New Challenges for Consumers?

The first quarter GDP growth numbers are finally in, and it wasn’t as pretty a picture as many analysts thought. Markets had been bracing for an unfavorable inflation reading—that much had already been gleaned from recent CPI and PPI reports. Yet, inflation continued to surprise, exceeding consensus expectations with the broadest measure of prices, the GDP price index, clocking in at an overheated 3.1% annualized. The core PCE price index was even more of a shocker coming in at a smoking 3.7% in the first quarter. This was three tenths of a percentage point above the consensus estimate of 3.4%.

It was another rude reminder for fixed income traders. Their dream of six or seven interest rate cuts this year would remain just that, a dream. This breathed new life into the higher for longer trade, sending bond prices lower and Treasury yields across the maturity spectrum skyward. The 10-year Treasury yield hit a five-month high on Thursday, and we don’t rule out the possibility yields may soon be challenging their October peaks of around 5.0%. We pushed back our forecast for the first Fed rate cut to September from July with the latest inflation numbers top of mind.

None of this is good news for the economic outlook. The toxic brew of rising interest rates, delayed Fed rate cuts, and unrelenting inflation could soon take a toll on the consumers’ willingness and ability to spend. Consumers are increasingly having to choose where they put their diminishing spending power. Even though real consumer spending remained strong in March, real disposable personal income growth has slowed sharply over the past year and the personal savings rate has fallen to a low 3.2%, a level not seen since late 2022. The sharp increase in both nominal and real interest rates across the maturity spectrum will, no doubt, put an additional drag on real consumer and business spending growth, including the housing market, in the quarters ahead. The latest Fed Beige Book noted reports that consumer discretionary spending is weak, and consumers are becoming more price-sensitive.

At the same time, more U.S. borrowers are falling behind on their credit card and motor vehicle payments as the combination of higher interest rates and elevated inflation takes a toll. According to the latest data from the New York Fed, the 30-day delinquency rate on credit cards and motor vehicles hit 8.52% and 7.69% respectively in the fourth quarter, the highest rate since the immediate aftermath of the Great Recession. The weaker-than-forecast 2.5% annualized real consumer spending growth in the first quarter is likely just the beginning of what we believe will be a series of slower quarters for consumer spending ahead until inflation cools and the Fed takes its foot off of the monetary brake.

FOMC Preview: No Jay Mayday on May Day

Fed Chair Jay Powell, in his last public comments before the blackout period around the April 30-May 1 FOMC meeting, alerted that policymakers were perturbed by recent indications of sticky inflation and resilient growth. With rate cuts pending until the Fed has “gained greater confidence that inflation is moving sustainably toward 2 percent”, Powell said: “The recent data have clearly not given us greater confidence and instead indicate that it’s likely to take longer than expected to achieve that confidence.” He added, “it’s appropriate to allow restrictive policy further time to work”.

And policy is restrictive. In real terms (subtracting the core PCE inflation rate), the midpoint of the fed funds target range currently sits at 2.6%, the highest since just before the start of the Great Recession in late 2007. It’s above the prior 0.8% peak in the spring of 2019 that proved to be too onerous for the economy at the time (causing the Fed to cut rates by 75 bps during the summer-autumn months). It’s above the historical median of 1.6% (dating back to 1960 and employing the effective funds rate before the early 1980s). And it’s even above all FOMC participants’ projections of the neutral real rate that range from 0.4% to 1.8% (with a median of 0.6%). In saying it’s appropriate to give this restrictive policy more time to work, Powell is also stating that there’s no need to raise rates (at least for the time being).

For the policy statement released on May 1 (a.k.a. May Day), we’re expecting some changes, particularly related to quantitative tightening (QT), with tapering plans probably to be detailed separately. The Minutes from the March 19-20 FOMC meeting (released April 10) revealed that, for Treasuries, “participants generally favored reducing the monthly [$60 billion] pace of runoff by roughly half” and maintaining the $35 billion cap for MBS since it’s not proving to be binding. We see the cap for Treasuries declining to an MBS-matching $35 billion but wouldn’t be surprised if both thresholds dropped to $30 billion [1].

The rest of the statement could be repeated verbatim, but we also wouldn’t be surprised to see some tweaking designed to reinforce the notion that the policy-on-hold horizon is extending. In the press conference, we reckon Powell will reiterate his recent comments. Questions will be asked about what it would take for the Fed to put rate hikes back on the table, after pivoting away from them in December. We suspect the answer will be that rates are already “sufficiently restrictive” and it’s only a matter of time before they bite more effectively. But if they don’t start biting harder soon, and the data themes of stickiness and resiliency persist or worsen, we reckon Powell and his policymaking colleagues would have no problem sounding the ‘Mayday’ signal and consider further rate hikes.

