Jay Powell is maintaining a calm demeanour about the US economic outlook, but perhaps too much so. The Federal Reserve decided to hold interest rates steady at its midweek meeting, though it did adjust its tone, citing moderating job gains and rising unemployment as signs of a cooling economy. This opens the door to potential rate cuts in September.
The issue is that weakening economic activity can often accelerate, potentially leading to a recession. Has the Fed waited too long to act?
Since May, US economic data has increasingly surprised on the downside, according to Citi’s Economic Surprise Index. However, signs of America's slowdown were evident before the Fed's recent shift in focus. Full-time household employment began declining towards the end of 2023, and credit card delinquencies surpassed pre-pandemic levels around the same time.
The US avoiding a forecasted recession in 2023 has bolstered confidence in a soft economic landing this year and perhaps led to overly optimistic interpretations of data. For example, second-quarter economic growth exceeded expectations with a 2.8 percent annualized rate, which was seen as a sign of a healthy economy. However, a closer look reveals underlying weaknesses.
Government spending, supported by a substantial deficit, has propped up growth. Job gains have been bolstered by a surge in public sector hiring. Consumer expenditure, when broken down, shows the largest spending contributions come from essentials like rent, utilities, health, and food, rather than discretionary items. Consumption growth is also outpacing income.
These seemingly strong numbers hide a weaker underlying economy.
Leading economic indicators also look concerning. The ISM manufacturing New Orders Index is in contraction territory, historically a reliable recession signal. Jobless claims rose to an 11-month high last week, small businesses are cutting hiring plans, and many consumer-facing companies have reported earnings misses.
The primary cause is the Fed’s interest rate policy. The Committee considered cutting rates at its July meeting and might regret not doing so. Annual US inflation, measured by the Fed’s preferred personal consumption expenditures index, was within 0.5 percentage points of the central bank’s 2 percent target in June. Price pressures are also decreasing: the job market is cooling, and wage growth is slowing.
A precautionary rate cut midweek wouldn’t have equated to a substantial easing. Many households and businesses will still face high borrowing costs if they have to refinance fixed-rate loans. The question is whether they should face current peak rates or something slightly lower, in line with easing demand. Goldman Sachs recently estimated the median optimal interest rate, based on various monetary policy rules, to be closer to 4 percent. All this suggests the Fed might be applying too much pressure for too long.
Market signals are also ominous. Based on the yield curve slope, the New York Fed estimates a greater than 50 percent chance of a recession in the coming year. Stock valuations appear stretched as well. The concentration of the S&P 500 index, with the top seven tech stocks comprising over 30 percent of its value, makes it vulnerable to a correction in the bullish AI narrative.
By September, the Fed may realize that demand has been overly restrained and might need to implement more significant cuts — possibly a 0.50 percentage point reduction instead of a 0.25 point cut. This could unsettle equity markets.
While this scenario might seem unlikely now, the economy doesn’t slow in a linear manner. The ongoing and deeper-than-expected loss of economic momentum could become a self-reinforcing spiral. Joblessness, delinquencies, and bankruptcies could suddenly spike, and a market priced for a soft landing could quickly unravel. The recessionary warnings are flashing and should not be ignored.
Some argue that rate cuts would only fuel an asset bubble. The prospect of rate cuts may partly support equities, but the S&P 500’s relentless climb has recently faltered as investors question whether AI can generate the revenues needed to justify the substantial capital investments being made. This shift in sentiment has occurred even as rate cuts become more likely.
