Mark Vitner

In light of recent political news, new inflation data, and next week’s FOMC meeting, we are releasing some supplemental thoughts to our most recent monthly forecast. We have also updated the forecast with the latest GDP and personal income data.

As we noted in the CAVU Compass, second quarter real GDP surprised to the high side, as increased inventory building added 0.8 percentage points to growth. Inventories are one of the most volatile components of GDP and hardest to forecast ahead of the advance report. Businesses appear to have stocked up as a precaution against lengthening delivery times due to the disruptions to shipping around the Red Sea, as well as to rising fears of a Longshoremen’s strike.

The advance report will be revised next month, and the BEA will release comprehensive revisions going back the past five years in September.

We look for the Fed to set the table for lower interest rates at the July FOMC meeting and then further outline the mechanics of how monetary policy impacts the economy at the annual Jackson Hole symposium. The first quarter-point cut should come in September, followed by another cut in December. We expect a total of four or five quarter point cuts, pulling the federal funds rate down to around 4.25%.

The yield curve should flatten as cuts become more evident and possibly normalize. This is usually a warning sign of a recession. The economy will be at risk during this transition and uncertainty surrounding the election may cause businesses to hold off on major projects.

The economy still has a great deal of stimulus left over from the pandemic, which is driving investment in new plant and equipment and important infrastructure. Consumer spending is being driven by higher asset prices and slower but still solid wage and salary growth.

As for politics, the most likely outcome remains a republican sweep in November, although the odds have diminished somewhat due to Biden handing off the democratic nomination to Kamala Harris. Either way, we expect major stimulus programs such as the Inflation Reduction Act and Infrastructure Act to remain in place in 2025. The “Trump tax cut” will likely be extended.

The political environment remains unusually volatile, and we will get a better read after the democratic convention and likely first Trump-Harris debate in September. – Mark Vitner, July 26, 2024

The inflation fever has finally broken, paving the way for lower interest rates. Nearly every major price index moderated meaningfully during the second quarter. The headline Consumer Price Index even posted a modest decline at the end of the quarter, as lower gasoline prices pulled the headline number down. Core inflationary pressures are also easing, with the core CPI slowing to 3.3% year-over-year in June and core services prices moderating to a 5.1% gain. Price pressures are also easing further back in the production pipeline. The Producer Price Index slowed to just 2.6% year-over-year in June, while average hourly earnings slowed to just a 3.9% rise over the past 12 months.

Suddenly, inflation looks far less menacing. The headline Consumer Price Index fell 0.1%, marking its first monthly decline since July 2022 and the largest drop since the throes of the pandemic back in 2021. A 2% seasonally adjusted drop in energy prices was responsible for much of June’s drop. Gasoline prices tumbled 3.8% in June, following a 3.6% drop the prior month. Food prices are also moderating. Overall food costs rose 0.2% in June and are up just 1.1% over the past year. Prices at the grocery store have risen 1.1%, while prices at restaurants are up 4.1%. With June’s decline, the CPI is now up 3.0% year-to-year, compared to its peak of 9.1% in June 2022 and just 2.3% prior to the onset of the pandemic.

The core CPI has also moderated, rising just 0.1% in June and just 3.3% year-to-year. The core CPI peaked back in September 2022 at 6.1% and was just 2.4% before the pandemic. The moderation in price increases is broad-based. Airfares (-5.0%) and lodging (-2.0%) were two of the more notable price drops in June and are consistent with recent comments about the competitive price environment from Delta Airlines CEO Ed Bastian. Core goods prices were mixed. Prices for new vehicles fell 0.2%, while prices for used vehicles fell 1.5%. Prices for recreation goods rose 0.4%, with pet products rising 0.8%. Overall, core goods prices have fallen 1.7% over the past year, largely reflecting a 10.1% drop in used vehicle prices.

Services prices, excluding energy services, rose just 0.1% in June. Shelter costs are also cooling, with both rent and owners’ equivalent rent rising 0.3% in June, which is close to the pace averaged prior to the pandemic. Several areas that have been problematic in recent months moderated in June, including motor vehicle repair costs and medical care services, which both rose 0.2%. Motor vehicle insurance remains a problem area, with costs rising 0.9% in June and 19.5% over the past year.

