Markets Cheer Latest Fed Projections

Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.

Equities notched strong gains last week as investors grew more optimistic that the Federal Reserve would cut rates in the coming months and the economy would avoid slipping into recession. The upbeat assessment was fueled by updated forecasts from Federal Reserve board members following the Fed’s rate policy meeting. The latest Summary of Economic Projections, or so-called “dot plot,” shows members of the Fed still expect to cut interest rates three times by a total of 75 basis points before year-end. While investors cheered the median expectation of three cuts, it is noteworthy that overall, the projections were more hawkish than they were at the end of 2023. The dot plot released in December 2023 showed four officials expected four cuts in 2024, while one official saw six reductions. The latest estimates show just one official anticipates four cuts and no policymakers projecting six cuts. In fact, nine of the 19 board members called for just two cuts or fewer in the coming year.

The forecast for rate cuts comes despite the Fed now expecting the Core Personal Consumption Expenditures (PCE) index—its preferred inflation measure—to be 2.6 percent by the end of this year, which is 0.2 percent higher than the forecast made three months ago. Similarly, the group’s outlook for real GDP growth in the coming year was also adjusted upward. The latest median expectation now pegs inflation-adjusted growth of GDP to come in at 2.1 percent for the year, up from December’s expectations of 1.4 percent.

Although the latest forecasts were embraced by investors, they also highlight that the path forward for the Fed is far from certain. As we’ve noted over the past several months, the job market and pace of wage growth are focal points for the Fed as it tries to bring inflation down to its 2 percent target. Powell underscored this point in his latest press conference, saying, “We don’t think [that] inflation was ... originally caused ... mostly by wages. That wasn't really the story. But we do think that to get inflation back down to 2 percent sustainably, we would like to see continuing gradual movement of wage increases at still high levels but back down to levels that are more sustainable over time.”

And while wage growth has eased during the past year as the labor force participation rate for prime aged workers (those between 25 and 54 years old) returned to—and now exceeds—pre-COVID levels, we don’t believe there are enough people on the sidelines that will be brought back to the workforce to create any sustainable meaningful slack in the labor market. As such, we believe unless economic activity slows, leading to diminished demand for workers or even net job losses, the pace of easing wage pressures will slow and potentially stall before it reaches a level consistent with sustainable 2 percent inflation. If wage growth remains elevated, it could lead to a continuation of inflation pressures.

Additionally, there’s the matter of recent inflation trends. PCE and Consumer Price Index (CPI) data for the first two months of the year has been stronger than expected. Similarly, as we noted in a recent commentary, additional measures of inflation show a similar pattern of rising price pressures. While there remains a debate whether the PCE and CPI readings reflected seasonal statistical noise, during his press conference following the latest Fed meeting, Chairman Powell acknowledged that the numbers warranted additional patience on the part of the Fed Open Markets Committee before it concludes that it can safely begin making dramatic moves on rates without risking inflation pressure reemerging.

“We’re in a situation where, if we ease too much or too soon, we could see inflation come back, and if we ease too late, we could do unnecessary harm to employment and people’s working lives. And so we do see the risks as two-sided, so it [the first rate cut] is consequential, we want to be careful; and fortunately, with the economy growing, with the labor market strong, and with inflation coming down, we can approach that question carefully and let the data speak on that,” Powell said.

Put simply, we continue to believe that progress in bringing inflation sustainably down to 2 percent has stalled. As such, we think the market is getting ahead of itself in expecting cuts to begin soon. Should the Fed hold rates higher for longer as it waits for more clarity on the inflation front, we believe it raises the risks of a mild, brief recession.

Wall Street wrap

Forward-looking indicators increase: The latest Leading Economic Indicators (LEI) report from the Conference Board showed its first uptick since February 2022. The February LEI reading rose 0.1 percent after January’s 0.4 percent decline. The uptick in the reading was driven by a rise in the number of hours worked in manufacturing, the stock market’s recent surge, the Leading Credit Index, and an increase in residential construction. Despite the rise in February, the measure is now down 5.1 percent on an annualized basis over the past six months. The six-month diffusion index (the measure of indicators showing improvement versus declines) came in at 30 percent. The Conference Board notes that when the diffusion index falls below 50, and the decline in the overall index is 4.4 percent or greater over the previous six months, the economy is in or on the cusp of a recession.

While we welcome the improving trend over the past few months, the index continues to flash caution. In a statement accompanying the report, Justyna Zabinska-La Monica, senior manager, Business Cycle Indicators at the Conference Board, noted, “Despite February’s increase, the Index still suggests some headwinds to growth going forward. The Conference Board expects annualized US (gross domestic product) growth to slow over the Q2 to Q3 2024 period, as rising consumer debt and elevated interest rates weigh on consumer spending.”

Business activity slowed: U.S. business activity slowed in March but remained in expansion territory. The latest preliminary data from the S&P Global Composite Purchasing Managers Index, which tracks both the manufacturing and service sectors, shows that the Composite Output Index reading declined slightly to 52.2 (levels above 50 indicate growth), down from February’s final reading of 52.5.

