Fed’s September Song

There was much market anticipation for Chair Powell’s speech this week at the Kansas City Fed’s Jackson Hole Economic Policy Symposium, with participants poised to parse it for clues to the timing and magnitude of the policy rate cuts that had already been hinted at. The modestly titled tome “Review and Outlook” did not disappoint. Powell signaled the start of rate cuts next month (all underlines are ours). “The time has come for policy to adjust. The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks.”

Now that inflation “increasingly appears” to be on a sustainable path to the 2% objective, it was also very clear what is concerning the Fed the most. “We will do everything we can to support a strong labor market as we make further progress toward price stability… The current level of our policy rate gives us ample room to respond to any risks we may face, including the risk of unwelcome further weakening in labor market conditions.” The labor market data will now be getting an extra market focus going forward.

Friday’s speech follows this week’s release of the Minutes from the July 30-31 FOMC meeting. Compared to the market’s initial interpretation of Powell’s presser comments, it turns out that there was more support for an immediate rate cut. More than just a few participants were, or would be, on board. And support for a September action was more widespread. The key passages were:

• “Several observed that the recent progress on inflation and increases in the unemployment rate had provided a plausible case for reducing the target range 25 basis points at this meeting or that they could have supported such a decision.”

• “The vast majority observed that, if the data continued to come in about as expected, it would likely be appropriate to ease policy at the next meeting.”

The FOMC was closer to cutting rates at the end of last month than originally assumed. And, given the data flow since (e.g., the 0.2 ppts jump in the jobless rate and further ebbing of the shorter-term inflation trends), Chair Powell’s Jackson Hole speech confirmed that the Fed is now at the point of paring. Indeed, we judge we’re also now at the point where the data no longer have to persuade the Fed to cut policy rates. The easing thresholds of further “good” data on inflation and no further weakening of the labor market data have been crossed.

However, the data can still dissuade the Fed from cutting at a specific confab (timing) and they can still determine if a bigger-than-25-bp action is warranted (magnitude). The next reports on employment (Sept. 6) and the CPI (Sept. 11) still have roles to play (along with next week’s complex of PCE-related figures).

On balance, our Fed call remains the same, we expect a sequence of quarter-point rate cuts beginning on September 18 with the easing cadence slowed after March as policy rates head into the 3% range. And the net risk also remains the same, that rates could be cut even more aggressively.

Economic and Fed Paths are Clear

Signs of an economic slowdown are becoming more visible now, but fears that the Fed needs to make bigger-than-usual 50 basis point cuts to avoid a recession are also not strongly supported by the data. Economists have consistently underestimated the strength and resilience of this expansion and there is little reason to believe labor market and financial conditions have deteriorated to such an extent to materially change that view. July retail sales showed surprising strength and next week’s personal income and spending report is expected to show more of the same, with the caveat that real income growth remains challenged.

Let’s turn to some of the recent indicators that support the slowdown story. The Chicago Fed National Activity Index for July sank to -0.34, its lowest reading since January and a noticeable deterioration from June’s -0.09. The index is a broad-weighted average of 85 indicators of national economic activity. A negative number means economic activity has fallen below its historical trend rate of growth. While pointing to further slowing, it is not flashing a recession signal either; in fact, the index was lower in January and October of last year (Chart 1).

There was also more weakness than forecast in the Conference Board’s Index of Leading Economic Indicators (LEI), suggesting the recent economic slowdown may linger. The LEI plunged 0.6% in July compared to a 0.2% decline in June. Half of the 10 leading indicators fell last month, led by ISM new orders, the interest rate spread, and average consumer expectations; but there was improvement from a leading credit index, stock prices, and nondefense capital goods orders. While the LEI has been in nearly constant decline since the Fed started hiking rates, the year-on-year drop has been moderating and no longer points to recession (Chart 2).

Finally, the preliminary August S&P Global Manufacturing PMI slipped further into contraction territory at 48, its lowest level of the year, highlighting the strong headwinds still blowing on the production side of the economy. But the S&P Global Services PMI came in stronger than expected at 55.2, the third consecutive month over 55, and the best string of service sector performance since the first quarter of 2022.

