Regional Market Summary Q2 2024

Sticking the (soft) landing: Consumer spending strong in the face of weakening labor market

Quarterly Market Report Q2 2024

Written by Bill Polley, Ph.D., Director of Business Intelligence, Quad Cities Chamber

One of the most exciting events of the Olympic Games is the gymnastics competition. The feeling of suspense builds as the routines become more complex. As the athlete nears the end of the routine, you can almost feel the crowd holding its collective breath as the athlete flies through the air toward the landing that will make or break the entire performance. The stakes are high as the landing alone can be the difference between a gold medal and nothing at all. Then comes the feeling of elation when the athlete "sticks the landing," as they say. The phrase itself has become part of everyday language to indicate the successful completion of a task.

Over the last year, economic commentators have spoken of the prospects for a "soft landing" after a long cycle of interest rate increases by the Federal Reserve. Much like a gymnast desires to land a routine in such a way that absorbs the shock and avoids crashing to the ground, so the Federal Reserve wants to allow economic activity to slow down, but not fall too much. A strong economy can absorb the shock, pause the fast pace of growth momentarily and then resume a sustainable pace going forward.

In monetary policy, the stakes are even higher than in the Olympics. Instead of a gold medal, the prize is avoiding a recession and preventing unemployment from spiking too high. Furthermore, the Federal Reserve only gets one chance to get it right. Turning points like the present one have happened just a handful of times in the last generation. So it is easy to see why so much attention has been given to this topic lately. While the discussion has been ongoing for a while, we are at last reaching that critical phase that makes or breaks the entire routine.

At the time of this writing, the advance estimate of real gross domestic product (GDP) growth for the second quarter was 2.8%. This was up from the final estimate of 1.4% for the first quarter. This was better than some expected. As I noted in our last Quarterly Market Report (late May), the Blue Chip consensus ranged from about 1 to 3%, so the actual number came in near the top end of the professional forecasters' expectations.

Ordinarily, a strong GDP number like this would not be associated with talk of the Fed cutting interest rates. As I wrote last quarter, a number over 2.5% could have given cover to inflation hawks. However, this is not an ordinary situation, and since May the labor market - which was in much better shape in the first quarter - has weakened enough that there are no more arguments remaining that would prevent a rate cut in September. On August 23, Fed Chair Jerome Powell gave one of the most anticipated and most consequential policy speeches in recent memory at the Fed's annual symposium in Jackson Hole, Wyoming. The message of that speech can be summed up in his own words, "The time has come for policy to adjust. The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks." The market has interpreted those words as meaning that a rate cut in September is essentially a done deal. Concerning the labor market, Powell said, "It seems unlikely that the labor market will be a source of elevated inflationary pressures anytime soon. We do not seek or welcome further cooling in labor market conditions." Quite a change from even a few months ago.

The current Atlanta Fed GDPNow forecast for the third quarter is 2%. However, the Blue Chip consensus is just under 2%. As with the second quarter, I think the Blue Chip consensus is going to be closer. The Atlanta Fed number has come down from earlier in the month, and will probably converge toward the Blue Chip consensus. It is also possible that second quarter GDP as well as the next couple quarters will be revised downward. Early estimates tend to be a little high around turning points, or even inflection points.

First quarter GDP rebounds

Source: U.S. Bureau of Economic Analysis. Gross Domestic Product (Advance Estimate).

Monetary policy is more restrictive than you might think

Some market analysts would say that the Fed is finally catching up and acknowledging the slowing labor market. After all, the anticipation of an interest rate cut has been building for almost a year now. The inflation hawks both inside and outside the Fed have argued quite strongly that rates needed to stay higher for longer to try to wring out the last bit of inflation and get the inflation rate back to the Fed's stated goal of 2%. Not even the weaker GDP growth in the first quarter was enough to sway them. The first signs of a slowing labor market were also not enough. While there are still a handful out there who would argue for a more hawkish stance just on principle, the signs of weakness have now convinced the majority.

One of the strongest arguments for the Fed easing its policy stance is that monetary policy has actually become more restrictive over the last year even while the Fed funds rate has remained unchanged. The reason for this is that it is the real interest rate that influences the economy. In other words, it is the interest rate adjusted for inflation that matters.

