A lot of ground was covered this past week. The data is still relatively mixed. We have seen worse than expected numbers come out of flash manufacturing and services PMI for August, at 51.3% and 44.1% respectively, compared to the median forecasts of 51.9% and 49.0%. New home sales dropped 12.6% in July compared to June, below median expectations and a 6.5 year low. It’s clear inflation and the rate environment is negatively impacting the housing sector to a great degree. Durable goods orders remained virtually unchanged in July, in actual terms slightly down a tiny 0.01%. When looking deeper into this figure however, excluding defense, durable goods orders are actually up 1.2%, and excluding transportation the number is up 0.3% from June. Core capital equipment orders were actually up 0.4% in July, slightly above expectations. Transportation and defense are highly volatile and there was a recent drop in military contracts, so in my view the latest durable goods orders figure doesn’t look so bad overall. Despite higher interest rates demand for equipment is still strong.
However, core capital goods shipments rose 0.7% in July. If we look at core capital goods orders vs shipments in millions of dollars, it clearly shows that the gap between the two has shrunk since early last year. The gap has reduced by 21% month over month (July vs June). This signals to me that while current demand for capital goods is still relatively strong and a tad higher than shipments in dollar terms, it’s not as strong as it once was relative to shipments. To me this shows the impact of rate hikes in moderating some of this demand.
Initial jobless claims was 243,000 at recent week-end August, lower than the 248,000 figure at final week-end July and below the projected 255,000 figure. The labor market is still currently tight even in this suboptimal economy. The revised Q2 real GDP figure was -0.6%, better than the -0.9% number that was initially reported albeit still a negative figure. Some people consider two consecutive quarters of negative GDP growth to be a recession, and while the economy is by no means in good shape, it certainly doesn’t feel like a recession, at least right now. As of today, I do not think we are in recession. But we are fast approaching one. More on this later.
There was a continuation of good news on inflation. The PCE index or Personal Consumption Expenditures index fell 0.1% in July. This was likely due to falling gas prices which are subject to volatility and this is why it’s not really a clear cut signal of moderating inflation. However, core PCE (which takes out fuel and food prices) rose 0.1% slightly under the 0.2% projection. Year-over-year PCE was 6.3% in July compared to 6.8% in June, and core year-over-year PCE was 4.6% in July, slightly lower than the 4.8% expected and 0.2% less than the number for June. So these are somewhat encouraging figures on inflation and we all hope that it continues to decrease over time.
Some relatively positive results were also released for other metrics. Real disposable personal incomes were up 0.3% in July which is a good sign. Consumer spending adjusted for inflation rose 0.2% in July. But let’s not get ahead of ourselves, these are small increases. To me these results signal that the economy is not where it needs to be, but also not yet in recession.
Now on to my thoughts on Fed chair Jerome Powell’s comments at Jackson Hole. In my view, this was nothing but a hawkish speech from Powell.
He laid out that the Fed’s overarching goal is price stability and moving inflation back down to the 2% goal, and that it will use its tools “forcefully” to do so.
He stated that reducing inflation will require a “sustained period of below trend growth”, and very likely a “softening of labor market conditions.” Powell went on further to say that while higher interest rates, slower growth, and softer labor market conditions will bring down inflation, “they will also bring pain to households & businesses.” But, this pain is the “unfortunate cost of reducing inflation and a failure to restore price stability would mean far greater pain.” This shows me that moderating inflation is the Fed’s ultimate concern and they don’t mind tanking the economy into a recession to reduce inflation to normal levels.
In his speech Powell also said that while the lower inflation readings for July were welcome, “a single month’s improvement falls short of what the committee will need to see before we are confident that inflation is moving down.” This is exactly the thinking I laid out in my previous post. July’s inflation numbers are certainly good news, but there are many factors that contribute to a single month’s reading that might not carry on in the future. People are still paying higher prices each time they checkout, so inflation is still high and continuing to permeate itself. A slowdown or pause on rate hikes now would be the wrong policy since there is no strong, clear, and widespread confirmation of moderating inflation and inflation expectations in the near-term are still high. High inflation expectations can push inflation higher. Powell mentioned this later on in his speech, which I will get to.
