In this week’s “Three on Thursday,” we turn our attention to the Federal Reserve’s (“the Fed”) upcoming meeting and the anticipated outcome. With signs of a softening labor market, yesterday’s consensus-expected 0.2% CPI report, and today’s more moderate report on producer prices, it is all but certain the Fed will cut interest rates next week. The key question remains: by how much—25 or 50 basis points? 

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Implications:   Producer prices grew at a modest pace in August and year-ago comparisons continue to temper after rising in early 2024.  However, energy prices have played an outsized role in the slower inflation readings of late, and stripping out this volatile component shows the Federal Reserve still has some work to do.  Nevertheless, it is a near certainty that the Fed will begin the rate cut process next week, with the first of what we anticipate will be many 25 basis point rate cuts ahead.  Headline producer prices rose 0.2% in August, are up 1.7% in the past year.  The 0.2% inflation reading for August was held back by a 0.9% decline in energy prices, which are now down 8.4% in the past year.  Food prices – the other historically volatile category – rose a modest 0.1% in August.  Strip out these two components shows “core” prices rose 0.3% in August and are up 2.4% in the past year, nearly unchanged from the 2.5% reading for the twelve months ending August 2023.  Diving into the details of today’s report shows service prices lead the index higher, rising 0.4% in August and up 2.6% in the past year.  The August increase in services was led by final demand services less trade, transportation and warehousing (+0.3%), while margins for trade services rose 0.6%.  Prices for goods were unchanged in August and are completely flat from a year ago.  Within goods, rising costs for non-electric cigarettes were offset by the abovementioned decline in energy costs.  Further back in the supply chain, prices in August declined 0.1% for intermediate demand processed goods and fell 3.7% for unprocessed goods.  The direction of inflation moving forward is very likely to be dictated by 1) the services side of the economy, which suffered heavily during the COVID shutdowns but has since returned to the forefront and 2) changes in the money supply, which, after surging in 2020-21, peaked in early 2022. Although the M2 measure of money has been rising gradually since October, it’s still down 3.1% from the peak in April 2022. Too little growth in the money supply means continued downward pressure on both inflation and economic growth.  We will be watching the path of M2 growth closely as the Fed starts cutting rates. A sharp resurgence in M2 growth would bring with it the risk of accelerating inflation. Does the Fed have the patience to ease at a slow and steady pace, or will they overreact at signs of economic trouble? Only time will tell, but the stakes are high and the Fed’s record is less than pristine.

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Implications:   Headline inflation matched expectations in August, likely sealing the deal for the start of rate cuts at the Fed’s meetings next week.  After considerable progress against inflation from mid-2022 to mid-2023, many believed the end of “temporary” pandemic inflation problems was in sight.  But then inflation pressures reignited in the first quarter of 2024, casting doubt on the Fed’s ability to cut rates.  Now it appears that inflation has resumed its downward trend; consumer prices are up 2.5% in the last year – the lowest level since the inflation scare began in early 2021 – and have been slowing lately, up at 1.1% and 2.0% annualized rates in the last three and six months, respectively.  We have said for some time that easing in inflation will come should the Fed have the resolve to let the lagged effects of tighter monetary policy do its work.  After surging in 2020-21, the M2 measure of the money supply peaked in early 2022. Although it’s been rising gradually since October, it’s still down 3.1% from the peak in April 2022.  The lagged impact of this tighter monetary policy appears to finally be making its way into lower inflation.  However, even as the headline inflation picture is improving, it doesn’t look as rosy when digging below the surface.  First, some of this improvement has come from declining energy prices, which fell 0.8% in August and are down 4.0% in the last year.  Excluding energy, consumer prices are still up 3.0% in the last year.  Stripping out energy and its often-volatile counterpart – food prices (+0.1% for the month) – “core” prices came in hotter than expected, rising 0.3% while the year-ago comparison remained unchanged at 3.2%.   Meanwhile, a subset category of prices the Fed has told investors to watch closely and is a useful gauge of inflation in the service sector – known as the “Supercore” – which excludes food, energy, other goods, and housing rents, rose 0.3% in August.  These prices are up 4.5% in the last year, worse than the 4.0% reading in the year ending in August 2023.  While the market consensus is for rate cuts to begin next week, the big issue is by how much.  These data suggest a more gradual path toward lowering rates.  For now, our base case is that the Fed will cut rates by a quarter percentage point at each of the three remaining meetings this year and continue that pattern well into 2025.  Although inflation risks are dissipating, we are not at the finish line yet.  No matter which way you cut it, inflation is still running above the Fed’s 2.0% target (now for the 42nd consecutive month) and could re-accelerate should the Fed overreact and ease policy too much.

