23 August 2024

US economic data suggests a soft landing

It is well known that the Federal Reserve’s target for inflation is 2%. What is less well known is that the target is meant to be an average rather than a ceiling.

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That is, the Fed wants inflation to be 2% plus or minus 1%. In other words, a range of 1% to 3% would satisfy the Fed. By that definition, the Fed has achieved its target. For the first time since March 2021, the year-over-year percentage change in the consumer price index (CPI) fell below 3%. Not surprisingly, many investors interpreted this as confirming the likelihood that the Fed will cut interest rates in September. Indeed, there is probably no one who thinks otherwise. Let’s look at the details.

In July, the CPI was up 2.9% from a year earlier and up only 0.2% from the previous month. In fact, since April, the CPI is up only 0.1%. Thus, inflation is clearly abating. When volatile food and energy prices are excluded, core prices were up 3.2% from a year earlier, the lowest level since April 2021. Core prices were up 0.2% from the previous month.

Energy prices were up only 1.1% from a year earlier while prices of food eaten at home were also up 1.1%. Yet prices of food eaten away from home were up 4.1%. This reflects the fact that inflation in services remains high, with prices up 4.9%, driven by rising labor costs. Meanwhile, prices of durable goods were down 4.1% while prices of non-durable goods were up 1.3%. The biggest component of services is shelter, with prices up 5.1%. When shelter is excluded from the CPI, prices were up only 1.7%. Moreover, the shelter component of the CPI reflects the impact of home prices with a long lag. There is good reason to expect shelter inflation to diminish further.

The good news for services inflation is that labor market tightness is easing. This should lead to an easing of wage pressure. Moreover, recent data indicated strong growth of labor productivity, meaning that the inflationary effect of wage gains is reduced. Thus, the Federal Reserve may likely feel comfortable in cutting interest rates in September. On the other hand, the fact that headline and core inflation have been receding slowly suggests that the Fed’s mission is not yet accomplished. Consequently, the futures market’s implied probability that the Fed will do a 50-basis-point cut in September fell from 50% before release of the CPI to 45% afterwards.

The recent pessimism about US economic growth might have to take a back seat given today’s report on retail sales. Spending was up sharply in August, surprising investors and reducing the expectation for a dramatic cut in interest rates by the Fed. On the other hand, most of the increase in retail sales was due to strong demand for automobiles. The report doesn’t necessarily imply a strong consumer sector. Let’s examine the details.

In July, total retail sales (not adjusted for inflation) were up 1% from the previous month, the fastest growth in more than a year. Spending at automotive dealerships was up 3.6%. When this is excluded, retail sales were up a more modest 0.4%. There were other segments of retailing that performed well. For example, spending at electronics and appliance stores increased 1.6%, building materials was up 0.9%, and grocery stores was up 1%. On the other hand, spending at clothing stores fell 0.1% while spending at department stores fell 0.2%.

Meanwhile, the Federal Reserve reported that industrial production fell 0.6% from June to July, partly due to the impact of a hurricane. Thus, it is not clear if the industrial economy is weakening. On the other hand, the National Federation of Independent Business (NFIB) reported that its survey of small business managers found optimism at the highest level since February 2022. This measure is said to be a good leading indicator of economic performance. Moreover, the NFIB said its survey found that concern about the prices that small businesses pay has receded to a level barely above where it was before the pandemic. Thus, inflationary worries have clearly abated.

The panoply of economic news led to a sharp increase in equity prices and a modest increase in bond yields recently. Many investors evidently saw the news as reducing the likelihood of a significant slowdown. At the same time, investors remained confident that the Federal Reserve will soon cut rates.