On an overall basis, the CPI rose at a 2.8% annual rate, and the core CPI slowed to a 3.4% pace. Price pressures are also moderating further back in the production pipeline. The Producer Price Index rose just 0.2% in June and has slowed to just 2.7% over the past year. Average hourly earnings rose just 0.3% in June and have risen just 3.9% over the past year, down from a recent peak of 5.9% in March 2022. The inflation data should remain relatively benign over the next few months, although higher freight rates may raise the price of imported goods impacted by shipping disruptions around the Red Sea.

While inflation is still running well above the Fed’s 2% target, it has moderated enough for the Fed to begin lowering interest rates. We expect the Fed to make the case for a quarter-point cut in the federal funds rate at its July 30 meeting and look for three or four more quarter-point cuts over the next year. The financial markets will likely get ahead of themselves once again, as they did late last year when the Fed indicated they had likely finished hiking interest rates for this cycle. Shortly after the December FOMC meeting, the financial markets were pricing in 6 or 7 rate cuts for 2024. That view progressively gave way during the first four months of this year, following a string of stronger-than-expected economic reports.

Monetary policy works with a long and variable lag, with the bulk of the impact of a shift in policy typically taking at least a year to 18 months to take hold. This view has been challenged in recent years because of the growing role financial markets play in allocating credit. The financial markets tend to rally in anticipation of the Fed’s first move, which pulls some of the impact of monetary policy shifts forward. Reductions in mortgage rates and interest rates on auto loans, credit lines, and credit cards will not occur until well after the Fed begins to cut short-term interest rates. The effectiveness of the monetary policy transmission mechanisms will be the focus of this year’s Jackson Hole Economic Symposium held in late August.

The timing of the Fed’s next move is only one of the concerns. There is also a great deal of uncertainty about how much the Fed will ultimately cut interest rates. The magnitude of the Fed’s cuts is governed by Newton’s First Law of Motion, namely that an object in motion will remain in motion at the same speed and trajectory until it is met with an unbalanced force. The Fed demonstrated this when it aggressively raised interest rates (unbalanced force) in 2022 and 2023 to combat rising inflation. The larger-than-expected rate hike was needed to upend what was then the worst bout of inflation in more than forty years.

Today, however, the economy remains near full employment and inflation, while above the Fed’s target, is moderating in a way that the Fed should need to lower rates less aggressively. In terms of physics, the Fed needs to lower rates just enough to break the economy’s downward momentum without reversing the moderating trend in inflation. That is why we believe the Fed will ultimately make four or five quarter-point cuts and then hold the federal funds rate around 4% until economic growth either reaccelerates or decelerates further.

Recent comments by Fed officials suggest there is an emerging consensus that the labor market has already moved back into balance. Attitudes changed considerably following the June employment report, which showed employers adding 206,000 jobs that month but also sharply reduced estimates for job growth in April and May. Employers added an average of just 177,000 jobs a month during the second quarter, which is close to what we had expected based on our analysis of the Quarterly Census of Employment and Wages data.

Fed Governor Christopher Waller noted in a recent speech to the Federal Reserve Bank of Kansas City that he felt “current economic data are consistent with a soft landing” and that he would be looking for “data over the next couple of months” to confirm that view. Waller went on to say that he felt the labor markets were now back in balance and that inflation was moving toward price stability. Waller’s remarks, along with statements by Fed Chair Powell and other Fed officials, suggest they would like to look at another couple of months of data before cutting interest rates, making a move before September unlikely.

The Fed will get to see quite a bit of data between now and their September 17-18 FOMC meeting, including two more rounds of ISM reports, two more employment reports, an early estimate of the annual revision to nonfarm employment, two more months of retail sales data, two more months of CPI reports, and the first two estimates of second quarter GDP growth. We expect the output and employment data to remain consistent with a soft landing. The jobs data may even slow a bit, as recent gains have been highly concentrated within a handful of industries. The unemployment rate has trended up to 4.1% and is now at the upper end of the Fed’s long-run view of full employment.

On August 21, the BLS will also release the Q1 Quarterly Census of Employment and Wages data, which are the primary source data for the annual revisions released in February of each year. Our latest estimate puts the size of that revision at around 0.4 percentage points to the downside, which means that employers added roughly 750,000 fewer jobs than has been reported through March of this year. The QCEW data are a big reason why we expected nonfarm payrolls to slow to around 180,000 per month by the middle of this year.

While employment growth has slowed, the latest retail sales data show that consumer spending remains robust. Industrial production also rose solidly in Q2. We now estimate real GDP grew at a 2.2% annual rate during the second quarter, and we could see an upside surprise from increased inventory building.

