Tighter Lending Conditions Will Likely Weigh on Economic Performance

The Federal Reserve’s aggressive monetary policy tightening is slowly helping to moderate inflation, but it has a long way to go to tame price increases in the sticky services components which will likely require restoring balance in the labor market. Bank failures in mid-March have led to investors expecting a much more dovish Fed in 2023, however, as they predict that the central bank will increasingly consider financial stability alongside its 2% inflation target. Wage pressures remain strong driven by a shortage of workers and consumption is chugging along while GDP growth is weakening. Monetary policy operates with long and variable lags and is likely to weigh further on consumer spending and economic activity later this year as 475 basis points of interest rate hikes with the possibility of more on the way are digested. These factors point to growing risks of the economy lapsing into stagflation, an environment of slower economic growth alongside higher-than-trend inflation.

The rate of overall inflation remains high but has moderated against the backdrop of slowing consumption and tighter financial conditions. The Federal Reserve’s (the Fed) preferred gauge of inflation, the core PCE, is at 4.6% as of February, almost two and a half times the Fed’s 2% target. The Fed may continue raising the federal funds rate from its 4.88% level in order to dampen inflationary pressures, consistent with its Summary of Economic Projections. The Fed’s projections imply a terminal rate of 5.13% and no rate cuts for the rest of the year but market participants don’t think the economy and markets can handle that. Odds favor interest rate cuts during the 3^rd quarter of this year while the move at the May meeting carries a 64% probability of a 25-basis point hike and 36% odds of a pause. Market expectations have shifted meaningfully since the middle of March, as bank failures have led to the marketplace forecasting faster rate cuts against the backdrop of a Fed that they think will increasingly consider financial stability alongside its inflation mandate.

In addition to rate hikes, the Fed has increased the pace of its balance sheet reduction program to a monthly cap of $95 billion from $47.5 billion in the prior months, further constraining the money supply and financial conditions alike. During the two weeks ending March 22^nd, however, bank troubles led the Fed to inject $392 billion into the economy, a result of the emergency Bank Term Funding Program. While the emergency program is in place for at least one year, it’s unclear how much more the banks will use the program as Fed efforts to help the banking sector offset the progress made on its inflation mandate. The Fed has expressed a strong commitment of keeping rates higher for longer until it sees convincing evidence of inflation returning to the 2% target, even as economic conditions continue to deteriorate. Tighter lending conditions at banks in the aftermath of the March scares are also likely to weigh on economic and employment growth. The week ending March 22^nd featured the sharpest contraction in lending and deposits since the 2008 financial crisis. Lending conditions and deposits have continued contracting since, constraining households and businesses of capital while pressuring bank operations.

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Leading economic indicators point to 1^st quarter GDP growth of 0.4%.

Below, we examine what leading economic indicators portent to our picture of the evolving economic landscape. This is our view at the moment and our projections may be confirmed or we may have to adjust them as different, new information, including freshly released economic indicators, are made available.

Initial Unemployment Claims

Even with the Fed aggressively hiking interest rates and consumer spending slowing, the labor market remains strong. Initial unemployment claims have been volatile in the last few months against the backdrop of labor shortages, real wage growth and tighter financial conditions. A broad view of the labor market misses an apparent contradiction—the tech sector has laid off more than 332,000 workers in 2022 and 2023 while banks and some companies in other sectors have also implemented layoffs and hiring freezes. Some companies, however, are hoarding labor due to difficulties with hiring during the pandemic and the current labor shortage resulting, in large part, from historically low labor force participation. The low participation rate results in large part from Americans retiring early during the depths of COVID-19 pandemic, discouraged workers upset about income and growth prospects, a skills mismatch as companies struggle to match job openings with job applicants and to a lesser extent from working age Americans on the sidelines due to long-haul Covid. Additionally, employers have been hiring to position strongly for the next cycle with proper staffing levels instead of trimming labor in the present and playing catch up later. Corporate margins remain elevated from a historical basis, and companies can afford to sacrifice profitability in the short term to benefit from the next economic cycle via scale expansion, market share gains and earnings growth.

We expect the economic slowdown, tighter credit conditions and higher interest rates to eventually lead to modestly higher unemployment in 2023 as tighter monetary policy gets digested, financial conditions tighten and pandemic-era savings become depleted. Fiscal stimulus has been limited in 2023 and 2022 compared to 2021 and 2020 while persistent inflation has emerged as a new generational headwind, slowing consumer spending. During times of monetary policy tightening and higher interest rates, business revenue tends to slow because financing the production of goods and services becomes more expensive, leading to possible layoffs as businesses attempt to sustain profit margins. An increase in initial unemployment claims would point to the following changes: lower consumption/demand, lower inflation, lower long-term interest rates and lower GDP growth. If initial unemployment claims drop significantly, demand will rise, inflation will rise, long-term interest rates will rise and GDP growth will rise. The next unemployment release will be on April 13^th. It is currently expected to be 205,000, a decrease from the previous week’s reading of 228,000. Should the actual number be much lower or higher, we would have to adjust our outlook by slightly raising or lowering our estimate for economic indicators and ultimately our estimate for GDP.

