March Economic Commentary: Easing Inflation and Strong Labor Market Influence Fed’s Interest Rate Mantra of "Higher for Longer"
Expectations for the timing and number of interest rate cuts by the Fed in 2024 were sharply revised in February due to the ongoing strength of the labor market and recent strength in inflation readings. At the beginning of February, five to six cuts in the Fed Funds rate during 2024 were forecast to begin in May. By the end of the month, markets had backed off the number of cuts to three beginning in June or July. “Higher for longer” is now the accepted mantra as it applies to the Fed’s interest rate policy.
Inflation & Consumer Spending
For the second month in a row, the January Consumer Price Index (CPI) surprised to the upside with the headline rate growing 0.3% for the month and 3.1% year-over-year. For reference, 2.9% was expected. The core CPI grew at 3.9%, whereas 3.7% was expected. Much of the strength in the January report came from goods and services that are historically less volatile – a potential concern for the Fed.
Importantly, the Fed’s preferred measure for inflation, the core Personal Consumption Expenditure Index (PCE), increased at the fastest monthly pace since January 2023 bringing its year-over-year reading to 2.8%, down from 2.9% year-over-year the previous month. Although some of the strength in the January reading could be attributed to a re-weighting of some of the components, inflation is still above the Fed’s 2.0% target, and while it is trending in the right direction, it has not yet provided the Fed with the needed evidence to confidently say that inflation is moving sustainably toward their target.
While inflationary pressures in January were elevated, there were several reports that showed that consumer spending was slowing after ending 2023 on a heated pace. Consumer spending in January grew only 0.2% following a strong showing of 0.7% in December. On an inflation-adjusted basis, consumer spending declined for the first time since August. With Disposable Personal Income growing 0.3% in the month, the savings rate was able to improve to 3.8%, but it still remains well below the historic average of 8.0% to 9.0%. The latest edition of the Fed’s Beige Book for the seven weeks ended February 26 provided anecdotal reports of increased price sensitivity on the part of consumers who continue to trade down and shift spending away from discretionary purchases.
Lending Standards & Economic Indicators
The January Senior Loan Officer Survey reported that banks, on balance, tightened lending standards further for most loan categories in fourth quarter 2023, although the net share of banks tightening was lower than in third quarter 2023. While not as many banks are continuing to tighten their lending conditions any further, less than 2.0% are easing. In addition to tight lending standards, banks report increasing spreads of loan rates over their cost of funds for commercial and industrial (C&I) loans, as well as weaker demand for all categories of loans. Regarding banks' outlooks, they reported expecting lending standards to remain basically unchanged for C&I and residential real estate loans, but to tighten further for commercial real estate, credit card, and auto loans. In addition, banks reported expecting loan demand to strengthen across all loan categories, and loan quality to deteriorate across most loan types.
The leading economic indicators for January continued their decline for the 23rd consecutive month, led by declines in the average workweek, building permits, as well as the ongoing inverted yield curve.
The second reading of real GDP in fourth quarter 2023 was revised down 0.1% to 3.2%, and the ISM manufacturing survey for January declined to 47.8 from 49.1 with the new orders, employment, and production components all showing weakness.
Labor Market & the Fed’s Outlook
The February employment report had two different versions of the labor market, depending on the survey. The establishment survey showed a healthy gain of 275,000 jobs but came with a significant downward revision of 167,000 to the prior two months. Nearly 75% of the job growth came from healthcare, leisure and hospitality, and government.
The household survey, on the other hand, showed a decline of 184,000 jobs. Over the past three months, the establishment survey has reported a total gain in employment of 794,000 jobs while the household survey has shown a loss of 898,000 jobs. The unemployment rate, which is calculated from the household survey, increased to 3.9% from 3.7% and is now at the highest level since January 2022. Average hourly earnings grew 0.1% bringing the year-over-year increase to 4.3%, down from 4.4%.
One final takeaway from the employment report is the index of aggregate hours worked so far in first quarter 2024 is flat. That has important implications for GDP growth this quarter. Barring a significant increase in this index during March, first quarter growth will have to come from an increase in productivity.
In his scheduled two-day testimony before Congress last week, Fed Chair Powell indicated that there is no urgency to lower interest rates. “We’re waiting to become more confident that inflation is moving sustainably at 2.0%...when we do get that confidence – and we’re not far from it – it’ll be appropriate to begin to dial back the level of restriction.”
The Fed continues to grapple with concerns about cutting interest rates too soon and re-igniting inflationary pressures versus holding rates high for too long and pushing the economy into recession. The extent of the lagged effects of the ongoing tight monetary policy are difficult to accurately anticipate. Due to the Fed’s dual mandate of price stability and maximum employment, the decision to lower interest rates, and the pace at which easing proceeds, will likely be dictated by the strength of the labor market as long as inflation continues to ease.
