Employment weakness cements our view

Chief Economist Eugenio J. Alemán discusses current economic conditions.

August’s employment report, which was weaker than markets were expecting but stronger than our call, cements our view that the easing cycle will begin during the next Federal Open Market Committee Meeting (FOMC), which takes place September 17-18.

We know that markets are still pricing in a 50 basis points reduction in the federal funds rate, but we make the case for a 25 basis point reduction below.

But going back to the employment numbers, we believe that markets were being overly optimistic in expecting jobs in August to have increased by 165,000 (Bloomberg expectations), versus our call for a 120,000 increase and an actual number of 142,000, which is probably going to be revised downward and approach our call in the months to come. Thus, we don’t think that a mistake by markets expecting such a strong number versus the actual should be a reason for the Federal Reserve (Fed) to cut 50 basis points during the FOMC meeting.

Furthermore, the rate of unemployment was slightly (very slightly!) lower in August, at 4.221% compared to a July rate of 4.253%, and that is, today, more important for the Fed than the employment number, as it is going to continue to argue that the “rate of unemployment is higher today compared to a year ago” but it is still low compared to history.

Federal Reserve: Beware of animal spirits

The Fed has a very difficult decision ahead, with economists, analysts, and markets predicting between 25 basis points to 50 basis points reductions during the September FOMC meeting. Furthermore, we have seen predictions of, at most, 125 basis points cuts for the federal funds rate before the end of this year. This seems to be over the top, but we could construct potential scenarios where this may be required.

For now, the Fed has a roadmap in place that it can use to start its easing cycle: the June dot plot. In that dot plot Fed members’ views on the federal funds rate indicated one, 25 basis point cut, before the end of this year. We agree that this dot plot is out of date and that the dot plot scheduled to be released after the next FOMC meeting will show a very different roadmap for the federal funds rate. But the Fed knows that it has two more meetings before the end of the year and there will be plenty of opportunity for it to lower the federal funds rate during those two meeting according to “incoming data.”

We (and the markets) are concerned that the Fed may be behind the curve as we have said in the past. However, bygones-are-bygones and there is no use in looking back. The most important thing is doing what is right for the economy today. And we still believe that a 25 basis points cut to start the cycle is the safest path for the Fed today.

The reason for our belief is that, typically, the Fed’s changes to short-term interest rates affect longer-term rates and thus mortgage rates. Mortgage rates normally follow the yield on the 10-year Treasury, and that rate has already moved down ahead of the Fed’s move. Thus, for now, the only thing the Fed needs to do is to acknowledge the market’s move.

But a 50 basis points reduction in the federal funds rate during the next meeting, without a previously released dot plot and Summary of Economic Projections (SEP) with its forecast for the U.S. economy could send the wrong signal.

The most important thing to remember is that, at this junction, the Fed continues to be concerned with the economic tailwinds still being provided by fiscal policy while at the same time it doesn’t want to spook the ‘animal spirits’ into concluding that the economy is in trouble because that would have the potential to become a self-fulfilled prophecy.

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Consumer Price Index is a measure of inflation compiled by the US Bureau of Labor Statistics. Currencies investing is generally considered speculative because of the significant potential for investment loss. Their markets are likely to be volatile and there may be sharp price fluctuations even during periods when prices overall are rising.

Consumer Sentiment is a consumer confidence index published monthly by the University of Michigan. The index is normalized to have a value of 100 in the first quarter of 1966. Each month at least 500 telephone interviews are conducted of a contiguous United States sample.

Personal Consumption Expenditures Price Index (PCE): The PCE is a measure of the prices that people living in the United States, or those buying on their behalf, pay for goods and services. The change in the PCE price index is known for capturing inflation (or deflation) across a wide range of consumer expenses and reflecting changes in consumer behavior.

The Consumer Confidence Index (CCI) is a survey, administered by The Conference Board, that measures how optimistic or pessimistic consumers are regarding their expected financial situation. A value above 100 signals a boost in the consumers’ confidence towards the future economic situation, as a consequence of which they are less prone to save, and more inclined to consume. The opposite applies to values under 100.

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GDP Price Index: A measure of inflation in the prices of goods and services produced in the United States. The gross domestic product price index includes the prices of U.S. goods and services exported to other countries. The prices that Americans pay for imports aren't part of this index.

The Conference Board Leading Economic Index: Intended to forecast future economic activity, it is calculated from the values of ten key variables.

The Conference Board Coincident Economic Index: An index published by the Conference Board that provides a broad-based measurement of current economic conditions.

The Conference Board lagging Economic Index: an index published monthly by the Conference Board, used to confirm and assess the direction of the economy's movements over recent months.

The U.S. Dollar Index is an index of the value of the United States dollar relative to a basket of foreign currencies, often referred to as a basket of U.S. trade partners' currencies. The Index goes up when the U.S. dollar gains "strength" when compared to other currencies.

The FHFA House Price Index (FHFA HPI®) is a comprehensive collection of public, freely available house price indexes that measure changes in single-family home values based on data from all 50 states and over 400 American cities that extend back to the mid-1970s.

Import Price Index: The import price index measure price changes in goods or services purchased from abroad by U.S. residents (imports) and sold to foreign buyers (exports). The indexes are updated once a month by the Bureau of Labor Statistics (BLS) International Price Program (IPP).

ISM New Orders Index: ISM New Order Index shows the number of new orders from customers of manufacturing firms reported by survey respondents compared to the previous month. ISM Employment Index: The ISM Manufacturing Employment Index is a component of the Manufacturing Purchasing Managers Index and reflects employment changes from industrial companies.

ISM Inventories Index: The ISM manufacturing index is a composite index that gives equal weighting to new orders, production, employment, supplier deliveries, and inventories.

ISM Production Index: The ISM manufacturing index or PMI measures the change in production levels across the U.S. economy from month to month.

ISM Services PMI Index: The Institute of Supply Management (ISM) Non-Manufacturing Purchasing Managers' Index (PMI) (also known as the ISM Services PMI) report on Business, a composite index is calculated as an indicator of the overall economic condition for the non-manufacturing sector.

Consumer Price Index (CPI) A consumer price index is a price index, the price of a weighted average market basket of consumer goods and services purchased by households. Changes in measured CPI track changes in prices over time.

Producer Price Index: A producer price index (PPI) is a price index that measures the average changes in prices received by domestic producers for their output.

Industrial production: Industrial production is a measure of output of the industrial sector of the economy. The industrial sector includes manufacturing, mining, and utilities. Although these sectors contribute only a small portion of gross domestic product, they are highly sensitive to interest rates and consumer demand.

The NAHB/Wells Fargo Housing Opportunity Index (HOI) for a given area is defined as the share of homes sold in that area that would have been affordable to a family earning the local median income, based on standard mortgage underwriting criteria.

The S&P CoreLogic Case-Shiller U.S. National Home Price NSA Index measures the change in the value of the U.S. residential housing market by tracking the purchase prices of single-family homes.

The S&P CoreLogic Case-Shiller 20-City Composite Home Price NSA Index seeks to measures the value of residential real estate in 20 major U.S. metropolitan.

Source: FactSet, data as of 7/7/2023