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Retail Sales

Consumers are slowing their spending as economic conditions weaken. This slowdown is occurring against the backdrop of tighter financial conditions and higher prices. After growing rapidly during most of the past three years due to support from strong monetary and fiscal stimulus, retail sales have slowed and when accounting for inflation, have contracted in many recent months. This trend is especially true with goods, with recent gauges of manufacturing activity showing the sharpest contractions since the heights of the COVID-19 pandemic in April 2020. On the other hand, however, some months have been unexpectedly strong, as ample job opportunities and extended credit card usage offset overall weakness.

Consumer spending is likely to slow further as pandemic-era savings dwindle and the Fed continues to tighten credit conditions and raise rates, dampening demand, especially for big-ticket items. Fiscal stimulus has been limited in 2023 and 2022 compared to 2021 and 2020 while persistent inflation has emerged as a new generational headwind, constraining consumer spending on a relative basis. During times of monetary policy tightening and higher interest rates, consumption tends to slow because goods and services become more expensive to finance. A continued slowing or contraction of retail sales would point to the following changes: lower consumption/demand, lower inflation, lower long-term interest rates and lower GDP growth. If retail sales growth ramps up again due to monetary policy easing, consumption/demand will rise, inflation will rise, short-term interest rates will fall and GDP growth will rise. The next month’s release will be on April 14^th. It is currently expected to decline to $695.09 billion, a 0.4% month-over-month drop, an unchanged rate of decline from the previous month’s $697.88 billion, a 0.4% fall from January. Should the actual number be much lower or higher, we would have to adjust our outlook by slightly raising or lowering our estimate for economic indicators and ultimately our estimate for GDP.

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Consumer Sentiment

Consumer sentiment is bouncing along low levels as financial conditions tighten and inflation persists. Sentiment was high for much of the past three years supported by strong monetary and fiscal stimulus, but it has weakened significantly. Since June 2022 however, consumer sentiment has found a floor in recent months, driven by falling gasoline prices, stabilizing interest rates and ample job opportunities although it remains at historically low levels still. Fiscal stimulus has been limited in 2023 and 2022 compared to 2021 and 2020 while persistent inflation has emerged as a new headwind, weakening consumer sentiment on a relative basis. During times of monetary policy tightening and higher interest rates, sentiment tends to weaken because employment conditions and business revenue growth generally soften while goods and services become more expensive to finance, hampering consumers. This time though, employment conditions are likely not to weaken as much due to the current labor shortage and historically elevated corporate margins. Continued low levels of consumer sentiment would point to the following changes: lower consumption/demand, lower inflation, lower long-term interest rates and lower GDP growth. If consumer sentiment ramps up again due to monetary policy easing, consumption will rise, demand will rise, inflation will rise, short-term interest rates will fall and GDP growth will rise. The next month’s release will be on April 14^th. It is currently expected to be 62.7, remaining near the previous month’s reading of 62, a fall from February’s 67 level. Should the actual number be much lower or higher, we would have to adjust our outlook by slightly raising or lowering our estimate for economic indicators and ultimately our estimate for GDP.

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Building Permits

The real estate industry is weakening dramatically under the weight of near all-time low home affordability driven by high prices and high mortgage interest rates. Building permits are falling against the backdrop of tighter financial conditions and a lack of homebuyers. After growing at a strong level for most of the past three years, supported by strong monetary policy stimulus and an increased demand for housing outside of urban areas due to the pandemic, building permits have slowed and are now in contraction territory. Expectations of further slowing is expected as the Fed continues to tighten credit conditions and raise rates, slowing demand in this capital intensive, economically cyclical, interest-rate-sensitive industry. Significant home price growth has pressured affordability to near its worst level in history, leading to significant contractions in mortgage applications and a significant higher share of rental apartment construction. During times of monetary policy tightening and higher interest rates, building tends to slow because real estate becomes much more expensive to finance. A continued contraction in building permits would point to the following changes: lower consumption/demand, lower inflation, lower long-term interest rates and lower GDP growth. If building permit growth ramps up again due to monetary policy easing, demand will rise, inflation will rise, short-term interest rates will fall and GDP growth will rise. The next month’s release will be on April 18^th. It is currently expected to come in at 1.519 million seasonally adjusted annualized units, a 2% decline from the previous month’s 1.550 million, a 15.8% gain from January. Should the actual number be much lower or higher, we would have to adjust our outlook by slightly raising or lowering our estimate for economic indicators and ultimately our estimate for GDP.