Elections in France and the United Kingdom saw the far-left win enormous majorities and brought a new prime minister to the UK. We see the growing frustration in both nations being driven by the persistence of large budget deficits, which has prevented both the right and the left from enacting policies favored by their constituencies. The one thing both nations’ elections have in common is that the huge electoral victory was not driven by widespread support for Labour or the New Popular Front (NFP) but rather apathy and frustration with the incumbent party – Conservatives in the UK and Macron’s Centrist Alliance in France.

If there is a message for the US, it is that voters are restless and looking for change. The critical question is whether there are the fiscal resources available to deliver that change. The financial markets are fearful that what fiscal discipline was left in France and the UK will be jettisoned in favor of more populist spending.

The election landscape has changed dramatically in the US as well, following Joe Biden’s disastrous debate performance on June 27. A series of gaffes during the debate and in the weeks afterward has called into question whether Joe Biden will be the Democratic candidate in November. That is still the base case, at least before the failed assassination attempt on President Trump and President Biden’s Covid-19 diagnosis. Current polling shows Trump leading slightly in the national polls but well ahead in most swing states. Republican House and Senate candidates are also doing well, and enthusiasm is stronger for the GOP than it is for the Democrats, raising the possibility of a Republican sweep in November.

If Trump wins and the GOP takes both houses of Congress, we expect to see a full extension of the 2017 tax cuts. We would also likely see a rollback in regulations and some easing in restrictions on oil and gas exploration and pipeline construction. Trump has also vowed to boost tariffs and use the revenue to cut taxes. We see this as less likely. Trump would also likely scale back incentives for EVs but would not completely reverse programs currently in place. The infrastructure law would remain as is, or possibly be tweaked slightly.

The Misery Index, which is the sum of the trailing inflation rate and unemployment rate, does a good job of capturing voter angst and closely tracks various consumer confidence measures. The Misery Index is lower today than it was when Joe Biden took office. Inflation is higher and unemployment is lower. Unfortunately for Biden, both are moving in the opposite direction and lower inflation does not mean lower prices; it simply means they are rising less rapidly.

June’s surprising strength in retail sales, which saw core retail sales climb 0.9% and included upward revisions to the April and May data, has boosted expectations for Q2 GDP growth. Moreover, the strength in retail sales at the end of the quarter means that spending in the current quarter starts off at a high level. We still see the economy losing momentum. We see real GDP climbing at a 2.2% pace in Q2, helped by a resilient consumer, continued strong gains in business fixed investment, and increased inventory building, part of which likely reflects some precautionary moves ahead of a feared longshoreman strike.

While real GDP growth looks to be on firmer ground, the economy still appears to be in a near textbook soft landing. Overall growth has slowed, allowing inflation to moderate. The soft landing has come about due to tighter monetary policy, which has slowed demand, and increased immigration, which has boosted labor force growth. The unemployment rate has risen 0.4 percentage points since the start of the year to 4.1% and is likely headed slightly higher.

The Federal Reserve is expected to make the case for a quarter-point cut in the federal funds rate at its July 30 FOMC meeting. We expect four or five quarter-point cuts in total and look for the funds rate to settle at around 4.25%. Long-term rates will decline only modestly from current levels and will rise slightly as economic growth strengthens again in 2025. We look for the spread between conventional 30-year fixed-rate mortgages and 10-Year Treasuries to gradually narrow, bolstering home sales and housing starts next year.

Economic activity has been confounding through the first half of 2024. Following a string of stronger employment gains and robust retail sales reports, economic growth turned out to be much weaker than expected, with the revised data now showing real GDP grew at just a 1.3% pace during the first quarter. Conditions were not nearly as weak as the headline data suggests, however, as private final domestic demand – the sum of consumer spending, business investment and residential construction – rose at a 3.1% pace, which is roughly in line with the prior two quarters.

One of the more confounding aspects of the current economic environment is the persistently low levels of consumer sentiment and business confidence amidst seemingly solid economic growth. Consumer sentiment and Small Business Confidence remain at levels more commonly associated with recessions, even though real GDP—the broadest measure of economic activity—has grown 3% over the past year and the unemployment rate has remained below 4% for the past two years. Various explanations for this discrepancy have been offered, ranging from consumer views being tainted by political bias to a hangover from the pandemic.

