Rates Unchanged, but Fed Says More Work Needed to Rein In Labor Market

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

Equities finished the week lower as the Fed’s still-firm stance on rates disappointed investors. As expected, the Federal Open Markets Committee (FOMC) left rates unchanged at its meeting last week, but a majority of members signaled they thought that an additional hike may be necessary this year to fully quash what they see as the lingering threat of price pressures reigniting. During a press conference following the latest FOMC meeting, Fed Chairman Jerome Powell acknowledged that significant progress had been made on containing price pressures but that more work remained to rein in stronger than expected economic growth that contributed to a stubbornly strong labor market.

To be sure, Powell acknowledged there are some recent signs that the employment picture may be cooling modestly but also that the current imbalance is inconsistent with the Fed’s stated target of 2 percent inflation. As such, the Fed left the possibility that it may hike rates again and need to leave raters higher for a longer period of time than previously expected. The Fed also reduced its forecast for rate cuts next year from 100 basis points to 50.

The Fed’s firm stance on rates is consistent with our belief that it is unlikely to declare victory in the battle against inflation until wage growth consistently comes down from its current 4.5 percent year-over-year rate to a range of 3.25 percent to 3.5 percent. We believe the most likely path for the Fed to achieve that goal is, unfortunately, through an uptick in unemployment. Indeed, the Fed’s latest forecast calls for unemployment to move higher, to 4.1 percent from the most recent reading of 3.8 percent. While the Fed’s stance on rates was much as we expected, its forecast for economic growth going forward was considerably more optimistic given its expectations for the employment picture.

The Fed now expects gross domestic product (GDP) to grow by 2.1 percent for the year—more than double its forecast of 1 percent issued in June of this year. Board members project GDP growth of 1.5 percent in 2024, despite acknowledging that at current levels, interest rates are acting as a material drag on the economy. While it is possible the Fed may be able to engineer a soft landing, we continue to believe that a more likely scenario is the cumulative effects of the 525 basis points in rate hikes over the past year and a half will begin to seep more broadly into the economy and cause the weakness that has been primarily on the goods side to permeate into the services side of the economy.

When asked about a soft landing, Powell said it’s a “primary objective” but not a “baseline expectation.” But he further noted that the worst thing the Fed could do is fail to rein in price stability, saying, “If you don’t restore price stability, inflation comes back.” As such, the Fed is likely to err on the side of doing too much, which is why we believe a recession is the mostly likely outcome. Fortunately, with inflation falling as it has and inflation expectations well anchored, the Fed should have room to cut rates to soften the blow of an economic downturn.

Wall Street Wrap

Forward-looking indicators fall again: The latest Leading Economic Indicators (LEI) report from the Conference Board continues to suggest that the economy is either in recession or on the cusp of one. The August LEI reading declined 0.4 percent. The latest measure marks 17 consecutive months of decline. The reading is now down 7.5 percent on an annualized basis over the past six months. Despite the six-month diffusion index (the measure of indicators showing improvement versus declines) improving slightly to 40 percent, weakness continues to be widespread. The Conference Board notes that when the diffusion index falls below 50, and the decline in the overall index is 4.2 percent or greater over the previous six months, the economy is in or on the cusp of recession. The diffusion index first fell below 50 in April 2022 and the overall reading first exceeded the negative 4.2 percent level in June of 2022.

The streak of declining readings points to a rocky road ahead. In a statement accompanying the report, Justyna Zabinska-La Monica, senior manager, Business Cycle Indicators at the Conference Board, noted, “The leading index continued to be negatively impacted in August by weak new orders, deteriorating consumer expectations of business conditions, high interest rates, and tight credit conditions. All these factors suggest that, going forward, economic activity probably will decelerate and experience a brief but mild contraction. The Conference Board forecasts real GDP will grow by 2.2 percent in 2023 and then fall to 0.8 percent in 2024.”

