Economic Commentary: Year Begins with a Disconnect Between Market Expectations and Fed Predictions for Interest Rate Movement in 2024

Undoubtedly, the most important news affecting the economy during December was the Fed’s acknowledgement following their December 13-14 meeting that the Fed Funds rate has probably peaked for the current cycle. However, they “need to see more evidence that inflation pressures were abating to become confident in a sustained return of inflation to 2.0%.” The biggest open question, then, is whether the Fed will be easing because they see inflation moving back to their 2.0% target, or because they are more concerned about the lagged impact on the economy of their aggressive tightening campaign since March 2022.

Inflation Trends

The November CPI report showed that headline inflation increased 0.1% during the month with the year-over-year change declining to 3.1% from 3.2% the prior month. Core inflation increased 0.3%, leaving the year-over-year figure at 4.0%. Stripping out the shelter component from the headline CPI, the month-to-month change was -0.1% for the second month in a row, bringing the year-over-year increase to 1.4%. The Producer Price Index (PPI) was unchanged for the month, thus forecasting less consumer pricing pressures down the road. The year-over-year PPI is now 0.9%. The Fed’s favored measure of inflation, core Personal Consumption Expenditures (PCE), came in at 0.1% for November and has been at or below 0.2% month-to-month for five of the past six months. The year-over-year reading is now 3.2%, which is down from 3.5% the prior month.

Incomes, Spending & Lending

Personal incomes rose 0.4% in November while spending increased 0.2%, enabling the personal saving rate to increase to 4.1% from 4.0%, but it remains below pre-pandemic levels near 8.0%.

Reflecting tight lending standards and higher interest rates at banks, total loans and leases at all commercial banks are only up 2.3% year-over-year as of the end of December, compared with an 11.4% growth rate at the end of 2022. Commercial and Industrial (C&I) loan growth is particularly weak at -0.9% year-over-year. Although not all banks are continuing to tighten their lending standards, virtually no one is easing. Bank credit – which is the amount of credit available to businesses or individuals for loans – is contracting year-over-year for only the third time in the past 75 years.

Banks have approximately 15% of their assets in cash, a relatively high number, in part because they are preparing for new rules on capital and liquidity from the Fed, but also as a cushion to avoid having to sell underwater securities to satisfy withdrawal demands, as evidenced by what happened last spring.

Leading Economic Indicators & Manufacturing

There is no change in the message coming from the leading economic indicators. They have been declining for 20 consecutive months. For the month of November, the biggest drags came from consumer expectations, manufacturing new orders, interest rates, and building permits.

The ISM manufacturing Purchasing Managers Index for December showed that economic activity in the manufacturing sector contracted for the 14th consecutive month, and only one out of 18 industries posted any growth. The critical New Orders portion of the survey has been contracting for 16 consecutive months.

The Labor Market

The December payroll employment report showed a gain of 216,000, and the prior two months’ gains were revised down by 71,000. Once again, gains were concentrated in the non-cyclical sectors of government and health care jobs. The unemployment rate remained at 3.7%, as the household survey showed a drop of 683,000, while the labor force contracted by 676,000. Average hourly earnings rose 0.4%, which was higher than expected, bringing the year-over-year figure to 4.1% from 4.0%.

The employment-to-population ratio declined to a 12-month low at 60.1% from 60.4%. Full-time employment decreased by 1.5 million – the biggest drop since April 2020 – while people holding more than one job increased by 222,000. Typically a sign of a softening labor market, temporary jobs fell 33,000.

The Job Openings and Labor Turnover (JOLTS) report for November indicated that job openings declined for the third month in a row to the lowest level since March 2021. Hirings declined by 363,000 to the lowest level since April 2020. The weakness in hiring was spread across all sectors. The overall supply/demand balance in the labor market is improving, but demand is still greater than supply.

Interest Rate Expectations

As mentioned previously, the Fed’s message after their December meeting indicated that they are not likely to be increasing interest rates again during this cycle. “Our actions have moved our policy rate well into restrictive territory, meaning that tight policy is putting downward pressure on economic activity and inflation, and the full effects of our tightening likely have not yet been felt,” they commented.

The Fed noted that the economy has slowed since third quarter and consequently adjusted their economic projections. Year-end 2023 PCE inflation is now projected to be 2.8% - down from their September projection of 3.3% – and 2.4% at year-end 2024. Real GDP in 2023 was upped to 2.6% from 2.1% and lowered to 1.4% from 1.5% in 2024. The Fed Funds rate has been forecasted to end 2024 at 4.6%, indicating three cuts during the upcoming year.

Markets are pricing in five cuts in interest rates beginning in March or May, however there was nothing in the minutes of the Fed’s meeting to suggest that the Fed is close to starting to cut rates, or that it plans to cut rates as much as markets are currently expecting.

The real (inflation adjusted) Fed Funds rate is now at the highest and most restrictive level since 2007. If the Fed’s projections for 2024 are accurate, the real Fed Funds rate will be 2.2% (4.6% Fed Funds – 2.4% inflation), which is only slightly less restrictive than today’s real Fed Funds rate of 2.7%. In addition to their interest rate policy, the Fed continues to reduce their balance sheet by about $95 billion per month – another policy tool that tightens liquidity.

In short, while interest rates may have peaked, the Fed appears willing to keep rates elevated until they see a more substantial slowdown in the economy and sustained easing of inflationary pressures.