June Economic Commentary: Consumers bearing the brunt of policies’ unintended consequences

John Beuerlein
John Beuerlein
Chief Economist
Pohlad Companies

We’re one month into the Federal Reserve’s declared war on inflation. Volatility in the financial markets has increased as investors are positioning for the anticipated economic slowdown resulting from the Fed’s tighter monetary policy. Except in a few instances, it is too soon to see the impact in economic data, however. Consumer spending indicates a continued imbalance between supply and demand. The Fed’s actions are focused on slowing the demand side of economic activity, but the supply side of the economic equation also continues to aggravate inflationary pressures.

Consumer Metrics: CPI, Disposable Income, Savings Rate
The year-over-year Consumer Price Index (CPI) for April fell to 8.3% from 8.5%. The decline was largely due to favorable comparisons to year-ago figures as the big rise in prices in March 2021 was deleted from the calculation. As we go through the year, easier comparisons to last year’s inflation numbers are expected to result in lower year-over-year numbers. Still, inflation will be elevated and likely higher than the Fed wants to see. Energy, food, and shelter costs are all rising because of insufficient supplies relative to demand. Consequently, markets expect the Fed to continue raising interest rates throughout the year.

As discussed in previous commentaries, disposable personal income adjusted for inflation is indicating that incomes are not keeping up with inflation. Consumer purchasing power is eroding, resulting in the need to dip into savings or increase the use of credit. The savings rate, at 4.4%, is the lowest since 2008. The latest consumer credit figures showed the biggest jump on record: $52 billion in March. Although consumer balance sheets are in good shape, there is a question of how long the current level of spending by consumers can be sustained as financial conditions tighten. The drag on consumer budgets from higher essential costs like food and energy is leaving less room for discretionary merchandise purchases.

Housing Market
One area of the economy that is showing some immediate effects of the Fed’s tightening policy is the housing market. With mortgage rates now at 12-year highs and home prices appreciating at nearly 20% year over year, home affordability is at the lowest level since 2008. This is evidenced by the slowing in both existing and new home sales – both are down year-to-date. Pent-up demand and lack of inventory will likely keep prices supported, but the rate of price appreciation will probably fall back to mid-single digits this year. First-time home buyers are being particularly impacted. The supply of lower-priced homes is not nearly enough to satisfy demand.

The May employment report showed a better-than-expected gain of 390,000 in non-farm payrolls with the unemployment rate holding at 3.6%. The labor force participation rate ticked up to 62.3% from 62.2%. Year-over-year average hourly earnings growth eased to 5.2% from the previous month’s reading of 5.5%. Surveys of firms’ compensation plans suggest this is the beginning of a gradual deceleration in wage growth coming over the rest of the year. The labor market remains tight, but as the Fed raises interest rates, the job market is expected to slow.

Fed Funds Rate
The Fed is responding to the highest inflationary pressures of the last 40 years by increasing the Fed Funds rate and beginning to reduce the size of its balance sheet. The combination of these two strategies have never been used in a high-inflationary environment such as we have today, and at a time when the overall economy is already starting to slow. The Fed is expected to increase the Fed Funds rate by another 50 basis points (bp) at each of their next two meetings (June 15 and July 27). Markets are pricing in additional increases of 25 bp at each of the remaining meetings this year, which would bring the Fed Funds upper target to 3.00% by February 2023. Such an upward move in the Fed Funds rate, in addition to the ongoing unwinding of the Fed’s balance sheet, will definitely cause the economy to slow.

The economy is experiencing the unintended consequences of the extraordinary fiscal and monetary policies that were designed to support demand during the pandemic coupled with the impact of unforeseen supply chain disruptions. The resulting imbalance between supply and demand is causing the inflationary pressures of today. It is unknown whether the Fed will pull back from their tightening strategy if the economy weakens more than expected, or if they will continue to fight the war against inflation. Fear that the Fed may make a policy mistake at this important juncture is the source of the present volatility we’re seeing in markets today.