Taken together, we see a picture of softening growth but not halting growth. The outlook may indeed turn on future labor market and financial conditions. The BLS just released its preliminary estimate of the annual benchmark revision of the official payroll data, which will be finalized and released in February 2025. As explained in Sal’s Thought, the revisions are of some concern but do not confirm that job growth is weak. Bottom line, the labor market is cooling but is not yet cold.

Finally, measures of overall financial conditions do not yet appear to be that tight and have actually loosened notably since earlier this month when stock prices were plunging on growing recession fears (Chart 3). While a major and sustained stock market correction could be a catalyst for an economic downturn, the Fed will not base its interest rate decisions on a stock market correction that hasn’t yet occurred. In short, it remains a muddled growth picture as you might expect with the Fed looking to end the monetary tightening of the last two years. But the picture that continues to dominate is one of moderating growth and not an arresting of growth or seizing up of the labor market that would warrant above-average 50 basis point rate cuts from the Fed.

Labor Market Weaker But Not Weak

The once-mighty job market is losing steam quicker than thought. The Bureau of Labor Statistics’ preliminary benchmark revision led to a sizable downward adjustment to nonfarm payrolls in the year to March. The downgrade of 818,000 on a seasonally adjusted basis, or -0.5% and averaging 68,000 per month, the sharpest since 2009. While the final benchmark revision (in February) could get marked up, the new data partially corroborate the weakness evident in the household survey, where job growth has ground to a halt in the past year. That weakness, especially in recent months, has sent the jobless rate spiking higher.

While the weak household survey and revised payroll figures raise concerns about the health of the labor market, they are not reason enough to push the panic button. Of the two surveys, payrolls is more reliable because it covers many more workers, including those with multiple jobs. It also better captures positions held by unauthorized immigrants, which have been a source of job growth largely missing from the household survey. The other reason not to panic is that the preliminary revised figures could be upgraded because the survey that it’s based on (the Quarterly Census of Employment and Wages) also largely excludes unauthorized immigrants (as they do not qualify for unemployment insurance). In fact, final revisions have skewed to the upside in recent years likely for that reason. In addition, though slowing, payrolls are by no means falling off a cliff. Even with the revisions, monthly payroll gains averaged a healthy 174,000 in the year to March. While the pace has since ebbed further to an average of 154,000, that’s still in the normal range.

One upside of the payrolls revision is that labor productivity growth could get bumped up. At 2.7% y/y in the second quarter, it’s already running a full percentage point stronger than the three-decade norm. An upgrade would be positive for inflation and long-run growth.

Will the revisions have much bearing on the Fed’s September decision? Probably not. True, policymakers are increasingly concerned about the rising jobless rate, and the revision won’t ease their discomfort. But it may still take another bad jobs report to spur an aggressive start to the easing cycle.

Is Rising Stress Among Lower-income Workers a Risk to the Expansion?

Although many lower-income families are struggling with higher living and borrowing costs, weaker spending likely won’t trigger a recession.

A popular perception is that, while most Americans are weathering the rise in living and credit costs reasonably well, many lower-income earners are struggling to stay afloat. Several large retailers have singled them out as a source of spending fatigue, with PepsiCo’s CEO saying, “the lower-income consumer in the U.S. is stretched” and Disney’s CFO stating, “the lower-income consumer is feeling a little bit of stress”. The general sense is that lower-income earners have shifted spending from discretionary purchases to essentials, and are at risk of cutting further into the bone, dragging the economy down in the process.

No doubt lower-paid workers took the brunt of the inflation shock. Compared with their better-off peers, they spend a greater share of their take-home pay on necessities such as food, rent and auto insurance, which have become increasingly expensive, rising 19%, 20%, and 50%, respectively, in the past three years, versus 15% for the overall CPI basket. The bottom 20% of income earners spent about 16% of their budget on food and 25% on shelter in 2022 (the most recent data available from the Consumer Expenditure Survey), compared with a lesser 11% and 18% for the top income quintile.

