January Economic Commentary: Momentum continues to slow despite resilient labor market

John Beuerlein
John Beuerlein 
Chief Economist 
Pohlad Companies

Evidence of a slowing economy continues to mount with almost every economic report being released despite the resilience of the labor market. Although inflation remains a topic of concern at the Federal Reserve, factors that include easing supply shortages, the impact of the strong U.S. dollar, and a sharp decline in global shipping costs should continue to provide downward pressure to inflation in the upcoming year. Nevertheless, the Fed recently increased their expectations for the ultimate peak level of interest rates and stated that “a restrictive policy stance would need to be maintained” for some time.

Consumer Price Index and Savings
The November CPI report showed monthly inflation below market expectations for the second month in a row. The headline CPI increased 0.1% (expected at 0.3%), and the core CPI (excluding food and energy) rose 0.2%. On a year-over-year basis the headline CPI is now 7.1% (down from a peak of 9.1% in June), and core CPI is now 6.0%. Core goods inflation (excluding food and energy) was down 0.5% in November after declining 0.4% in October. The disinflationary trend is likely to continue as the slowdown in shelter inflation should begin to register in early 2023.

As a result of softer inflation readings in the past two months, we have started to see some improvement in the real (inflation adjusted) disposable personal income. On a year-over-year basis, however, this metric has been negative every month in 2022 and is now -2.5%. With real personal consumption expenditures growing at 2.0% year over year, the consumer has utilized savings and credit to fill the gap. The personal savings rate is 2.4% — the third-lowest savings rate in the past 60 years. Most of the savings are concentrated in the upper-income households; the lower- and middle-income households have used up most/all of their savings and are now relying on credit. To that end, year-over-year consumer credit is up by the highest percentage in the past 20 years.

Retail and Manufacturing
Retail sales fell 0.6% in November – a sign of consumer stress and an indication that the economy was losing momentum going into the end of the year. Industrial Production confirmed this weakness with a deep cutback in the output of U.S. consumer goods in November.

The Leading Economic Indicators (LEI) index continues to decline and is now at the lowest level since March of 2021. Year-over-year LEI is -4.5%, a reading that historically has foreshadowed an upcoming recession.

The ISM manufacturing index declined to a two-and-a-half-year low of 48.4 in December. Of note, the new orders index fell to 45.2 from 47.2 – a level usually only seen in runups to recessions. Output has weakened as a result of four consecutive months of shrinking orders. Additionally, the ISM survey indicated reductions in order backlogs, better supply chain performance, lower prices, and better inventory levels. The non-manufacturing ISM declined from 56.5 in November to 49.6 in December. Both ISM indices are now below 50, indicating economic contraction.

The December Employment report continued to show the resilience of the labor market as non-farm payrolls increased 223,000 and the unemployment rate dropped back to a 50-year low at 3.5%. Most of the cyclical sectors showed softness in hiring, however. Companies have been slow to lay off workers for fear of not getting them back when the economy improves. Instead, the average weekly hours worked have been steadily reduced and are now at 34.3 (down from a peak of 35.0 in January 2021), and manufacturing overtime hours are at their lowest levels since June 2020. Temporary help fell 35,000 for the fifth consecutive monthly decline – this has been a good leading indicator of upcoming labor market weakness. Another sign of easing in the labor market was the fact that the year-over-year average hourly earnings growth dropped back to 4.6% — a trend welcomed by the Fed but still more elevated than desired. The Fed is looking for an easing in the demand for labor. The labor market is still a long way from a level consistent with non-accelerating inflation and is adjusting very slowly.

Federal Reserve
Notwithstanding the documented slowing in the economy, the Fed raised the Federal Funds rate by 50 basis points (bp) at their December 14 meeting. The minutes from that meeting indicate that the Fed needs to see “substantially more evidence of progress to be confident that inflation was on a sustained downward path.” Their Summary of Economic Projections (SEP) showed some surprising changes from the September SEP. The Fed revised up the 2023 year-end core PCE inflation to 3.5% from 3.1%, GDP for 2023 was revised down to 0.5% from 1.2%, and unemployment was revised up to 4.6% from 4.4%. The projection for the Fed Funds rate was 5.1% at the end of 2023 and 4.1% at the end of 2024. In short, the message was to expect rates to stay higher for longer. Markets do not agree with these projections and expect the Fed to start lowering rates by the end of 2023. Only time will tell, but one thing is for certain: the path of the economy over the coming 12-24 months is highly dependent on the decisions to be made by the Federal Reserve.

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