Inflation pressures have continued to ease
Cracks in the Labour market are starting to appear
A slowdown in consumer spending is underway
The Wimbledon Championship Tournament is in full swing, with the men’s and women’s finals scheduled to take place this weekend! Watching the momentum shifts as each player tries to gain an advantage over his/her opponent during each match is mesmerising. These extended matches can go on for hours, which feels like an eternity when you’re playing the game. In many ways, watching tennis is a lot like the volleying back and forth between the financial markets and the Federal Reserve (Fed) these days. The resilience of the economy has kept Fed rate hikes in play, with policymakers not willing to let their guard down regarding the need for further rate hikes. However, after 500 basis points (bps) of rate hikes over the last 16 months, the market does not think the Fed will deliver the two additional bps rate hikes they have pencilled in for 2023. Here are three reasons why we think that the Fed will end its tightening campaign after a final 25 (bps) rate hike in July:
The Fed is getting a ‘grip’ on inflation | The June inflation report confirmed our view that price pressures are receding, with inflation remaining on a clear, decelerating path. The headline measure of inflation slid for the twelfth consecutive month, falling to 3.0% on a year-over-year basis, its longest stretch of declines since the early 1980s. The core measure, which excludes food and energy prices, declined to 4.8% – its slowest pace since November 2021. More importantly, the core measure is now below the current fed funds rate, something that has occurred only 20% of the time over the last 20 years! The internals of the inflation report were also encouraging, with inflation in travel-related areas moderating (airline fares were down 8% MoM), used car prices declined 5% MoM (the ~10% decline in the July Manheim Used Vehicle Value Index suggests further declines are likely) and the all- important shelter component rose +0.4% MoM (its slowest pace since January 2022). Shelter carries a high weight in the inflation index, so decelerating prices are welcome news for the Fed. While shelter costs are still running at a 7.8% annual pace, other real time indicators, such as Rent.com’s rent trends, are reporting a 0.6% YoY decline in rents. Given the long lags in which house price trends get captured in the official statistics, it’s worth noting that if the shelter component was replaced with Rent.com’s rent trends, the core inflation measure would be below the Fed’s target of 2% at +1.3%!
Labour market’s ‘advantage’ is eroding | The labour market’s resilience has been one of the biggest thorns in the Fed’s side throughout its tightening campaign. The supply/demand mismatch – which at its peak had nearly two job openings for every available worker – has pushed wages While this has been welcome news for workers, wages are running at a pace (4.4% YoY) that is not consistent with the Fed’s inflation objective. However, the labour market is becoming more balanced and there are some cracks beginning to show. First, the JOLTS survey of job openings has eased, and the quits rate has moved back to pre-pandemic levels. Second, the percentage of small businesses planning to increase employment in the NFIB Small Business Optimism Index declined to 15% – its lowest level since May 2020. This suggests that small businesses, which account for ~60% of total employment, could ease hiring in the months ahead. And finally, last week’s employment report showed the economy added 209K new jobs – its smallest monthly increase since December 2020. Our economist expects job growth will turn negative by the end of the year.
Consumers are moving to the ‘sidelines’ | The robust jobs market, solid wage gains and excess savings have been key factors behind the resilience of the economy, which is not surprising given that consumer spending accounts for nearly two-thirds of economic However, if the labour market continues to soften as our economist expects, consumer spending should also start to fade. In fact, there are already anecdotal signs that a consumer slowdown is underway. First, the shift from spending on goods to spending on experiences has been a big driver of growth over the last eighteen months. But anecdotal reports suggest that Disney and Universal are seeing a slowdown in traffic at their theme parks as consumers feel the pinch of recent price hikes. And one of our favourite real-time indicators, the Redbook Index, which tracks spending over 9,000 general merchandise stores, has turned negative on a year-over-year basis for the first time since September 2020. And finally, a back-to-school spending survey conducted by Deloitte estimates that spending will likely fall around 10% this year – its first decline in nine years.
Bottom line | The Fed is executing its playbook according to plan – get interest rates up quickly, keep tightening albeit at a more moderate pace and then hold rates steady to allow real rates to nudge higher as inflation recedes. While stronger than expected economic data in the first half of the year has kept the Fed in play, as the pace of job growth and inflation slow, the Fed should be able to raise rates one more time (at the July FOMC meeting) and then hold rates steady for an extended period of time.
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