Economy Commentary
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On The Way, Just Not In A Hurry

March 2024

FOMC members have made it clear that while they expect to begin cutting the Fed funds rate at some point in 2024, they are in no particular hurry to do so. Chair Powell recently reiterated that point in his semiannual monetary policy testimony to Congress, and though he did concede that the Committee was “not that far from” the point at which they will begin cutting the funds rate, “not that far” is of course relative to the length of the journey one is on. In terms of getting inflation back to the FOMC’s 2.0 percent target rate, that journey has been a long one, and while it may seem the end is in sight, the path along this last leg of the journey is proving to be rocky. Moreover, rather than having brightened the way for the FOMC, the recent economic data have acted more as a thick fog for the FOMC to make their way through. There is a difference between thinking you’re on the right path and being sure you’re on the right path, and until the FOMC feels more sure than they do right now, they will continue to tread carefully, seeing less danger in moving too slowly than in moving too quickly.

That the labor market data have been all over the map isn’t making the FOMC’s job any easier. The February employment report showed total nonfarm payrolls rose by 275,000 jobs, but at the same time showed the unemployment rose to 3.9 percent, the highest rate since January 2022. While the gains in nonfarm payrolls may seem impressive, the February employment report also showed that prior estimates of job growth in December and January were revised down by a net 167,000 jobs for the two-month period, an unusually large revision. Moreover, this continues a somewhat unsettling pattern of downward revisions to the initial estimates of job growth. With the exception of December 2023, the initial estimate of private sector job growth has been revised lower in each of the past thirteen months, in most cases significantly so.

The main culprit has been the notably low response rates to the establishment survey conducted each month by the Bureau of Labor Statistics (BLS) which is used to derive estimates of nonfarm employment, hours, and earnings. These low response rates leave bigger gaps for BLS to fill in with their own estimates, and as more source data become available over subsequent months, BLS revises their estimates. We expect that, for this same reason, the initial estimate of February job growth will also be revised lower. As for February’s increase in the unemployment rate, that increase is more than entirely accounted for by a reported decline in employment amongst those aged 16-to-24 years old – down by 466,000 in February – while employment amongst the “prime working age” cohort continued to rise, a dichotomy which has been in evidence for the past year. As such, we see February’s increase in the jobless rate more as noise than as a reliable signal of labor market stress.

The inflation picture is also less clear, and this remains the main concern of the FOMC, particularly after the January data suggested renewed inflation pressures. Here too, however, there was some degree of noise that made interpreting the data more challenging. The Consumer Price Index (CPI) rose by 0.3 percent in January, as expected, but the core CPI rose by 0.4 percent, in line with our forecast but a larger increase than expected by the consensus forecast. There was a certain degree of residual seasonality in the January CPI data, but the January data also showed a jump in owners’ equivalent rents, the largest single component of the CPI.

Still, in and of itself, the January CPI data did not suggest a sustained reacceleration in inflation, but other indicators were cause for concern. For instance, the Institute for Supply Management’s (ISM) monthly surveys of the manufacturing and services sectors showed firms in both broad sectors paying higher prices for non-labor inputs in January. While this was not surprising in the services survey, the extent to which the ISM’s gauge of non-labor input prices rose was. That the manufacturing survey showed rising costs for non-labor inputs did come as a surprise and ended a lengthy run of falling costs. Additionally, retail gasoline prices have risen sharply over the past several weeks, meaning that after a run in which falling gasoline prices acted as a drag on headline inflation, rising gasoline prices will add to headline inflation beginning with the February data and, if normal seasonal patterns hold, this will remain the case over the next several months.

For those hoping the February data would quell concerns over building price pressures, the early returns are not encouraging. The ISM’s February survey indicated further increases in costs of non-labor inputs in both the manufacturing and services sectors, and retail gasoline prices have continued to increase. While the FOMC may elect to look beyond headline inflation and focus on core inflation, sustained increases in input costs would ultimately feed through to core inflation. Moreover, the core CPI again surprised to the upside in February, and the annualized three-month change rose to 4.2 percent, the highest reading since last June. While it is too soon to know whether these price pressures will be sustained, this is nonetheless a perfect illustration of why the FOMC continues to insist that it is too soon for them to entertain discussions of cuts in the Fed funds rate.

While a cut in the Fed funds rate is not on the table for this month’s FOMC meeting, the Committee will release an updated set of economic and financial projections, including an updated “dot plot.” Recall that the prior set of projections, issued in December 2023, implied seventy-five basis points of funds rate cuts in 2024 and another one-hundred basis points of cuts in 2025. Analysts and market participants will be watching for any changes in this implied path of the funds rate. We will also be watching to see if the dot plot shows any changes in the “longer-run” value of the Fed funds rate. This is, for all intents and purposes, the Committee’s collective estimate of the “neutral” funds rate, i.e., the value of the Fed funds rate consistent with the economy being at full employment and inflation being at the Committee’s 2.0 percent target rate and, as such, neither adding to nor detracting from growth. With the exception of the projections issued in March 2022, the median estimate of the neutral funds rate has been 2.50 percent in each set of projections issued since June 2019.

Estimates of the neutral Fed funds rate can, and do, vary over time as perceived changes in the underlying fundamentals of the economy – primarily, growth in the labor force and productivity growth – change, and a neutral funds rate of 2.50 percent is indicative of weak underlying fundamentals. But, with the economy having proven so resilient in the face of higher interest rates and the rate of labor productivity growth having picked up considerably over the past three quarters, the FOMC may feel that it is time to raise their estimate of the neutral funds rate, which we expect them to do at this month’s meeting. One implication of a higher neutral funds rate, however, would be that policy is not at present as restrictive as many have perceived it to be over recent quarters, and by extension this would imply less scope for the FOMC to cut the funds rate going forward. While this would no doubt rattle the markets, we think that the most important point to keep in mind is that a higher neutral Fed funds rate would be consistent with better underlying economic fundamentals, which ultimately is a win all the way around.

Sources: Bureau of Labor Statistics; Institute for Supply Management

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