The weekly note
DECEMBER 7, 2023
This Week’s Developments in the US Economy
The Implications of a Potential Fed Pause and a Review of Key Indicators
During the most recent meeting of the Federal Open Market Committee (FOMC) on Tuesday, May 3, Federal Reserve Chair Powell signaled a potential pause in ongoing rate hikes. Mr. Powell acknowledged that the previous ten consecutive interest rate increases, combined with the impact of tightening credit conditions related to the collapse of regional banks in March and April, have brough policy to a sufficiently restrictive position needed to achieve a 2% target, albeit over some time. However, in acknowledging that it will take some time “for the full effects of monetary restraint to be realized, especially on inflation,” it seems clear that understanding whether policy is sufficiently restrictive—or perhaps overly restrictive—cannot be known until policy lags can be measured.
In order to gain a deeper understanding of the changes and momentum of crucial economic indicators that the Fed is likely monitoring for policy effects, we categorized a variety of indicators based on their impact areas (i.e. price, sentiment, and economic momentum) and assessed their annualized pace of change over three-, six- and twelve-month periods. To align with the Fed’s policy targets, for example, we view rates of change below 2% as “positive”, between 2% and the Fed’s year-end projection of 3.5% as “neutral”, and anything above 3.5% as “negative”. The results are illustrative of the potential for a long road ahead given the Fed’s repeated commitments to achieving a 2% target over time.
This Week’s Developments in the US Economy
The Potential for Peak Rates and the Road(s) Ahead
As inflation continues its slow decline toward the Fed’s target, the prevailing narrative on rates has shifted from how high to how long. Last week, headline PCE showed an October print that dropped from 3.4% to 3.0% year-over-year and core PCE, a measure closely monitored by the Fed, fell from 3.7% to 3.5%. Both measures are below the FOMC’s median projections for year-end 2023 from its September Summary of Economic Projections (“SEP”), and we will see an updated SEP at next week’s FOMC meeting. In our view, the deceleration in PCE measures is encouraging in suggesting inflation is on the appropriate path, but we are not there yet with respect to the Fed’s inflation target.
Opinions on the future of interest rates vary widely. In our view, considering moderating consumer data coupled with modest softening in the labor market, the economy currently is sufficiently resilient and provides cushion to the Fed’s commitment to see inflation to its 2% target before cutting rates. Using recent Fed members’ commentary on policy as a foundation for a base case, we explore a multitude of forks in the road ahead that may influence changes to that base case. Central to these scenarios is the health of the labor market, and we will see an update tomorrow (December 8th) with the monthly jobs report from the Bureau of Labor Statistics.
The Fed’s base case and other possible scenarios
As a base case, Fed members appear to be comfortable in holding rates where they are until inflation returns to their stated 2% target. Over the past couple of weeks, several Fed members have spoken publicly about monetary policy. Offering fairly consistent views with respect to policy being in restrictive territory, most have signaled that it is still too soon to consider rate cuts. Now in a “quiet period” before next week’s FOMC announcement, no new information will be available outside of scheduled data releases such as the jobs report. Highlighting the importance of assessing incoming data, many comments alluded to monetary policy being near or at a sufficiently restrictive level. Notably, Fed Chair Jerome Powell commented that it was “premature” to speculate on easing while suggesting that risks were more balanced with respect to under versus over tightening.
While Fed commentary provides context given the current environment, we note several areas of deceleration in economic activity, which could result in changes to our base case. The following are three potential scenarios—each differing in degrees of softening economic conditions—highlighting a range of perspectives of market observers that underscores a lack of consensus heading into 2024.
Soft Landing and Slow Deceleration of Inflation
Provided key economic factors remain stable—net new jobs over 100,000 per month on average, unemployment below 5.0%, and positive GDP growth—our view is that this provides the Fed with ample cushion to keep policy restrictive to its 2% inflation target. In line with the FOMC’s September SEP, this scenario assumes rate cuts would take place late in 2024.
GDP Growth Falls Well Below Potential but Short of a Recession
The Atlanta Fed’s GDPNow model is projecting Q4 GDP growth in the low 1% range, which is in line with market consensus, suggesting a modest economic slowdown may occur in the near term. This would likely accelerate the decline in inflation even if the labor market remains healthy. If we see consecutive quarters of below-potential GDP growth through H1 2024, the Fed may accelerate the timetable for interest rate cuts to ease downward pressure on the economy and avoid a hard landing. In our view, rate cuts could begin in mid-2024.
A Mild Recession Combined with a Meaningful Slowdown in the Labor Market
An outside case in our view, a third scenario involves rate reductions as early as the FOMC’s March 2024 meeting. This assumes Q4 GDP comes in below potential and high velocity GDP Nowcasts project negative GDP growth in Q1 2024. In our view, this would highlight an increasing economic drag from prolonged and aggressive monetary policy, which could negatively affect companies' profitability, potentially prompting layoffs, and result in an acceleration in unemployment. Key indicators to watch for this scenario are Q4 GDP print and the Q1 2024 monthly jobs reports (particularly the unemployment rate).
What the Labor Market Is Telling Us Now
The potential for a soft landing versus a mild recession appears to hinge on the health of the labor market. While showing signs of slight cooling, the labor market remains tight with robust monthly job gains. Unemployment figures are historically low and wage growth, despite decelerating in recent months, remains meaningfully higher compared to the previous cycle.
Highlighting softening labor market conditions, this week’s JOLTS report showed job openings dropping to 8.7 million, well below the previous month’s reading and consensus figures at 9.3 million. While the current reading is the lowest level since March 2021, it remains well above the previous cycle’s average of approximately five million.
We view the December 8 jobs report as one of several key labor market prints that will help inform perspectives on the trajectory of the US economy. However, our view is that current economic conditions continue to provide sufficient cushion for the Fed to maintain policy in its restrictive position.
Market Rates, Catalytic Indicators, and the Week Ahead
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