Economic Update – Third Quarter 2023
Senior Vice President
Director of Treasury & Risk Management
Summer of 2023
It’s been a hot summer of rising interest rates. The Federal Reserve raised short-term rates by .25% in July to 5.50%. Since the employment market, although weakening, is not showing signs of stress and consumer spending is moving along steadily, the markets’ fear of recession began to fade, long-term rates also rose, with the 10-year Treasury rising .40% to a high of 4.21%, before falling back to 4.08% today. Chairman Jerome Powell has been promoting the “rates higher for longer” narrative and the markets seem to believe him.
In his Jackson Hole speech on August 25th, he stated that inflation, though falling, is still too high, although he referenced lags in policy and said it should continue to fall. He acknowledged that rates have reached his “restrictive” goal (more on that later) and threatened more rate hikes. He also stated that the Phillips curve may have steepened. Wait, what? Are they bringing that back? I didn’t know there were any Phillips curvers left. The Fed tightens 525 basis points in 17 months. Money supply is in outright decline. Inflation is falling. Yet the unemployment rate has barely moved, at 3.8% in August, compared to 3.50% in February, 2020, before the pandemic began. The fact that inflation went way up (due to their foolish expansion of money supply and supply chain issues) and now is coming way down while unemployment remains rangebound discredits the Phillips curve. Oh, brother! And the markets expected a theoretical discussion on r*, or the neutral rate of interest; Powell virtually ignored it in his speech. I will tell you that r* is a lot lower than today’s rates.
Several Fed Regional Presidents have given speeches lately and said that they prefer not to raise rates again. Philly President Harker and Atlanta President Bostic are among them. I agree with them. Payroll employment has been falling and job openings just unexpectedly fell again in July by 330,000 to 8.827 million; in fact 1.5 million job openings have disappeared since April. And employers are hoarding their workers because the new hiring environment has been so difficult. We also saw a surprise increase in productivity in 2Q23 of +3.7% after a drop of -1.2% in 1Q23, which should temper some of the worries about wage growth if we can keep it going. Alan Greenspan taught us that the potential supply of labor is not just those unemployed (6.4 million) but also those not in the labor force who want a job (5.3 million). The pool of available workers stands at 11.7 million in August, 2023.
Are Rates Restrictive?
What exactly does it mean for Fed policy to be “restrictive?” It means getting the policy rate, or Fed Funds rate, above inflation so that a positive number, or real rate, would result after subtracting inflation from the Fed Funds rate. Every inflation measure that I track closely is below Fed Funds, or 5.50%, resulting in restrictive positive real rates of varying degrees.
Fed Funds is .80% over annual core CPI of 4.7% and 2.30% over annual headline CPI of 3.2%. Fed Funds is 1.80% over 2Q23 core PCE of 3.7% and 3.00% over the PCE deflator of 2.5%. Fed Funds is 1.50% over the annualized 2Q23 employment cost index of 1.0%. Fed Funds is even 1.40% over 2Q23 nominal GDP of 4.1% (real GDP was 2.1%). So, yes, rates are restrictive. And the FIBER leading inflation index and M2 money supply are both falling year-over-year, by -2.2% and -3.7% respectively, so inflation trends are pointing down. So, Mr. Powell, are you ready to stop raising rates?
Summer of Fun
Is everyone having a great summer? I hear from many friends and colleagues about their travels and spending over the past several months. I see the consumer spending data, most recently retail sales were +.7% and personal spending was +.8% in July and this strength was expected. The Federal Reserve is frustrated, however, by their inability to dampen demand with their rate hikes, but this is a behavioral issue with consumers, not an economic one. People are simply ready to have fun this summer, go on vacation, travel (as evidenced by demand for passport renewals), make the most of entertainment, eat out, and spend money if they want. Taylor Swift, Beyonce, and Barbie all know this well. I agree with the summer of fun theory that will precede a period of reckoning when the fun is over (according to Dr. Anirban Basu). There are warning signs of what’s on the horizon for that reckoning, including credit card debt reaching a record $1 trillion and student loan payments set to resume on October 1st. It’s fun to spend but paying off debt not so much.
Speaking of fun, I was fortunate to be able to travel with family to France, Luxembourg, Germany, and Switzerland in July. I’ve never seen so much construction equipment in my life! Paris is readying for the 2024 Olympics and Notre Dame is still encased in scaffolding, but what of the construction all over the rest of France, Germany, and Switzerland? It certainly looked like the economies were booming there, despite reports to the contrary. We had a wonderful time and I fulfilled a dream to see the Swiss Alps and the Matterhorn.
