Will the Fed Risk Overheating the Economy?

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

In the early stages of the post-COVID spike in inflation, perhaps no word became more controversial in economic circles than “transitory.” That’s because it was interpreted to have different meanings by different people. Federal Reserve Chairman Jerome Powell was among the first to use it to reflect his belief that the spike in prices was driven by temporary supply and demand imbalances and would not result in elevated price pressures becoming embedded in the economy. However, others defined transitory to mean short-lived and saw Powell’s use of the term as a sign the Federal Reserve was falling behind the curve in bringing inflation pressures to heel. Eventually, the controversy led Powell to discontinue the term’s use for a more detailed discussion of price pressures.

While inflation pressures did persist longer than many—including us—had originally expected, they have so far proven transitory based on Powell’s original definition. Much as we had forecasted at the time, as the economy pushed further past the impacts of the pandemic, the price pressures that resulted from COVID faded. However, we now believe that we are on the other side of the same inflation coin and that the disinflationary process that played out throughout much of 2023 and into this year could also prove to be transitory. That’s because of the factors that drive the various stages of a business cycle.

Over long periods of time, the U.S. economy expands and has a natural trend rate of growth—think of it like the speed limit. However, the economy doesn’t move at a consistent speed from one year to the next. Instead, it drifts through periods of expansions followed by contractions, sometimes racing well above its natural trend rate of growth or cruising well below it. This movement around its long-term trend is known as the business cycle, and history shows this is a natural, inevitable process.

One way to gauge where we are in the business cycle is to look at the output gap. This is the difference between the actual output of the economy and its potential output. When the gap is positive (the boom times), the economy is growing in excess of its expected capacity, which means companies are having a tough time keeping up with demand. A negative output gap (bust) means the economy is sluggish and operating below its expected capacity. The economy can exceed its natural capacity for brief periods but cannot produce above that limit for a sustained period. This brings us back to the focus of our concerns—the labor market. The sustainable pace of economic growth is a function of labor capacity (the number of workers available) and the productivity level of those workers. An upswing in productivity or a surge in the ranks of available workers can boost economic growth above its long-term trend line. However, eventually it reverts back to the mean. As we detailed in our latest Quarterly Market Commentary, we don’t believe we are likely to see either of these ingredients for above-average growth materializing in the near term.

Given the thin pool of available workers, companies have had to bid up for employees in hopes of luring them away from existing jobs. As such, we worry that the current dynamic could lead to the transition from transitory COVID-based inflation to more traditional wage-based price pressures typical of the end of a business cycle. While the pace of wage gains has been receding from post-COVID highs, wage increases are still above the level at which the Fed feels comfortable that the potential for wage-based inflation is fully in check. As such, we believe the Fed is unlikely to aggressively cut rates to stimulate a seemingly still growing economy at a time when unemployment is low and wage growth remains above the 3 to 3.5 percent pace the Fed sees as consistent with its goal of 2 percent inflation. Put simply, we believe the risk of reigniting price pressures by stoking growth in an economy that already appears to be running at capacity is too great at this time. Instead, we continue to believe the more likely path calls for the Fed to maintain rates near current elevated levels until the employment picture cools and wage growth recedes.

To be sure, comments from members of the Fed during the past several weeks praising the progress on inflation while noting that the success has come against the backdrop of a still strong job market raise the possibility that it could stray from its playbook of clamping down on the economy when the annual pace of wage growth exceeds 4 percent. If the Fed did opt to lower rates, we expect the path would be similar to that taken by former Federal Reserve Chairman Alan Greenspan in 1996. Back then, the Greenspan-led Fed modestly trimmed rates to sustain a still strong economy and then raised them to turn down the heat on the economy. While the effort did extend the business cycle, eventually the economy succumbed to the natural progression of every business cycle before it fell into a brief recession in 2001. However, given Powell’s previous statements as recently as October that “additional evidence of persistently above-trend growth, or that tightness in the labor market is no longer easing, could put further progress on inflation at risk and could warrant further tightening of monetary policy,” we continue to believe that any potential rate cuts will be modest until the job market shows signs of softening.    