He went on to say that the Fed was moving its policy stance to a “level that will be sufficiently restrictive to return inflation to 2%.” Powell also said, “at some point as the stance of monetary policy tightens further it will likely become appropriate to slow the pace of increases.” Fed-pivot believers clung to this statement. It’s certainly true that the Fed will slowdown, pause, and maybe even cut rates at one point but this won’t be for a while. Restrictive monetary policy will obviously need to stay in place for some time to get to a 2% year-over-year inflation rate. You don’t go from an 8.5% year-over-year CPI to 2% in the blink of an eye. The same is true for PCE.
As Powell stated later, “the historical record cautions strongly against prematurely loosening policy.” Another line of his that oozes monetary hawkishness. Powell drew on three important lessons of historical inflation dynamics, two of which I believe are more important to talk about it in this post.
His second of third point in his speech referred to the role inflation expectations play in terms of inflation. He said that while “longer-term inflation expectations are well-anchored….it’s not grounds for complacency.” He continued further stating, “if the public expects that inflation will remain low and stable over time then absent major shocks it likely will.” “Unfortunately, the same is true of expectations of high and volatile inflation.” As I stated earlier, people are still experiencing high inflation every time they buy something. High prices for goods and services are still here and still affecting people every day. With consumers continuing to endure the reduction in their purchasing power daily, they typically expect things to only get worse in this regard.
Trends and patterns tend to continue in their path until they reverse for a variety of factors. I believe human sentiment is similar. To tie this to inflation, if near to medium-term inflation expectations continue to stay high, inflation will only worsen. More people will buy things in the immediate since they expect the price for the particular product they want to be higher in a few months, surging demand for the product now. Businesses will take advantage of this, raise their prices and voila you have higher inflation. The same phenomenon is true of input prices for businesses. This is why the Fed is going to and will need to take forceful action. It will also need to communicate its message clearly to the public and make sure its narrative is well established and understood. So far I think Powell and the Fed are doing great on this front and this speech was a great example of clear messaging and communication.
Powell drew on historical US inflation in the 1970’s and said that in the 70’s, “as inflation climbed, the anticipation of high inflation became entrenched into the economic decision making of businesses and households.” “The more inflation rose, the more people came to expect it to remain high and they built that belief into wage and price decisions.”
Powell’s third of third point on historical inflation dynamics in the US was that the Fed must “keep at it until the job is done.” This again reiterates the hawkish policy the Fed intends to deploy. He continued, stating, “history shows us that the employment costs of bringing down inflation are likely to increase with delay, as high inflation becomes entrenched in wage and price setting.” “The successful Volker disinflation of the 1980’s followed multiple failed attempts to lower inflation over the previous fifteen years.” “A long period of very restrictive monetary policy was ultimately needed to stem high inflation, and to start the process of getting inflation down to low and stable levels that were the norm, until the spring of last year.” “Our aim is to avoid that outcome by acting with resolve now.” As I stated in my previous post, inflation is like that bug you think you killed only to see it alive and well hours later. I whole heartedly agree with Powell’s thinking here and believe the historical parallel he used was very much appropriate.
So my overall opinion based on the recent data and Powell’s speech is that the US economy will be entering a recession very soon. It’s hard to see an outcome otherwise. Powell laid out his and the Fed’s clear intent to continue increasing rates for the foreseeable future till prices become stable. He also didn’t mince his words and said that while this will bring pain, failure to reduce inflation will bring greater pain. I absolutely agree with this. Since we are starting to see signs the economy is cooling, specifically in manufacturing and core capital goods, continued rate hikes will only further plunge the economy downward into recession. The rate hikes may not have affected labor markets much to this point, but continued rate hikes will.
Markets priced in Powell’s speech negatively with the Dow plunging more than 1000 points, the NASDAQ plunging 497+ points and the S&P down 141 points as well. The markets are starting to get the message too.
As far as what the rate hike will be in September, obviously the Fed will be looking at new data which will factor into their decision, and Powell’s speech was very hawkish. However, I do think they are trying to engineer a soft landing through their policy and also messaging which is very important (as they should attempt to, because why not?). The ultimate question is can they really achieve this? I do not know. Overall, I will continue to stick with my 50-basis point rate hike prediction for September as I stated in my previous post. Powell’s speech at Jackson Hole was very hawkish, but we also have to be careful to read into it too much and a 50-basis point hike is still quite the rate hike if you ask me.
Overall, I believe the US will be in recession soon. But how soon you may ask? Well, it’s incredibly difficult to predict when a particular event such as a recession will occur. If I was to put a vague time frame on it, I’d say late 2022, early 2023.
See you in my next post. Have a great day!