The October employment report did it. The Fed’s tightening cycle is over. After eleven rate hikes since March 2022 totaling five percentage points, the Federal Reserve ought to be finished raising rates. Inflation is falling and growth is slowing. The odds that the Fed will achieve its 2% inflation target within the next 12 months have now increased significantly.
The question now is, what comes next?
In what follows, we explain why the Fed is finished raising rates. We then consider what follows. The answer, sadly, points to a harder-than-necessary landing for the economy and markets. That will matter for Main Street, Wall Street and, quite possibly, for Pennsylvania Avenue.
Categoric statements are rarely correct, especially when it concerns something as complex as the macro-economy. No single data point is decisive. Nevertheless, Friday’s employment report confirmed what a host of other indicators are telling us, namely that the US economy is finally slowing after an eighteen-month onslaught of Fed rate hikes. Together with falling rates of headline and core inflation, as well as moderating wage pressures, a clearer picture has emerged. The Fed will soon accomplish its goal of reducing US inflation to the two-percent core rate that it defines as ‘price stability’.
But at what cost? Here, greater uncertainty exists. Yet history and the dataflow suggest the odds of a US recession in 2024 are rising, and fast. To make matters worse, with inflation still above its desired range, the Fed is in no hurry to pivot and tackle recession risk. Fiscal policy is even more handcuffed by the combination of obsessively partisan politics and the usual impasse of the coming election year.
In short, if a recession arrives in 2024, both monetary and fiscal policy will be slow to respond, increasing the odds of the downturn, as well as its depth and duration. That bodes poorly for the economy, employment, and the stock market—as well as for incumbents in Washington, DC.
Why the Fed is Done
The Fed has repeatedly noted that sustainably achieving its 2% inflation target will require some slack in the economy and the labor market. Well, that’s happening. From its low point of 3.4% in April 2023, the US unemployment rate has risen to 3.9% in October. That’s close to the ‘Sahm Rule’, a shorthand measure for recession.
But it isn’t just the unemployment rate. The rate of job creation has been falling steadily for the past eighteen months. In the runup to every US recession from 1945 to 2020, a declining rate of jobs growth preceded actual job losses.
The reason is simple. Economies are characterized by self-reinforcing feedback loops. In good times, rapid jobs growth supports household incomes and sentiment, underpinning demand, which further boosts jobs growth. When economies slow, fading jobs growth stalls household disposable income growth and increases consumer anxiety, leading to weaker spending that impinges corporate profits, causing firms to cut costs, chiefly via layoffs.
To wit, labor demand is already slowing, shortening the average workweek for private employees to its post-pandemic lows. The picture is even more grim in manufacturing, where hours worked have plunged, 35,000 jobs were lost last month, and survey data from the Institute of Supply Management indicate contractions are now underway in production, new orders, employment, inventories, backlogs, exports, and imports. Based on the Federal Reserve’s calculations, US industrial production ground to a standstill in September. The Federal Reserve Bank of Atlanta’s GDPNow estimates place fourth quarter US real GDP growth at 1.2%, just above stall speed, and ominously also show a sharp deceleration in US consumer spending to a 1.5% rate, down from its 4.1% pace in the third quarter.
All this comes at a time when inflation is decelerating. Core consumer price inflation has fallen from a peak of 6.5% in March 2022 to 4.1% in September. Using the most recent data, the three- and six-month annualized rates of core CPI inflation are now 3.1% and 3.6%, respectively. Those figures would have a ‘two-handle’ were it not for the inclusion of owners equivalent rent (OER, a proxy for housing costs), which is presently running at a 7.1% rate. But as is widely recognized, OER embeds massive lags. Web-scraping measures of actual rents (e.g., from Zillow), suggest that annualized rent inflation has fallen to 1.1%. Put those more realistic rates into the core inflation figures, and the Fed’s target is essentially met.
In the labor market, meanwhile, wage inflation is also slowing. The year-on-year rate of average hourly earnings has fallen to 4.1%. On a three-month moving average basis, wage inflation is down to 3.4%, a rate consistent with the Fed’s inflation target (after adjusting for trend productivity growth). Other data, including the latest figures on unit labor costs tell a similar story of wage moderation (notwithstanding the recent headlines made by selective union settlements).
What Comes Next
In short, the Fed is well on its way to achieving its inflation target. And because the economy is now slowing below trend, that achievement looks sustainable. However, we should not expect the Fed, whose reputation was (unfairly) tarnished by its 2021 characterization of inflation as ‘transitory’, to now ‘declare victory’. But its ‘inactions’ going forward will reveal its recognition that the mission is all-but accomplished.
That is not the same thing, however, as preparing for the consequences. Over the next few quarters, policymakers and investors will come to understand that the goal of reducing inflation harmlessly will not be achieved in this cycle.
The warning signs are already apparent—slowing employment growth, a falling workweek, and a manufacturing recession are plain in sight. Weakness is likely to now beget weakness, pushing the economy towards contraction.
Nor will the Fed respond quickly. Fearing for its credibility it will not want to be seen as prematurely relaxing its vigilance. The Fed probably won’t ease until core personal consumption inflation readings have fallen decisively below 3.0%, an outcome that remains months away.
The cost of defending the Fed’s institutional credibility will therefore be borne by the economy and investors.
US fiscal policy also cannot come to the rescue. That’s not, as is commonly believed, because of large Federal government deficits or debt, per se. The US government is hardly borrowing constrained. But the political will to take countercyclical action, given divided government in Washington and the gridlock of an election year, rules out tax cuts or spending increases to support the economy before 2025.
Implications
By which time it will be too late. If negative feedback loops (exacerbated by the fading effects of 2021-2023 fiscal stimulus) take hold, the downturn is apt to come in the next 6-12 months.
For investors, a recession has predictable consequences. For one, profits growth will slump. And with the consensus of analysts expecting nearly 12% profits growth next year, earnings disappointments will be large. After all, never in the postwar period have profits expanded when the economy has contracted. Hence, the outlook for US and global equities is grim. And, as profits go, so goes employment, reinforcing the downturn.
High quality bonds, including longer duration Treasuries, on the other hand, will fare better. Investors will shift holdings from riskier allocations now in stocks and company bonds into Treasuries, readily providing the funds to absorb even larger US federal government deficits (as tax revenues plunge and spending on unemployment insurance rises).
The dollar, which has enjoyed a strong run on the back of higher US interest rates, will be vulnerable as bonds rally and, somewhat later, the Fed cuts rates.
Finally, a 2024 recession could challenge the received wisdom about next year’s elections. As Yale economist Ray Fair has noted over decades of research, the economy is typically decisive for US presidential election outcomes. Recessions hurt incumbents. Given the already slim predicted advantage of the Democratic nominee (most probably President Biden) over his Republican rival (most probably former President Trump) of 51-49% in the Fair model, next year’s presidential election outcome could well hinge on whether the US economy slumps into recession.
