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Jay Powell is keeping calm about the US economic outlook — perhaps overly so. The Federal Reserve opted to hold interest rates at its midweek meeting, though it adjusted its tone, citing moderating job gains and rising unemployment as signs of a cooling economy. That opens the door to cuts in September.
The problem is that weakening activity tends to feed off itself, meaning a cooling economy can quickly turn into a recessionary one. Has the Fed left it too late?
Since May, US economic data has indeed started to surprise to the downside, according to Citi’s Economic Surprise Index. But, signs of America’s slowdown had been emerging well before the Fed’s recent change in emphasis. Full-time household employment started weakening towards the end of 2023, credit card delinquencies rose above pre-pandemic levels around then, too.
That the US avoided a forecasted recession in 2023 has helped keep faith in an economic soft-landing this year — and has perhaps contributed to favourable interpretations of data. Take the above-expectation economic growth figures for the second quarter. The 2.8 per cent annualised rate was taken as evidence that the US economy is in fine fettle. But dig deeper, and you see the flaws.
Government spending — backed by a hefty deficit — has helped prop up growth. Jobs have been bolstered by a public sector hiring spree, too. What about consumer expenditure? Break it down and the largest spending contributions come from essentials such as rents, utilities, health and food rather than discretionary stuff. Consumption growth is outpacing income as well. Indeed, seemingly “strong” numbers belie a weaker underlying economy.
Leading economic indicators look troubling, too. The ISM manufacturing New Orders Index is in contraction territory, and has been a decent signal for a recession in the past. Jobless claims rose to an 11-month high last week, small businesses have been cutting hiring plans, and many consumer-facing companies have recently recorded earnings misses.
The proximate cause is the Fed’s interest rate policy. The Committee debated cutting rates at its July meeting, and could end up lamenting not doing so. Annual US inflation — measured by the Fed’s preferred benchmark of the personal consumption expenditures index — came within 0.5 percentage points in June of the central bank’s 2 per cent target. Price pressures are also on a downward trend: the jobs market is cooling, and wage growth is easing.
A precautionary cut midweek would not have equated to a substantial easing either. Many households and businesses will still face steep borrowing costs if they have to refinance fixed-rate loans coming up for renewal. The question is whether they should face current peak rates, or something slightly lower, in line with easing demand. For measure, Goldman Sachs recently estimated the median optimal interest rate, based on various monetary policy rules, to be closer to 4 per cent. All this points to the Fed pressing too hard on the brakes, for too long.
Market signals are looking ominous, too. Based on the slope of the curve of bond yields over time, which has been an unreliable indicator recently, the New York Fed estimates an above 50 per cent chance of a recession in the coming year. Stock valuations appear stretched, too. Indeed, the concentration of the S&P 500 index — with the magnificent seven tech stocks making up more than 30 per cent of its value — makes it vulnerable to a correction in the bullish AI narrative.
Some argue that rate cuts would only encourage an asset bubble. The prospect of rate cuts may in part support equities, but the S&P 500’s relentless upward march has recently wobbled as investors begin to question whether AI can deliver the revenues needed to cover the hefty capital investment currently being committed. That has happened even though rates cuts are coming into view.
The problem is that by September the Fed may realise that demand has been overly restrained. It may then need to front-load more cuts — punting for a 0.50 percentage point reduction, instead of a 0.25 point cut. That would worry equity markets.
This may seem unlikely now, but the economy does not slow in a linear manner. The loss of economic momentum, which has been happening for longer, and is deeper, than many seem to appreciate can become a self-reinforcing spiral. Joblessness, delinquencies and bankruptcies can suddenly spike, and a market priced for a soft-landing could quickly unwind. The recessionary warnings are flashing, they should not be taken lightly.