Looking For Clarity? Then Look Elsewhere
May 2023
Things are seldom as they seem. With all apologies to Gilbert and Sullivan, there is perhaps no better way to summarize the economic data over the past few months. Okay, sure, we could apply that to most of the economic data since the onset of the pandemic, but rather than recapping the last three-plus years of often confusing and contradictory data there’s more than enough from the past three months to occupy our space here. And, as if processing decidedly mixed messages from the economic data wasn’t tricky enough, uncertainty over matters such as the debt ceiling, the banking system, and where the FOMC goes from here makes trying to plot the likely course of the economy, and in turn the markets, seem little more than a fool’s errand.
The initial estimate from the Bureau of Economic Analysis shows real GDP grew at an annualized rate of 1.1 percent in Q1 2023, considerably below expectations. The biggest factor behind the surprisingly soft GDP growth print was a modest draw in business inventories which, thanks to the quirks of GDP accounting, took 2.26 percentage points off top-line real GDP growth. It is worth noting that the modest decline in business inventories in Q1 came after five consecutive quarters of robust inventory accumulation as firms scrambled to rebuild stocks which had been significantly run down by the combination of supply-side impairments and artificially boosted demand. With growth in both consumer and business spending clearly slowing in the early months of 2023, it could be that firms felt inventories were more or less right-sized.
While Q1 growth wasn’t as sluggish as the headline growth print implies, neither was it as vigorous as implied by real private domestic demand – combined consumer and business spending. To be sure, we frequently note that we see real private domestic demand as a more meaningful indicator than top-line real GDP growth, in part reflecting how frequently swings in inventories distort measured real GDP growth, and the 2.9 percent annualized growth in real private domestic demand booked in Q1 is the fastest quarterly growth rate since Q2 2021. What we find concerning, however, is that much of this growth reflects the unusually strong growth reported in January in series ranging from consumer spending to core capital goods shipments, which was more than enough to offset what was generally weak February and March data. So, when looked at on a quarterly average basis, real private domestic demand looked healthy in Q1, but when looked at on a monthly basis, it seemed clear that Q1 ended on a much softer note than it began on, raising the question of just how much momentum the economy took into Q2.
At first glance, the April employment report would suggest a spring revival, with total nonfarm employment rising by a surprisingly strong 253,000 jobs and the unemployment rate falling to 3.4 percent, matching January as the cycle low. In keeping with our general theme of things seldom being what they seem, however, there is less to the April employment report than meets the eye. For starters, prior estimates of job growth in February and March were revised down by a net 149,000 jobs for the two-month period. Additionally, job growth has become less broadly based over the past three months, a trend which, should it persist, would be a worrying sign as to the staying power of this expansion. At the same time, the drop in the unemployment rate was primarily a function of a decline in the size of the labor force. Other labor market indicators show a further decline in job vacancies in March that left the level of vacancies lower than at any point since April 2021, and a further reduction in the rate at which workers are voluntarily quitting jobs. Along with a slowing trend rate of job growth, these are signs of a cooling labor market.
To that point, growth in average hourly earnings has clearly decelerated over the past several months, which some see as a sign of easing inflation pressures. We, however, see slowing growth in average hourly earnings as more a function of the mix of jobs added over the past four quarters, with lower-wage industry groups such as leisure and hospitality services, retail trade, and education and health services accounting for over fifty-five percent of all jobs added in the year ending with March 2022. This mix bias has weighed on average hourly earnings, thus holding down year-on-year growth.
Our argument is bolstered by the recent release of the Q1 Employment Cost Index (ECI), a measure of labor costs free of the mix bias that plagues the average hourly earnings metric. The ECI showed year-on-year wage growth of 5.0 percent in Q1, the fourth straight quarter of growth at or above five percent. It is worth noting that, like many private sector analysts (us included), the FOMC sees the ECI as the superior gauge of wage growth. To the extent FOMC members see a strong link between wage growth and inflation, there has not yet been nearly a strong enough deceleration in wage growth to inspire confidence that inflation will settle back at their 2.0 percent target rate any time soon.
The inflation data are sending their own mixed messages of late. Recall that in March, lower energy prices acted as a drag on headline inflation, a drag that reversed in the April data and which will reverse again in the May data. These swings aside, headline inflation is decelerating, but the same cannot be said for core inflation, which is proving to be frustratingly persistent. This is largely a reflection of core services price inflation not yet having eased. But, one implication of inventories being right sized, to the extent that is the case, is that firms will no longer feel compelled to offer sizable discounts in order to clear unwanted stocks (think back to the 2022 holiday shopping season), which in turn means that goods price disinflation will no longer act as a brake on overall inflation.
This could leave the FOMC in a most uncomfortable position. That core inflation has stubbornly refused to budge over the past few months would suggest that, even after having raised the Fed funds rate by twenty-five basis points at their early-May meeting, the FOMC is not yet finished raising the funds rate. Growing concerns over the potential economic fallout from stress in the banking system, however, raise the bar for further rate hikes higher than would otherwise be the case. The Federal Reserve’s Q1 survey of commercial bank loan officers shows further tightening in lending standards and further softening in loan demand. In their policy statement issued following their May meeting, the FOMC noted that tighter credit conditions “are likely to weigh on economic activity, hiring, and inflation.” In that sense, tighter credit conditions can serve as a substitute for additional funds rate hikes, but the two are anything but equivalent as, unlike central bank policy rates, credit crunches cannot be precisely managed, let alone contained.
This isn’t to say a full-blown credit crunch is inevitable, but neither can one be ruled out at this point. The reality is that the outlook is no clearer to the FOMC than it is to the rest of us, and there are some potentially significant dark clouds looming over the economic landscape. This is a recipe for the considerable volatility seen in equity and fixed income markets over the past several months to be with us for some time to come.
As of May 8, 2023
Sources: Bureau of Economic Analysis; Bureau of Labor Statistics; U.S. Census Bureau; Federal Reserve Board of Governors
