Chief Economist Eugenio J. Alemán discusses current economic conditions.
The question many economists, as well as market participants, asked themselves after the June Federal Open Market Committee (FOMC) meeting was why the Federal Reserve (Fed) paused its federal funds rate hike campaign if they were going to increase it again in July anyway. What did waiting for 5 weeks to resume hikes mean for monetary policy? We thought, naively, that it was because the Fed, as it has argued so many times, was data-dependent and was willing to wait some more time to see how the lagging effects of monetary policy were affecting the economy.
This brings us to an anecdote from a personal experience of Fed policymaking. Regional Federal Reserve banks schedule meetings with business representatives in their districts to produce the Beige Book, which is published 8 times per year. During our careers as economists, we participated in several of those meetings as one of the representatives from the financial industry. We remember that during one of those meetings, the ‘dot plot’ discussion came into a big disagreement, with Fed representatives arguing that the ‘dot plot’ was not a forecast of the path of the federal funds rate. Conversely, many industry representatives argued that it actually looked like a forecast. In the end, Fed representatives had the upper hand because they were the ‘owners’ of the ‘dot plot’ and we finally adopted their position that it wasn’t an actual forecast on the path of the federal funds rate. This remained relatively true until Wednesday, July 26, 2023, when we finally had the opportunity to prove them wrong.
In fact, on Wednesday, July 26, 2023, the dot plot seemed to actually be a forecast for the future path of the federal funds rate. Even in the face of very good data on inflation and even in terms of employment, the Fed disregarded the data and moved to increase the federal funds rate after pausing for just one month. This makes the odd decision in June even odder and will probably remain as one of the most intriguing and unsolved mysteries of monetary policy for all of the 21st century! The decision was so odd that even Chairman Powell had trouble explaining it during his press conference after the July FOMC meeting.
Since this is the case, we have updated our expectation on the federal funds rate and now expect another 25 basis point increase before the end of this year. The reason? This is what the dot plot showed in June. That said, this may change in September, when the next FOMC meeting is scheduled and when the new Summary of Economic Projections (SEP), which includes a new dot plot, is going to be released. At that time, we will have to update our expectations regarding the federal funds rate matching what the dot plot shows.
Talk of a soft landing intensifies
Talk of a soft landing has intensified lately as the U.S. economy has remained stronger than expected even in the face of very high interest rates, which clearly means that, so far, these higher interest rates have not been binding for economic activity.
As we have argued in the past – see, for example, our “Thoughts of the Week” for December 9, 2022, what happened during the COVID-19 pandemic was not a typical monetary cycle, and thus monetary policy has not been efficient in achieving its intended effects. Furthermore, although the factors driving economic activity during that period are dwindling, i.e., excess savings have been almost completely depleted, employment is still riding high and, together with lower inflation – which has improved purchasing power of incomes, have been enough to keep the economy stronger than expected. However, we are expecting both personal consumption expenditures as well as employment to continue to slow down during the second half of the year, which means that we expect weaker economic growth going forward.
But there is something else happening today that is contributing to economic growth: strong growth in investment. Although investment is one of the most interest sensitive sectors of the economy, nonresidential investment has shown positive rates of growth for 12 consecutive quarters, that is, since the third quarter of 2020. Recent drivers of nonresidential investment growth have been investment in structures, driven by the effects of the Inflation Reduction Act (IRA) as well as the CHIPS Acts, and equipment investment added a strong boost to nonresidential investment during the second quarter of the year, up 10.8%, after two consecutive declines. All and all, gross private domestic investment added almost a full percentage point (0.97 percentage points) to economic growth during the second quarter of the year after subtracting 2.22 percentage points from GDP growth during the first quarter of the year.
Thus, as personal consumption expenditures continue to slow down in the second half of the year, the U.S. economy is going to start to rely more and more on the growth rate of—and contributions from – investments, which is the most unreliable contributor to U.S. GDP growth and is poised to continue to be negatively affected by higher interest rates going forward. It is true that the IRA and the CHIPS Acts will continue to add some tailwind momentum, but we still think that the combination of headwinds coming from higher interest rates and slowing consumption will take the economy into a very mild recession by the end of this year.
Economic and market conditions are subject to change.
