July Economic Commentary: Momentum slows as inflationary pressures continue

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The elevated inflation we are experiencing is a game changer for an economy that has been used to low inflation and low interest rates. Incoming data for the month of May and early June indicated that inflationary pressures are not abating and expectations for continued high inflation are becoming more entrenched in consumers’ minds. Consequently, the Fed hiked the Fed Funds rate by 75 basis points (bps) at their June 15 meeting. The Fed’s actions are focused on slowing the demand side of economic activity, but the supply side of the economic equation also continues to aggravate inflationary pressures.

Consumer Metrics
The year-over-year Consumer Price Index (CPI) for May unexpectedly increased to 8.6% (the highest since 1981) from 8.3%. The primary drivers of the increase were food and energy. Absent food and energy price increases, the core measure of CPI showed that cyclical pressures are also mounting. Rising energy prices are impacting the cost of everything that relies on fuel (airline tickets, delivery services, etc.), and rising housing costs are beginning to work their way into the index. The surge in energy prices during June will be reflected in the CPI report to be released on July 13, with expectations that headline CPI will rise above the May reading.

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Personal income and spending data showed that real consumption (adjusted for inflation) fell by 0.4% in May while April’s gain was reduced to 0.2%. Most measures of inflation-adjusted income are negative, indicating that incomes are not keeping up with inflation. Consumer purchasing power is eroding, resulting in the need to dip into savings or increase the use of credit. The drag on consumer budgets from higher essential costs like food and energy is leaving less room for discretionary merchandise purchases. Reflecting this, the recent University of Michigan surveys of consumer sentiment and current conditions both logged record-low readings. The economy is clearly entering the second half of the year with less momentum.

Commodity Prices
While the cost pressures mentioned above are attracting the most attention, there are also some early signs that some of these pressures are easing as the economy slows. During the second quarter, many commodity prices declined. To name a few: natural gas (-3.9%), wheat (-12%), copper (-22%), and lumber (-31%). Additionally, the recent Purchasing Managers surveys indicated some easing in supply chain disruptions, but that was coupled with weaker new orders and rising inventories, suggesting weakening demand.

Employment
The June employment report showed a better-than-expected gain of 372,000 in non-farm payrolls with the unemployment rate holding at 3.6%. Disappointingly, the labor-force participation rate ticked down to 62.2% from 62.3%. If the participation rate had remained at 62.3%, the unemployment rate would have risen to 3.9%. Year-over-year average hourly earnings growth eased to 5.1% from the previous month’s reading of 5.3%. The labor market remains tight, but momentum is slowing as the Fed raises interest rates. There are 1.9 jobs available for every unemployed person. The Fed is counting on the strong demand for labor to mitigate the increase in unemployment as the economy slows.

Fed Policies
The minutes of the June 15 Fed meeting stated that “participants concurred that the economic outlook warranted moving to a restrictive stance of policy” and suggested that tightening would need to be even more aggressive if inflation stays high. The Fed Funds futures are pricing in a 98% probability that the Funds rate will increase by another 75 bps at their July 27 meeting. Additional rate increases are priced in for the remaining three meetings of the year, with Fed Funds ending the year at 3.5% — double the current level. Of course, the path of rate increases is dependent on the path of inflation.

Recognizing that their actions will slow the economy, the Fed’s recent Summary of Economic Projections (SEP) for the end of 2022 had some substantial changes from their previous SEP in March. Headline PCE inflation expectations were increased from 4.3% to 5.2%, and real GDP decreased from 2.8% to 1.7%. Unemployment is forecast to gradually rise to 4.1% by the end of 2024, an implicit admission that a recession is likely as a result of their actions. Chair Powell has said that the Fed will continue hiking rates until there is “clear and compelling” evidence that inflation is coming down. The problem with that statement is that inflation is a lagging indicator. Couple that with the fact that the full impact of Fed actions takes 12-18 months to work their way through the economy. There is a clear risk that inflation will not fall fast enough for the Fed to recognize the cumulative impact of its actions in time to moderate its policies. Tightening monetary policy into a slowing economy has substantial risks in its execution.