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Friday’s employment report suggests the US economy may be slowing down faster than most investors think.

Nonfarm payrolls increased 142,000 in August, but revisions to June and July brought the net gain down to a modest 56,000.  And the details were worse.  We like to follow payrolls excluding three sectors: government, education & health services, and leisure & hospitality, all of which are heavily influenced by government spending and regulation (that includes COVID lockdowns and reopenings for leisure & hospitality).  That “core” measure of payrolls rose only 25,000 in August and is up only 31,000 total in the past three months.

In particular, government plus education & health care jobs have made up 37% of all the net payroll increases since the pre-COVID peak in February 2020, an unusually large share.

For August itself, things looked better if you focus on civilian employment, an alternative measure of jobs that includes small-business start-ups, which rose 168,000 for the month.  However, it’s hard to make a strong case for the US economy if you stick with that civilian employment measure.  The August gain was the largest in five months but civilian employment is down compared to a year ago, with a loss of 66,000 jobs.  Even worse, full-time employment is down one million from a year ago while part-time employment is up 1.1 million over the same timeframe.   

Another recent report from the Labor Department revised down the payroll increase in the year ending in March 2024 by 818,000.  That makes sense given that payrolls had been previously estimated to have grown 2.9 million during this period while civilian employment was estimated to have grown 642,000.  But even after reducing payroll growth by 818,000 that still leaves a large gap.  One way to close that remaining gap is an upward revision to population numbers due to high immigration, which would lift civilian employment, as well.  But another way would be an even larger downward revision to payrolls.     

This week the Labor Department will report on inflation and we – and the consensus – expect a moderate 0.2% increase in consumer prices for the month of August.   In turn, that would mean that CPI prices were up around 2.5% from a year ago, which should translate into PCE inflation (the Federal Reserve’s preferred measure) of 2.3%.  That’s a big drop from the 3.3% gain in PCE prices in the year ending in August 2023 and suggests that by the early part of next year inflation may temporarily hit or go under the Fed’s 2.0% target.

Why is this happening?  Why is the economy slowing and inflation decelerating?  Because monetary policy has been tight.  After surging in 2020-21, the M2 measure of the money supply peaked in early 2022.  Although it’s been rising gradually since October, it’s still down 3.1% from the peak in April 2022.

The Fed obviously realizes this, hence all the talk about cutting short-term interest rates.  For now, our base case is that the Fed will cut rates by a quarter percentage point at each of the three remaining meetings this year (starting next week) and continue that pattern well into 2025.

The problem is that the Fed still thinks its focus should be on rates, not the money supply.  If growth in M2 picks back up quickly, we risk a return to higher inflation, like we did multiple times in the 1970s.  If growth in M2 remains lackluster in spite of rate cuts, the landing could get harder than anyone thinks.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Implications:  The Fed is almost certainly going to start cutting rates on September 18, the only issue is by how much.  Today’s report on the labor market suggests the first cut will be by 25 basis points, instead of half a percentage point.  Dark clouds are appearing on the horizon, but job growth continued in August, the unemployment rate ticked down slightly, and wage growth accelerated.  The news on jobs was mixed.  Nonfarm payrolls increased 142,000 in August, but revisions to June/July brought the net gain down to a modest 56,000.  We like to follow payrolls excluding government (because it's not the private sector), education & health services (because it rises for structural and demographic reasons, usually doesn’t decline even in recession years, and is often responding to government policies), and leisure & hospitality (which is still recovering from COVID Lockdowns).  That “core” measure of payrolls rose only 25,000 in August and is up only 31,000 total in the past three months.  However, civilian employment, an alternative measure of jobs that includes small-business start-ups, rose 168,000 in August, the largest gain in five months.  As a result, the unemployment rate ticked down to 4.2% for the month.  The problem with civilian employment is that it’s down 66,000 from a year ago, with the employment of full-time workers down 1.0 million.  By contrast, even with the preliminary benchmark revision announced recently, payrolls are up about 1.9 million in the past year.  The most positive news in today’s report is that average hourly earnings climbed 0.4% and are up 3.8% from a year ago, which means more purchasing power for workers and pay increases that have outstripped inflation in the past twelve months.  Another bright spot in August is a 0.3% gain in total hours worked, which are up 1.1% from a year ago.  Given that monetary policy is now tight, the economy and inflation are both decelerating, and it takes time for shifts in monetary policy to influence growth and inflation we expect the Fed to start cutting rates in September and continue to do so at the meetings beyond.  

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In this week’s edition of “Three on Thursday,” we look at the Federal Reserve’s financials through the second quarter of 2024. Back in 2008, the Federal Reserve (the “Fed”) embarked on a novel experiment in monetary policy by transitioning from a “scarce reserve” system to one characterized by “abundant reserves.” In addition to inflation, this experiment has resulted in some other developments that are worrisome.

