Viewpoint
April 19, 2024 | 14:50
April 19, 2024
A Solid Q1 Seems Assured, but Does That Mean No Landing? |
Macroeconomic forecasters these days, like the Federal Reserve, are more data-dependent than usual. Facing higher-than-normal economic and financial uncertainty, they are putting more weight on each day’s data releases to inform their outlook on the Fed, inflation, and the consumer. The problem with being hyper-data-dependent is that your near-term forecasts can suffer badly from recency bias. |
The last two weeks of economic data have provided plenty of new food for thought. The message from the March reports was that the inflation problem is far from over and the Fed’s job to restore price stability is, at best, a work in progress and, at worst, a battle that is being lost. The view that turns out to be correct will very much depend on the next few months of incoming data. A stronger-than-expected March retail sales report, along with upward revisions to previous months, point to stronger real consumer spending growth in the first quarter—closer to 3.0% a.r. instead of the 2.3% we were initially forecasting. Unfortunately, it is very difficult to extrapolate this first quarter strength into future quarters. It only takes a cursory review of past data to notice that one quarter of strong consumer spending growth tells us very little about the next quarter’s growth rate. Just last year, Q1 real consumer spending was a sizzling 3.8% a.r. only to slip to a lackluster 0.8% rate in the second quarter. Most forecasters, to varying degrees, have marked up their 2024 outlook for inflation and economic growth. We, at BMO Economics, have done so only modestly; but some forecasters have gone even further, taking out all Fed rate cuts for this year and penciling in a ‘No Landing’ baseline forecast for the economy. We think such a dramatic change from just a few months of unexpectedly “hot” consumer inflation, payroll gains and retail sales remains a pretty wide stretch and is probably an over-reaction. In short, we remain firmly in the ‘Soft-Landing’ camp. To do otherwise would be to basically deny the laws of economics and monetary theory altogether. We still anticipate a meaningful economic slowdown this year, though acknowledge the possibility it may take somewhat longer to develop and may not be quite as deep as projected six months ago. Just because the slowdown may be delayed, however, does not mean it is not coming at all. The Fed's aggressive rate hikes (since March 2022), have prompted a dramatic increase in real interest rates across the Treasury maturity spectrum. These rising real interest rates will continue to nibble away at consumer and business demand until signs of a softening labor market, weaker corporate profits and retail sales, and deterioration in credit quality and demand become clearer. One can quibble about the potency of the monetary medicine the Fed has delivered so far, but not its eventual effect. If you truly embrace the ‘No Landing’ scenario, you basically are saying the Fed’s monetary policy is either perfectly calibrated or completely ineffective. Either way, you will probably be wrong, eventually. I am reminded of the old traders’ adage “don’t fight the Fed”. If it remains the Fed’s goal to bring inflation back to its 2% target, it will eventually be successful in doing so. If anything, the recent stubbornness of core inflation suggests the Fed will need to see more real cooling of consumer and business demand, and probably the labor market, to achieve it. |
Central Banks: The Ebb and Flow of Confidence |
Amid this week’s global gathering of central bank officials in Washington, D.C., Fed Chair Powell and Bank of Canada Governor Macklem shared the stage in a moderated discussion on Tuesday (April 16). We suspect Jay may have been a bit envious of Tiff when it comes to inflation. Powell took the stage still under the shadow of last week’s U.S. CPI report. Recall, the core index posted its third consecutive 0.4% increase in March, with the supercore metric posting even larger moves in all three periods. |
Back in January, the FOMC shifted its forward guidance saying policy rate cuts were unlikely until it had “gained greater confidence that inflation is moving sustainably toward 2 percent”. How the various underlying inflation trends are performing is a critical input here, particularly the often-Fed-cited three- and six-month changes (Chart 1). What the FOMC needs to see among these trends to gain the most confidence is no number above the 3% range, with most below it. And a decelerating pattern as you shorten the tenors of the changes. However, what the Fed is seeing is the opposite… the stuff of confidence erosion. On stage, Chair 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.” And “it’s appropriate to allow restrictive policy further time to work”. |
In stark contrast, Macklem took the stage basking in the light of the morning’s Canadian CPI report. The two core measures most mentioned by the BoC, CPI-Trim (mean) and CPI-Median, posted their third consecutive set of results in the 0.0%-to-0.1% range. Among all the underlying metrics (Chart 1 again), the confidence-building criteria are being completely satisfied. Macklem said: “That does suggest that underlying inflationary pressures are continuing to ease, so we continue to be moving in the right direction.” Six days earlier, Macklem said: “we are seeing what we need to see, but we need to see it for longer to be confident that progress toward price stability will be sustained”. Another month of data might not be ‘long’ enough, but two months probably is (the April CPI is due May 21), particularly with Macklem musing a “June rate cut is within the realm of possibilities”. When it comes to inaugural central bank rate cuts, we’ve been forecasting June 5 for the BoC and July 31 for the Fed. This week’s CPI data and Macklem’s comments have increased confidence in our Bank call. Confidence in our Fed call, however, is buckling. The data trends still have time to turn around. For example, there are three employment and CPI reports still to come, but all three must now be Fed confidence-boosters. As such, if May-released data fail to deliver, we’ll be pushing our Fed forecast to September or later. |
Housing Takes the Brunt of Fed Policy |
Home buyers can only wish the Fed was in more of a rush to reduce rates. While most sectors continue to show resiliency, the housing market isn’t one of them. After a solid start to the year when mortgage rates pulled back from 23-year highs, existing home sales fell 4.3% in March. A reversal in borrowing costs has kept affordability in the tank at the same time that other housing-related costs—insurance, taxes, maintenance—are soaring. Sales remain below year-ago levels and about 20% below long-run norms; this after 2023 marked an even worse year than the Great Recession. Soft demand is taking the steam out of rising prices, which are still up nearly 5% in the past year due to a low supply of listings. While 30-year mortgage rates above 7% are curbing demand, it’s the sub-3% and 4% rates of two years ago that are choking supply by keeping owners locked into current loans and homes. Sellers might also be waiting for new rules on realtor fees to take effect in July which promise to reduce commissions, while buyers might be waiting to see if prices slip in response. Weak demand isn’t lost on home builders. They started almost 15% fewer units in March than in February, holding below year-ago levels. Despite faster population growth, starts have fallen more than 20% since the Fed started tightening. And sagging building permits aren’t pointing to a snappy comeback. In fact, the NAHB housing market index is barely above breakeven levels in April. Also dissuading buyers is a soft rental market. An earlier surge in apartment construction has lifted apartment vacancy rates to 6.7% in March from under 4% in 2021. Though not high historically, vacancy rates are now modestly above pre-pandemic levels. As a result, rent growth has moderated from earlier dizzying heights. After soaring almost 16% y/y in early 2022, Zillow’s Observed Rent Index cooled to a 3.6% pace in March. According to Apartment List, the median rent paid for new apartment leases has fallen modestly in the past year. Softer rents will help on the inflation front, while also weighing on sales. It's cheaper to rent than own a home. CBRE estimates that average new mortgage payments are 38% above average apartment rents as of late 2023. The wide affordability gap favoring renters didn’t exist before prices went berserk in the pandemic. A struggling housing market suggests restrictive monetary policy is working to cool demand—at least for the 4% of GDP tied to residential construction. But unless the remaining 96% of the economy loses resiliency, as we suspect it will, policy rates could stay high for longer, hurting those trying to get a leg up on the housing ladder. |