Fed is getting what it wants for the holidays
The U.S. economy is slowing across the board.
Federal Reserve Chair Jerome Powell appeared to take a premature victory lap at his monetary policy speech at the Brookings Institution last week in Washington, sparking a powerful sigh-of-relief rally in both stocks and bonds. But last Friday’s November jobs report demonstrated that wage inflation still is running hotter than the Fed or the financial markets had expected. That likely will prevent policymakers from executing an early pivot from rate hikes to rate cuts.
Regardless, due to the hawkish Phillips Curve trade-off between inflation and unemployment the Fed has engineered over the past nine months, it still is getting its wish, as the economy is slowing across the board. Inflation is starting to slip, though still elevated. In October, annualized core CPI was up 6.3%, core PPI up 6.7% and core PCE up 5%. Progress, to be sure, but the Fed’s not done yet with hiking interest rates and shrinking its balance sheet to get inflation back to its 2% long-term target.
The price that policymakers have said they are willing to pay is slower economic growth and higher unemployment. The risk is growing that the economy is on a glide path into recession at some point over the next two years. The Fed knows that, and we believe it is on the verge of downshifting to a less aggressive pace. After four consecutive 75 basis-point rate increases, we expect a half-point hike Dec. 14 and two quarter-point hikes in the first quarter of next year. The fed funds rate could peak at a terminal rate of 5% at that time.
Housing takes a hit Responding to the tightening, mortgage rates have more than doubled from 3% to 7% so far this year. The housing market index has cratered from 84 to a 2-year low of 33 over the past year, pending home sales have plunged and prices declined 1.2% month-over-month (m/m) in September, the largest such decrease since the housing bubble burst.
Manufacturing slowing The ISM manufacturing index has plummeted from a 38-year high of 64.7 in March 2021 to a 2-year low of 49 in November 2022 and is inching uncomfortably closer to a recession reading of 45. All six of the regional Fed manufacturing indexes we monitor have fallen to 2-year lows over the past 16 months.
Business & consumer confidence lower Michigan sentiment and the Conference Board’s consumer confidence index fell to 4-month lows in November, and in October the NFIB small business optimism index declined for the first time in three months. The Leading Economic Indicators (LEI) index, historically a reliable recession forecaster, has declined eight months in a row and nine times in the past 10 months
Consumers still spending into Christmas Although Back-to-School (BTS) sales rose a healthy 9.3% y/y this year, it's roughly half the pace of the outsized 16.3% surge enjoyed during BTS 2021. (Average growth over the previous five years is 3.7%.) Similarly, Christmas sales could rise by a solid mid-single-digit pace in 2022 and still be significantly lower than 2021, when sales had 16.4% year-over-year growth. (Average growth over the previous decade is 4.2%.) Importantly, the personal savings rate declined to a 17-year low of 2.3% in October, likely impacting consumers with less income.
Cracks in the labor market foundation Although nonfarm payrolls remain solid, the household survey has lost jobs in each of the last two months, the participation rate has declined for the past three months and Challenger layoff announcements soared to a 3-year high in November. The ADP private payroll survey has dropped 75% over the past year, the JOLTS survey of job openings is down 13% from its record high in March and continuing unemployment claims have risen 23% over the past six months.
Are stocks irrationally exuberant? Benchmark 10-year Treasury yields have fallen from a 14-year high of 4.25% six weeks ago to 3.5% today, while 2-year yields have declined from 4.80% to 4.20%. This 70-basis point 2/10 yield-curve inversion suggests bond vigilantes are pricing in this growing risk of recession.
Has the midterm election rally run its course? Stocks, however, are following a different path. After the S&P 500 fell 27.5% from the beginning of the year to mid-October, we expected stocks to enjoy their seasonal midterm election rally. Stocks typically rise 15-20% if voters deliver divided federal government. Equities are now 17.5% higher over the past seven weeks. Technically speaking, they’ve met overhead resistance, with both the 200-day moving average and a downward-sloping quadruple top. With earnings estimates coming down for the fourth quarter and for full-year 2023, stocks could soon be under pressure to revisit the mid-October lows.
Tweaking our GDP estimates The fixed-income, liquidity and equity investment professionals who comprise Federated Hermes’ macroeconomic policy committee met last Wednesday to discuss the possible peak in inflation and the Fed’s likely response:
- The Bureau of Economic Analysis recently revised 2022 GDP growth from 2.6% to 2.9%, up substantially from the second quarter’s -0.6% contraction. Despite the Fed’s 75 basis-point hikes in each of July and September, BTS spending was relatively strong, up 9.3% y/y.
- Policymakers added another 75-basis point hike Nov. 2, and we forecast a half-point increase at the Federal Open Market Committee meeting on Dec. 14. Christmas spending could slow to perhaps half of last year’s strong season, but that’s still a healthy pace. So, we raised our GDP growth estimate in the fourth quarter of 2022 from 0.1% to 1.2%. The Blue Chip consensus raised its from 0.2% to 0.4% (in a range of -1.0% to 1.7%). The Atlanta Fed’s GDPNow model is at 4.3%,
- We raised our full-year 2022 GDP growth estimate from 1.6% to 1.9%. The Blue Chip increased its from 1.6% to 1.8% (within a range of 1.5% to 1.9%).
- We increased our full-year 2022 forecast for core CPI growth from 5.7% to 5.9% (it was 6.3% in October 2022) and left our full-year 2022 prediction of core PCE growth unchanged at 5% (it was 5% in October 2022).
- We increased our first quarter of 2023 GDP growth estimate from -0.7% to 0.2%. The Blue Chip consensus reduced its from -0.2% to -0.6% (within a range of -2.8% to 1.3%).
- We raised our second quarter of 2023 growth prediction from -1.2% to -0.4%. The Blue Chip consensus reduced its estimate from -0.1% to -0.3% (within a range of -2% to 1.4%).
- We reduced our third quarter of 2023 growth forecast from -0.6% to -1.25%. The Blue Chip consensus lowered its estimate from 0.7% to 0.4% (within a range of -1.5% to 2.2%).
- We also reduced our fourth quarter of 2023 growth estimate from -0.6% to -1.25%. The Blue Chip consensus cut its from 1.3% to 0.9% (within a range of -0.8% to 2.3%).
- As a result of those adjustments, we raised our full-year 2023 GDP forecast from -0.4% to 0.1%. The Blue Chip consensus left its unchanged at 0.2% (within a range of -1% to 1.4%).
- We reduced our full-year 2023 forecast for core CPI from 4.1% to 3.9% and for core PCE from 3.6% to 3.4%.