October provided another month of slowing economic data, but inflationary pressures remain elevated, resulting in the Fed increasing the Fed Funds target rate by another 75 basis points (bps) to 4.0% at their November 2 meeting. The 3.75% increase in the Fed Funds rate this year is the fastest increase in this measure since 1980. Meanwhile, the ongoing reduction of the Fed’s balance sheet is further reducing liquidity in the economy and in markets.
Consumer Price Index
The Consumer Price Index (CPI) for September increased 0.4%, double market expectations. On a year-over-year basis it is up 8.2%. While down from the July reading of 8.5%, it remains elevated and continues to pressure the Fed to increase rates. Drawing the most attention was the increase in the core CPI (excluding food and energy) which was up 0.6% for the second month in a row, resulting in a year-over-year figure of 6.6% (a 40-year high). The shelter component comprises 41% of core CPI and is providing the most upward pressure on this metric. Although rents are starting to ease, their impact is not likely to feed through to weaker core inflation until next year.
The initial reading for real GDP in 3Q22 was a notable +2.6% annualized. Digging into the details, however, the increase was totally due to a 2.8% improvement in net external trade. This strength in exports is unlikely to be sustained as the global economy slows. A better measure of underlying economic demand, final sales to private domestic purchasers, increased by a mere 0.1% annualized. That was the worst reading for this metric since 2Q20 at the outset of the pandemic and illustrates the impact of the Fed’s higher interest rates on domestic demand.
Income and Credit
Disposable personal income adjusted for inflation has now been negative on a year-over-year basis for 10 consecutive months. Average weekly earnings (adjusted for inflation) are down 3.8% on a year-over-year basis. This has caused consumers to decrease their savings to the lowest level since 2008, and consumer credit is up a record $348 billion year over year. Rising consumer debt at a time of rising interest rates is never a good combination.
Through September, the Leading Economic Indicators Index has been flat or down for seven consecutive months and is now at a 15-month low. Historically, such a string of declining readings has only happened when the economy is in or nearing a recession.
The employment report for October was a mixed bag with the payroll survey showing a broad-based 261,000 increase in non-farm payrolls, while the household survey reported a 328,000 decline in employment. The 261,000 increase in non-farm payrolls was the smallest monthly payroll increase since December 2020. The household survey showed a slight decline in the labor force, resulting in the unemployment rate increasing to 3.7% from 3.5%. The actual number of unemployed rose to the highest level since February. On the earnings front, average hourly earnings grew at 4.7% year over year, down from the 5.0% year-over-year pace last month, suggesting that wage increases are peaking but remain too hot for the Fed’s 2% inflation target.
Although announcements of layoffs and hiring freezes by large companies such as Amazon have started to surface, the labor market is still a long way from a level consistent with non-accelerating inflation. Consensus has the unemployment rate increasing to 5% over the next 18 months.
The economy is in the process of reacting to the steep rate hikes implemented so far by the Fed. The next Federal Reserve Open Market Committee meeting is December 14. Prior to that meeting they will have seen the CPI reports for October and November along with the employment report for November. The strength of the economy reflected in those reports will go a long way in determining the magnitude of any interest rate increase announcement from that meeting. As of now, the futures market is pricing a 50 bps increase for that meeting with a total of another 75 bps increase by their June 2023 meeting. That would bring the Fed Funds upper target level to 5.25%. Market expectations are subject to revision, however. After all, at the beginning of 2022, the futures market was only pricing a Fed Funds rate of 1.00% by mid-2023. Now it’s pricing 5.25%—big changes in market expectations in less than a year. The Fed has confirmed that they are not going to pause their tightening any time soon, and banks are also tightening their lending standards for almost all categories of loans. The availability of credit is declining, and its price is increasing. All of this points to slower economic growth and a high likelihood of recession 2023. At this time, the severity of any recession is unknown since that will depend on the timing and extent of Fed actions.