The Federal Reserve increased the Fed Funds rate by a quarter point last week. Markets had fully anticipated the increase, and the Fed delivered. Markets surged a day after the increase, showing approval of the Fed’s commitment to fighting inflation.
Eye on the Economy surely thought the Fed would hold in September, for several reasons. The core rate of inflation is not out of control, with a gradual downward trend. The labor market had a good report last month, but prior to that, payroll growth had been soft. And despite above target headline inflation, long run inflation expectations are largely anchored. Implied inflation five years out is just above 2%. We also expected a resolution to the Iran War by this time, with oil declining along with it. We were certainly not anticipating diesel at $6.50 a gallon, the price last week.
The increase in the Fed Funds rate is secondary to what is happening with longer rates. The 10-year Treasury yield surpassed the 5% threshold and now may remain around or above 5% until we see further progress on energy prices and inflation. The last time the 10-year yield was this high was 2007, just before the start of the Great Recession. A 5% Treasury yield is certainly not what the Treasury Secretary had in mind, promising stronger growth, but a federal deficit moving toward 3% of GDP. Growth in the supply side of the economy was going to reduce inflation, therefore putting downward pressure on the 10-year yield, while stronger GDP growth would help bring the deficit down as a percent of GDP. Tariffs, the Iran War and deficits and debt have interfered with those projections.
The implications of a 5% Treasury yield are far reaching, but perhaps the biggest is the impact on interest rates for consumers and businesses. Mortgage rates have gone up and are now over 7%. This will not bring any help to the ailing housing sector. Higher mortgage rates will impact the supply of new homes, putting further pressure on home prices, but also curtail demand for home sales. Significant price erosions are not likely. And higher rates will also impact mortgage payments, adding to the affordability problem. A 5% return might also be tempting to investors, adding volatility to the stock market, as investors move from stocks to bonds.
The 5% yield is not just an inflation and oil price story. Growth is also contributing to higher rates. The 10-year rate surged last week as economic indicators pointed to strong growth in both the services and manufacturing sides of the economy. The GDPNow tracker of the Atlanta Fed has GDP growing at 5%. And last week, retail sales came in much more strongly than expected.
Across Louisville Metro, similar to the U.S. picture, there is a disconnect between growth in the economy and payrolls. To be sure, Eye on the Economy was expecting faster growth in payrolls by this time of the year, but so far, it has been largely muted. Growth in manufacturing, which is happening, was expected to boost regional payrolls. However, that has yet to occur. Louisville payrolls peaked in mid-2024 at approximately 719,000 but have been moving sideways since. Most recent data have Louisville area jobs at about 710,000. These estimates are subject to measurement errors too.
But “help” was on the way for manufacturing by way of tariffs. Louisville area manufacturing payrolls peaked back in late 2022. Tariffs were supposed to resurrect manufacturing, and more importantly, add “lots of jobs”. While there is now growth in manufacturing nationally, jobs are not necessarily following. Since Liberation Day in early 2025, regional manufacturing payrolls have been largely negative, with the region losing manufacturing jobs since. One of the reasons is the uncertainty around tariffs, and spats with our neighbor to the North do not help.
But another reason is the separation of manufacturing jobs and investment in capital goods. Normally, when manufacturers invest in capital goods, like big equipment used for production, employment follows. This makes sense. As manufacturers buy more equipment for expansion, they need more workers to operate the equipment.
Since the latter part of 2023, this relationship has been moving in separate directions. Manufacturers are investing in capital goods, but the jobs are not following. In fact, the jobs are moving in the opposite direction. One conclusion is that businesses are investing in equipment to increase productivity, but don’t need the people due to advances in technology and automation. That is, we can produce more, but with fewer people.
Productivity is positive for the economy and the companies achieving those productivity gains, and this is where education and skills become increasingly important. Quite simply, as companies strive for productivity gains, employees need the skills and knowledge to compete in a more automated and fast-arriving artificial intelligence environment.
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