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Consumer Price Index is a measure of inflation compiled by the US Bureau of Labor Statistics. Currencies investing is generally considered speculative because of the significant potential for investment loss. Their markets are likely to be volatile and there may be sharp price fluctuations even during periods when prices overall are rising.
Consumer Sentiment is a consumer confidence index published monthly by the University of Michigan. The index is normalized to have a value of 100 in the first quarter of 1966. Each month at least 500 telephone interviews are conducted of a contiguous United States sample.
Personal Consumption Expenditures Price Index (PCE): The PCE is a measure of the prices that people living in the United States, or those buying on their behalf, pay for goods and services. The change in the PCE price index is known for capturing inflation (or deflation) across a wide range of consumer expenses and reflecting changes in consumer behavior.
The Consumer Confidence Index (CCI) is a survey, administered by The Conference Board, that measures how optimistic or pessimistic consumers are regarding their expected financial situation. A value above 100 signals a boost in the consumers’ confidence towards the future economic situation, as a consequence of which they are less prone to save, and more inclined to consume. The opposite applies to values under 100.
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GDP Price Index: A measure of inflation in the prices of goods and services produced in the United States. The gross domestic product price index includes the prices of U.S. goods and services exported to other countries. The prices that Americans pay for imports aren’t part of this index.
The Conference Board Leading Economic Index: Intended to forecast future economic activity, it is calculated from the values of ten key variables.
The Conference Board Coincident Economic Index: An index published by the Conference Board that provides a broad-based measurement of current economic conditions.
The Conference Board lagging Economic Index: an index published monthly by the Conference Board, used to confirm and assess the direction of the economy’s movements over recent months.
The U.S. Dollar Index is an index of the value of the United States dollar relative to a basket of foreign currencies, often referred to as a basket of U.S. trade partners’ currencies. The Index goes up when the U.S. dollar gains “strength” when compared to other currencies.
The FHFA House Price Index (FHFA HPI®) is a comprehensive collection of public, freely available house price indexes that measure changes in single-family home values based on data from all 50 states and over 400 American cities that extend back to the mid-1970s.
Import Price Index: The import price index measure price changes in goods or services purchased from abroad by U.S. residents (imports) and sold to foreign buyers (exports). The indexes are updated once a month by the Bureau of Labor Statistics (BLS) International Price Program (IPP).
ISM New Orders Index: ISM New Order Index shows the number of new orders from customers of manufacturing firms reported by survey respondents compared to the previous month. ISM Employment Index: The ISM Manufacturing Employment Index is a component of the Manufacturing Purchasing Managers Index and reflects employment changes from industrial companies.
ISM Inventories Index: The ISM manufacturing index is a composite index that gives equal weighting to new orders, production, employment, supplier deliveries, and inventories.
ISM Production Index: The ISM manufacturing index or PMI measures the change in production levels across the U.S. economy from month to month.
ISM Services PMI Index: The Institute of Supply Management (ISM) Non-Manufacturing Purchasing Managers’ Index (PMI) (also known as the ISM Services PMI) report on Business, a composite index is calculated as an indicator of the overall economic condition for the non-manufacturing sector.
Consumer Price Index (CPI) A consumer price index is a price index, the price of a weighted average market basket of consumer goods and services purchased by households. Changes in measured CPI track changes in prices over time.
Producer Price Index: A producer price index (PPI) is a price index that measures the average changes in prices received by domestic producers for their output.
Industrial production: Industrial production is a measure of output of the industrial sector of the economy. The industrial sector includes manufacturing, mining, and utilities. Although these sectors contribute only a small portion of gross domestic product, they are highly sensitive to interest rates and consumer demand.
The NAHB/Wells Fargo Housing Opportunity Index (HOI) for a given area is defined as the share of homes sold in that area that would have been affordable to a family earning the local median income, based on standard mortgage underwriting criteria.
The S&P CoreLogic Case-Shiller U.S. National Home Price NSA Index measures the change in the value of the U.S. residential housing market by tracking the purchase prices of single-family homes.
The S&P CoreLogic Case-Shiller 20-City Composite Home Price NSA Index seeks to measures the value of residential real estate in 20 major U.S. metropolitan.
Source: FactSet, data as of 7/7/2023