Economic Monitor – Weekly Commentary
by Eugenio Alemán

Good June CPI print raises bets for rate cuts

July 12, 2024

The Consumer Price Index (CPI) was much better than expected in June, printing the first deflationary month for the index since July 2022 when it was -0.01%. June’s CPI was down by 0.1%, which took the year-over-year rate to 3.0% – the lowest year-over-year rate since March of 2021 (check the indicator section of this weekly for a more comprehensive view on June’s CPI numbers).

We want to repeat what we have said in the past: “One data point doesn’t a trend make.” However, the June data, after weaker than expected readings for April and May, confirm our suspicion that inflation numbers during the first quarter of the year were a fluke. As we have also said before, an institution as important as the Federal Reserve (Fed) cannot base its policy on something that may be an outlier. Now, June’s print confirms that what happened during the first quarter of the year was just that.

This was why we were very surprised when the Fed changed its view on the path for interest rates during the June FOMC meeting. If inflation has been coming down consistently with an economy growing above potential, it meant (against many pundits arguing otherwise) that above-potential economic growth was not a threat to a disinflationary path. Thus, using “a strong economy” argument to keep interest rates higher for longer made, in layman’s terms, no sense!

Now, because we believe the economy has slowed down and is probably growing at potential or

maybe just below potential, the path for inflation will continue to improve. Our concern is that monetary policy is a very blunt instrument and the Fed risks slowing down the economy too much.

There is good news on the housing front: because the yield on the 10-year Treasury follows what markets believe and not what the Fed is saying, lower yield on the 10-year Treasurys will help bring down mortgage rates. This could improve the prospects for residential investment, which has not been looking good over the last several quarters.

Is the U.S. fiscal deficit and the debt a serious issue?

Advisors’ questions via email as well as questions from audiences during presentations often focus on whether we believe the large U.S. fiscal deficits and the accumulation of these deficits over time (e.g., the U.S. debt) is a serious problem for the country. Many times, since we do not refer to the debt during our presentations, people think we are disregarding/dismissing one of the most important issues of our generation. But we are not. In fact, we already wrote a white paper on this topic several months ago, and you can find it here.

Questions and concerns on the sustainability of our deficits and the debt seem to have resurfaced recently due to S&P’s downgrade of France’s sovereign risk ratings. Here is a bit of background on S&P’s actions regarding France: “On May 31, 2024, S&P Global ratings lowered its unsolicited long- term foreign and local currency sovereign credit ratings on France to ‘AA-’ from ‘AA’ and affirmed its unsolicited ‘A-1+’ short-term foreign and local currency sovereign credit ratings. The outlook on the long-term ratings is stable.”1 In the overview of the decision, they pointed to “France’s general government debt” increasing “to about 112% of GDP by 2027 from about 109% in 2023.”

Some questioners compare the U.S. to France, asking how it is that the US has a better sovereign credit rating than France if our debt as a % of GDP is higher than France’s? This is in part due to definitional issues, as we discussed in our white paper, but it is also – and more importantly – due to the basic differences between the French and U.S. economies and tax revenues as a percentage of GDP. In the graph below we have U.S. federal debt, total as well as held by the public and the latter one, which is the one that counts (see our white paper for an explanation), is still less than what it is for France.

Some argue that what is happening has to do with the US exceptionalism or that risk agencies treat the U.S. differently, but it has to do with the fact that France’s government tax revenue as a percentage of GDP was about 46% in 2022, the highest within the OECD countries, while government revenue as a percentage of GDP was about 28% for the US. About 18 percentage points of those are federal government tax revenues while the difference (~10 percentage points) are state/local tax revenues.

Just for comparison purposes, we use below data from the OECD for 2021 (which is the latest data available) to see the major differences between the US and France.

Thus, a potential effort to increase tax revenues as a percentage of GDP for France is much more daunting than a similar potential effort by the US. Furthermore, France’s government expenditures as a percentage of GDP were close to 57% of GDP in 2023 while in the US, government expenditures as a percentage of GDP were 23.7%. To reiterate: from the country’s expenditure side, government expenditures are more than twice as a percentage of GDP in France than in the U.S., which means that any reduction in government expenditures could have a larger effect on that country’s ability to grow compared to the U.S. Risk agencies understand that such a comparison is not apples to apples. Rather, both countries’ characteristics are very different.

Why do politicians, left and right, shy away from fixing this problem?

The simple answer is that cutting expenditures and/or raising taxes is typically seen as political suicide and no politician is truly fiscally conservative, even if many times they try to sell themselves as such. Other times, politicians think that the fiscal situation will fix itself once the economy grows, or some believe in the “fiscal fairy godmother.” To some degree this was the case early in this recovery from the pandemic recession, but as inflation has come down and the industrial and fiscal packages (IRA, CHIPS Act, Infrastructure) have been put in place, the deficit has started to grow again as a percentage of GDP.

Furthermore, government revenues have not recovered with the stronger growth in the US economy, as many were expecting. Typically, deficits increase during recessions as the government spends more while taking less in government revenues, but once recessions are over and the economy resumes growth, tax revenues start to grow again. However, during this post- COVID recovery, that has not been the case. Thus, at a time when government expenditures have continued to go up, tax revenues have not kept expanding as expected.

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Economic and market conditions are subject to change.

Opinions are those of Investment Strategy and not necessarily those Raymond James and are subject to change without notice the information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. There is no assurance any of the trends mentioned will continue or forecasts will occur last performance may not be indicative of future results.

Consumer Price Index is a measure of inflation compiled by the U.S. Bureau of Labor Studies. Currencies investing are 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.

The National Federation of Independent Business (NFIB) Small Business Optimism Index is a composite of ten seasonally adjusted components. It provides a indication of the health of small businesses in the U.S., which account of roughly 50% of the nation's private workforce.

The producer price index is a price index that measures the average changes in prices received by domestic producers for their output. Its importance is being undermined by the steady decline in manufactured goods as a share of spending.

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