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Implications:  Activity in the US service sector continued to tread water in what has been a shaky past few months for the ISM Services index.  The overall index ticked up a tenth of a point to 51.5 in August while industry growth was split, with ten out of eighteen major service industries reporting growth and seven reporting contraction.  Looking at the details, the major measures of activity were a mixed bag.  The new orders index rose to a three-month high at 53.0, while the business activity index declined to 53.3.  These are roughly in-line with their monthly averages in 2024, but lower than the average levels from 2022 and 2023.  Service companies have taken note of slowing activity as they’ve begun to pull back on hiring.  Case in point, the employment index has been in contraction territory for six out of the last nine months.  Employment comments note of hiring freezes and some companies are no longer backfilling positions when people leave or retire.  Despite signs of slowing activity, inflation remains the dominant theme in comments from survey respondents.  The prices paid index rose to 57.3 in August – the highest reading of any category in the report – with thirteen out of eighteen major industries paying higher prices for the month.  Developments in this category are important as the service sector has been a main driver for stubbornly high inflation over the last two years.  Our expectation is that inflation and growth in the sector decelerate as the lagged impacts from a drop in the M2 measure of the money supply from early 2022 through late 2023 take effect. In employment news this morning, initial jobless claims declined 5,000 last week to 227,000.  Meanwhile, continuing claims declined 22,000 to 1.838 million.  Also on the labor front, ADP’s measure of private payrolls increased 99,000 in August versus a consensus expected 145,000.  We’re estimating tomorrow’s government report will show a nonfarm payroll gain of 177,000 with the unemployment rate ticking down to 4.2%.

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Implications: The trade deficit in goods and services ballooned to a two-year high of $78.8 billion in July as imports grew much faster than exports.  However, we prefer to focus on the total volume of trade, imports plus exports, as it shows the extent of business and consumer interaction across the US border. This measure increased sizably in July, rising by $8.4 billion. Total trade volume is up 6.9% from a year ago, with exports up 5.0% and imports up 8.4%.  Although the pickup in imports is good news, part of this is being pulled forward as companies make sure they have adequate supplies before a potential dockworkers’ strike by East and Gulf Coast workers. There also continues to be a major shift going on in the pattern of US trade.  Year- to-date through July, imports from China were up only 0.1% versus the same period in 2023 and down 24.8% versus the same period in 2022.  China used to be the top exporter to the US.  Now the top spot is held by Mexico; China has fallen to number three with Canada now in second place.  Meanwhile, global supply chain pressures have eased substantially over the past few years.  This was confirmed by the New York Fed’s Global Supply Chain Pressure Index in July, with the index -0.09 standard deviations below the index’s historical average. For some perspective, two years ago in the month of July the index sat 1.80 standard deviations above the index’s historical average.  Also in today’s report, the dollar value of US petroleum exports exceeded imports once again.  This marks the 26th consecutive month of the US being a net exporter of petroleum products.

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Implications:  The ISM Manufacturing index missed consensus expectations once again in August and the details of the report are worrisome.  Activity in the manufacturing sector has now contracted for twenty-one out of the last twenty-two months.  Overall, twelve of the eighteen major manufacturing industries reported contraction in August while five reported growth and one reported no change.  Despite an increase in the overall index, the two most important parts of the report – demand and output – both worsened in August.   Looking at the details, the new orders index dropped to 44.6, the lowest level since May 2023, marking the twenty-second month in the last two years where the index has been below 50.  Manufacturing companies have been able to scrape by despite weak demand by focusing on their order backlogs, which were artificially boosted with pent-up activity from the COVID years.  That index, which remained deep in contraction territory at 43.6, has been below 50 for twenty-three consecutive months.  However, it looks like this reprieve for weaker demand may be coming to an end as the production index fell to the lowest level since the COVID lockdown months at 44.8.  Survey comments from manufacturing companies have noted dwindling backlogs, which are prompting them to take cost actions.  This can be clearly seen in the employment index, which remains near the lowest level since the COVID lockdown months at 46.0.  Of the eighteen major manufacturing industries, just three reported an increase in employment, while ten reported a decline.  The weakness in the ISM Manufacturing index underpins a growing list of economic data pointing to a slowdown in growth.  We expect to see continued manufacturing weakness in the second half of 2024 as the bill for reckless and artificial spending by our government from the COVID years comes due and the lagged impacts from the drop in the M2 measure of the money supply from early 2022 through late 2023 take effect. In other news this morning, construction spending declined 0.3% in July, led by large drops in homebuilding and health care projects.

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