the economic outlook and the performance of financial assets. First, it remains an open point of debate whether the inflation surge of recent years was driven primarily by supply- or demand-side effects. If supply-side effects dominated, than inflation should gradually moderate on its own, with monetary policy playing a supporting role through its impact on inflation expectations. If instead demand-side factors were the primary driver, then it will take further weakening in the labor market to re-anchor inflation at the central bank’s target. This debate is clouded by a second factor, potential structural changes in the US and global economy in the wake of COVID. It is quite possible that reshoring and the energy transition, and the fiscal policies that promote them, could serve as new sources of inflation pressure for the foreseeable future. If so, the Federal Reserve may need to push harder on the brakes if it chooses to defend its inflation objective
[1] Bloomberg.
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