December Economic Commentary: Economic Activity Slows and Consumers Feel the Pressure as the End of 2023 Nears
The recent edition of the Fed’s Beige Book reported that economic activity in eight out of the 12 Federal Reserve districts was flat or in contraction during the first six weeks of the current quarter. Inflationary pressures continue to ease as consumer spending slows from an elevated pace during the third quarter. The lagged effects of the Fed’s tight monetary policy of the past 21 months are likely to become most evident over the coming months as GDP growth is expected to slow into the spring.
Consumer Pressure & Headline Inflation
Real (inflation adjusted) retail sales were down 0.2% in October, and year-over-year real retail sales were down 0.7%. Spending was concentrated on essentials. The delinquency rate on credit cards at least 30 days past due at the end of the third quarter rose to just over 8.0% from 7.2% in the second quarter. This is the highest delinquency rate since the third quarter of 2011. Whether it’s from exhausted “excess savings,” the resumption of student loan payments, higher interest rates, tighter lending standards, or growing debt burdens, the U.S. consumer is coming under pressure.
The October CPI report showed that headline inflation was unchanged during the month with the year-over-year change declining to 3.2% from 3.7% the prior month. Core inflation increased 0.2%, bringing the year-over-year figure to 4.0%. Stripping out the shelter component from the headline CPI results in a 1.5% year-over-year increase. The report on the Producer Price Index (PPI) followed the tame CPI data, with the headline coming in at -0.5% for the month – the steepest decline since April 2020 – and year-over-year PPI is now 1.3%. The Fed’s favored measure of inflation, core Personal Consumption Expenditures (PCE), came in at 3.5% year-over-year. Overall inflation pressures are subsiding, but with the reported core CPI and PCE measures still significantly above the Fed’s goal of 2.0%, the Fed will be slow to lower rates unless something breaks in the economy.
The Lending Market
The quarterly Senior Loan Officer Survey showed that credit conditions remain unusually tight, and demand for loans remains weak as higher interest rates make borrowing too expensive for new business ventures. Credit for households and small businesses is becoming difficult to obtain. The net percentage of banks willing to make consumer installment loans has fallen to historically low levels. Although not all banks are continuing to tighten their lending standards, virtually no one is easing.
Reflecting the tightening of lending standards along with the year-over-year decline in deposit levels, bank credit – the amount of credit available to businesses or individuals for loans – is contracting year-over-year for only the third time in the past 75 years.
Leading Economic Indicators & Employment
There is no change in the message coming from the leading economic indicators; they have been declining for 19 consecutive months. For the month of October, the biggest drags came from consumer expectations, stock prices, and manufacturing new orders.
The November payroll employment report showed a gain of 199,000, which included 47,000 workers returning from strikes (auto and Hollywood). Factoring out the gain from the returning strikers, the increase was about the same as October’s increase of 150,000. Gains were concentrated in the non-cyclical sectors of government and health care jobs. In cyclical sectors, only 26,000 jobs were added. The unemployment rate declined from 3.9% to 3.7%, the participation rate improved a tick to 62.8%, and average weekly hours rose. Average hourly earnings rose 0.4% as well, which was higher than expected, bringing the year-over-year figure to 4.0% from 4.1%.
Inflationary pressures from the labor market are easing, however, with unit labor costs declining by 1.2% annualized in third quarter, while rising only 1.6% year-over-year. Non-farm productivity in third quarter was a strong 5.2% annualized, bringing year-over-year productivity to 2.4% – the strongest in two and a half years. Wage gains are less of a concern considering the acceleration in productivity seen over the past year. If you take the year-on-year gain of 4.0% in average hourly earnings and combine it with a 2.4% increase in productivity over the past 12 months, that is consistent with the 2.0% target for price inflation.
In a sign of weakening labor demand, the October JOLTS report showed that job openings fell to their lowest level since March 2021, new hirings were down, layoffs up, and voluntary quits were down.
Interest Rates
From the middle of October, when yields peaked, until now, the 10-year Treasury yield has declined 80 basis points as investors are sensing that recent soft economic data will keep the Fed from raising interest rates any further. Markets believe that we have seen the peak in interest rates from the Fed and are pricing in a lengthy pause in interest rate actions. The timing of the first interest rate cut is forecast to occur in May 2024, with a total of four cuts by the end of 2024. The Fed is unlikely to suggest any timing of a change in their interest rate policy until it actually occurs.
The real (inflation adjusted) Fed Funds rate is now at the highest and most restrictive level since 2009. Even if the Fed does not increase rates any further, declining inflation pressures will effectively cause the real Fed Funds rate to increase – a form of passive tightening. In addition to their interest rate policy, the Fed continues to reduce their balance sheet by about $95 billion per month – another policy tool that tightens liquidity.
Financial conditions are restrictive and liquidity constraints are emerging across a broad front. The credit cycle is turning with negative implications for default rates, credit spreads, and corporate profitability. There is a decline in the supply of credit and a decline in the demand for credit at the same time. This is causing a contractionary credit cycle that is slowing economic activity.