Finally, we’ve taken the occasion of another sticky inflation report (this week’s PCEPI for March) to push back our projection for the Fed’s inaugural rate cut to September from July. Given the data flow over the past three months, the net risk to our 2024 rate cuts call would seem to rest on the side of one or none.

[1] We see QT continuing at this clip until early next year (around March), until reserves drop to $3.0 trillion (currently averaging $3.5 trillion). At this point, and by design, reserves would still be more than “ample”, with the last legs down allowed to unfold organically owing to the expansion of other Fed liabilities such as currency amid a same-sized balance sheet. We also assume the monthly MBS cap will remain in place indefinitely. So, as of around April 2025, net purchases of Treasuries will start offsetting MBS roll-off. [^]

Inflation Reheats

The March personal spending report confirmed what the consumer price data already told us: inflation has regained a spark following surprisingly rapid progress last year. The core PCE price index popped 3.7% annualized in Q1, after slowing to a 2.0% pace in the prior two quarters (i.e., price stability). While the yearly rate held steady at 2.8% in March, steamier short-term trends suggest the underlying rate is still running north of 3% (i.e., not price stability).

The services sector remains the fuel for inflation’s fire. While core goods prices fell slightly in Q1 (helped by cheaper autos and furniture), services prices spiked 5.4% annualized, the most in a year. And the heat goes well beyond rents, as ‘supercore’ services prices (excluding housing and energy) shot up 5.1%. Some idiosyncratic items are at play, such as zooming auto insurance premiums. But the strength spans a much broader range of services, including discretionary areas such as recreational (+5.4%) and personal care (+7.9%).

The pickup in inflation reflects several factors. Consumer spending on services remains strong (4.0% a.r. in Q1), led by strength in recreational services (4.8%). This, in turn, stems from accelerating employment and income gains, with personal income spiking 7.2%. Wages are now rising faster than prices, juicing spending power. That’s also giving businesses some renewed pricing power, as shoppers bite their tongue and cough up. Because of still-tight labor markets, wages are running a little faster than productivity, giving businesses more reason to hike prices. In addition, pandemic-led shifts in seasonal adjustment factors might be contributing to the upturn in the price data.

All may not be lost, however. If consumer spending decelerates somewhat further this year in response to past rate hikes and diminished savings, services inflation should subside. That would keep the door open for Fed rate cuts.

California Outlook: Dreaming of Better Days

Executive Summary

• California’s gross state product (GSP) increased 2.1% in 2023, modestly trailing U.S. GDP growth of 2.5%. However, the underperformance in GSP last year was not quite as severe as it was in the labor market, suggesting a somewhat higher level of productivity growth in the state. California’s job growth last year was last among the 50 states, while its moderate GSP growth put it in 32^nd place among the rest of the states.

• California job growth is forecast at 1.0% in 2024, below the long-run average of 2.8% from 1940-2023, though just modestly below the expected national rate.

• The state was already facing a large budget deficit at the time the 2024/2025 budget was proposed in January, but weaker-than-anticipated revenues since then point to a further deterioration. The Legislative Analysts’ Office recently updated revenue projection is roughly $24 billion below the governor’s budget, suggesting the budget deficit could spike to $73 billion at the time of the May revision.
• California’s population has declined for three consecutive years, the first annual drop since records began in 1901. Population declines are expected to persist this year and next amid sluggish job growth, skyrocketing utility bills, and poor housing affordability.
• California’s unemployment rate is climbing faster than the nation’s, up 1.5 ppts since the August 2022 low to 5.3% in March, and is now the highest in the nation. However, we expect it to rise only slightly further and average around 5.5% over the next two years.
• California home sales rose in the first two months of the year, but some of that was reversed, as sales slid 7.6% month-on-month in March on the back of higher mortgage rates. Still-elevated mortgage rates, poor affordability, and low existing inventory will continue to weigh on the residential market over the next two years.
• After eight consecutive monthly declines, California home prices have been climbing since July. Prices increased 7.7% from a year earlier in March. California’s home prices are forecast to advance 5.7% this year as demand continues to outpace limited supply and then slow to 2.0% in 2025 amid weak job growth and stabilizing housing starts.