Figure 2 illustrates how the real interest rate has changed. The real rate is calculated by subtracting the inflation rate from the market interest rate. A good short-term measure of this would be the difference between the two-year Treasury security and the Fed's preferred measure of inflation, the personal consumption expenditures (PCE) price index.

For most of the time since the mid-2010s, the real rate has been positive, but close to zero as the Fed held interest rates low for an extended period of time following the financial crisis in 2008. Post-COVID, the real rate went negative as inflation rose far above the two-year Treasury. As the Fed began to raise the fed funds rate, the two-year Treasury moved up while inflation decreased. Around May of last year (close to the time the Fed halted the rate increases), the two-year Treasury caught up with inflation and the real rate turned positive. The higher the real rate (greater difference between the two-year Treasury and inflation), the more restrictive monetary policy is in real terms.

This is a strong argument for easing the Fed funds rate now before this gap widens further. Inflation is likely to continue to slowly inch down, meaning that market rates must come down at the same rate just to keep monetary policy from becoming even more restrictive.

Inflation picture slowly improving

In our last Quarterly Market Report, I noted that PCE inflation had crept back up from 2.5% in February to 2.7% in March. Since then, it has slowly but steadily come back down to about 2.5% in July.

In the Midwest region, inflation progress has stalled with the consumer price index (CPI) now at 2.7%. (The PCE inflation rate is not calculated by region.) Part of the reason for the stalled progress is that rent and owner's equivalent rent have increased over the last year, reflecting steady appreciation of home values which had previously been lagging the rest of the country. Given that price dynamics in real estate are quite different from the rest of the economy, this is going to make additional progress on inflation quite slow until supply pressures ease in the housing market. Lower mortgage rates could spike prices even further as demand picks up. However, this effect is likely to be temporary.

Regional consumer and business spending up; expectations down

The Federal Reserve "Beige Book" summary of economic conditions noted that the Chicago district (where we are located) experienced increased consumer and business spending. However there were some areas of weakness noted. Construction and manufacturing spending were down, and some suppliers in some sectors noted rising inventories from lower demand. They also noted the rise in layoffs in manufacturing around the district and lower farm commodity prices, which we have noted previously.

While there are pockets of weakness, particularly in construction, heavy equipment manufacturing, autos and aerospace, the overall outlook for the district remains positive with a slight increase in activity expected over the next year. The Beige Book also reports that nationwide expectations of economic growth have decreased.

The Chamber's own Business Outlook Survey in this Quarterly Market Report agrees with the expectation of slower growth.

Both Iowa and Illinois performed above the national average on the Weekly State-Level Economic Conditions Index during the second quarter. Consumer and business spending, along with travel and tourism are boosting the regional economy. Recent layoffs have likely not been reflected in the data, so we may see some retrenchment in the regional numbers in the third quarter.

Source: Baumeister, C., Leiva-Leon, D., and Sims, E. (2021). Tracking Weekly State-Level Economic Conditions. Unpublished paper. Notre Dame University, Banco de Espana, National Bureau of Economic Research, and Center for Economic and Policy Research.

Conclusion

Will the U.S. economy "stick the landing" and make it a soft one? While we have been asking this question for the better part of a year, the answer may soon be upon us. Manufacturing and construction have been disproportionately impacted by higher interest rates, and "higher for longer" would have been likely to create recession-like conditions in the region.

With lower rates now definitely on the way, business spending should start to pick up going into next year. As long as the pace of rate cuts can keep up with declining inflation, a soft landing is still possible. The probability of recession in the next year is higher than it was a year ago, but still far from certain.

Even so, because of the concentration of manufacturing in the Midwest in general, as well as in the local area, the slowdown will likely be more significant here compared to the rest of the country. That being said, once rates start coming down, activity could pick up faster here than in other areas as well as long as other cyclical factors (commodity prices, foreign exchange, etc.) move in the right direction. That could make this moment a good time to position for the next upturn going into 2025 and beyond.

The landing is the most nerve-wracking part of the routine. The crowd is holding its breath. If economic conditions can normalize without spiking inflation or unemployment, then Chair Powell and the Fed deserve the gold medal in monetary policy.