Economic Monitor – Weekly Commentary
by Eugenio Alemán

The resilience of the U.S. economy: It’s all about employment, and the consumer

May 26, 2023

As markets and investors are waiting to hear the good news of a potential resolution to the debt ceiling issue, the U.S. economy has continued to plow ahead. The economy has paid little attention to the stress in financial markets created by the recent failure of several regional banks, which seems to have tightened credit markets even further, and to the delayed negotiations regarding the debt ceiling, which continue to cloud the expectations for future economic growth.

So, let’s recap what happened during the COVID-19 pandemic, during which time the economy kept churning due to the large transfers of income from the Federal Government to individuals and firms. That is, during and in the aftermath of the COVID-19 pandemic, much of the growth in economic activity was due to the savings accumulated during the pandemic. Yes, employment was also coming back strongly after the first months of the COVID-19 pandemic, providing an income flow lifeline during that period to those employed as well as those getting hired again, but the excess or accumulated savings helped Americans battle the rise in prices (inflation) that ensued as the economy recovered. An economy with less than full employment but with robust financial conditions by businesses and individuals due to the fiscal policies put forward by the Trump and Biden administrations kept the ball rolling during 2021 as well as 2022 despite the strong increase in prices.

However, as excess savings continue to be depleted, inflation is slowing and employment has remained relatively strong, Americans are depending less on the savings accumulated during the pandemic and are starting to fund their purchases with the growth in real disposable personal incomes. That is, it is now the flow of ‘old-fashioned’ real disposable personal income that is driving economic activity rather than any help from the U.S. Federal Government, which should be good news for markets and for the sustainability of economic growth. However, we are still forecasting a mild recession starting in the third quarter of this year as we expect the increase in the federal funds rate to continue to put downward pressure on economic activity going forward

Inflation takes a bite out of real incomes in April

Although we had a good start to the second quarter of the year in terms of both income and expenditures, inflation in April continued to take some of this strength away, as real disposable personal income remained flat during the first month of the second quarter. However, Americans dipped into savings once again in April to support an increase in real personal consumption expenditures. But this cannot go on forever so inflation has to continue to go down if we expect the economy to continue to grow. Although PCE inflation was stronger than expected in April we should see lower inflation readings in May, which will help bring down inflation again on a year-earlier basis.

This is the reason why the state of the labor market, and employment, as well as the path of future inflation, will remain so important for the U.S. economy and for the prospects for future growth. Weakness in employment and higher inflation will do away with the current income lifeline, and then the economy will probably go into recession. Thus, anything related to the state of the U.S. labor market and inflation will continue to drive economic headlines.

Furthermore, and as we have said in the past, if the labor market weakens considerably, we are concerned with those that have complemented their incomes/excess savings with higher credit card borrowing over the last year or so. Credit card borrowing, which is the sector of the borrowing market that commands the highest interest rate of all the credit sectors, could be the catalyst that helps bring consumption down if Americans start losing their jobs. Furthermore, for financial firms engaged in credit card lending, a weakening of the labor market will also have consequences, as credit card lending is uncollateralized, and firms will have trouble collecting on those debts.

Thus, Fed officials will pay very close attention to the incoming inflation number for May to see if they change their expectations about what to do with the federal funds rate. Today, markets have priced a further 25 basis point increase in the rate, to 5.50%. However, we still believe that the Fed will refrain from increasing the federal funds rate in June because we expect better inflation readings in May. Having said this, at this moment, it is hard to know what Fed officials are going to do. For now, we are sticking with our pause call for June.

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Economic and market conditions are subject to change.

Opinions are those of Investment Strategy and not necessarily those Raymond James and are subject to change without notice the information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. There is no assurance any of the trends mentioned will continue or forecasts will occur last performance may not be indicative of future results.

Consumer Price Index is a measure of inflation compiled by the U.S. Bureau of Labor Studies. Currencies investing are generally considered speculative because of the significant potential for investment loss. Their markets are likely to be volatile and there may be sharp price fluctuations even during periods when prices overall are rising.

The National Federation of Independent Business (NFIB) Small Business Optimism Index is a composite of ten seasonally adjusted components. It provides a indication of the health of small businesses in the U.S., which account of roughly 50% of the nation's private workforce.

The producer price index is a price index that measures the average changes in prices received by domestic producers for their output. Its importance is being undermined by the steady decline in manufactured goods as a share of spending.

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