Wall Street wrap

Data out last week suggests that conventional wisdom may be underestimating challenges facing the economy going forward.

Inflation edges lower: Last week’s Personal Consumption Expenditures (PCE) Index from the Bureau of Economic Analysis showed that core PCE, which strips out volatile food and energy prices, rose 0.2 percent in December, up from November’s 0.1 percent gain. On a year-over-year basis, core PCE now stands at 2.9 percent, down from the prior month’s reading of 3.2 percent and at the lowest level since March 2021. The report showed headline inflation rose 0.2 percent in December, up from November’s monthly decline of 0.1 percent, and is up 2.6 percent year over year, marking the second straight month at that level. Once again, the cost of services was the driver of higher prices, with a 0.34 percent rise from November’s reading, while goods prices declined 0.2 percent. While the report indicates prices continue to decline, other inflation measures we follow paint a more complicated picture. The Consumer Price Index has shown areas where price growth remains stubborn, and measures such as the Cleveland Federal Reserve’s inflation reading (called the Cleveland Median CPI) have shown an uptick in price pressures in recent months.

The discrepancies from the various inflation measures highlight the murky and sometimes conflicting picture painted of the post-COVID economy. We believe that the difference in data highlights the need for caution as the Fed considers the timing of potential rate cuts.

GDP shows strong growth: Estimates from the Bureau of Economic Analysis (BEA) out last week showed the U.S. economy grew faster than expected in the fourth quarter, thanks to still robust consumer spending. The preliminary estimate showed that real gross domestic product (GDP) grew at a seasonally adjusted annual rate of 3.3 percent. For the full year, the economy grew at a 2.5 percent pace, an acceleration from 2.2 percent growth in 2022. Growth in the fourth quarter was primarily driven by robust consumer spending, which accounted for 1.91 percent of the total growth for the quarter, with government expenditures adding .56 percent. Goods spending was up 3.8 percent, and services rose2.4 percent. Meanwhile, gross private domestic investment slowed to 2.1 percent from the prior quarter’s pace of 10 percent, and government was up 3.3 percent. Similar to the discrepancies in inflation measures, gross domestic income (GDI), a different measure of growth calculated by the Bureau of Economic Analysis, indicated that through the end of the third quarter the economy was stagnant. The GDI number for the fourth quarter will be released in late March along with the third estimate of GDP.

Business activity improves: U.S. business activity rose to start the year. The latest preliminary data from the S&P Global Composite Purchasing Managers Index, which tracks both the manufacturing and service sectors, indicated that economic growth accelerated in January. The Composite Output Index reading rose to 52.3 (levels above 50 indicate growth), up from December’s final reading of 50.9. The latest reading marked the highest level since July 2023.

The report shows the manufacturing side of the economy is treading water, with a headline reading of 50.3, up from December’s final reading of 47.9. Services also came in with a slight improvement with a reading of 52.9, up from the prior month’s 51.4. Demand in the services sector continues to ease, with the latest report showing a third straight month of declining new orders.

New orders were strong for both sides of the economy, with manufacturing seeing new orders move into expansionary territory for the first time since October 2023 and at the fastest pace since May 2022. Likewise, new orders for services saw the strongest gains in seven months.

Pertaining to inflation, the latest readings suggest that the pace of rising prices has continued to ease, with a composite reading of 51.7. The services side of the economy accounted for the easing of price pressures, with readings for prices charged marking the slowest growth rate since May 2020. It’s worth noting, however, that as the manufacturing side has shown some flickers of life during the past two months, so has inflation on that side of the economy. According to the latest data, prices charged by manufacturers rose for a second consecutive month. The latest increase was the largest recorded since April 2023. The uptick in manufacturing inflation comes at a time when input costs for goods makers are also rising. The report shows that input costs rose to the highest level since April 2023 due to challenges in sourcing materials and higher fuel and shipping costs.

