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Burden of Proof

Updated: Mar 4

It does not please the Court

The Economy's Deceleration Isn't Yet Enough to Warrant Rate Cuts


Inflation Under the Microscope

Christopher Waller, a recent appointee to the Federal Reserve Board of Governors, has publicly questioned the case for interest rate cuts. In Latin, the saying goes semper necessitas probandi incumbit ei qui agit, or that the necessity of proving the merit of a charge should always fall on she or he would bring it. In other words, it is those arguing for lower interest rates that must offer proof of fact that interest rates are unnecessarily high.


We wrote last time that the United States economy has been slowing since the fourth quarter of 2023, and that we have no reason to expect that its deceleration is marked enough as yet to warrant a cut in interest rates. Though last week's Consumer Price Index showed a reacceleration in the rate of inflation, we opined that the numbers were likely the result of mismeasurement and didn't reflect underlying price dynamics. Counseling patience, we advised waiting until we received the results of the Bureau of Economic Analysis' Personal Consumption Expenditures data for confirmation of the rate and direction of inflation. This is a critical data set because it tells us two things about the economy: first, it tells us what was spent by consumers, which as we've written before accounts for 70 cents of every dollar spent in America; second, it tells us what income was earned, which is a pretty decent leading indicator of future spending. The data were elucidating but not revelatory.

.23% increase in consumption

We saw a small increase in consumption in January of .23% which works out to be an annualized rate of about 2.8%. While still above the Fed's stated 2% goal, it's below 3%, which is consistent with falling inflation (disinflation, or a slowing rate of inflation). We shouldn't place too much faith in tenths of a percent, however, as these are merely samples and are safely protected from prying minds by a near-impenetrable shield of error. So, we tend to pay more attention to trends than levels, and the trend has been consistently downward.


When we adjust for the change in prices, we see that the change in consumption was actually slightly contractionary, registering .11% in the month of January on a seasonally-adjusted basis. This means that adjusted for inflation and the typical pullback in spending in January, Americans spent a bit less. This is no reason for alarm. As you can see in the chart below, this happens from time to time, and the decline in spending is well within recent ranges that have seen economic expansion.

Real PCE shrank .11%, or 1.3% annualized

When we look at the Federal Reserve's preferred measure of inflation, we see that inflation came in higher on a month-over-month basis, at .35% or 4.3% annualized. That's still a pretty normal rate of change on a monthly basis, as you can see in the chart below.

Inflation as measured by the PCE was .35%, or 4.3% annualized

When we look at the year-over-year change, prices have risen 2.4%, much closer to the Fed's target, and probably a cause of some relief within the halls of the US's Central Bank.

Taken together, contracting real spending and lower year-over-year price inflation indicate that the Fed's restrictive interest rate policy is having its intended effect.

PCE Price Index up 2.4% year-over-year

These measures are for prices in general, but these also contain volatile food and energy prices that contribute to volatility in the measure. For this reason, we seek out measures of core inflation that exclude volatile prices to try to isolate price signal. First, let's examine inflation with Food and Energy prices stripped out. Using this measure, we see that inflation rose to 2.85% year-over-year.

PCE excluding Food and Energy was 2.85% year-over-year

While an inflation rate of 2.85% for core inflation is comforting to policymakers, when we further remove the effects of housing--which experienced substantial, significant lasting impact from the war on COVID-19--we can see that inflation is registering at a quiescent 2.2% on a year-over-year basis.

Further removing the impact of housing price inflation, core inflation is nearly 2% year-over-year

Unfortunately for those in the lower half of the income distribution, this means that those items which constitute the largest share of their monthly budget will continue to see price increases for the goods and services they buy the most of. That will certainly impact discretionary spending, which will likely spell trouble for retail consumption.

A final method of isolating price signal is to eliminate outliers by level rather than category. Doing so confirms what we have seen elsewhere: inflation remains elevated (3.16% year-over-year), but not rampant. Core inflation continues its descent, is already within the Fed's target range, but isn't so low as yet that the Federal Reserve is willing to lower interest rates to prevent unnecessary contraction in economic activity. Faint traces of a decline in demand are too indistinct to give the Fed pause, though they are now admittedly on the lookout for them.

Eliminating outliers, inflation registered a 3.1% year-over-year increase

The Picture for Labor and Income

Turning now to income, we can see that Real Disposable Income is back to pre-COVID levels after registering a sharp drop in January. We should await another few months of data to confirm this trend, but a decline in Real Disposable Income presages a pullback in consumption in the months ahead as workers find their paycheck's real purchasing power diminished. A change of this size, however, is cause for concern.

