Economic slowdown on top of lower inflation begs for major adjustments

Many months ago it became abundantly clear that the Fed had extinguished the inflation fires that were stoked in 2020-21, and therefore lower interest rates were called for. More recently, we see that the economy has lost a lot of its forward momentum, and that also argues for lower rates. 10-yr Treasury yields have fallen meaningfully in recent months, but short-term interest rates are still very high.

The December jobs report was not as healthy as many claimed: private sector jobs were up at a mere 1.2% annualized pace in the past six months. Meanwhile, commodity prices are falling, as the dollar remains relatively strong. Used car prices are sharply deflating, both in real and nominal terms. 

The December NAPM service sector report showed significant slowing and even some emerging weakness, while the NAPM manufacturing index has been flirting with recessionary levels for months. Housing is still under enormous pressure from high prices and high mortgage rates. Housing hasn't been this unaffordable for decades.

Fortunately, reserves remain abundant at $3.3T, and credit and swap spreads remain very low. Bank credit (loans and leases) is up 2.5% in 2023. C&I Loans fell by 1.1% in 2023, but overall there is no sign of a credit squeeze. The economy is slowing, but as yet there is no sign of an imminent recession.

If the Fed waits too long to respond to these developments, deflationary pressures will build and the economy will be needlessly saddled with extra problems to deal with.

Some charts to illustrate these points and others:

Chart #1

Chart #1 shows the level of private and public sector jobs. In the past year or so, the growth of private sector jobs (the ones that really count) has been decelerating, while the growth of public sector jobs has been accelerating. Adding more public sector jobs does not stimulate the economy. A bigger government and outsized federal spending generates headwinds for economic growth.

Chart #2

As Chart #2 shows, the growth rate of private sector jobs has been decelerating markedly over the past two years. In the past six months, private sector jobs have grown at a mere 1.2% annualized pace. (I like to look at the trend over a 6 month period because month-to-month variations can be random and very misleading at times.) In the 10 years prior to the Covid crisis, private sector jobs grew by about 2% per year. The current pace of private sector jobs growth is barely enough to deliver 2% real GDP growth.

Chart #3

Chart #4 compares the health of the service sector in both the US and Eurozone economies. Both have deteriorated in recent years. The December service sector PMI report released last week was surprisingly weak, while the Eurozone service sector has been in recessionary territory for months.

Chart #4

Chart #4 shows that the hiring plans of US service sector businesses was shockingly weak in December. If this were a typical economy, I would be tempted to say we are already in a recession based on this number. But "things are different" this time, mainly because monetary policy—while tight—has not created a liquidity shortage as it has prior to all past recessions. (See Chart #10 for more details.) In any event, it's only one month's number, and it could turn out to be a fluke, as the next chart suggests.

Chart #5

Chart #5 is another measure of the health of the service sector (Business Activity) and it suggests that conditions are pretty normal. 

Chart #6

Chart #6 suggests that the economy is on a healthy footing, because announced corporate layoffs are historically low and they have declined meaningfully from where they were a year ago (when everyone began calling for a recession). This suggests that the economy has already made some important adjustments and it is thus unlikely to be blindsided by weak growth.

Chart #7

Chart #7 shows the number of initial weekly claims for unemployment, which remain relatively low. Recessions are typically preceded by rising layoffs, whereas now we have seen a decline in layoff activity in the past six months. Recessions happen when businesses suddenly find they have to cut costs; today the problem for many small businesses is that they can't find enough people to fill the jobs they have. 

Chart #8

Chart #8 compares the value of the dollar (inverted) vs. the level of inflation-adjusted, non-energy commodity prices. Commodity prices have a strong tendency to move inversely to the strength of the dollar. As the blue line shows, the dollar is off its highs, but it is still relatively strong. Commodity prices are being dragged down by the strong dollar, as is usually the case. The dollar is usually strong when monetary policy is tight, so it's reasonable to assume from this that tight monetary policy is creating deflationary pressures in the commodities market. (Deflation = falling prices.) If this continues we will likely see some very low or negative CPI prints in coming months. And by the way, the national average of regular gasoline prices is down by a whopping 40% since mid-2022. 

Chart #9

Chart #9 shows the real and nominal value of the Manheim Used Vehicle Value Index. Used car prices have been deflating for the past two years! And this trend looks set to continue, since prices are still substantially higher than their historical trends. Note how inflation-adjusted prices were relatively stable from 2003 through 2019.

Chart #10

Chart #11

As Chart #10 shows, housing affordability hasn't been so low in decades. The combination of high prices (both in real and nominal terms) plus very high mortgage rates (6-7%) is a killer. Chart #11 shows that applications for new mortgages have plunged over 70% from the highs of the mid-2000s, and are back down to levels not seen since 1995. Very few people can afford to buy the typical house at today's prices and interest rates. Something has got to give here: prices and/or interest rates need to fall significantly.

Chart #12

As Chart #12 shows, bank reserves remain abundant from an historical perspective. Interest rates are high relative to inflation (the classic definition of "tight" money), but liquidity is still abundant. I've been arguing this point for years: abundant liquidity is an excellent defense against recessions. Without abundant liquidity a weak economy can trigger panic. It's like what happens as people try to exit crowded theater when someone yells "fire!" It's a mad dash for the limited exits, and panic ensues and people get hurt. With abundant liquidity, it's like being in an open-air theater with no walls and no doors, so it's easy to exit. Nobody needs to panic. Without panic selling, economic life can go on because markets remain liquid.

2024 is shaping up to be the Year of Adjustments. The Fed needs to stop worrying about inflation. Interest rates need to fall, and housing prices need to fall. On the fiscal front, federal spending needs to fall—we can't go on having multiple trillion-dollar annual deficits that result almost entirely from excessive spending, as Chart #13 shows:

Chart #13