Weekly Economic Commentary

Markets continue to push for more from the Federal Reserve

Chief Economist Eugenio J. Alemán discusses current economic conditions.

Markets have made themselves clear for a while: they want more rate cuts than what Federal Reserve (Fed) members seem to be willing to accept at this time. Many economic forecasters have moved decisively towards either a soft landing or a full-fledged reacceleration in economic growth. The Atlanta Fed GDPNow is estimating Q1 2024 GDP growth coming at 4.2%. At the same time, other economists are sounding the alarm that the Fed is risking sending the economy into a recession if it does not lower interest rates soon. One of the arguments being that the longer it keeps interest rates high the greater the probability that economic activity slows down and/or it goes straight into a recession.

Another argument is that annualized inflation rates over the last several months are already at the 2% target rate or below and that there is no longer a need to have interests so high, even though the Fed continues to argue that it is not annualized inflation rates for the last several months that guide monetary policy. Deafness is not only geared towards the Fed Chairman Jerome Powell’s commentaries. Markets have been selectively deaf for a while, lowering rates on their own, bringing the yield on 10-year Treasury’s from a high of 5% late last year to just about 4.0% today, which will breathe even more life into the housing market, one of the typical sectors the Fed targets when it conducts monetary policy. It seems that Chairman Powell’s press conference following the Federal Open Market Committee (FOMC) meeting on Wednesday, where he stated: “The committee needs greater confidence that inflation is moving towards the 2% target”, isn’t quite getting the attention that we think it deserves.

If you are confused, you are not alone

So, let’s recap and look at what we believe is happening. First, the last economic cycle, as we have argued many times before, was not a monetary cycle. Thus, those arguing that interest rates are too high fail to recognize that excessive lending did not happen so there hasn’t been a retrenchment in lending that would have affected economic growth. It is true that lending is weak today because of high interest rates but that hasn’t prevented the economy from growing strongly. There is one exception to this: credit card lending. But even credit card lending hasn’t seen a retrenchment and has continued to grow unabated even at these extremely high interest rates.

This is one of the biggest risks today for the Fed, especially if employment growth starts to show weakness, because many of those borrowing at such high credit card interest rates are subprime and/or lower-income borrowers and their ability to pay back those balances could be compromised if the economy enters a recession. However, as we saw today, employment growth remained very strong in January 2024 so consumption will remain strong even with high interest rates.

Second, real residential investment responded negatively to higher mortgage rates, by posting nine consecutive declines on a quarter-on-quarter, annualized basis until the second quarter of 2023. However, real residential investment has recovered somewhat, posting two consecutive positive quarters during the third and fourth quarters of last year. New home sales are expected to continue to improve as mortgage rates have continued to come down while the supply of homes, both for new home sales and existing home sales remain limited; new home prices remain strong, and it seems that new home construction companies still have some wiggle room to offer enough incentives to keep the sector prospects alive. Existing home sales are depressed because it seems that homeowners are not willing to sell their homes and face mortgage rates that are double what they have on their current loans. At the same time, the labor market as well as the new work-from- home mantra has provided the stability they need to continue to wait for lower mortgage interest rates.

Real nonresidential investment has not reacted at all to higher interest rates as it is clear that the three bills passed during the last several years, the CHIPS Act, the IRA, and the Infrastructure Bill, have all contributed to keeping real non-residential investment on a tear.

Government spending has also been strong with both federal as well as state and local governments adding considerably to economic growth during the last six quarters.

Finally, consumer demand has been on a roll, not because of excess savings accumulated during the pandemic but because employment has remained strong, and as long as employment remains strong consumers will remain bullish on their personal situation, supported by improvements to real disposable personal incomes coming from both, wages and salaries as well as the disinflationary process, plus some help from credit card borrowing.

Economic and market conditions are subject to change.

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Consumer Price Index is a measure of inflation compiled by the US Bureau of Labor Statistics. Currencies investing is generally considered speculative because of the significant potential for investment loss. Their markets are likely to be volatile and there may be sharp price fluctuations even during periods when prices overall are rising.