Falling from 4.3% to 2.1%

Although last Friday was the first Friday of the month, we won't receive Payrolls data until this coming Friday. Payrolls is our most important economic indicator in the United States, as consumption patterns are informed by employment levels. Initial Claims for Unemployment Insurance showed a slight pullback this past week, coming in at 215,000.

That was a slight increase and well within normal ranges. When the economy is up this close against--or indeed, beyond--the natural rate of unemployment, an adverse change is likely magnified in its import. Of course, at the margin, there are likely those who shift with some regularity between employed- and unemployed-status, and these will contribute to wiggles in the data that require a trend in order to be compelling evidence of change.


Still, the change in Initial Claims was also reflected in the Continuing Claims data, indicating that the long-term unemployed might be finding it tougher to rejoin the workforce.

The four-week moving average ticked up .15%

If the labor market is as tight as we think it is, we would expect this number to be stable or declining. We'll get better reads on the state of the labor market this week. An interim measure, though, is the Savings Rate. This tends to rise when workers are concerned about their economic future, as when workers are concerned about their employment prospects, they begin to save for a rainy day. Incidentally, we saw a small uptick in the Saving Rate, rising from 3.7% to 3.8%.


We also see pullback in Consumer Credit, as worries about future ability to service debt payments dissuade consumers from financing their purchases. The change in Consumer Credit from November to December, was particularly marked, falling precipitously from 5.65% to .37%. It may be that the increase in the use of buy-now-pay-later schemes--about which we've recently received numerous anecdotes--account for this rapid change, but the plural of anecdote isn't data, and we wouldn't be surprised if this weren't an early signal of consumer trepidation.

Rapid change from 5.65% annual rate of expansion to .37%

Housing and Manufacturing

Meanwhile, over in the Real Economy, New Single Family Homes Sold fell. While not unusual for the Winter, these values are seasonally-adjusted. The pace of home sales is worth keeping an eye on, as each home sale represents an expansion in credit as well as income for the largest group of self-employed persons in America, the construction contractor.

The pace of sales fell from 7.2% to 1.5%

If we look at Construction, spending fell into contractionary territory, from 1.1% to -.16%.

Total Construction Spending fell into negative territory

This is likely due in part to tightening in financial conditions, as the price of a 30 Year Mortgage increased. It's still off its highs, and relatively inexpensive compared to history, but higher mortgage rates mean lower house prices and fewer home sales.

Off recent highs, but still less than 7%

Manufacturing activity in the US fell. Shipments were down again, contracting from -.6% to -.9%.


Inventories were down slightly, falling from .28% to .22%. A recent buildup in inventories intimated lower demand, but it is too early to judge whether manufacturers will be able to move the funds they have tied up in inventories along in their cash generation cycle.


Since New Orders were dow--and down quite a bit--from a quarter of a percent to -6.1%, it is unlikely that a ramp up in production is in the cards in the near term.


Unfilled orders were also down, from 1.3% to essentially flat, completing the picture of a manufacturing slowdown.

Sharp deceleration from 1.3% to .17%

The US has a service-oriented economy, so changes in Manufacturing won't have an immediate impact. However, these changes do inform us of what's going on in the real economy, which is a pretty strong predictor of real growth. Falling inflation along with signs of falling growth increase the likelihood of Fed rate cuts this year. Our models suggest a rate of real growth of 3.25%, down substantially from mid-January readings of nearly 4%. Much is due to the outsized impact the Payroll numbers have had on our models because of their recent impressive strength. Corporate Earnings have been positive but not spectacular, meaning that employers will have little incentive to shed workers. But if conditions deteriorate beneath the pressure of too-high real interest rates (nominal interest rates less inflation,) this can change quickly and violently. But that is unusual and typically the result of an exogenous shock.


We therefore expect robust hiring to recur this coming Friday. In the meantime, the picture of slower, but still positive economic growth should be further clarified by the ISM Services readings we receive tomorrow morning. We expect strength in services to outweigh weakness in manufacturing, and for interest rates to continue to bite harder. A mid-year interest rate cut still seems like a safe bet, but now that this is the consensus opinion, our saying so makes us a little nervous since we so rarely believe that the market is correctly discounting all available information. It seems to be doing so now, so we won't be contrarian just for the sake of being contrarian. However, the recent repricing of equities higher seems to us to stretch the S&P 500's already bendy valuation a bit too far, though not to the point where we consider a snapback imminent. Onward to Friday.

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