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Weekly Update 9/9/2022: Fed’s Beige Book Shows Signs of Moderating Economic Growth & Inflation

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Domestic Economic News

The US service sector expanded in August at the fastest pace in four months amid a pickup in business activity and new orders, while price pressures continued to ease. The Institute for Supply Management’s services index edged up to 56.9 from 56.7, data showed Tuesday. The median forecast in a Bloomberg survey of economists called for the gauge to soften to 55.3. Readings above 50 signal growth. Measures of business activity and new orders both advanced to their strongest readings of the year, reflecting both an ongoing shift in spending habits and steady wage gains. Demand strengthened abroad as well, with export orders expanding at the fastest pace in nearly a year. The upbeat report points to resilient and robust consumer demand for services despite high inflation, rising interest rates and general uncertainty about the economic outlook. Prices paid by service providers settled back to 71.5 last month, the softest print since January 2021. While still historically elevated, the figure adds to other signs of easing inflationary pressures. The group’s employment index rose 1.1 points to 50.2 after contracting in the prior month, suggesting modest service-sector hiring in the month. The government’s August jobs report last week showed the smallest gain in leisure and hospitality employment since a decline at the end of 2020. The ISM report also pointed to an easing of supply constraints. A gauge of supplier delivery times lengthened, but to a lesser degree than in the prior month. Meantime, order backlogs grew at the softest pace in three months.

The US trade deficit shrank for a fourth straight month in July, reflecting a decline in the value of imports and a slight pickup in exports that are seen helping provide a lift to third-quarter economic growth. The gap narrowed by 12.6% from a month earlier to $70.65 billion, the smallest since October, Commerce Department data showed Wednesday. The median estimate in a Bloomberg survey of economists called for the deficit to narrow to $70.2 billion. The figures aren’t adjusted for inflation. The value of goods and services exports increased 0.2% to a record $259.3 billion while imports declined 2.9% to a five- month low of nearly $330 billion. Inbound shipments of consumer goods plummeted 9.8%, the most in data back to 1992. US retailers are likely dialing back orders with overseas suppliers as they focus on getting inventories more in line with sales. Rapidly rising prices are weighing on domestic demand, limiting Americans’ wherewithal to spend. The leftover income is increasingly being spent on services and experiences in the wake of a pandemic-fueled boom in outlays on merchandise. On an inflation-adjusted basis, the July merchandise trade deficit shrank to $103.4 billion, the smallest since October.

Applications for US unemployment insurance fell for a fourth straight week to the lowest since May, suggesting demand for workers remains healthy despite an uncertain economic outlook. Initial unemployment claims decreased by 6,000 to 222,000 in the week ended Sept. 3, lower than all estimates, Labor Department data showed Thursday. The median estimate in a Bloomberg survey of economists called for 235,000 new applications. The four-week moving average, which smooths out volatile week-to-week moves, fell to 233,000 -- the lowest since early July. Continuing claims for state benefits rose 36,000 to 1.47 million in the week ended Aug. 27. When the figures were released stock futures dipped – once again evidence that points to a better than expected economy caused equity futures to drop as traders interpret that as a catalyst for the Fed to dig their heels in on interest rates.

Interest Rate Insight and the Fed

The Federal Reserve said US economic growth prospects were weak and set to slump further over the next year, while price growth showed signs of decelerating. “The outlook for future economic growth remained generally weak, with contacts noting expectations for further softening of demand over the next six to twelve months,” the Fed said Wednesday in its Beige Book report, typically published two weeks before each meeting of the policy-setting Federal Open Market Committee. Naturally the negative report sent the major equity averages higher – such is the world we are living in right now! Price levels “remained highly elevated,” but nine districts reported some degree of moderation in their rate of increase, the report showed. The Fed has been raising interest rates aggressively to try and cool demand to bring down inflation that has remained above 8% for five straight months. A separate release Friday showed US hiring remains robust, and a report next week will detail inflation for the month of August. Chair Jerome Powell has pledged to raise interest rates and keep them there “for some time” to curb price increases. In a highly anticipated speech at the central bank’s annual Jackson Hole conference last month, he said the central bank’s tight policy would likely bring “some pain” to households and businesses. The Fed raised its target range for interest rates to 2.25% to 2.5% in July, including two back-to-back 75-basis-point increases at its last two meetings. Policy makers have signaled they will again increase the benchmark by a large amount at their September confab, though whether it’ll be 50 or 75 basis points remains a coin toss in market pricing.

Federal Reserve Chair Jerome Powell said the US central bank will not flinch in its efforts to curb inflation “until the job is done.” “We need to act now, forthrightly, strongly as we have been doing,” Powell said Thursday in remarks at the Cato Institute’s monetary policy conference in Washington. “My colleagues and I are strongly committed to this project and will keep at it.” He spoke with a moderator in a virtual question-and-answer session. U.S. central bankers are raising interest rates rapidly to curb the hottest inflation in four decades. They next meet on Sept. 20-21 and Powell has kept the option open for another 75 basis-point move, following increases of that size in June and July, or a half-point increase. He’s said the decision depends on the “totality” of the incoming data. Officials will get an important update on Tuesday with the release of consumer prices for August. Economists surveyed by Bloomberg forecast an 8.1% rise for the 12-month period versus 8.5% in July. “The Fed has and accepts responsibility for price stability,” he said, noting that history cautions against prematurely loosening policy. That reiterates a warning he issued Aug. 26 at the Fed’s annual retreat in Jackson Hole, Wyoming.

