When the Federal Reserve launched its war against inflation last year, Fed Chairman Jerome Powell made it clear that he was willing to accept slower growth and possibly a recession in order to squeeze inflationary pressures out of the economy. Most economists agreed that a recession would be the inevitable result of the Fed’s successive interest rate hikes.
Two months into the new year, consumers are spending less, economic growth has slowed, the inflation rate has declined (although arguably not as much as the Fed would like), and the over-heated housing market has cooled.
But employment remains stubbornly resilient, with layoffs in some sectors (technology among them) more than offset by strong hiring and steady wage growth in others, the services sector primary among them. Do these contrary indicators suggest that the Fed will have to continue tightening to control inflation, or do they suggest, rather, that the Fed is in the process of guiding the economy in to the soft landing that most analysts had deemed impossible?
Can the Fed win the battle against inflation without bloodying the economy? The answer is far from clear.
As the Fed surveys the inflation battlefield, employment strength is a major concern. Employers added more than 500,000 jobs in January and the unemployment rate fell to 3.4 percent, its lowest level in more than 50 years. The muscular report surprised both analysts and the Fed – the latter, not in a good way.
“Today’s jobs report is almost too good to be true,” e Julia Pollak, chief economist at ZipRecruiter, wrote in a note to investors. “Like $20 bills on the sidewalk and free lunches, falling inflation paired with falling unemployment is the stuff of economics fiction.”
Daniel Zhao, lead economist for Glassdoor, a job review site, was also stunned by the employment data. “The Fed has a New Year’s resolution to cool down the labor market,’ he told CNBC, “and so far, the labor market is pushing back.”
The Fed was not amused. The employment data were “stronger than anyone I know expected,” Powell said in a speech shortly after the labor report was posted. “It kind of shows you why we think [controlling inflation] will be a process that takes a significant period of time.”
Meeting about a week before the report was issued, the Federal Open Market Committee (FOMC), the Fed’s rate-setting arm, voted to raise the Fed’s benchmark interest rate by one-quarter of a point, back—pedaling from the more aggressive half-point increase December and the glass-rattling 75-point jump in November.
Some analysts speculated that the January rate increase would have been higher had it come after the jobs numbers were released. But Powell made it clear before then that the Fed was far from ready to declare the war against inflation won.
“[The expectation that inflation] will go away quickly and painlessly…is not the base case,” he told a business audience. “The base case for me is that…we’ll have to do more rate increases…We’re going to react to the data,” he added. “So if we continue to get, for example, strong labor market reports or higher inflation reports, it may well be the case that we have to do more and [will have to] raise rates more than has been priced in.” Translation: The Fed anticipating more tough love ahead for the economy.
Housing Recovery Beginning?
The Fed’s interest rate hikes have already had a major impact in the housing market, a major source of inflation concern, although for the Fed, not the only one. Existing home sales posted their eleventh consecutive month-over-month decline in December, as year-over-year sales fell by more than 34 percent for the month.
Home prices declined by 0.6 percent in November – the fifth month-over month decline in the closely watched S&P CoreLogic Case-Shiller National Home Price Index. Year-over-year increases of 7.7 percent in November and 9.2 percent in October were the first annual increases below double digits in nearly two years.
Analysts point out that the Case-Shiller index is a lagging indicator, reflecting sales completed more than two months earlier. As a result, the December report does not reflect the impact of lower mortgage rates, which have fallen below 6 percent after topping 7 percent at their peak last year.
Reflecting those lower rates, pending sales of existing homes increased by 2.5 percent in December. The year-over-year decline of nearly 23 percent, which Redfin reports for the four weeks ending January 29, doesn’t sound positive, but it’s an improvement from the 33 percent annual decline reported for November, and the smallest decline since last September. Redfin’s “Demand Index”, measuring requests for home tours reported by Redfin agents, has increased by nearly 20 percent from its October low, and the Mortgage Bankers Association says mortgage applications have increased by nearly 25 percent over their low point last year.
Industry executives view these improvements as ‘green shoots” indicating that the housing market is beginning to recover, holding promise for the spring homebuying season. “This recent low point in home sales activity is likely over,” Lawrence Yun, the NAR’s chief economist, said recently. “Mortgage rates are the dominant factor driving home sales,” he noted, “and recent declines in rates are clearly helping to stabilize the market.”
Rebound – “Still a Long Way Off”
If home builders are seeing evidence of that stability, it’s not reflected in the National Association of Home Builders’ confidence index, which declined for the twelfth consecutive month in December, reaching its lowest level in 10 years. But the NAHB’s chief economist, Robert Dietz, finds some good news in that otherwise negative report. The “silver lining,” he says, is that the confidence decline is “the smallest in the past six months,” an indication, he believes, that “we are possibly nearing the bottom of the cycle for builder sentiment.”
But even with that bit of positive news, builders aren’t anticipating a robust recovery this year. On the contrary, the NAHB expects market weakness to continue through year-end, with recovery not likely until 2024.
Kiernan Clancy, senior U.S. economist at Pantheon Macroeconomics, agrees. “[While] home sales have now largely adjusted to the collapse in demand since late 2021,” he wrote in a note to investors, “a sustained recovery likely remains a long way off.”
Recession Debate Continues
So where does that leave the debate over the prospects for a soft landing or a serious downturn? Optimists say there is enough evidence that higher rates are having the desired (slowing) effect to prevent the Fed from pushing rates high enough to trigger a recession; pessimists say a strong employment market and a recovering housing sector will force the Fed to keep pushing rates higher.
On the optimists’ side, count Treasury Secretary Janet Yellen, who told The Basis Point: “You don’t have a recession when you have 500,000 jobs and the lowest unemployment rate in more than 50 years. What I see is a path in which inflation is declining significantly and the economy is remaining strong. Instead of the economy cracking as Fed hikes rates to squash inflation, “ she argued, “some data points show things are actually going well.”
David Burritt, who heads U.S. Steel, also thinks a soft landing is possible, and maybe likely. “We’re in this transitional period with a lot of uncertainty,” he told the New York Times, “and frankly I think a lot of people think the Fed is doing a lot better job on this soft landing than what was expected.”
On the pessimists’ side – and he has a lot of company ─ is Neil Dutta, head of U.S. economics at Renaissance Macro. He thinks the Fed would be hard-pressed to see in recent indicators evidence that its rate-hikes to date have been had the desired effects. “They’ve been raising rates for a while,” he told the New York Times. “And all they have to show for it is an unemployment rate at 3.4 percent.”