May Economic Commentary: Inflation Improves as Markets Brace for Possible Recession

April witnessed ongoing stress among the regional banks as concerns have moved from unrealized losses in bank securities and the flight of uninsured deposits to the quality of loans on bank balance sheets and implications of the ongoing tightening of lending standards. Although there has been no immediate plunge in economic activity associated with the banking failures of the past two months, activity has continued to slow. Nevertheless, the Fed raised interest rates by 0.25 percent at their May 3 meeting and promised to keep rates elevated through the end of the year. Markets, however, have a different take on the expected path of interest rates.

The inflation picture continued its slow but steady improvement with the release of the March CPI report. Headline inflation increased only 0.1 percent month-over-month, and the year-over-year reading fell to 5.0 percent from the 6.0 percent year-over-year reading in February. Contributing to the soft reading in March, we saw year-over-year energy prices turn negative – it’s been a year since Russia invaded Ukraine causing energy prices to spike – and grocery prices eased for the first time in many months. Shelter inflation (rents) also eased, and this is expected to continue. Core CPI, excluding energy and food, increased 0.4 percent month-over-month and the year-over-year figure increased to 5.6 percent, a 10-basis point increase from February. The Fed’s preferred measure of inflation – Core Personal Consumption Expenditures – showed a slight improvement to 4.6 percent year-over-year. Improvement in inflation is expected to continue, but the rate of improvement appears to be slowing and measures of inflation remain stubbornly above the Fed’s 2.0 percent target.

Consumer Spending, Manufacturing & GDP
Retail sales fell 1.0 percent in March, while overall personal consumption expenditures were flat. After starting the year with strong readings in both measures, it is apparent that the unseasonably warm weather in January was a major factor for the early strength. Consumer spending has been slowing since the beginning of the year, and when adjusted for inflation, year-over-year retail sales are down 4.0 percent.

The Leading Economic Indicators declined for the twelfth consecutive month and continue to indicate an upcoming contraction in the economy.

The ISM manufacturing index for April showed a slight improvement but remains at a level that indicates contraction in the manufacturing sector. There was a corresponding report showing that Nondefense Capital Goods Orders, excluding aircrafts, were down again in March and have been down in five out of the last seven months. Rising interest rates and tighter lending standards are most often mentioned as the reason for the slowing.

The first reading of Real GDP in the first quarter indicated that the economy grew at a disappointing 1.1 percent annualized rate, down from the 2.6 percent annualized rate for the fourth quarter of 2022. Productivity in first quarter 2023 declined at a 2.7 percent annualized rate while unit labor costs grew at a 6.3 percent annualized rate.

Employment & The Labor Market
The employment report for April showed a strong 253,000 gain in jobs. That was offset by large reductions in the previous two months, and a total of 149,000 job gains in February and March were removed through revisions. The three-month average gain in payrolls is now down to 222,000 – the lowest number since January 2021. In another sign that the labor market is softening, JOLTS (the Job Openings and Labor Turnover Survey) reported that job openings are down 20 percent year-over-year. Employers are not as aggressive in looking for new workers, but they have not started broad-based layoffs either. Instead, they are reducing the average hours worked. The unemployment rate dropped to 3.4 percent from 3.5 percent, but the average work week is now only 34.4 hours – the lowest level since April 2020.

Average hourly wages increased 0.5 percent, which is the most since July 2022, bringing the year-over-year figure to 4.4 percent from 4.3 percent. The Fed’s favorite measure of wages, salaries and benefits – the Employment Cost Index – rose 4.9 percent year-over-year through March. Although wage growth is elevated, the average weekly earnings on an inflation adjusted basis are down 1.6 percent year-over-year and have been trailing inflation for the last two years. This is a predominant reason that consumer expenditures for non-discretionary items have been slowing.

Interest Rates & The Fed
Finally, the Fed held their scheduled Federal Open Market Committee (FOMC) meeting on May 2-3. The target range for the Fed Funds rate was increased by 0.25 percent to 5.00-5.25 percent. It is expected that this is the last increase in the Fed Funds rate for this tightening cycle. Chair Powell acknowledged that the potential impact of the banking crisis may effectively have the same impact on credit conditions, as would further increases in the Fed Funds rate, and he reiterated that the Fed intends to keep rates at least at this level through the end of the year.

The most recently released Senior Loan Officer Survey indicated that banks are continuing to tighten their lending standards – a process that began in third quarter 2022. The survey also indicated that demand for loans in all categories, except credit cards, was declining. So, we have a contraction in both the supply and demand for credit – a definite recipe for a slowing economy going forward.

Despite Powell’s rhetoric, markets are expecting a recession to commence that will drag down inflation more quickly than the Fed’s forecast. Consequently, three interest rate reductions by the end of the year are currently anticipated by the markets, beginning as soon as the September 19-20 FOMC meeting.


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