Consumer Sentiment is a consumer confidence index published monthly by the University of Michigan. The index is normalized to have a value of 100 in the first quarter of 1966. Each month at least 500 telephone interviews are conducted of a contiguous United States sample.

Personal Consumption Expenditures Price Index (PCE): The PCE is a measure of the prices that people living in the United States, or those buying on their behalf, pay for goods and services. The change in the PCE price index is known for capturing inflation (or deflation) across a wide range of consumer expenses and reflecting changes in consumer behavior.

The Consumer Confidence Index (CCI) is a survey, administered by The Conference Board, that measures how optimistic or pessimistic consumers are regarding their expected financial situation. A value above 100 signals a boost in the consumers’ confidence towards the future economic situation, as a consequence of which they are less prone to save, and more inclined to consume. The opposite applies to values under 100.

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GDP Price Index: A measure of inflation in the prices of goods and services produced in the United States. The gross domestic product price index includes the prices of U.S. goods and services exported to other countries. The prices that Americans pay for imports aren't part of this index.

The Conference Board Leading Economic Index: Intended to forecast future economic activity, it is calculated from the values of ten key variables.

The Conference Board Coincident Economic Index: An index published by the Conference Board that provides a broad-based measurement of current economic conditions.

The Conference Board lagging Economic Index: an index published monthly by the Conference Board, used to confirm and assess the direction of the economy's movements over recent months.

The U.S. Dollar Index is an index of the value of the United States dollar relative to a basket of foreign currencies, often referred to as a basket of U.S. trade partners' currencies. The Index goes up when the U.S. dollar gains "strength" when compared to other currencies.

The FHFA House Price Index (FHFA HPI®) is a comprehensive collection of public, freely available house price indexes that measure changes in single-family home values based on data from all 50 states and over 400 American cities that extend back to the mid-1970s.

Import Price Index: The import price index measure price changes in goods or services purchased from abroad by U.S. residents (imports) and sold to foreign buyers (exports). The indexes are updated once a month by the Bureau of Labor Statistics (BLS) International Price Program (IPP).

ISM New Orders Index: ISM New Order Index shows the number of new orders from customers of manufacturing firms reported by survey respondents compared to the previous month. ISM Employment Index: The ISM Manufacturing Employment Index is a component of the Manufacturing Purchasing Managers Index and reflects employment changes from industrial companies.

ISM Inventories Index: The ISM manufacturing index is a composite index that gives equal weighting to new orders, production, employment, supplier deliveries, and inventories.

ISM Production Index: The ISM manufacturing index or PMI measures the change in production levels across the U.S. economy from month to month.

ISM Services PMI Index: The Institute of Supply Management (ISM) Non-Manufacturing Purchasing Managers' Index (PMI) (also known as the ISM Services PMI) report on Business, a composite index is calculated as an indicator of the overall economic condition for the non-manufacturing sector.

Consumer Price Index (CPI) A consumer price index is a price index, the price of a weighted average market basket of consumer goods and services purchased by households. Changes in measured CPI track changes in prices over time.

Producer Price Index: A producer price index (PPI) is a price index that measures the average changes in prices received by domestic producers for their output.

Industrial production: Industrial production is a measure of output of the industrial sector of the economy. The industrial sector includes manufacturing, mining, and utilities. Although these sectors contribute only a small portion of gross domestic product, they are highly sensitive to interest rates and consumer demand.

The NAHB/Wells Fargo Housing Opportunity Index (HOI) for a given area is defined as the share of homes sold in that area that would have been affordable to a family earning the local median income, based on standard mortgage underwriting criteria.

The S&P CoreLogic Case-Shiller U.S. National Home Price NSA Index measures the change in the value of the U.S. residential housing market by tracking the purchase prices of single-family homes.

The S&P CoreLogic Case-Shiller 20-City Composite Home Price NSA Index seeks to measures the value of residential real estate in 20 major U.S. metropolitan.

Source: FactSet, data as of 7/7/2023