The modest slowdown in output growth stemmed from weak growth in the services side of the economy, which grew at the slowest pace in three months. The survey shows that business activity on the services side came in at 51.7, down 0.6 from February’s reading. The report shows, however, that the manufacturing side of the economy continued to improve, with a headline reading of 52.5, up from February’s final reading of 52.2 and the highest reading in the past 21 months.

Pertaining to inflation, the pace of rising input costs hit a six-month high, with services providers citing rising wages as a key driver. Both sides of the economy reported raising selling prices, with manufacturing reporting the quickest pace of increases in 13 months. Selling prices for services rose at the highest rate in eight months. In a statement accompanying the release, Chris Williamson, chief business economist at S&P Global Market Intelligence, noted, “The steep jump in prices from the recent low seen in January hints at unwelcome upward pressure on consumer prices in the coming months.”

Finally, the rate of job growth increased to the highest level this year. Manufacturing saw particularly strong growth in payrolls, with hiring levels reaching an eight-month high.

Existing home sales jump: The National Association of Realtors reported that existing home sales in the U.S. surged 9.5 percent in February to a seasonally adjusted annual rate of 4.38 million units. The one-month gain is the largest since February 2023. On a year-over-year basis, sales of existing units are down 3.3 percent.

The inventory of unsold homes was 1.07 million units, up 5.9 percent from January and a rise of 10.3 percent from year-ago levels. Along with a sharp increase in sales, the median price for existing homes reached $384,500 in February, which is 5.7 percent higher than year-ago levels. As more homeowners opt to move, the impact of the Fed’s rate hikes will likely take a larger bite out of consumers’ income, as existing fixed rate mortgages that were issued at low rates prior to the beginning of the current rate cycle will reprice at higher prevailing rates available now.

Similar to existing home sales, new construction activity picked up last month. The latest housing starts data from the U.S. Census Bureau shows residential starts rose 10.7 percent in February from the prior month to a 1.52 million annualized rate. On a year-over-year basis, starts were up 5.9 percent from February 2023. Single-family housing starts grew by 11.6 percent from January’s revised pace to a seasonally adjusted annualized rate of 1.13 million units. Meanwhile, multifamily starts were 392,000, up 8.3 percent from January’s revised pace of 392,000.

Total building permits also rose in February by 1.9 percent to 1.518 million. Single-family permits edged 1 percent higher than the prior month to 1.03 million; multifamily permits rose by 4.1 percent for the month but are now down 25.5 percent year over year.

Home builders feeling more optimistic: Thanks to lower interest rates and stronger demand, optimism among home builders improved last month. The latest sentiment reading from the National Association of Home Builders came in at 51, marking the highest reading since July 2023. The March reading marks the fourth consecutive month of improved optimism. While optimism has grown, builders continue to offer incentives to entice buyers, with 60 percent of respondents reporting offering some sort of concession, which is consistent with levels seen each month since September 2022. The portion of builders cutting prices on new homes fell to 24 percent from a level of 36 percent at the end of 2023.

Jobless claims point to a firm employment picture: Weekly initial jobless claims were 210,000, down 2,000 from last week’s upwardly revised figure. The four-week rolling average of new jobless claims came in at 211,250, an increase of 2,500 from the previous week. Continuing claims (those people remaining on unemployment benefits) stand at 1.807 million, a decrease of 4,000 from the previous week’s revised total. The four-week moving average for continuing claims rose to 1.8 million, up 5,000 from last week’s downwardly revised figure.

The week ahead

Monday: The Chicago Federal Reserve Bank releases its national activity index. The report provides a look at economic activity across the country as well as related inflationary pressures, and we will be watching for signs of slowing economic growth.

The U.S. Census Bureau will release data on new home sales for February. We’ll be looking at this data to assess the impact of recent fluctuations in mortgage rates on demand for newly built homes.

Tuesday: The Conference Board’s Consumer Confidence report will come out in the morning. Given the Federal Reserve’s ongoing focus on the employment picture, we will continue to focus on the labor market differential, which is based on the difference between the number of respondents who believe jobs are easy to find and those who report challenges finding work.

We’ll be watching the S&P CoreLogic Case-Shiller Index of property values. Prices overall have moved higher in the past few months. We will be looking to see if home prices continue to rise, which could lead to higher inflation readings several months from now.

Data on durable goods orders for February will be released to start the day. We’ll be watching for signs that businesses are continuing to pull back spending in light of economic uncertainty.

Thursday: The Bureau of Economic Advisors will release its final update to fourth-quarter gross domestic product estimates for the fourth quarter of 2023. Earlier estimates came in much stronger than expected, and we will be looking for any significant changes to the pace of growth.

Initial and continuing jobless claims will be out before the market opens. Initial filings were down slightly last week, but the four-week rolling average of continuing claims rose. We will continue to monitor this report for signs of changes in the strength of the employment picture.

Friday: The February Personal Consumption Expenditures price index from the U.S. Commerce Department will be out before the opening bell. This is the preferred measure of inflation used by the Federal Reserve when making rate hike decisions.

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