Solid Output Growth in the Third Quarter

According to the advance estimate for third quarter real GDP, output growth slowed marginally, from 3.0% to 2.8% on a seasonally adjusted annualized rate. Real personal consumption expenditures increased 3.7%. Investment expenditures were weak, growing at 0.3%. Government consumption expenditures and investment grew at 5.0%, led by federal expenditures that grew at 9.7%, the largest since Q1 of 2021.

To better understand what drove the increase in real GDP, it is useful to look at what contributed to overall growth. To do so, the BEA essentially “weights” the change by the share in output. So, while consumption grew at 3.7% it constitutes about 70% of output. On the other hand, while federal government expenditures grew at 9.7% the share is only about 7% of the total. While consumption, government spending and exports increased their contributions to output growth, investment and imports decreased their contributions with imports being a drag on growth.

A MURKY Inflation Outlook

The recently released Personal Consumption Expenditure (PCE) index data sends a mixed message on inflation. Measured relative to a year ago, inflation is down, either from 2.27% to 2.09% for the PCE, or from 2.72% to 2.65% for core PCE (excluding food and energy). These are the numbers that have been making headlines. However, the monthly annualized inflation rate rose sharply, from 1.39% to 2.13% for the PCE, and from 1.89% to 3.09% for the Fed’s preferred core PCE measure. As we have said many times in the past, the monthly inflation numbers are quite volatile — as seen in the figures below. Meanwhile, the year-over-year measures take many months to reflect a change in trend. Our preferred trend measure splits the difference. By this measure, inflation rose in September, from 1.77% to 1.89% for the PCE, and from 2.26% to 2.53% for core PCE.

An Anemic Jobs Report

Employment in October increased by a scant 12,000 jobs. Indeed, the private sector actually shed 28,000. The labor market was roiled by weather and strikes, making it difficult to understand the stance of the labor market. Many economists “expected” a weaker report, something like 100,000 jobs, but note that the deviation from expected and actual is often quite large. To add to the dismal looking report, there was another 112,000 downward revision over the past two months. Average hours of work remained at 34.3 and average hourly earnings rose $35.33 to $35.46.

The household survey also showed some weakness, but keep the hurricanes and strikes in mind. The labor force fell 220,000 and the participation rate fell to 62.6 from 62.7. The number employed fell by 368,000 and there was a 150,000 increase in the number unemployed. The unemployment rate increased slightly, from 4.05% to 4.15%.

Policy Outlook

The real-side picture is mixed: a strongish GDP report, but a weak employment report. Abstracting from the strike activity affecting the employment numbers, the October reading for the labor market is still feeble, particularly compared to September’s strong report. Core PCE inflation is still running at least half a point above the Fed’s 2% target.

One way to try to make sense of all this is to look at the real Federal funds rate: that is, the nominal rate less inflation. The current target for the Fed funds rate is 4.84%. Core PCE inflation for October was 2.54% using our trend measure, or 2.65% as measured year over year. Consequently, the real Fed funds rate is 2.2-2.3%. Whether or not this value is considered high depends on what one things is the “natural” rate of interest: the rate that would prevail if the economy is operating at potential (full employment), and inflation is stable. If one puts credence in the estimates of the New York Fed, it is. So, then one must ask whether now is the appropriate time to continue loosening monetary policy. The answer to this question depends chiefly on: (1) whether one thinks enough tightening has been applied to bring inflation into a “glide path” to 2%; and (2) whether the real side of the economy is (starting to) display weakness. For our money, inflation is job one for the Fed, and there’s still work to be done.

The BLS’s CPI report for July saw increases in month-over-month CPI inflation (from -0.67% to 1.88%) and core CPI inflation (from 0.78% to 2%). Granted, the June inflation rates were quite low, and the July rates are within the mythical 2% range. Meanwhile, on a year-over-year basis, CPI inflation fell (from 2.98% to 2.92%) as did core CPI inflation (from 3.28% to 3.21%). Our measure of trend CPI inflation rose from 1.58% to 1.68%; trend core CPI inflation fell from 2.46% to 2.31%.

