Over the past month, things have improved for the US economy. The latest report on inflation according to the consumer price index showed signs of cooling. Measures of growth — of employment report at retail sales – held up. All of this could point to a safe path for the Federal Reserve to ease its interest rate hikes, let the economy normalize and keep the United States from slipping.
But this good news does not mean that the US economy is still out of the woods. From inflation to consumer spending, there are clear signs that the economy is still in real danger of being pushed into a recession.
Cooler but not cool
Over the past few weeks, signs of a staggering slowdown in inflation have been the change that has garnered the most attention and raised hopes. July saw an improvement in several inflation metrics, including a 0% month-to-month price variation for the consumer price index, mainly due to lower energy prices. Despite the apparent breakthrough, it is premature to ring the green light bell.
Even with improvements in these traditional measures, the underlying measures of inflation are still hot. Take, for example, the Cleveland Fed’s median CPI, which attempts to measure “average” inflation by looking at the price change of the median element of the basket of goods tracked by the CPI. The indicator is particularly interesting because, as the Cleveland Fed noted in its research on the new measure, “the median CPI provides a better signal of the underlying trend in inflation” than measures of inflation more closely monitored. So while core CPI, the traditional measure that excludes volatility in food and energy costs, rose only 3.8% in July, the The Cleveland Fed measure rose 6.5% in July and up 7.6% on average over the last three months. This is not an acceptable level of inflation to declare the problem solved.
Wage growth is another sign that America’s battle against high inflation is far from over. The Atlanta Fed Median Salary Growth Tracker was 6.3% in July and 6.7% on average over the last three months. Wage growth can fuel broader inflation when it rises much faster than business productivity. Given productivity, the Atlanta Fed measure must be closer to 3.5-4%. Although Americans’ expectations for inflation over the next 12 months have come down somewhat, they still stand at 6.2%. “This points to a risk of inflation on the upside as workers negotiate higher wages that companies could pass on to consumers by raising prices,” San Francisco Fed the researchers wrote about expectations.
In short, the reasons to expect inflation to remain firm over the next few quarters are compelling, even as a handful of top-tier goods suffer significant price drops.
The consumer stumbles
Any discussion of the strength of the US economy must begin with the consumer. US consumers have a lot going for them: low unemployment, accumulated savings and strong household balance sheets. Even though gross domestic product fell in the first half of 2022, consumption held up. Yet the economic outlook is about shifts at the margin, and at the margin, consumer strength is deteriorating. Several points stand out:
- Private domestic demand – the share of GDP attributable to US consumer and business demand minus the effects of international trade, business inventories and government spending – cooled in the first half of the year. It is a key measure used by economists to predict job growth. With strong private demand, consumers are reporting that while labor market conditions are strong, momentum is waning. Some increase in the jobless rate seems inevitable, despite July’s impressive jobs report. Weekly initial unemployment insurance claims tend to increaseand layoff announcements are spreading beyond the tech sector, with companies like Walmart and Wayfair announcing cuts. In fact, in a survey of American companies by the accounting firm PwCabout half of respondents said they were planning layoffs.
- The slowdown in private demand comes at a time when total hours employed put to work jumped. This means that companies’ revenues are growing at a slower pace even as the amount they have to pay workers is rising rapidly, a sign of lower labor productivity and tighter profit margins. Companies will inevitably try to protect their margins by combining a slowdown in hiring with a reduction in compensation.
- Even with the slowdown in incomes, how much people spent in the first half of the year increased. This means that the increase in consumer spending in the first half of the year was driven exclusively by the fact that they dipped into their savings. This cannot continue indefinitely. Even if people’s incomes are relieved by lower gasoline prices, there’s a reasonable chance that households will use it to replenish their cash reserves rather than go out and spend.
I don’t like to bet against the US consumer, but if the labor market is likely to slow with high inflation risk, it’s hard to support the US consumer.
Housing market woes
Another red flag for the economy comes from the housing market, where activity has stalled. Rising mortgage interest rates have reduces demand for housing. Door-to-door sales pending and contracts signed on existing properties have collapsed, implying a significant drop in closures over the next few months.
With demand cooling, builders will have to focus on clearing the huge backlog of homes they’ve already sold but haven’t yet completed construction instead of starting to build new homes. Not surprisingly, housing completions (homes being completed) have picked up, while housing starts (homes under construction) have slowed. This gap will continue to close and, at the same time, the number of units under construction will decrease.
Fed Chairman Jerome Powell said talked about a housing market reset. It’s clear that this shakeout is underway, but it’s far from over. According Conference Board datathe number of people planning to buy a home in the next six months has fallen to its lowest level since February 2013.
Companies do not want to invest
While consumers and the housing market aren’t likely to trigger a strong economic recovery, fixed investment by non-residential businesses — businesses spending money to upgrade equipment and software — is unlikely. an engine of growth. On the one hand, GDP growth expectations have weakened, and as growth prospects weaken, business investment tends to slow (and vice versa). We can already see companies becoming more prudent in their spending. Regional surveys six-month capital spending intentions point south. And the tech industry, which has accounted for the majority of real non-residential business fixed investment growth over the past two years, has been hit by a strong stock market selloff, rattled by rising interest rates. It is also the industry most responsible for the recent increase in layoffs.
Overall, the signs are even worse. Europe is sliding into recession, while China’s zero COVID policy kept a slow down growth in this region. Given that there is no incentive for companies to try to invest to meet demand elsewhere, companies are likely to hit the pause button on their spending plans until the outlook is less bleak.
And what about the Fed? Is a pivot to slow interest rate hikes — or even cut rates to support the economy — near? I think it’s unlikely. For starters, Fed officials have been very vocal in recent weeks about their plans to continue hiking rates. During his much-anticipated speech Friday at the Fed’s annual conference in Jackson Hole, Wyoming, Powell even went until warning of “some pain”. And even slowing the pace of increases – not yet achieved – is not the same as cutting interest rates. Importantly, officials expressed reluctance change their policy in no time. A premature easing of inflation-reduction policy with inflation rates still high risks raising inflation expectations and entrenching a higher inflation rate in the economy.
If you want to know how worried you are about the cooling economy, it’s worth looking at stock market progress. Stock price movements boil down to three factors: interest rates, actual and expected earnings, and the risk premium. The strong performance in equities in July and most of August can largely be attributed to lower interest rates as investors assumed the Fed would ease. But there is no sign that the Fed is done climbing or that inflation is slowing, which is why Powell’s speech contributed to a huge selloff on Friday. Add to that the fact that the economy will continue to slow, putting downward pressure on corporate earnings, and you have a setup for another stock market sell-off.
Over the past two months, things have started to look up for the economy. But as Americans return from their summer vacations, they will face a real chance of a slowdown — or even a recession — this fall and winter.
Neil Dutta is Head of Economics at Renaissance Macro Research.