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PMI-Manufacturing

Tighter financial conditions and slowing consumption are contributing to a sharp decline in manufacturing activity. After expanding at a strong level for much of the past three years, supported by strong monetary and fiscal policy stimulus and increased demand for manufactured goods rather than services due to the pandemic, manufacturing activity has contracted. New orders, the largest component of the PMI, has been in contraction territory for a few months, signaling depressed demand for big ticket items, historically a leading indicator of not just the manufacturing sector, but of the entire economy. Expectations of continued slowing is expected as the Fed continues to tighten credit conditions and raise rates, slowing demand in this capital intensive, economically cyclical, interest-rate-sensitive industry. During times of monetary policy tightening and higher interest rates, manufacturing tends to slow because manufactured, durable goods like furniture, automobiles, airplanes and factory equipment become much more expensive to finance while loan qualification standards increase. A continued contraction in manufacturing activity would point to the following changes: lower consumption/demand, lower inflation, lower long-term interest rates and lower GDP growth. If manufacturing activity ramps up again due to monetary policy easing, demand will rise, inflation will rise, short-term interest rates will fall and GDP growth will rise. The next month’s release will be on April 21^st. It is currently expected to be 48, a decline from the previous month’s reading of 49.2, remaining in contraction territory. Should the actual number be much lower or higher, we would have to adjust our outlook by slightly raising or lowering our estimate for economic indicators and ultimately our estimate for GDP.

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Money Supply

The rates of inflation and economic growth are weakening against the backdrop of a contracting money supply. The money supply, inflation and economic growth shift a great deal due to the Fed’s monetary policy. After increasing drastically since the emergence of COVID-19 to help businesses and households cope with pandemic disruptions, the money supply has contracted from its April 2022 peak, but increased in March due to the Fed’s efforts to support the banking system. The Fed has pivoted from an accommodative monetary policy stance towards a restrictive one because it recognizes that money supply growth during years 2020 and 2021 contributed to today’s high inflation. The more persistent inflation ends up being, the longer the Fed will have to maintain a restrictive position and therefore, limit money supply growth while also taking financial stability into account. At this point in time, the aggregate money supply is contracting again because the Fed has a long road of tightening ahead in order to achieve the 2% inflation target while liquidity support to banks has slowed significantly. The Fed has embarked on an aggressive rate hiking campaign and has increased the pace of balance sheet reduction to a monthly cap of $95 billion from $47.5 billion in the months prior. While events in March led to a balance sheet increase however, balances have contracted significantly for two consecutive weeks. A contraction in the money supply would point to the following changes: lower consumption/demand, lower inflation, lower long-term interest rates and lower GDP growth. If money supply growth ramps up again due to monetary policy easing, consumption will rise, demand will rise, inflation will rise, short-term interest rates will fall and GDP growth will rise. The next month’s release will be on April 25^th. It is currently expected to increase to $21.36 trillion, a 1.4% month-over-month rise from the last month’s $21.06 trillion, which was a 0.6% decline from January. Should the actual number be much lower or higher, we would have to adjust our outlook by slightly raising or lowering our estimate for economic indicators and ultimately our estimate for GDP.

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Yield Curve

The yield curve is severely inverted against the backdrop of tighter financial conditions and weak economic prospects. As the 2-year yield rose much faster than the 10-year since January 2022, a bear-flattening move from a much steeper level from the previous two years, the yield curve remains in deep inversion territory (-60 bps), signaling economic contraction ahead. The money supply increase led to a rise in inflation which compelled the Fed to raise short-term rates significantly. The longer end of the curve, the 10-year maturity, didn’t rise as fast because longer term economic growth and/or inflation isn’t expected to rise as strongly as short-term rates did. The yield curve inversion is telling us that there’s little chance the U.S. economy can handle the monetary policy tightening that’s in the pipeline without a recession. In this case a bull-flattener, where the 2-year would fall slower than the 10-year would be desirable but that would require inflation expectations to significantly come down further, which is unlikely to occur. Although inflation expectation figures are off their peaks, we believe inflation will prove stickier and more resilient than the market thinks. Against the backdrop of persistent core inflation and a tight labor market, the expectation in the coming months is to see a bear-steepener where the 10-year widens its spread against the 2-year due to an increase in inflation expectations. The main drivers of structurally higher inflation in the medium to long-term are the shift from globalization towards regionalization, geopolitical tensions, relative inefficiencies regarding supply chains and the commodity complex, continued deficit spending and labor shortages. If the yield curve remains severely inverted, it points to lower consumption, lower demand, lower inflation, lower long-term interest rates and lower GDP growth. If the yield curve steepens again due to monetary policy easing, demand will rise, inflation will rise, short-term interest rates will fall and GDP growth will rise. The yield curve inversion (2s, 10s) has predicted the last 6 out of 6 recessions.

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Economic Indicators & The Economy

Below is a picture showing how leading, coincident and lagging economic indicators reflect household, business, and government activity. Leading indicators provide early signals of future economic health while coincident and lagging indicators confirm the economic trend in later periods.

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