Economic Update | The Fed is Just About Done

submitted by

Uric Dufrene, Ph.D., Interim Executive Vice Chancellor for Academic Affairs, Sanders Chair in Business, Indiana University Southeast

After more than a year of interest rate increases, the Federal Reserve finally issued a pause. While such a decision was not absolute, the market was mostly expecting one and had already incorporated in stock prices.  The interesting takeaway was that the Fed indicated that two more rate hikes were likely for the rest of the year. While two more rate hikes are possible, market participants doubt that such rate increases will occur. Current pricing is predicting one additional increase for the remainder of the year, followed by cuts in 2024, with the first reduction coming in January 2024.

The Fed did not have any choice but to talk tough. Even though this last meeting came with a pause, the Fed had to open the door for additional rate increases the rest of the year. Due to credibility challenges, linked to a delayed response in initially hiking rates, the Fed was not able to say that it would pause indefinitely or reduce rates this year. Two rate increases, however, are suspect. The labor market does remain tight, but signs continue to point in the direction of softening. The last report for unemployment claims came in at 264,000, the highest since October 2021. This level of unemployment claims does not signal that we are in a recession now, but claims are trending higher.  As we approach the 300,000 level, the economy will continue to soften and over 300,000 weekly claims will point closer to a recession. 

The inflation story is going to be the major factor in setting the stage for no additional hikes and an extended pause, or another hike or two for the rest of this year. The latest report on inflation showed that the headline number for inflation, the Bureau of Labor Statistics Consume Price Index (CPI), continued to show deceleration.  The headline number, which includes the cost of food and energy, increased by .1% in May. The annual rate was 4%, compared to a rate that was approaching 9% just a year ago. A monthly increase of .1% is equivalent to a 1.2% inflation rate, significantly under the preferred Fed inflation target of 2%. The core rate, which excludes food and energy, is a bit stickier, coming in at 5.3% on an annual basis; last May it was 6%. This is the primary reason why the Fed has indicated that it intends to increase rates further beyond the pause of last month.  When you remove the cost of shelter and used cars and trucks, the rate declines to 4.2%. Given that shelter makes up a significant chunk of overall CPI, we will continue to see deceleration in the annual rate of inflation as the cost of shelter continues to moderate, primarily due to rentals. So, while there is still additional progress that needs to be made, the scales will tip more toward inflation deceleration, and not acceleration. That’s why the Fed’s intent on increasing rates further will erode as we go through the year. We may see one more increase, but two is going to be very doubtful. 

The unemployment rate for Indiana inched upward in May, moving to 3.1%, compared to April’s 3.0%. Last May, the state’s unemployment rate was 2.9%. The labor force saw small gains, and the number of unemployed edged upward, thus explaining the uptick in the unemployment rate. The number of payrolls increased by almost 11,000, with most of this growth coming in the government sector. Manufacturing payrolls declined by about 2,000 as the nation’s manufacturing sector experiences softening. The latest ISM (Institute for Supply Management) measure came in less than 47, which denotes contraction in national manufacturing. Industrial production, which is a measure of the economy’s industrial strength, saw additional deceleration, and the year-over-year change is approaching negative territory.  A negative change in industrial production, while not always (the period ranging from 2016 to 2017 being the exception), usually coincides with a recession. 

We’ll likely escape a recession for 2023, but softness will continue to emerge in various corners of the economy.  Inflation will continue to ease, and in the end, two additional rate hikes from the Fed are in doubt.

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