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By David W. Berson, Ph.D.
Summary
At least for now, a Goldilocks scenario is playing out, with slowing (but still positive) economic growth, slowing (but still higher than desirable) inflation, unemployment near 50-year lows, and solid job and wage gains (but slowing for both). Not everything is positive, with manufacturing activity declining. But the good outweigh the bad and equity and fixed-income markets responded with strong price gains over the month.
Economic Activity
The broadest measure of the economy, real GDP, grew at a solid pace in the fourth quarter, rising at an annualized pace of 2.9 percent (following 3.2 percent in the third quarter). While this is good news on the surface, the details are not as positive. Specifically, we look closely at the two major components of GDP (personal consumption expenditures, and business fixed and residential investment), which we can call core GDP (officially, this is “final sales to private domestic purchasers”). The other components of GDP – inventories, trade, and government – can be highly volatile from quarter to quarter and so detract from a view of underlying economic growth. Just as overall real GDP growth understated underlying economic activity in the first half 2022 (with two consecutive negative quarters of growth), it overstated it in the second half. Core spending remained positive throughout the year, although it slowed as the year progressed. For the fourth quarter, core spending grew by only 0.25 percent. An even better view of the trend in economic growth is the four-quarter change in core spending, which ended the year up by 0.97 percent. Not recessionary growth, but pretty slow.
Despite the significant slowing of the underlying economy, the job market remained strong. Nonfarm payroll gains for January exploded, rising by 517,000, the strongest gain in almost a year and well above market expectations. Additionally, the unemployment rate slipped to the lowest level since 1969 at 3.4 percent. The Job Openings and Labor Turnover Survey (JOLTS), which is broader than the monthly employment report but is lagged by a month, showed continued strength for December. In particular, the number of job openings rose to a near-record 11.0 million people for the month. When compared with the number of people unemployed, there were nearly two job openings for every unemployed worker (1.92 to be exact). Moreover, the quit rate – which is high when people are confident about finding a new job – remained at 2.7 percent, close to an all-time high. The strong job market, with many more jobs than job seekers, continues to push wages higher. The Employment Cost Index, a very broad measure of worker compensation, grew by 1.0 percent for December; and while this is down a tad from prior months, it is still strong. Over the past year, this measure of worker compensation is up by 5.1 percent.
But not all the news on the economy was as positive last month. The Institute of Supply Management’s (ISM) manufacturing survey index fell further into contraction territory in January, below the breakeven level of 50 for a third consecutive month. On the other hand, the ISM services survey rebounded from a one-month drop into contraction territory, climbing to 55.2 for January, about the average for most of last year. Personal consumption expenditures (PCE), the broadest measure of consumer spending, fell in each of the most recent two months for which we have data (and dropped a bit more when adjusted for inflation). With PCE representing the largest component of spending in the economy, at around 70 percent of GDP, further slowing here increases the chances of negative overall – and, importantly, core economic growth. Although January data on retail sales and PCE won’t be available until closer to the end of this month, one of the largest components of consumer spending is for light vehicles (autos plus light trucks). There was some good news here, with January data showing a rebound in sales to an annualized pace of 15.7 million units – the fastest since May 2021. This is likely to give the consumer spending data for January a positive kick.
Inflation and the Federal Reserve
With data through December, all of the major measures of inflation showed moderation through year-end, with some significant slowing over the last several months of 2022. The Consumer Price Index (CPI) grew by 6.4 percent in December from a year earlier, with the core rate (excluding the volatile food and energy components) up by 5.7 percent. The highs for these measures were 9.0 percent for the overall CPI (June) and 6.7 percent for the core CPI (September), indicating that there has been substantial slowing in recent months. The annualized growth rate for the CPI over the last three months of the year was only 1.8 percent, with the core CPI up by 3.1 percent – emphasizing the slowdown in recent months.
Despite the slowdown in inflation, the 12-month trend rates remain above the Federal Reserve’s long-term goal of 2.0 percent. (Note that the Fed prefers to use broader measures of inflation coming from the PCE price index, but the story is not materially different than that told by the CPI.) With the job market still very strong, solid real GDP growth over the second half of last year, and inflation still above the Fed’s goal (albeit moving closer to it), the Fed raised the federal funds rate at the start of February for the twelfth time in this tightening cycle, moving the target range up to 4.50-4.75 percent. A year ago, the range was 0.00-0.25 percent. Moreover, the Fed suggested that it was not finished tightening policy.
Financial Markets
In anticipation of additional Fed tightening, short-term interest rates moved up during January. For example, the yield on the 3-month Treasury note ended December at 4.42 percent and ended January at 4.70 percent – roughly equivalent to the 25-basis point (bps) increase in the federal funds rate that occurred on February 1. This is no surprise, as short-term rates are closely tied to Fed policy and the federal funds rate. But longer-term rates tend to be more forward-looking, with expected inflation and expectations for future Fed policy moves being important determinants. Unlike short-term rates, long-term rates fell over the course of the month. The 10-year Treasury note yield fell from 3.88 percent at the end of December to 3.52 percent at the end of January, from a combination of lower inflation expectations and reduced expectations for Fed tightening, with rising market probabilities of Fed easing this year. And with relatively “dovish” comments from Fed Chair Powell after the conclusion of the FOMC meeting on February 1, along with the smallest rate hike since April 2022, the yield dropped to 3.39 percent (although it rebounded back to 3.53 percent after the exceptionally strong jobs report for January).
Equity markets also had a great January, helped by lower long-term interest rates and increasing expectations of lower short-term rates if/when the Fed eases (or at least less tightening than previously expected) – all with an economy that is still growing. A soft landing, indeed! The large-cap S&P 500 Index rose by 6.2 percent over the course of the month, the mid-cap S&P 400 Index jumped by 9.1 percent, and the small-cap S&P 600 Index soared by 9.4 percent. The level of the large- and small-cap indexes are now at more than 5-month highs, with the mid-cap at its highest level in more than 9 months.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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