The Economy is Not a Morality Play
As we wrote last month, the US economy seems to have arrived and is now passing an inflection point, or the point on a plane curve at which curvature changes sign. US GDP growth peaked at 5.2% (revised upward from 4.9%), inflation that had plateaued at 3.4% for three months resumed its downward fall, and long-term bond yields have declined by 80 basis points (tenths of a percent.)
Unemployment has been ticking up slightly toward its natural rate, average hourly earnings are increasing at a monthly pace consistent with the Federal Reserve's inflation target, and Nonfarm Payrolls are similarly taking a break from their earlier meteoric ascent.
Hire rates are down, Quit rates are flat, Continuing unemployment claims are up, all suggesting the labor market is reverting toward balance between supply and demand for workers.
Banks continue to contract the amount of credit they offer, personal savings have declined and begun to rebound a bit, and consumer credit has expanded. These are all signs that the torrid pace of consumption that drives 70% of the American economy has decelerated from a gallop to a canter.
The leading economic indicators we follow suggest GDP growth of 2%, clearly a lower gear than that which sped the economy along in Q3, but not one that is anemically below potential output.
Beware the Krampus
And yet, calls for recession are as yet either early or in error. Economic contraction and economic recession are related but different concepts. Economies undergo frequent expansions and contractions as they progress through the broader wave motion we call the business cycle. This is because what we see as a single wave is only the surface level observation of multiple waves interacting with each other. Recessions result from a decline in employment accompanied by a retrenchment in consumer demand. These then become mutually reinforcing to produce a prolonged economic contraction that often requires an exogenous shock, such as a change in interest rates or a replacement of demand, to break.
Looking at the pace of retail sales, inventories to sales, industrial production, and the level of unemployment, you don't see levels consistent with recession, but rather moderation. The economy is coming off of what has been an extraordinary run, and that it is coming off its sprint does not mean that it has stopped or begun backtracking.
That said, longer term indicators show that a more marked deceleration could be in the offing. Sales of large ticket items like houses, cars, furniture and appliances are declining--all of which one would expect given the change in interest rates we've witnessed over the past year.
That's why the Federal Reserve uses interest rate policy to effect changes in the broader macroeconomy. Unfortunately, the interest rate level and rate of change mostly impact these longer-wave--and therefore, lagging--economic components the most. It takes a while for them to be impacted by changes in interest rates, on the upswing as well as the downswing. Now that the Fed has effected the immediate change in production and consumption that it wanted to see, it must now be vigilant to the risk of having done too much. But given that inflation is still viewed as Public Enemy Number One, it prefers to err on the side of caution by doing too much and thereby injuring growth, rather than doing too little and thereby aiding inflation.
In sum, the direction of economic growth in the United States has changed sign. This is not to say that it faces imminent weakness. The opposite seems to be true at the moment. There are early indications that trouble could emerge in the next several quarters, but these indications are not dispositive. After such a long stretch in which the heights of euphoria were tested, it feels to us like there should be repercussions. For there to be no moral consequences for having it so good for so long is not how morality plays are supposed to end.
But the economy is not a morality play; it is an absurdist murder mystery. For as the saying goes, expansions don't die of old age; they are murdered. The too high real interest rates is a future suspect; a liquidity-driven credit crisis in 2025 is another. There are those who are suspiciously looking sideways at the commercial real estate market and their accomplices, small and regional banks. These and others that we do not yet recognize at all lurk just outside the light of our feeble candle's power to illuminate. In the meantime, we hope that all our clients and readers enjoy the holiday season and the opportunity it affords to take a step back, reflect, recreate, and enjoy those things that make life worth living.