May Economic Commentary: U.S. Economic Growth Moderates as Labor Market Cools

The U.S. economy continues to move forward, albeit at a slower pace, with a labor market that is cooling as supply and demand are becoming more balanced. The impact of the Fed’s tight monetary policy of the past two years is becoming more evident in many areas of the economy after a longer than assumed lag. Inflation, however, is proving to be more stubborn than expected. In the absence of any unexpected weakening in the labor market, the Fed is being patient before initiating an easing in monetary policy to ensure that their inflation goal of 2.0% will be achieved.

Inflation

The strong gains in the January and February Consumer Price Index (CPI) no longer appear to be just a bump in the road to get inflation back to 2.0%. The March headline CPI increased 0.4% for the second month in a row, causing its year-over-year growth rate to increase from 3.2% to 3.5% – the highest year-over-year reading since last September.

The Core CPI also increased 0.4% for the third month in a row. That is the hottest string of month-to-month price increases since early last year. Price increases were concentrated in medical costs, auto insurance premiums, and rents. Although the year-over-year Core CPI remained unchanged at 3.8%, the three-month annualized rate has accelerated to a 10-month high of 4.5%.

The Core PCE deflator is the Fed’s preferred measure of inflation, and it was unchanged from February to March at 2.8% year-over-year. However, the three-month annualized rate jumped to 4.4%, which is the highest since March 2023.

Consumer Spending

The strength of consumer spending continues despite slowing growth in real disposable personal income. After a weak start to the year in January, real consumer spending has posted back-to-back strong monthly gains of 0.5%. Real consumer spending has accelerated from 1.7% year-over-year growth in March 2023 to 3.1% year-over-year growth in March 2024. At the same time, real disposable personal income growth has eased from 4.4% year-over-year growth in March 2023 to 1.4% year-over-year growth today. As a result, the personal saving rate has declined from 5.2% a year ago to 3.2% today. Spending is coming mainly from savings and credit card usage, not income.

LEI, Manufacturing & Services Indices

The Leading Economic Indicators index (LEI) moved lower again in March and has been down in 24 out of the last 25 months after a one-month improvement in February. Components that pushed the LEI lower in March were the yield spread, new building permits, consumers’ outlook on business conditions, new orders, and initial unemployment insurance claims. Overall, the LEI continues to point to a fragile outlook for the U.S. economy.

Both the ISM Manufacturing Index and the Services Index fell to 49.4 in April indicating moderate contraction in the manufacturing sector and softness in spending for services. This is the first time that both indices have been below the 50 level – which is considered to be neutral – since December 2022. The sub-category of new orders was weaker in both indices suggesting some further near-term softness.

GDP & Employment

The initial reading of Real GDP in first quarter 2024 showed a moderation in growth from the 3.4% annualized rate in fourth quarter 2023 to a 1.6% annualized pace. This was the weakest quarterly gain since second quarter 2022. Weakness in net exports and inventories was the biggest drag on the headline number. Outside of those two areas, however, the report was more encouraging. Real final sales to private domestic purchasers were up 3.1% annualized, marking the third quarter in a row this metric has been above 3.0% annualized.

The April employment report indicated a moderation in job growth and earnings growth. Non-farm payrolls increased 175,000, the smallest increase in six months, and there were downward revisions of 22,000 to the prior two months. The Household survey showed a small increase of 25,000 jobs while the labor force increased by 87,000, causing the unemployment rate to move up to 3.9%. Average hourly earnings grew 0.2% in the month bringing year-over-year growth to 3.9% from 4.1% in March, the first time this has been below 4% since June 2021.

Moderation in the labor market was also evident in the March Job Openings and Labor Turnover Survey (JOLTS). Job openings fell to the lowest level in more than three years and the quits rate fell to its lowest level since August 2020, pointing to slower wage growth in the coming months.

Interest Rates & The Fed

As expected, at the May 1 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 sixth consecutive meeting. The committee acknowledged the “lack of further progress” on inflation and Chair Powell stated that “we do not expect that it will be appropriate to reduce the target range for the Federal Funds rate until we have gained greater confidence that inflation is moving sustainably toward 2.0%.” He went on to say that gaining greater confidence is likely to take longer than previously expected but added that he thinks it is “unlikely” that the next policy rate move will be a hike.

Also announced was the committee’s decision to slow the pace of the decline of their securities holdings. The cap on Treasury redemptions will be lowered from the current 60 billion per month to 25 billion per month as of June 1. The cap on agency securities remains unchanged. This move will effectively reduce the supply of Treasuries which should reduce some of the upward pressure on Treasury yields.

The Fed believes that current monetary policy is restrictive enough to bring inflation back to their 2.0% target over time. Their focus now is on how long to keep policy restrictive. They are on hold until they can more clearly see if the recent plateauing of inflation pressures above their 2.0% target is temporary or more enduring. Either way, interest rates are expected to stay higher for longer than forecast at the beginning of the year. Recognizing their dual mandate of price stability and full employment, if inflation does not re-accelerate, the pace of lowering interest rates will likely be dictated by the strength of the labor market. Markets are now expecting two interest rate cuts this year starting at the September FOMC meeting.