Home builders turn pessimistic: The latest sentiment reading from the National Association of Home Builders (NAHB) came in at 45, down from the prior month’s reading of 50 and the first time optimism fell below 50 percent since April of this year. The latest report marks the second consecutive month of declining optimism as mortgage rates continue to hover above 7 percent. In a statement accompanying the release, NAHB Chief Economist Robert Dietz noted the impact higher rates were having on the industry: “High mortgage rates are clearly taking a toll on builder confidence and consumer demand, as a growing number of buyers are electing to defer a home purchase until long-term rates move lower.” To offset the impact of higher interest rates, nearly three in five respondents—59 percent—reported offering some sort of incentive to entice buyers, with 32 percent reporting they cut prices on new homes, up from 25 percent in August.

The dampened outlook for builders was consistent with the latest housing starts data from the U.S. Census Bureau. Overall, residential starts decreased 11.3 percent to a 1.283 million annualized rate, the lowest level since June 2020. Single-family housing starts in August fell 4.3 percent from July’s revised pace to a seasonally adjusted annualized rate of 941,000 units. The latest estimate marks a 2.4 percent increase on a year-over-year basis. Meanwhile, multi-family starts were 342,000, down 26.3 percent from July’s revised pace of 464,000.

While starts were weaker than expected, permits rose to 1.543 million, the fastest pace since October 2022. Both single-family and multi-family permits rose (with single-family units notching a 2 percent rise) and are now up 7.2 percent year over year. Overall, these numbers remain well below their post-COVID highs. Current high mortgage rates have negatively impacted housing affordability, and we believe the housing sector as a whole will continue to face headwinds in the coming months.

NAR existing home sales continue to ease: Although they have pushed lower, both housing starts and permits have been supported by the lack of inventory and high mortgage rates that continue to hamper existing home sales. The National Association of Realtors (NAR) reported that existing home sales in the U.S. declined 0.7 percent in August to a seasonally adjusted annual rate of 4.04 million units. This is near the low of 4 million set in January of this year and is well off the post-COVID high of 6.56 million set back in October 2020. Besides the 4 million in January 2023 and 4.03 million in December 2022, this is the slowest pace since late 2010. On a year-over-year basis, sales were down 15.3 percent.

The inventory of unsold homes was 1.1 million units, the smallest August inventory in data back to 1999.

Business activity continues to slow: U.S. business activity showed little sign of change in September as economic growth continued to soften. The latest preliminary data from the S&P Global Composite Purchasing Manager’s Index, which tracks both the manufacturing and service sectors, indicated that the economy grew at the slowest pace since February of this year. The Composite Output Index reading dropped to 50.1 (levels above 50 indicate growth), down from August’s final reading of 50.2. While still technically in expansion territory, the latest measure reflects ongoing weakness on the manufacturing side and continued softening on the services side.

Manufacturing continues to be mired in contraction, with a headline reading of 48.9, up from August’s level of 47.9.

While the services sector remains in growth mode, that growth is the slowest it has been in eight months, with a headline reading of 50.2, down from last month’s reading of 50.5.

Jobless claims decrease: Weekly jobless claims were 201,000, down 20,000 from last week’s upwardly revised figure. The four-week rolling average of new jobless claims came in at 217,000, down 7,750 from the previous week’s revised average. Continuing claims (those people remaining on unemployment benefits) fell to 1.662 million, a decrease of 21,000 from the previous week.

The week ahead

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. Home sales and prices overall have continued to tread water over the past few months, with some regions showing stability while others see prices continue to fall. We will be watching to see if current mortgage rates have continued to keep a lid on home prices.

Wednesday: Data on durable goods orders for August 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: Initial and continuing jobless claims will be announced before the market opens. Initial filings were down last week, and we will be watching to see whether last week’s decrease was a temporary blip or a sign of continued strength in the job market.

Friday: The August 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. We will be scrutinizing this report with a particular focus on the services side of the reading.

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