Macro view of August 2024

Eugeniu Chirau

Sep 24, 2024

In August, investors focused on macroeconomic statistics that could serve as a basis for the Fed to lower interest rates in September. The most significant for the Fed are statistics on inflation and the labor market. Both were encouraging. Inflation over the past 12 months has decreased to 2.5%. In the core basket, price growth was 3.2%; this is still somewhat above the Fed's target by the end of the year, but still within the scenario allowing for a rate cut. The unemployment rate fell to 4.2 from 4.3% a month earlier. Many people who re-entered the labor market were able to find jobs. The economy as a whole added 142,000 jobs in August and 1.48 million since the beginning of the year.

The rise in unemployment we observed earlier was not caused by mass layoffs, i.e., it does not indicate obvious problems in the economy. On the contrary, the increase in labor supply is a positive factor for it. The balance of supply and demand for labor is now significantly closer to an equilibrium (neutral for GDP growth and inflation) state than before. The number of job openings now slightly exceeds the number of unemployed people — there are 1.1 vacancies per unemployed person. This has not happened since the start of the pandemic — in 2020, hiring sharply decreased, and in the following years, on the contrary, there was a significant labor shortage, and the ratio rose to 2.

This means that wages are unlikely to grow too quickly (faster than labor productivity growth and inflation), thus they will not cause an acceleration of inflation. Over the past 12 months, the average hourly earnings in the US increased by 3.8%. This is higher than inflation, but considering the significant growth in labor productivity in the US (in the last quarter it increased by 2.5% annually), wage growth looks quite modest. In other words, inflation in the US is decreasing, and the labor market has reached a more balanced state, where wage growth should not lead to a new surge in inflation. This is especially important given that core inflation, largely dependent on the service sector and labor costs, remains above the Fed's target, and moderate wage growth plays a key role in stabilizing inflation at the target level.

US GDP grew by 3% in the second quarter, and according to the Atlanta Fed GDPNow estimate, the growth rate in the third quarter remained at the same level. Consumption is still the main driver of growth, and despite a reduction in savings levels, there is no clear drop in either retail sales or overall consumption levels. Apparently, lending is still compensating for depleted savings, which raises some concerns about the stability of such growth. At the same time, the average level of credit load and delinquencies among the population is comparable to pre-pandemic years and does not indicate any obvious short-term problems. Essentially, as long as the economy is growing, demand for labor remains high, and financial conditions are extremely favorable (primarily high credit availability and low credit spreads), consumers should not experience obvious problems. This does not guarantee a 'soft landing' for the economy, but in the absence of any significant supply-side shocks (disruptions in the supply of energy, food, or goods), as well as in the absence of credit shocks (for example, the collapse of any financial system participant), a reassessment of risk demand accompanied by an increase in credit spreads, and a reduction in credit availability, there are no obvious reasons to expect a 'hard landing' for the economy. Potential problems with refinancing low-quality debt in the coming years could become one of the triggers for an increase in credit spreads and a decrease in risk demand, but how the refinancing process will proceed will become clearer in 2025 and 2026 when large volumes of bonds mature.

In Europe, inflation is lower than in the US, which allowed the ECB and the Bank of England to take the first steps towards lowering interest rates. In the eurozone, inflation at the end of August reached 2.2%, in the UK — also 2.2%, and taking into account the equivalent of own housing rent — already 3.1%. GDP at the end of the second quarter grew in both regions — growth rates were 0.8 and 2.4% annually, respectively. The labor market situation, unlike in the US, remains more tense. In both the eurozone and the UK, the unemployment rate decreased, amounting to 6.4 and 4.1%, respectively. At the same time, wages continue to grow at rates significantly exceeding inflation, at 4 and 5.1%, respectively. Unlike in the US, labor productivity in Europe is not growing, i.e., the labor market situation is more inflationary than in the US. This is clearly visible in the growth of service prices, which is 4.2% in the eurozone and 5.7% in the UK. Without cooling the labor market and reducing the rate of wage growth, it will be more difficult for European regulators to reduce core inflation to target levels.

The key factor in slowing inflation in the US and Europe has been the cheapening of energy, raw materials, and food. This makes progress in reducing inflation extremely sensitive to global economic growth and the availability of energy and raw materials, putting price stability at risk in the event of a recurrence of supply shocks (for example, as in 2022). Europe remains more vulnerable to such shocks compared to the US, and less progress in stabilizing labor markets and wage growth rates only increases these risks.

The above somewhat confirms current expectations for interest rate cuts in the US and Europe. If earlier investors believed that the ECB and the Bank of England would lower rates faster than the Fed, by early September the situation changed. Analysts predict that European regulators will lower rates by only 50 basis points by the end of the year, and the Fed by 125 basis points. It is expected that by mid-2025, the Fed rate will fall below the Bank of England's rate, and the gap with the ECB will narrow to 100 basis points. Optimism about the Fed's rate cut led to the yield on two-year US Treasury bonds falling 1.1–1.3 percentage points below the yield on three-month bonds. Even before the crises of 2000, 2008, and 2020, investors were more cautious in their forecasts about the speed of rate cuts.

This week, the Fed and the Bank of England made decisions on interest rates. The American regulator lowered the rate by 50 basis points to 5%, exceeding economists' forecasts, who expected a 25 basis point cut. However, this decision matched investors' expectations, which was reflected in futures prices. The Bank of England, as predicted, left the rate at 5%. These decisions practically did not change medium-term investor expectations, and debt markets reacted calmly. Medium-term US Treasury bonds even fell slightly in price, which probably reflected a reassessment of investor expectations hoping for more radical monetary policy easing.

It is important to note that both investors and members of the Fed's Open Market Committee agree: there are no clear signs of significant economic cooling or rising unemployment caused by mass layoffs. Investors' optimism about interest rate dynamics is difficult to explain based on objective macroeconomic analysis. There is almost no doubt that the situation in the US looks more stable and less inflationary compared to Europe, but a sharp rate cut and improved financial conditions increase the risks of reversing the progress achieved in fighting inflation. Without significant signs of economic deterioration, the Fed is likely to act more cautiously than investors expect. This is already partially reflected in the regulator's forecast, which indicates a slower rate cut compared to expectations embedded in futures prices.

Of course, this does not rule out the possibility of other scenarios. For a more radical change in monetary policy, there must be strong reasons, such as a recession or a serious supply shock. There are no clear signals that such events will occur in the near future, making cautious monetary policy easing the most reasonable scenario for the Fed. However, overly cautious behavior also carries risks. First, it can lead to an increase in defaults on high-yield bonds due to large maturities in the coming years. Second, given that the economy responds to interest rate changes with a significant time lag, the Fed needs to make decisions in advance, based not only on current macroeconomic data. A delayed rate cut may not be able to quickly prevent a recession, which requires earlier policy easing.

In August 2023, Jerome Powell said: 'We are navigating by the stars under a cloudy sky.' The Fed's latest decision confirms this metaphor. What economy lies behind the 'clouds' will become clearer in the coming months. In the context of medium-term positioning, the specific decision in September is less important than the sequence of all future regulator actions. As long as investors trust the Fed's goals of achieving target inflation and full employment, there is no strong reason to believe that monetary policy will significantly diverge from the actual economic situation. Accordingly, there is no reason for a significant revision of medium-term expectations for inflation and the level of real rates necessary to achieve it.