Lower-income families also had a thinner buffer to shield themselves from the inflation blow. Unlike higher-paid workers, they didn’t accumulate much savings during the pandemic, based on a comparison of post- and pre-pandemic trends in deposits and money market funds (Chart 1). And, while the next lowest income quintile did save more than before, this cache appears to be exhausted. Lower-income families also profited much less than other groups from the hot stock market. According to the Fed’s Distributional Financial Accounts, the bottom two income quintiles held just 2.8% of total equities and mutual fund shares in the first quarter, compared with 86.7% for the top quintile.

Faced with multiple challenges, it’s younger—and mostly lower-income—persons who were compelled to cut debt in the past year (Chart 2). In particular, new auto loans and residential mortgages fell sharply for younger people. Although older and upper-income groups also faced higher borrowing costs, many profited from increased interest payouts on investments. Personal interest income surged more than $200 billion (or 13%) in the two years to the second quarter, or almost 1% of total income, with the bulk going to wealthier families. In addition, although most homeowners with fixed loan rates were shielded from tighter monetary policy, upper-income families benefitted more as they have higher rates of ownership. By contrast, lower-income families spend a disproportionate share of their budget on credit card and auto loan payments, which have risen sharply alongside policy rates. In 2023, total interest paid on consumer debt rose more than three times faster than that on mortgages from the previous year, according to BEA data. Renters also missed out on the steady climb in house prices, while watching rents soar. Not surprisingly, more renters than homeowners fell behind in paying bills in 2023, according to the Fed’s Survey of Household Economics and Decisionmaking.

Still, despite these headwinds, there’s no clear evidence that low-income earners are pulling back in a big way. In fact, a New York Fed survey found that their rate of spending growth, though moderating, has held up better than that of upper-income groups (Chart 3). This could reflect earlier low rates of joblessness and strong pay increases, as well as student loan forgiveness freeing up some disposable income even as payments resumed last fall. In recent years, wages rose faster for lower-income workers due to acute shortages in low-paying industries, such as leisure and hospitality, and rising minimum wages in many states (Chart 4).

Younger people (who tend to have lower incomes) have also not fallen behind on debt payments, including credit cards, at a materially faster rate than others (Charts 5 and 6). However, their rate of delinquency does remain higher than that of older borrowers. In addition, in contrast with a moderating growth trend for most types of loans, overall credit card balances have surged in the past year (by 10.8% to Q2). This suggests that more families, and likely lower-income ones, are tapping one of the most expensive types of credit to juggle everyday expenses. The average rate on credit cards has spiked seven percentage points in the past two years to around 22%, the highest since at least 1996.

Of equal concern, the employment tide that has kept lower-income workers afloat might be going out. Based on the household survey, persons aged 20 to 34 years suffered net job losses in the past year to July, in contrast with continued moderate gains for older (and often higher paid) workers between the ages of 35 and 54 years. The unemployment rate has risen somewhat faster for persons under 25 than over. Due to a looser labor market, younger workers are also likely seeing slower wage gains, which could explain a recent further sag in confidence for lower-income consumers (Chart 7).

With job and wage growth moderating, more lower-income families are bound to cut spending and default on loan payments in the second half of the year. But that doesn’t mean they will derail the economic expansion, for several reasons. First, barring an external shock, the economy should retain some resilience due to expansionary fiscal policies and generally manageable household debt, thereby avoiding widespread layoffs. Second, the Fed is expected to begin easing policy this fall, providing much-needed rate relief for borrowers. Third, ebbing inflation will support real wage growth. And, most importantly, the bottom 40% of income earners spend about half (57%) as much annually as the top income quintile (based on 2022 data). So, the economy could still keep chugging along even without their full support, so long as higher-income families pick up the slack. And, in a lower interest rate and inflation environment, that is exactly what they are likely to do next year.

Bottom Line: Lower-income households are struggling more than others to make ends meet. However, barring further cracks in the job market or delayed Fed rate relief, most should weather the storm without pulling the economy onto the recession shoals.