Chief Economist Eugenio J. Alemán discusses current economic conditions.
The Federal Reserve (Fed) still has a very tough job ahead to bring inflation down to its 2% target over the long run while facing pressures from markets, which have a very different timetable than the Fed. At least, this is what transpired from the Fed’s June Federal Open Market Committee meeting (FOMC) Summary of Economic Projections (SEP) and dot plot.
Furthermore, the Fed is facing a highly unsynchronized business cycle in the U.S. economy. Normally, economic cycles are synchronized, that is, they go up and down in a relatively synchronized fashion even though one sector is, typically, the culprit for generating the cycle in the first place.
A typical monetary tightening cycle starts as the Fed increases interest rates, that is, tightens credit, and the most interest-rate sensitive sectors of the economy, particularly residential investment, take a plunge. Clearly, this was happening just before the COVID-19 pandemic, as the Fed’s tightening campaign started in 2016. However, as the COVID-19 pandemic commenced, the Fed relaxed monetary policy once again and the housing market, that is, residential investment, took off again. But that cycle ended once the Fed started increasing interest rates last year due to the strong increase in inflation.
Residential investment has fallen for eight consecutive quarters, on a quarter-over-quarter, annualized basis, and while it was still negative during the first quarter of the year, the decline wasn’t as large as in the previous seven quarters, which is another sign that the housing market has stabilized somewhat from the fall experienced during 2022.
But as the graph below shows, this time has been different, so far, as the large decline in residential investment has not been followed/accompanied by a decline in construction employment. And we don’t buy into the argument that the reason for not seeing a decline in construction employment is because firms are ‘hoarding’ workers.
Picture this: A construction company paying construction workers a salary for doing nothing… or a restaurant owner, with the slim margins that exist in that industry, paying workers to sit tight and do nothing, knowing that these workers make more money out of tips than out of wages, waiting until business improves.
What is happening to the construction industry is, perhaps, one of the reasons why Fed officials are still considering more increases in interest rates before the end of the year. That is, it is willing to sacrifice the housing market, so it is this sector that carries the torch for economic activity. The problem with this is that its efforts could generate other issues in other industries, as we saw earlier in the year with the banking sector issues as well as issues in the commercial real estate sector.
However, the biggest problem the Fed has today is that some service sectors, especially those sectors related to the food and beverage as well as leisure and hospitality industry, are still strong relative to history and they continue to exercise their pricing power. And because these sectors have excess capacity and don’t need to invest much in their businesses in order to expand, they have been, so far, immune to the credit tightening cycle. Furthermore, many of these businesses survived the COVID-19 pandemic because of the help of the US government through PPP loans and thus are in relatively good shape compared to previous periods.
In the graphs below we can see that although some of these sectors’ growth has moderated during the last year or so, they are still growing at rates that are high compared to the recent past. As we said before, this means that these sectors are still exercising strong pricing power, as the graph on the next page also shows, which tends to keep inflation on the high side compared to what the Fed would like to see.
To conclude, while the Fed has come a long way in fixing our inflationary issues, we still face a long road ahead. The current credit tightening has still not been enough to slow down the U.S. economy in order to bring down inflation faster and more sustainably. Some service sectors are still enjoying strong pricing power and the Fed has to continue to try to slow those sectors in order to achieve its 2.0% inflation target.
We still believe that the Fed needs to be patient and buy more time, as the direction of inflation is correct even if the speed is not. In the end, it will all depend on how much more important the direction is compared to the speed at which inflation is moving. This will determine whether the Fed moves twice more before the end of the year and if it moves in July or ‘skips’ July and then moves in September.
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. Currency 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 with 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 measures 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 weight 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 the 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 the 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 measure the value of the residential real estate in 20 major U.S. metropolitan.
Source: FactSet, data as of 5/26/2023
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