Forward-looking indicators remain underwater: 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 December LEI reading declined 0.1 percent after November’s 0.5 percent decline. The reading is now down 5.8 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 40 percent. 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.

Despite some modest improvements in the data, 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, “As the magnitude of monthly declines has lessened, the LEI’s six-month and 12-month growth rates have turned upward but remain negative, continuing to signal the risk of recession ahead. Overall, we expect GDP growth to turn negative in Q2 and Q3 of 2024 but begin to recover late in the year.”

Another sign of slowing growth: As we’ve noted in the past, when looking at national data we like to dig deeper and look at indicators at the state level to assess whether trends in the national data are being distorted by a few outliers or represent a broad trend. One such example is the state unemployment data released by the Bureau of Labor Statistics. The report out last week shows that unemployment for December moved higher in 15 states, lower in one state and stable in 34 states and the Disctrict of Columbia. However, an analysis of the state data shows that as of the end of December, 18 states saw their three-month moving average unemployment levels increase by 0.5 percent or more from previous three-month moving average lows that had occurred since December 2022.

This is significant because it shows that 36 percent of the states are now triggering the so-called Sahm rule. According to this rule, developed by former Federal Reserve economist Claudia Sahm, since 1960, every time the three-month moving average unemployment rate rose by 0.5 percent or more from the previous low, a recession has followed. Additionally, going back to 1976, whenever this large a portion of the states have broken the Sahm rule, a recession has followed.

The importance of state-level unemployment data is also highlighted by its inclusion in the calculation of the State Coincident Index produced by the Federal Reserve Bank of Philadelphia. The index looks at state employment numbers (among other economic measures) to calculate a state-based growth diffusion index. The latest reading, based on December state data, was 20, which was a marked improvement from the prior reading. However, for the fourth quarter, the reading was just six, which suggests the latest GDP figure may be inflated. In fact, the three-month average is at a level that has typically coincided with recessions.

Jobless claims rise: Weekly initial jobless claims numbered 214,000, an increase of 25,000 from last week’s upwardly revised figure. The four-week rolling average of new jobless claims came in at 202,250. Continuing claims (those people remaining on unemployment benefits) were at 1.833 million, an increase of 27,000 from the previous week. The four-week moving average for continuing claims declined slightly to 1.835 million, down 13,250 from last week’s upwardly revised figure.

The week ahead

Tuesday: The Bureau of Labor Statistics (BLS) will release its Job Openings and Labor Turnover Survey report. We’ll watch for whether the gap between job openings and job seekers is continuing to narrow, which would help ease wage pressure for businesses.

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 over the past few months. We will be watching to see if home prices continue to rise, which could lead to higher inflation readings several months from now.

Wednesday: The focus for the day will be on the Federal Reserve as it releases its statement following its monthly meeting. We expect the Fed will hold rates steady, and we will be listening for forward guidance on the path and timing of rate changes going forward. We will also be listening to comments on the current state of the employment picture and wages.

Thursday: Initial and continuing jobless claims will be announced before the market opens. Initial filings rose last week, and the four-week rolling average of continuing claims declined. We will continue to monitor this report for signs of changes in the strength of the employment picture.

Friday: The BLS will release the Jobs report. We’ll be watching to see if the slowing pace of job and wage gains continued in January. Importantly, we will be monitoring the labor force participation rate to see if the recent rise in new entrants joining the workforce is continuing. A rise in labor force participation could help ease the current elevated wage pressures.

Follow Brent Schutte on X (formerly Twitter) and LinkedIn.

Commentary is written to give you an overview of recent market and economic conditions, but it is only our opinion at a point in time and shouldn’t be used as a source to make investment decisions or to try to predict future market performance. To learn more, click here.

There are a number of risks with investing in the market; if you want to learn more about them and other investment-related terminology and disclosures, click here.