Chief Economist Scott Brown discusses current economic conditions.
In a speech to the National Association for Business Economics, Fed Chair Powell said that “if we conclude that it is appropriate to move more aggressively by raising the federal funds rate by more than 25 basis points at a meeting or meetings, we will do so.” He added that “and if we determine that we need to tighten beyond common measures of neutral and into a more restrictive stance, we will do that as well.” Powell had said the same thing during his March 16 press conference. At issue is the notion of a “soft landing,” where economic growth slows to a more sustainable pace consistent with a strong job market and low inflation. Powell appeared to be optimistic that the Fed can make that happen.
A year ago, when inflation began to pick up, the Fed was not very concerned. Price increases were narrow, confined to a limited number of sectors where prices had been depressed by the shutdown of the economy a year earlier. By the summer of last year, price increases had begun to broaden across categories, reflecting supply chain issues and a sustained increase in the demand for goods. Fiscal policy support in 2021 (direct deposits to individuals in January and March, expanded unemployment benefits, and child tax credits) boosted disposable income. The Fed expected that the absence of this support in 2022 would lead to slower growth in consumer demand and inflation would decline. The situation in Ukraine has further boosted oil prices. Higher gasoline prices will add significantly to the March CPI (due April 12).
While wage growth has picked up, real average hourly earnings have declined. Personal income should post a strong gain in February (to be reported March 31), led by growth in aggregate wage and salary income, but not enough to outpace inflation. Real personal income is the primary driver of consumer spending growth.
Motor vehicle sales and housing have traditionally been viewed as the canary in a coal mine. Weakness is an early sign of recession. However, both sectors remain supply constrained. Motor vehicle production is still restrained by shortages of parts (especially, semiconductors), but there is plenty of demand. Similarly, shortages of labor and materials are limiting housing construction. Higher home prices and rising mortgage rates have further reduced housing affordability, but demand appears to have remained relatively strong. Note that vehicle and home sales decline in a recession, and pent-up demand helps to fuel a strong recovery when the recession comes to an end. Ongoing supply constraints will make it difficult to gauge the impact of monetary policy, which may be a key reason for the Fed to be cautious as it raises short-term interest rates.
For many years now, business fixed investment has appeared to be largely independent of interest rates. Expansions are fueled more by cash on hand, and strong earnings over the last year have been supportive. We talk about “the business cycle” – not “the consumer cycle” – because expansions and recessions tend to be led by business investment. At the top of the cycle, we often see malinvestment (think of the dot-com boom), which can unwind in painful ways. In past decades, inventory adjustment played a significant part of the business cycle. The rise of scanners and computers in inventory management in the late 1980s and 1990s, together with a shift to production outside the U.S., have made inventory swings much more modest. However, inventories can play a part in the quarterly GDP figures (faster inventory growth added 4.9 percentage points to 4Q21 GDP growth, while slower inventory growth will subtract from 1Q22 growth).
Powell pointed out that the Fed had achieved soft landings (or “soft-ish” landings) in 1965, 1985, and 1994 – raising short-term interest rates without tipping the economy into recession – and appeared to be on track to achieve a fourth soft landing ahead of the pandemic. Powell added that “no one should expect that bringing about a soft landing will be straightforward in the current context.” After all, the Fed’s chief policy took, the federal funds rate, is “a blunt instrument, “not capable of surgical precision.” Powell said the “today the economy is very strong and is well positioned to handle tighter monetary policy.”
Powell is an optimist, no doubt. Instilling confidence is part of the job. However, getting to a soft landing could by a lot more challenging this time. Inflation is far above the Fed’s 2% goal. An inflationary mindset may now be more firmly rooted. Supply constraints in labor and materials may last a lot longer. Tighter monetary policy won’t do much to encourage supply, but demand should be slowed. That may require more aggressive Fed action in the months ahead. Of course, the Fed may end up tightening policy less aggressively, but that would be because the economy is slowing more than intended.
Recent Economic Data
Durable goods orders fell more than expected (-2.2%) in February, partly reflecting a 30.4% drop in civilian aircraft orders. Ex-transportation, orders fell 0.6%, following strong gains of the three previous months.
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The Chicago Fed National Activity Index edged down to +0.51 in February (vs. +0.59 in January). The three- month ticked down to +0.35 (vs. +0.37), consistent with above-trend growth in the near term.
New home sales fell 2.0% in February (±11.9%), to a 772,000 seasonally adjusted annual rate.
The Pending Home Sales Index fell 4.1% in February, following a 5.8% decline in January (-5.4% y/y). Demand apparently remains strong, despite higher mortgage rates, but supply remains constrained.
Initial claims for unemployment benefits fell to 187,000 in the week ending March 19, the lowest since September 1969. The four-week average was 211,750, consistent with extremely tight labor conditions.
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The Chicago Fed Advance Retail Sales (CARTS) data showed a 1.1% decline in the second week of the month, following -1.4% in the previous week. March sales are expected to be down 3.2% from February.
The University of Michigan Consumer Sentiment Index fell to 59.4 in March, down from 59.7 at mid-month and 62.8 in February. Pessimism on inflation increased (one-year-ahead expectations at 5.4%, the highest since November 1981), but consumers remained optimistic about the job market.
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