Economic Update | Is Optimism About to Fade?

submitted by
Uric Dufrene, Ph.D., Sanders Chair in Business, Indiana University Southeast

–Will consumer spending finally take a hit? 

The last economic update pointed to the surge in small business optimism as measured by the NFIB Small Business Optimism Index. The last report showed one of the largest increases in optimism on record. We also provided a rationale for resilient consumer spending, driving a significant portion of the nation’s economic growth over the past year. In our view,  consumer spending has been driven primarily by stronger household balance sheets and a labor market that continues to run strong. Changes to overall optimism, along with cracks in the labor market, could begin to adversely impact consumer spending, raising challenges for the overall macroeconomy. 

Preliminary reports suggest that consumer mood may be starting to recede. Preliminary estimates of the University of Michigan Consumer Sentiment Survey were released last week, and there was a sudden drop in consumer sentiment with the Index coming in much weaker than expected. Digging through some of the details in the survey also shows potential consumer red flags. When asked about future business conditions one year out, the index also declined, adding to the prior month’s drop. While not the largest consecutive decline in the past 30 years, the two-month drop would rank in the top 10%. When asked about prices one year out, there was also a significant increase, with inflationary expectations increasing by a full percentage point. In the past ten years, there are only two instances where the expected inflation in a year was higher than a 1 percent increase.    

Since September, investors started pricing in higher rates on the 10-Year yield. A combination of growth and inflation would push government yields higher because of Trump pro-growth policies. This trend persisted until January 10th, with the yield peaking at 4.8%.  Since then, the 10-Year Treasury declined to 4.5%, dropping by 30 basis points in less than a month. With the 10-Year now showing some retreat, are markets now pricing in lower inflation, since the 10-Year reflects a combination of growth and inflation? Going back to September again, inflationary expectations 5 years out were at 1.98%, or close to the Fed’s desired goal of 2%. With the most recent pricing of 5-Year Treasuries and TIPS (Treasury Inflation Protected Securities), inflation expectations five years out have risen to 2.6%. The recent Michigan survey showed a significant pickup in inflation expectations one year out, and bond markets show a pick-up in inflation as well. Hence, lower 10-Year yields, in the presence of increasing inflationary expectations, could imply slower growth ahead, upending some of the “Trump trades” markets were betting.     

One month is not a trend, but we did see softer payroll growth with the most recent jobs report.  The BLS reported that the economy added 143,000 jobs, short of the 170,000 that was expected. Payroll growth from the establishment survey was softer, but the household survey showed a big jump in the labor force and employment, resulting in a tick down in the unemployment rate.  The labor force participation rate edged upward, a favorable development for crucial labor force growth.  The Job Openings and Labor Turnover Survey (JOLTS) provided additional signs of a cooling labor market.  The number of openings declined by about 600,000, getting the closest to the number of unemployed since 2021.     

After being in contraction since 2022, manufacturing finally emerged in expansionary territory with the latest release of the ISM Report on Business. The latest ISM Index came in at 50.90, pointing to expansion, and the first month above 50 since the last quarter of 2022. New orders were very strong, moving above 50 in November, and showing increases in December and January. Manufacturing growth will be crucial, especially if we see a slowdown in consumer activity.  Any rebound in manufacturing will support payroll growth for both Indiana and Kentucky economies. 

Back in 2022, consumer sentiment hit one of the lowest records in the history of the survey, largely due to 40-year high inflation. While consumers were in a foul mood, they continued to spend. Will any reversals in consumer sentiment finally begin to hit consumer spending, the largest segment of the economy? It bears watching.