Policy Implications

The Fed’s preferred measure of inflation is core PCE inflation rather than the CPI or core CPI inflation. The PCE is a broader measure than the CPI and removing the more volatile food and energy is a better way to track where inflation is heading. For example, this month fuel oil rose 0.9% over the month while piped gas services fell 0.7% over the month. Nonetheless, the CPI report provides a (noisy) signal of what can be expected from the PCE when it is released in a couple of weeks time. The figure below shows that our measures of trend core CPI and trend core PCE inflation generally move together, albeit not lock-step. It would not be too surprising to see July trend core PCE inflation come in lower than its June value of 2.6%.

The likely case for a cut in the Fed funds rate is that core PCE inflation is trending towards the Fed’s 2% target (even if it isn’t actually at 2%) along with real side weakness (witness the stock market’s reaction to the July employment gains). All of this with an eye to executing a “soft landing” (getting inflation under control without a inducing a recession).

By Paul Gomme and Peter Rupert

Today’s PCE report was largely foreshadowed by the CPI report two weeks ago. Our measure of trend core PCE inflation fell 0.8 percentage points, from 3.42% to 2.61%, compared to the 0.7 point fall in the corresponding CPI inflation rate. The year-over-year core PCE inflation rate fell a more modest 0.2 percentage points to 2.57%. Meanwhile, the month-over-month rate fell a whopping 2.15 points (compared to 1.6 points for CPI) to 1.0%.

The overall (non-core) PCE inflation rate fell to -0.1% on a month-over-month basis; our trend measure fell 1.2 points to 2.25%; and the year-over-year rate dropped a more modest 0.1 points to 2.56%. These changes are roughly in line with the earlier May CPI inflation numbers.

Policy Outlook

As we have earlier pointed out, our trend measures of inflation see through the volatile monthly inflation rate changes while at the same time responding rapidly to changes in the underlying inflation trend — unlike the annual inflation measures. While the monthly inflation rate for May is a welcome development, it is but a single report for a series known for its volatility; the FOMC is unlikely to respond to a single positive report. On the other hand, assuming that monthly inflation rates continue to come in near the FOMC’s 2% target, it will take many months for the annual inflation rate to similarly reflect this 2% rate. While our trend measure of PCE inflation has moved towards the 2% target, it isn’t there yet. Between now and the FOMC’s July 30-31 meeting is a single CPI report, and a PCE report on July 30. Unless the real side of the economy softens, we do not anticipate a rate cut at the end of July.

The FOMC meeting September 17-18 will have PCE inflation measures for July and August, as well as a CPI release on September 11. Given that CPI changes are typically subsequently realized in the PCE, there may be sufficient positive inflation developments by the September meeting to warrant a cut to the Fed funds rate. The only fly in the ointment is that the Fed takes pains to avoid the perception that it is in any way meddling in U.S. elections, and so may feel constrained to wait until after the presidential election.

By Paul Gomme and Peter Rupert

The BLS announced that payroll employment rose by 175,000. In addition, the BLS revised down previous estimates by a total of 22,000, down 34,000 in February but up 12,000 in March. Expectations by professional economists were in the 240,000 range. The slowing was evident pretty much across the board as can be seen in the charts below.

Employment gains in retail and health care, however, remained about the same over the last several months.

Temporary help services have been on a steady decline over the past two years, with only January this year showing an increase.

Average weekly hours of work fell from 34.4 to 34.3, leading to a decline in total hours of work.

The household survey showed an increase of 85,000 in the number employed, 63,000 more unemployed and no change in the labor force participation rate. The unemployment rate rose slightly from 3.83% to 3.86%.

Policy Outlook

The stock market shot up due to several events that occurred over the past week: Q1 GDP, PCE price index, Fed announcement after their meeting and today the employment report. We commented on the GDP and PCE price index reports here. Q1 GDP came in somewhat lower than expected and the PCE price index showed continued inflation pressures. Our bottom line was that while it may have slightly increased the probability of upcoming rate cuts, inflation was still stubbornly high. Indeed the FOMC statement contained the following comment, “The Committee does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2 percent.” Evidently, there has been no recent progress to that end.

Today’s jobs report seems to have the market increasing the odds of a rate cut by summer’s end. The WSJ called it “goldilocks job report for the Fed.” Does a downtick in employment lead to an imminent recession?

