Inflation Pressures Are Easing but Rate Cut Forecast Remains Uncertain

The New Year is beginning where the old one ended -- with uncertainty about when – or whether – the Federal Reserve will begin cutting interest rates.

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Recession fears, which had been inching higher, receded somewhat in October, as employment growth, low interest rates, and signs of life in the housing market offset concerns about a decline in manufacturing activity, anemic business activity, and slower worldwide economic growth.

Against that backdrop, the Federal Reserve cut interest rates for the third time this year, reducing its target fed funds rate by another quarter of a point, to a range of 1.5% to 1.75%.

While not ruling out further rate cuts, Federal Reserve Chairman Jerome Powell said that barring significant evidence of economic weakness, the current level is "likely to remain appropriate. If that changes, the Fed will respond accordingly," he added.  “[But] we would need to see a really significant move up in inflation ... before we would consider raising rates to address inflation concerns."

Jobs Grow, Wages Lag

Employment numbers for October came in stronger than expected.  Employers added 128,000 workers for the month, well above a consensus forecast that projected only 75,000 new hires. Revisions added 95,000 more jobs than were initially reported for August and September. 

The unemployment rate held steady at 3.6 percent – a little higher than the previous month’s 3.5 percent, but still near the lowest level in almost 50 years.  Wages also increased, by 0.2 percent, but the rate of increase has fallen well below the 3 percent average over the last 12 months. The overall hiring trend has also slowed.  Employers have added an average of 156,000 workers per month over the past six months compared with a monthly average of 232,000 earlier this year. 

In another potentially disturbing sign, the number of job openings declined for the third consecutive month in October – the first time since the Great Recession this indicator has logged three back-to-back year-over year declines, according to MarketWatch.

Other key economic indicators also have been flashing yellow:

  • The economy grew at an annualized rate of 1.9 percent in the third quarter, the second back-to-back reading below the first quarter growth rate of 3.1 percent.
  • Manufacturing activity has been falling steadily along with business investment, which is declining at the fastest rate in more than a decade, according to a recent report from Goldman Sachs.
  • Consumer spending increased slightly (by about 0.2 percent) in September, but retail sales fell for the first time in seven months and the savings rate increased to 8.3 percent from 8.1 percent in August. Consumer confidence also fell to the lowest level since June.

“While this is by no means conclusive evidence that the consumer is wavering (after all, the upward revisions reduce the impact of September’s declines), it nonetheless reinforces our ongoing concern that a spending retrenchment will ultimately trigger a more durable slowdown,” Ian Lyngen, head of rates research at BMO Capital Markets, wrote in a research note.

Sounding a more optimistic tone, Lynn Franco, director of economic indicators at The Conference Board, noted that despite the lower confidence reading, “confidence levels remain high and there are no indications that consumers will curtail their holiday spending.”

Housing:  Ups and Downs

The housing market continues to under-perform, producing results weaker than strong employment figures and wage gains would seem to support.  Skimpy inventories pushed prices up and pushed existing home sales down in September compared with the previous month.  But the seasonally adjusted annual rate of 5.38 million units was almost 4 percent above the year-ago level. 

An “unbalanced situation” created by rising prices and shrinking inventories is holding sales below expectations, Lawrence Yun, chief economist for the National Association of Realtors, told the Wall Street Journal.

Pending home sales, measured by an NAR index, increased by 1.5 percent in September compared with August – the fourth increase in the last five months ─ suggesting that sales may improve later this year. 

New Home Strength

While the existing home market has been lagging, the new home market seems to be strengthening.  Sales of new homes in August topped the year-ago pace by 15.5 percent.  New construction, the key to improving the persistent inventory problem, was less favorable, falling more than 9 percent in September compared with the August pace.  The decline was concentrated in the multi-family sector, where starts (which tend to swing sharply from month to month) plummeted by nearly 30 percent. Single-family starts inched above the year-ago pace by about 3 percent. 

Single-family permits, an indicator of future construction activity, increased by 2.8 percent to an annual rate of 919,000 units, the highest level since the beginning of this year. Although home builders are becoming increasingly optimistic (a National Association of Home Builders index hit a 21-month high in October), analysts are decidedly less upbeat. 

“Builders still aren’t producing enough new houses to satisfy demand,” an article in MarketWatch noted, “and they are unlikely to dramatically scale up construction in light of fresh worries about the health of the U.S. economy. [Uncertainty] is keeping home prices higher than they otherwise would be and effectively capping overall sales.”

Worrisome Gap

The rate at which home prices are rising has slowed significantly over the past year, but prices are still rising.  Average national home prices grew 3.2 percent year over year in August, according to the CoreLogic Case Schiller National Home Price Index.  That is roughly half the pace recorded in the same month last year, but still ahead of the rate at which wages are increasing. 

 “You can sit there and go, Oh my god, look how low mortgage rates are.’” Tom Lawler, founder of Lawler Economic and Housing Consulting, told the Wall Street Journal. “But then you go, ‘Look how high home prices are.’”

The NAR’s Yun shares that concern. “Going forward, interest rates will surely not decline in a sizable way,” he notes in a recent analysis, “so the changes in the median price will be the key to housing affordability.”

The widening gap between the rates at which housing prices and incomes are growing could signal an economic downturn, economists at the Council on Foreign Relations, a Washington think tank, are warning.  A similar gap appeared in the years preceding the “Great Recession” that began in 2008, Benn Steil, director of international economics at the CFR, and Benjamin Della Rocca, a former analyst with the group, note in a recent blog post.  “A parallel dynamic,” they say, “is playing out today.”  When income growth fails to match rising home prices, prices have to fall, and declining prices, in turn “drive down household spending, by way of the so-called wealth effect,” the economists explain

While consumers probably aren’t analyzing economic trends in the same way, they do appear to agree that a downturn is likely.  More than two-thirds of the respondents to  a recent poll conducted by YouGov said they are curbing spending and taking other steps  (including looking for a better-paying or more stable job) to prepare for a weaker economy.  More than 40 percent said they were not adequately prepared for a downturn.