We do not see anything sinister behind the split in consumer confidence. Economics is simply common sense made difficult. The survey data largely reflect common sense views, while the hard data come from incomplete data sets that are often revised repeatedly. By contrast, common sense—and most measures of consumer and business confidence—tend to hold near their original readings. Some of the strongest short-term relationships between confidence measures and hard economic data come from comparisons of irrefutable measures, such as swings in gasoline prices. The idea that this relationship would hold constant while biases are present elsewhere in the same data set is simply not credible.

There are some real issues with the soft data. Survey responses have fallen considerably since the pandemic, and many surveys have switched from telephone to computer-based methods. The pandemic itself also led to wide swings in various confidence measures. Relief payments caused a huge spike in confidence measures, as did initial news about a vaccine. Business surveys, such as ISM and NFIB, were significantly impacted by supply shortages, leading to unprecedented swings in supplier deliveries and new orders, which are now settling.

More recently, the survey data suggest the economy is stagnating. Much of this stagnation results from a decline in the proportion of consumers rating current economic conditions as ‘bad’ and a rise in those reporting conditions as ‘normal’. While overall, slightly more consumers rate current business conditions as ‘good’ rather than ‘bad’, the share rating current conditions as good is about half its pre-pandemic level, while the share rating conditions as bad is nearly one-and-a-half times higher. This assessment seems appropriate with the unemployment rate near its pre-pandemic level, but inflation considerably higher and the data closely resemble the Misery Index, which is the sum of the inflation rate and unemployment rate. The share rating conditions as normal is well above the highs seen in prior business cycles and is notably different from prior cycles.

The Consumer Confidence Index is comprised of five questions—two on the current state of the economy and three on the economy’s ‘future prospects’, or six months ahead. In addition to consumers’ views on current business conditions, their view on the current state of the labor market remains unambiguously positive. The share of consumers who believe jobs are ‘plentiful’ (37.5%) vastly outnumbers those who believe ‘jobs are hard to get’ (3.5%). Despite this advantage, consumers’ assessment of the current economic environment, which rose 2.5 points in May to 143.1, remains 26.2 points below its pre-pandemic level.

While consumers remain relatively optimistic about the present economic situation, they are deeply concerned about the economy’s future prospects. The expectations series is derived from three questions about the economy’s future prospects: an assessment of future business conditions, labor market conditions, and income prospects for the next six months. The expectations series rose 5.8 points in May but remains a significant 33.5 points below its pre-pandemic level and is now at a level, 74.6, that is typically seen only in recession periods. When asked about the likelihood of a recession within the next 12 months, 69% of consumers, up 4 points from April, said a recession was either ‘somewhat or very likely’.

Consumers’ lingering caution is evident in other surveys, including the University of Michigan Consumer Sentiment Survey, Gallup’s long-running most important problem survey, and most notably in a recent Guardian/Harris poll, which found that 56% of consumers feel the economy is currently in recession. The preponderance of survey evidence suggests a significant gap between solid economic data and individual perceptions of the economy.

One variable every survey shows as the top concern for consumers is the persistent rise in prices, particularly for everyday items such as groceries, gasoline, and housing. While the rate of inflation has moderated, the cumulative price increases since the pandemic are taking a toll on consumer finances. Grocery store prices are 26% higher than they were prior to the pandemic, while gasoline prices are up 39%. Apartment rent is up a cumulative 21%, and mortgage rates and financing costs for new and used vehicles have more than doubled. As a result, families earning the median income or less, which is more than half the country, are being squeezed and are making difficult choices on what to cut from their budgets.

The squeeze on household budgets has become increasingly evident in consumer spending data. Estimates for first-quarter retail sales were revised down sharply, and overall consumer spending, adjusted for inflation, rose at just a 2.0% annual rate. Moreover, all of that increase came from services, which climbed at a 3.9% annual rate. Spending on goods fell at a 1.9% pace, with outlays for durable goods declining at 4.1% and spending on nondurables, the majority of which are everyday items, falling at a 0.6% pace.

The pullback in consumer spending continued into the second quarter, with real personal consumption declining 0.4% in April. Spending on goods retreated further, with spending on nondurable goods tumbling 0.5% and spending on big-ticket items declining 0.1% in inflation-adjusted terms. Services outlays inched up just 0.1% after inflation, marking the smallest increase in eight months.

The weakness in goods spending reflects some underlying deterioration in household finances. The saving rate has fallen to just 3.6%, well below its long-run average of 5.8%. Delinquency rates on credit cards and car loans have risen in recent months, particularly among younger households.