Let’s take a look at my favorite leading indicators and see what they tell us about the future.
First, the Conference Board’s index of leading economic indicators has fallen 16 months in a row, most recently in July by -.4% and in June by -.7%. This is the index that worries me the most. The stock markets are projecting business as usual, with the S&P 500 up +17% year-to-date, while the Dow is up +5.1% and Nasdaq is +33%. This is such a relief after the negative returns on both stocks and bonds in 2022. But corporate profits are not looking good, having fallen or been flat for the past four quarters, and are suffering from higher interest rates, higher wages and prices, and often weak productivity. If profits do not turn positive, it’s hard to see how stocks can continue climbing.
Business surveys, including the ISM and S&P manufacturing ones and the Philadelphia and New York Fed manufacturing and services indices, are showing readings at recessionary levels. The Treasury yield curve remains inverted and has been since last year, which is likely contributing to a tightening of credit. The 10-year Treasury to 3-month Treasury is -1.28%. The 10-year to 2-year is -.85% and the 5-year to 2-year is -.64%. This is another indicator of future recession to heed, with a lag time of 16 months on average. If inverted curves are the leading indicator of recessions, then watch later for the re-steepening of the curve, which will be the real warning sign that recession is upon us.
The leading FIBER inflation index continues to fall year-over-year and was -2.2% in July and -4.9% in June, which is a good sign for inflationary pressures subsiding. Finally, M2 money supply has been declining on a year-over-year basis since December, 2022, with July at -3.7% and June at -3.6%. We have not seen outright year-over-year declines since the data series began in 1960 and some economists say the last time this happened was in the 1930s. So now you know. If huge increases in M2 caused inflation to soar, then the outright declines will cause it to fall.
This is nothing new. I’m always worried. Right now, there are so many weak spots in the economy that I feel GDP could end up in outright decline. Yes, you’ve heard all the talk about soft landings and maybe we can avoid recession altogether, but probabilities of recession are still very high.
Leading economic indicators are falling and have been for 16 months. I have never seen a Fed who threatened to raise rates when the index is this poor and the economy is showing signs of weakness. Mortgage rates are at a 20-year high and inventories on the sales market are low due to those with low interest rate mortgages not wanting to lose them. Redfin estimates that 62% of all mortgages are below 4%. Foreclosures and rental evictions have continued to rise after being on moratorium for so long after the pandemic. The commercial real estate market has seen a rise in loan defaults nationally, along with weakening prices. Business bankruptcies are up due to lower demand, over-indebtedness, and high borrowing costs. The trucking industry lost one of its’ giants amidst weaker demand, as Yellow went out of business, laying off 30,000 workers and idling 12,000 trucks.
Manufacturing and services surveys are declining as well as business and consumer confidence. Venture capital investments are down compared to a year ago. Oil prices are volatile and rising lately (thank you, OPEC) and pulling up gasoline prices toward $4.00 per gallon. Even the employment market is showing some weakness as job openings have fallen 1.5 million in four months to 8.8 million. Payroll growth is weaker, with August at +187,000, July at +157,000, and June at +105,000, which is much lower than the monthly levels earlier this year. The number of unemployed persons rose sharply in August by +514,000 to 6,355,000.
I didn’t even get to higher interest rates, declining money supply, and the ever-increasing debt of the US Government, which will pull GDP growth down below trend. NBER will drag their feet in declaring recession, until all of their criteria- real sales, production, employment, and real income- are dropping together. If the Fed believed at all in lags in monetary policy, they would lower rates immediately, so that six to nine months from now, I am not still worrying.
On a Personal Note
I’ve been writing economic updates for most of my career in investments and risk management, but I wrote my first newsletter on March 13, 2010 and has been a privilege to write them quarterly ever since. I hope that you took some of it to heart, laughed, cried, and most of all enjoyed reading. Recently, I announced my retirement from Penn Community Bank, effective in November, 2023, after 19 years at the Bank and 49 years in the banking industry. I hope that my writing has taught you about the markets, the economy, inflation, the Fed, and the Large Hadron Collider. I’ll publish at least one more newsletter in the fall and perhaps more beyond that.
As always, thanks for reading!
Senior Vice President
Director of Treasury & Risk Management