Economic Commentary: Cracks Beginning to Show as Labor Market Softens Further

The slowing of the economy during 2024 has been evident through many government reports and private surveys, but the resilience of the labor market has kept the hopes of a “soft economic landing” alive despite the continuation of the Fed’s restrictive monetary policy that was initiated in March 2022. With the July employment report, the last standing pillar of support for the economy, namely the labor market, is showing more serious cracks. The Fed’s two mandates – price stability and maximum employment – are now at the point where a restrictive monetary policy is no longer needed and in fact is likely counterproductive to the fulfillment of the two mandates.

Inflation & Productivity

June saw a continuation of the soft inflation readings that were recorded in May. The headline CPI for June was -0.1% after a 0.0% monthly reading in May, bringing the year-over-year number down to 3.0%. Core CPI was 0.1% in June after a 0.2% reading in May, bringing its year-over-year number down to 3.3%. The Fed’s preferred measure of inflation, the Core Personal Consumption Expenditure Index, also recorded two months of soft numbers: +0.2% in June following +0.1% in May. Its year-over-year reading is now 2.6%. Importantly, one of the Fed’s areas of concern, services inflation, has shown a muted 0.2% month-to-month increase for two consecutive months.

The year-over-year inflation readings are unlikely to show much improvement over the next few months as last summer’s low monthly inflation readings will make it difficult for the year-over-year readings to decline much further until late 2024. However, assuming soft monthly inflation readings continue, the Fed will have the needed confidence that inflation is moving sustainably toward their 2.0% target.

Supporting the trend of lower inflation was the report that productivity in second quarter 2024 re-accelerated to a 2.3% annual rate from 0.4% in first quarter. On a year-over-year basis, productivity is now growing at a 2.7% rate – higher than the long-term average of 2.0%. The improvement in productivity enabled unit labor costs to rise only 0.9% in second quarter and 0.5% year-over-year. Since peaking at 6.5% in second quarter 2022, year-over-year unit labor costs have eased for nine consecutive quarters.

Consumer Spending & Saving

Consumers remain the primary driver of economic growth. Consumer spending in second quarter 2024 grew at a 2.3% annual rate, up from 1.5% in first quarter. The composition of spending is changing, however, with consumers spending more on non-discretionary items and less on discretionary items as excess savings have been mostly depleted and higher delinquency rates for consumer loans are being reported. In the bigger picture, consumer spending has slowed from a 3.2% annual rate in the second half of 2023 to a 1.9% annual rate in the first half of 2024.

The monthly income and spending numbers provide additional insights. As of June, real (inflation adjusted) disposable personal income growth has eased from a 5.3% year-over-year growth in June 2023 to a 1.0% year-over-year growth today. At the same time, real personal consumption expenditures are up 2.6% year-over-year. As a result, spending is coming from savings and credit card usage, not income. The personal saving rate fell to 3.4% in June – well below the pre-pandemic average of 8.0%. The cooling labor market is also expected to weigh on spending growth going forward.

Key Indices

The Leading Economic Indicators (LEI) continue to point to a fragile outlook for the U.S. economy after declining again in June. The main drivers of weakness were new orders, consumer expectations, interest rates and jobless claims. The six-month diffusion index of the LEI has been below 50% for nine consecutive months.

The July reading for the ISM Manufacturing index declined to 46.8, the lowest level since November, suggesting that high interest rates and slowing demand remain headwinds. The production and employment subindices reflected slowing demand by declining to their lowest levels since 2020. Only 28% of industry respondents reported growth, which is down from 44% in June.

The initial reading of real GDP in second quarter 2024 showed a pickup in growth from the 1.4% annualized rate in first quarter to a 2.8% annualized pace, which was above expectations. The stronger growth in second quarter was mainly due to higher private inventory investment driven by a build-up in automobiles, as car dealers dealt with the effects of a cyberattack. The inventory build contributed 0.82% to the 2.8% reading. Without that elevated inventory number, GDP would have been closer to 2.0% and closer to expectations.

Labor Market

As mentioned previously, the July employment report was weaker than expected with non-farm payrolls improving by 114,000 versus expectations of 175,000. The prior two months were revised down by 29,000. The unemployment rate moved up to 4.3%, the highest level since October 2021. The increase in the unemployment rate was due to a 420,000 increase in the labor force, but only a 67,000 increase in employment according to the household survey. Average hourly earnings rose a less-than-expected +0.2% month and that brought the year-over-year pace down to +3.6% from +3.8% in June. This is the slowest pace of wage growth since May 2021 and well off the cycle peak of nearly +6.0%.

Initial jobless claims just reached the highest level since August last year, providing further evidence of a softening job market.

Interest Rates & The Fed

At the July 30-31 meeting of the Federal Open Market Committee (FOMC), the target range for the Fed Funds rate was maintained at 5.25% to 5.50% for the eighth consecutive meeting. In the post meeting press conference, Chair Powell laid the groundwork for a September cut in interest rates but kept open the FOMC’s options if data doesn’t come in as expected. Powell did say, “If the labor market were to weaken unexpectedly or inflation were to fall more quickly than anticipated, we are prepared to respond.” He also acknowledged that “the downside risks to the employment mandate are real now.” The next major opportunity to hear from Powell will be at the late August meeting in Jackson Hole, Wyoming. At that time, he will have seen another set of inflation numbers and may be more direct in signaling an interest rate cut at the September FOMC meeting.

The employment report was released two days after the FOMC meeting. With maximum employment being one of two Fed mandates, a change in Fed policy at their next meeting in September is now expected. At the same time, the Fed’s other mandate, price stability, continues to move credibly toward the 2.0% target for inflation. Yields on the 10-year Treasury bond have fallen 0.68% since the beginning of July, and markets are now pricing in four interest rate cuts over the next three FOMC meetings, scheduled for September, November and December.