Overall, balance sheets remain healthy. Household wealth has soared to new heights due to rising home values and a buoyant stock market. The economic split is significant. Homeowners who financed during the ultralow interest rate era have locked in housing costs and benefited from the strong run-up in home prices since the pandemic. Higher interest rates have also boosted interest earnings for upper-income households. For those earning the median income or less, it is a different story. These households are more likely to rent and less likely to own significant financial assets. Becoming a homeowner has become more difficult due to soaring home prices and higher mortgage rates.

The economic divide is affecting consumer spending. Families earning the median income or less are cutting back on non-essential purchases, impacting sales of goods and restaurant dining. Such cuts are necessary as groceries, housing, and transportation account for a larger share of their budgets. Spending on goods has decreased in three of the past four months and is now lower than it was at the start of the year. Upper-income households are faring much better. While middle and upper-income households account for the bulk of overall consumer spending, a larger share of their spending is on services, including travel, leisure, entertainment, wellness, and health care. Services outlays have held up well, rising in three of the past four months.

The financial divide among households is evident at major retail and restaurant chains. Walmart, Target, and Walgreens are cutting prices on thousands of everyday items, while McDonald’s, Wendy’s, and Taco Bell are expanding their value meals. This trend is visible at nearly all retailers and restaurants targeting middle- and lower-income consumers, leading to sales declines and plans to close underperforming locations. Cutbacks are particularly notable in areas where the minimum wage has increased substantially.

Increased discounting by retailers and restaurants will likely have only a modest impact on overall inflation. Goods, including food and energy, make up only 35% of consumer spending, with core goods accounting for less than 19% of the Consumer Price Index. Inflation has not primarily been driven by goods prices. Post-pandemic car prices spiked due to supply shortages and a shift from urban centers to car-dependent suburbs, but these shortages have since been resolved, and new and used vehicle prices have moderated.

Food price inflation has also subsided, although most households are unlikely to notice. Food prices have risen just 1.1% over the past year but remain roughly 25% higher than they were prior to the pandemic. While Walmart, Target, and several major grocery chains have committed to slashing prices on many widely used grocery items, food prices remain vulnerable to various external shocks. Labor costs at grocery stores have also risen along with prices, or even more in many markets, which will limit the extent of price markdowns.

Energy prices also show some signs of moderation. Gasoline prices have risen just 1.2% over the past year, and oil prices have slipped back below $80 a barrel in recent weeks. While energy production has ramped up in the United States, prices still remain vulnerable to geopolitical events around the world, as well as weather conditions closer to home. There is less capacity to accommodate a supply shock today. Strategic oil and gasoline stockpiles were tapped to help alleviate prices ahead of the midterm election and have not been replenished.

Core services prices remain the most challenging aspect of the inflation outlook. Much attention has been focused on housing costs, where asking prices for new rental apartments have fallen amidst an onslaught of new apartment completions. However, higher home prices and higher mortgage rates are keeping renters in place, and rents for renewals are still rising solidly. Price increases for many other key services, including health care, motor vehicle insurance, and admissions to concerts and sporting events, also remain problematic.

Inflation is expected to continue moderating as slowing economic growth cools off demand. Our forecast now calls for real GDP growth to rebound to a 2.7% annual rate. Consumer spending is packing much less punch than previously thought, and the housing market is struggling with higher mortgage rates. With home sales on a slower track, spending on furniture, appliances, and home furnishings is lagging, adding to the challenges retailers face from inflation-weary consumers. Business fixed investment is also expected to moderate this summer, as uncertainty about the presidential election causes businesses to hold off on capital projects.

While growth is slowing, Fed Chair Jay Powell made it clear that he does not see stagflation as a threat, and neither do we. Inflation should gradually decelerate but remain above the Fed’s target well into 2026. This will not prevent the Federal Reserve from cutting interest rates but will limit the extent of cuts outside of an outright recession. We expect the Fed to cut rates twice this year, with cuts in September and December, and anticipate two more quarter-point cuts in 2025. After that, with the economy still at full employment, we expect the Fed to hold the federal funds rate steady at a level roughly equal to nominal GDP growth.

The combination of full employment, near-potential real GDP growth, large federal budget deficits, and gradually decreasing inflation will keep long-term interest rates above 4%. We see upside risk to the 10-Year Note, particularly if the economy reaccelerates after the election. The FOMC has been steadily increasing its estimate of the long-run federal funds rate and we expect it to eventually rise from its current 2.60% to 3.25%, which would push the 10-Year Note to 4.80% with a normal upward-sloping yield curve.