Moderating core inflation shouldn’t, on its own, be enough to give Fed officials confidence that their job is done. Inflation will ultimately follow the trajectory of economic growth, which continues to surprise on the upside in the US. In this scenario, the Fed should consider further tightening of policy regardless of inflation forecasts for the rest of this year
Signs of abating inflation have lifted the spirits of investors, the White House and the general public this month. While a welcome relief, inflation tends to be a lagging rather than a leading economic indicator. More forward-looking measures of activity show economic growth picking up again and, should that be sustained, inflation will likely be a problem for households and a headache for policymakers once again next year.
The performance of financial markets, particularly stocks and corporate credit spreads, is the simplest way to argue that growth is picking up. The S&P 500’s total return so far this year is close to 20 percent. The Nasdaq 100 is up over 40 percent. The Markit CDX North America Investment Grade Credit Index is near its lowest level since early 2022, indicating confidence in the performance of high-quality companies. To the extent that markets represent the collective judgment of investors about the direction of the economy, things are pointing up.
Increasingly, there are hard numbers to substantiate this. Last week’s housing data showed single-family building permits climbed to a one-year high, rising 23 percent over the past six months. DR Horton, the largest homebuilder in the US, reported strong earnings and said the lack of resale inventory should continue to boost new home sales. Increased residential construction is likely to provide a meaningful boost to gross domestic product growth in the third quarter for the first time since the start of 2021.
There are signs of stability or reacceleration in the labor market as well. Initial jobless claims are at the lowest level in two months and the number of people collecting unemployment benefits has fallen modestly since a peak in April. Guy Berger, principal economist at LinkedIn, wrote last week that the platform’s gauge of workforce confidence has improved in recent months, potentially because employers have paused job cuts after the wave of reductions that came in the second half of 2022 and early 2023.
Improving stock and bond performance along with an abatement of the headwinds in the housing and labor markets are flowing through to confidence. This week’s Conference Board gauge of consumer sentiment came in at its highest level in two years, with all age and income groups showing gains. The recent Philadelphia Fed Business Outlook Survey showed that expectations for new orders six months from now have surged.
It’s this month’s shift in “vibes” — hard to quantify but unmistakably important — that represents the biggest upside risk to growth. The downturn in financial and housing markets last year, when households were already squeezed by rising inflation and interest rates, led consumers and businesses to brace for recession. Companies curtailed hiring and investment plans and shoppers pulled back on big ticket purchases even though job gains remained robust and nominal spending was increasing. Bloomberg Opinion contributor Kyla Scanlon coined the funk we were in a “vibecession.”
I argued recently that notable further declines in the core consumer price index are already baked in because of the lag with which new rental leases are reflected in the data. With financial markets, housing, jobs, worker incomes, and inflation all in a better place today than a year ago, and with recession fears no longer front of mind, what happens if corporations and households unleash those recently shelved plans to hire, invest and spend.
That would argue for an upside risk to economic growth at a time when the Federal Reserve expects, and is hoping for, below-trend activity. The summary of economic projections policymakers produced at their June meeting forecast very little real GDP growth in the second half of 2023 and just 1.1 percent for 2024. While second-quarter data is still pending, it’s likely that real GDP growth was around 2.5 percent over the past year at a time when both households and businesses were cautious. Merely repeating that in the next year, when the Fed is looking for growth closer to 1 percent, would likely mean parts of the economy are hotter than policy makers are comfortable with. The rise in commodity prices this month could be a leading indicator of what’s to come.
Given this backdrop, moderating core inflation over the next several months shouldn’t, on its own, be enough to give Fed officials confidence that their job is done. Inflation will ultimately follow the trajectory of economic growth. That still seems too strong to be consistent with their inflation objectives. Regardless of what the inflation data says for the balance of the year, the Fed should consider further tightening policy if economic activity continues to surprise on the upside.