Employment Outlook

California’s labor market has been underperforming the national average for more than a year as the tech layoffs, bank failures, and the writers and actors’ strikes have exacted a toll. Downward revisions for 2023 portray a markedly weaker picture of the state’s labor market than first estimated. Average monthly job growth in 2023 slipped sharply to 12,908 from the original estimate of 25,900, and December’s year ago percent change in total nonfarm jobs was revised down to 0.9% from 1.7%.

The current year is off to an uneven start. Nonfarm employment rose 0.1% in January, was unchanged in February and accelerated to 0.2% in March, on par with the U.S. average. Strong gains in healthcare and construction payrolls drove the latest increase, although the construction payroll gains were largely driven by a weather-related rebound (Chart 1).

The acceleration in March job growth pushed California’s year-on-year growth rate up to 1.2% from 1.0%, although it trails the nation’s robust pace of 1.9% by a wide margin. Information remains the primary sector behind the weak annual job growth due to tech and Hollywood layoffs though manufacturing and financial services also lost net jobs last month. Within the information sector, motion picture & sound and recording studios were responsible for 58.1% of the drop despite representing just 22.3% of total jobs.

California job growth is expected to climb 1.0% y/y in 2024 and 2025 after slowing sharply to 0.9% last year. High housing costs, still-tight monetary policy, zero population growth and mounting fiscal headwinds are expected to keep job growth muted near-term.

California’s unemployment rate is rising faster than the nation's, climbing 1.5 percentage points to 5.3% in March from a record-low of 3.8% in August 2022 (Chart 2). It is the highest among all 50 states. However, the jobless rate is expected to rise only slightly further, averaging 5.5% in 2024 and 5.6% in 2025.

Housing Outlook

The strong two-month rebound in California home sales was fleeting. Existing home sales slid 7.8% month-on-month in March following solid advances of 14.8% and 12.8% in January and February respectively. Mortgage rates increased to the highest level since November, worsening home affordability and undermining demand.

Home sales dropped from a year ago in three of the four main regions of the state, with the biggest decrease in the Central Valley (Chart 3). In contrast, sales rose in the Central Coast for the third straight month amid strong increases in Santa Barbara (+23.1%) and San Luis Obispo (+13.2%) Counties.

The state continues to suffer from too little home inventory for sale. The Unsold Inventory Index—which captures the number of months it would take to sell the supply of existing homes on the market at the current sales pace—rose to 2.6 in March from 2.1 in March 2023, but remains notably below the long-run average of 3.9 from January 2008 to December 2023 (Chart 4). Similar trends are evident across all four main regions of the state, pointing to widespread inventory shortfalls.

California’s median home price was $854,490 in March, up 6.0% m/m and 7.7% higher than a year earlier (Chart 5). Home prices have climbed year-on-year for the past nine months, but the median statewide home price is still 4.0% below the all-time high set in May 2022. Price gains from a year ago ranged from a modest 3.0% in the Central Coast to a sizzling 15.5% in the Bay Area.

Statewide home prices are projected to rebound 5.7% in 2024 from the modest decline of 1.8% in 2023.

California’s Demographic Challenge

Over the past few years, California has entered unfamiliar demographic territory symbolized by population declines. The state’s population slid 0.2% in 2023, the third consecutive yearly loss. Prior to 2021, California had never experienced a single year of population decline going back to 1901 according to the U.S. Census Bureau.

A significant driver of the state’s population loss has been residents moving to other states due to poor housing affordability. A survey by the Public Policy Institute of California noted about a third of state residents are considering moving out of the state due to high housing costs.

A declining birth rate—defined as the number of births per 1,000 population—is another factor behind the drop in population over the last three years. The birth rate was 2.49 in 1990 and fell to an estimated 1.61 in 2023, well below the rate necessary to support steady population growth (Chart 6). The birth rate is projected to remain essentially unchanged for the next three years, pressuring overall population growth.

California’s net out-migration reached a stunning 415,000 in 2021 at the height of the pandemic. While net out-migration has improved a bit over the last two years, it remains highly negative and is expected remain negative over the next few years.

The recent trend of population loss in California is forecast to persist in 2024 with drops of 0.3% and 0.1% in 2025 (Chart 7). Unaffordable homes, high utility bills, and congested freeways have compelled many state residents to move to lower cost locales.

That said, the Golden State's natural beauty and warm weather, not to mention its vibrant tech sector, suggest population flows could turn around in coming years.