Economists trimmed their US inflation forecasts through the end of next year, likely an encouraging sign for the Federal Reserve as it tries to keep price expectations anchored. Projections for the year-over-year personal consumption expenditures price index, the Fed’s preferred inflation gauge, were lowered 0.1-0.2 percentage point for each quarter. By the first quarter of 2024, it’s expected to average 2.4%, inching closer to the central bank’s 2% target. Excluding food and energy prices, the core measure is also seen gradually easing through late 2023, when it’s expected to average 2.7%, according to a Bloomberg survey of economists conducted from Sept. 2 to 7. Managing inflation expectations is important to the Fed as they can often become a self-fulfilling prophecy. Chair Jerome Powell said Thursday that the “clock is ticking” on ensuring that expectations remain anchored, since the longer prices stay elevated, the greater the risk that people will expect them to stay that way. Economists see the fed funds rate in a 3.5% to 3.75% range by the end of this year, up from the previous survey’s 3.25% to 3.5%. By the end of the first quarter, they project the benchmark rate to top out in a range of 3.75% to 4%.

The Fed is on an all-out mission to tame the worst inflation in a generation, trying to reel in demand across the economy by raising the cost of borrowing. That’s already taking a toll on the housing market and broader economic growth, and the economists see both weakening further. Sales of previously owned homes and new construction activity were both marked lower through early 2023. Gross domestic product is now forecast to increase an annualized 1.2% in the fourth quarter of this year and average just 0.9% growth in 2023, each a markdown of 0.2 percentage point from the previous month. The survey also showed that economists now see a 50% chance of recession over the next 12 months, a slight increase from August. The labor market is seen broadly holding up, with the national unemployment rate expected to peak at 4.3% in the second half of next year, compared to a current reading of 3.7%.

Impactful International News

The European Central Bank intensified its battle against record inflation by hiking interest rates by a historic three-quarters of a percentage point and pledging “several” further increases, even as the outlook for economic growth darkens. The unprecedented monetary-tightening step underlines growing alarm as price pressures in the 19-nation euro zone broaden beyond energy and the euro tumbles. The decision matched analyst expectations and brought the deposit rate to 0.75%. The euro slid against the dollar, while money-market investors boosted bets on further monetary tightening after the announcement. Accused of reacting too slowly to the upswing in inflation that began as Covid lockdowns ended and worsened when Russia invaded Ukraine, the aggressive move aligns the ECB more closely with the Federal Reserve, which is weighing a third straight hike of the same size this month. “This major step front-loads the transition from the prevailing highly accommodative level of policy rates towards levels that will ensure the timely return of inflation to the ECB’s 2% medium-term target,” officials in Frankfurt said a statement. “Over the next several meetings the Governing Council expects to raise interest rates further.” Addressing reporters after the announcement, President Christine Lagarde said policy makers reached their decision unanimously, and that the unprecedented tightening step wasn’t “the norm.”

“Determined action had to be taken,” she said. “For those who consistently repeat that the European Central Bank is lagging behind, I contend that we are on a journey that started back in December when we decided to put an end to asset purchases under PEPP. And now to continue on our normalization path with the front-loading exercise.” The ECB raised its outlook for inflation this year and next, while slashing its forecast for economic expansion in 2023. The 0.9% projection for growth next year is still more optimistic than the 0.7% median of predictions collected by Bloomberg. Bloomberg Economics sees an advance of only 0.4%. With the deposit rate above zero, the ECB also ended a system of so-called tiering that officials instituted in late 2019 to soften the effect on banks of negative monetary policy. Thursday’s decision highlights how ECB hawks still have the initiative on the 25-member Governing Council, emboldened by another overshoot in inflation last month to 9.1% -- more than four times the goal. Higher borrowing costs are unlikely to blunt the soaring energy prices behind that spike, with potentially worse to come after Russia halted natural gas supplies through a key pipeline. But the fear is that inflation expectations could spiral without aggressive hikes that will become ever-trickier to enact as Europe’s economy stumbles.

This week already saw political pushback as Spanish Prime Minister Pedro Sanchez warned that monetary tightening “must be made compatible with an economic-recovery path.” As the cost-of-living crisis saps demand, analysts foresee a euro-area recession starting this year, with some saying a downturn is under way now. The prospects for Germany, the continent’s largest economy, are bleak due to its outsized reliance on the Kremlin for energy. While it has filled gas-storage facilities more rapidly than targeted, they’re not sufficient to exclude rationing during the winter. But even with Deutsche Bank AG Chief Executive Officer Christian Sewing warning that a recession is coming, Bundesbank President Joachim Nagel wants the battle with inflation to be prioritized over economic growth. Higher rates may offer some support to the euro, whose slide below parity with the dollar has made imports, particularly of commodities, more expensive. In July, ECB officials “widely noted” that euro depreciation constituted an “important change” and “implied greater inflationary pressures,” according to an account of that meeting. Lagarde reiterated that the ECB doesn’t target a specific exchange rate but said it’s “very attentive” to the situation around the currency. Economists polled by Bloomberg reckon the ECB will raise the deposit rate until it reaches 1.5% -- broadly where analysts see the “neutral” interest rate that neither stimulates nor constrains the economy. Stay tuned!

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