To “see through” the effects of the pandemic recession, we removed a set observations from March to September 2020, since those effects were massive. In the figure, months during which the NBER determined the economy was in an expansion, and for which the monthly employment change was less than 175,000 are marked with red dots. There’s a lot of red dots. Looking at periods when the economy did well for a prolonged period of time, 1960s, 1990s, 2010s, the current job numbers look similar. Staring at this figure, it’s difficult to put a lot of credence in the notion that low job gains precede recessions. Or, to borrow a phrase, low job gains have predicted 9 of the last 3 recessions.

By Paul Gomme and Peter Rupert

The Bureau of Economic Analysis announced that, on an annualized basis, the personal consumption expenditures (PCE) price index increased 3.94% and core PCE (excluding food and energy) — the Fed’s preferred measure — rose 3.86%, up from 3.24% in the previous month. As we have commented many times, the monthly numbers are quite volatile and therefore we calculate a “trend” measure that we feel better captures the underlying trend, shown in red below. Both the trend measures indicate an uptick in inflation. These higher PCE inflation numbers were foreshadowed by the CPI release from about two weeks ago.

Earlier in the week the Bureau of Economic Analysis released its advance estimate for first quarter GDP. Output growth has decelerated from 4.9% in the third quarter of 2003 to 3.4% in the fourth quarter of 2023 and 1.6% in the most recent quarter. Personal consumption expenditures increased 2.5% in the first quarter after increasing 3.3% in the previous quarter. Indeed, consumer spending on services was a driving force in the most recent report. Investment increased 3.2% with the residential component increasing 13.9%, the largest increase since the fourth quarter of 2020.

The table below breaks down output growth by the contributions of its major components. The contribution of, say, investment (0.6 percentage points) is given by its growth rate (3.2%) weighted by its share of GDP (18%). Between 2023Q3 and 2024Q1, output growth has fallen by 3.3 percentage points. Of this decline, 0.4 percentage points (2.1 – 1.7) is due to consumption. Investment contributed 1.2 percentage points; government 0.8 points; and exports and imports have both contributed 0.5 points. This tells us that the fall in output growth has occurred due to all components of output, with particularly large contributions by investment and government spending.

Outlook

Over the last few months the likely prospect of several interest rate cuts became dimmer due to a rise in the underlying inflation trend. Has the deceleration in GDP growth over the last couple of quarters increased the likelihood of a rate cut? Given the rising trend in inflation it does not seem likely that a rate cut will happen any time soon.

Our measure of trend core PCE inflation now stands at 3.5% — considerably higher than the FOMC’s 2% target, and moving in the wrong direction. Some may point to the slower output growth numbers as a signal of lower future inflation. But, arguably the right thing to do at this stage is to raise interest rates. However, the FOMC has painted itself into a corner with earlier promises of lower interest rates. While it’s tempting to point to the real side weakness to justify a rate cut, in the longer term, addressing inflation is the better course of action as we learned in the 1970s when the U.S. was hit by stagflation — a stagnating real side along with high inflation.

Uh oh! While the year-over-year inflation rate as measured by the PCE deflator was essentially unchanged in February (it rose slightly, from 2.43% in January to 2.45%), the annualized month-over-month inflation rate, at 4.1%, is still running well above the Fed’s 2% target. Our measure of trend inflation rose half a point, from 2.6% to 3.1%. It bears repeating that our measure of trend inflation is designed to filter out much of the high frequency movements in the month-over-month inflation rate while responding in a timely fashion to changes in the trend.

The outlook is not much better when the “volatile” food and energy components of the PCE deflator are removed: The month-over-month inflation rate dropped from 5.6% to 3.2% (good), but is still well above the Fed’s 2% target (bad). The year-over-year inflation rate fell slightly, from 2.9% to 2.8%. And our measure of trend inflation was essentially unchanged, coming in at 3.16%.

The Policy Outlook

In a sense, the latest core PCE inflation numbers are not a surprise: they were foreshadowed by core CPI inflation which came out a couple of weeks ago. For the first two months of 2024, trend core inflation is up and is considerably higher than the Fed’s 2% target. If the monthly inflation rate continues to come in on the high side, expect to see the year-over-year inflation rate start to rise — just as it did in 2020-21. Along side the solid GDP growth and labor market, recent inflation makes it easier for those building a case for raising (or not lowering) interest rates.