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With Inflation All But Vanquished, Continued Tight Monetary Policy is Negatively Impacting the Real Economy

Despite the Fed reiterating its “higher for longer” mantra and softness creeping into the U.S. macroeconomic data, equity markets shook off the April jitters. Nasdaq turned in  a +1.1% gain on the week (ending May 10th), with the S&P 500 (+1.85%) and DJIA (+2.16%) showing even higher gains.

As we have noted in past blogs, the rental component of the CPI uses lagged data (red line on the chart), and also relies on its OER (Owners’ Equivalent Rent) survey (a single question to households in its survey which asks the dollar amount the respondent thinks their home would rent for in the current market). There is no observable data for this month-to-month comparison. But because we know from current market surveys that rents have been disinflating for the last five quarters (and are now deflating in some U.S. cities), and because of its large weight in the CPI, we know that CPI inflation will continue to march lower as the year progresses.

Furthermore, the much more accurate European inflation equivalent to the CPI, known as the HICP (Harmonized Index of Consumer Prices) which only uses observable prices (so that would exclude OER), produces a year over year consumer inflation in the U.S. of 1.9%, already below the Fed’s 2% target.

The Fed’s main inflation indicator is the PCE Deflator, more so than the CPI. The left-hand side of the PCE chart shows that “goods” are already deflating. The right-hand side shows that “services,” at 3.7% in April, are still a bit “hot.” But we expect that services inflation will continue to decline because, as discussed above, its biggest component, shelter costs, have recently pierced below the 0% line (black line in first chart (above)).

A look at the next chart shows that price increases for food, energy, and vehicles have been much slower than rent (shelter) increases even with the former’s upward move in 2020-2022.

As a result, 1) since goods prices are already deflating, and 2) since we know the near-term direction of shelter costs (flat to down), it appears that the direction of the CPI will be toward disinflation for the rest of the year.

Since this is the case, then why the Fed is waiting until those indexes, dependent on lagged data, come down to their 2% goal before starting to move monetary policy to a less restrictive stance is anyone’s guess. Economist David Rosenberg says: “It appears that year over year core PCE inflation will be 2.6% when May data are released. That’s what the Fed was predicting for year-end 2024 in March when the dot-plot showed three rate cuts in 2024!” And Rosenberg is one of the pundits that says that the Fed’s objectives may be more than just consumer price inflation, suggesting that they may be after “inflation” in the equity markets.

The Fed began their current tightening campaign in March 2022, so, as of this writing, it has been 26 months in duration. It is well recognized that monetary policy acts with a lag, but in this particular cycle, the lag seems to be longer than one would expect from an examination of recent history. While the tight monetary policy of this Fed looks to be achieving their inflation reduction goals, that same tight monetary policy is also impacting the real side of the economy in a negative way.

ISM Manufacturing and Services

Manufacturing has been in Recession for nearly a year and a half. The ISM Manufacturing Index has been in contraction (<50) for 16 of the last 17 months. In March, the index popped above the 50 mark (the demarcation line between expansion and contraction) for the first time since October ’22, only to fall back from 50.2 to 49.3 in April. Manufacturing continues to struggle.

The ISM Services Index, unlike the Manufacturing Index, has been positive since January ’22. It dipped into contraction in April as shown on the left-hand side of the above chart. As a result, the combined Manufacturing and Services Index is also showing a below 50 (contraction) reading.


With the release of the employment data earlier this month, the U3 Unemployment Rate rose from 3.8% to 3.9%, and the more comprehensive U6 Unemployment Rate rose to 7.4%, the highest it has been since November ’21. Note the general uptrend in the chart.

In addition, the seasonally adjusted initial claims for unemployment insurance spiked by +22K for the week ended May 4th, an unexpectedly large rise. This corroborates the decline in job openings to their lowest level since February ’21 and the large reduction in the number of voluntary quits that showed up in the most recent JOLTS (Job Openings and Labor Turnover Survey). We also note the 11-year low in hiring announcements for any April, as indicated by the placement firm of Challenger Gray and Christmas. That firm also noted a significant rise in layoff announcements for the month of April of +42K. Looking back at the last four years, we note that Challenger’s layoff announcements were +30K in April ’23, and <+10K for each April of ’22, ’21, and ’20.

The Consumer

Having spent their excess savings, i.e., the free money from the government (see left-hand chart below), with credit card balances at record highs, and with consumer loan delinquencies (both credit card and auto loans) on a rapidly rising path, it isn’t any wonder that consumer confidence is at its lowest level since July ’22 (right-hand chart).

In addition, the chart below shows that real Retail Sales per capital actually peaked in 2021 and have been flat since with nominal growth basically due to inflation with a small amount due to population growth.

Commercial Real Estate (CRE)

CRE defaults continue with one or more major foreclosures each week. The two featured here are:

  • 255 California Avenue, San Francisco (left-hand picture) is in talks to sell for around $50 million. In 2019, the building sold for $150 million.
  • The Waldorf Astoria in D.C., formerly the Trump International Hotel, sold by Trump in 2022 for $375 million, just defaulted on a $285 million loan (right-hand picture).
  • And in Chicago, the Selena Hotel filed for bankruptcy and will shut down after the city used it to house migrants and homeless.


While Q1 earnings have come in at new record levels, the forward guidance has been quite poor. Starbucks’ sales were off -4% in Q1 from year earlier levels. YUM Brands’ (KFC, Taco Bell, Pizza Hut) sales fell -2.9%. Nestle (sales -7.7% and Pepsi (-5.0%). These are just a few of the major fast-food operators showing declining sales. To say consumers appear to be cutting back appears to be an understatement. McDonalds indicated in its Q1 call that low-income clients are cutting back on fast food, while Coca-Cola’s CFO said that company sees “purchasing power compression in lower income echelons.” Yet, despite lower and disappointing guidance, equities continue to march toward new highs.

Final Thoughts

It appears that, for the rest of the year at least, inflation will continue to retreat. Note to the Fed: “The inflation dragon has been vanquished.”

As far as monetary policy is concerned, we’ve only seen the tip of the iceberg when it comes to the impact on the economy. Monetary policy acts with long and variable lags, and in the current episode, its impact was blunted by the “excess savings” accumulated by the consumer due to the cash gifts from Uncle Sam in 2022.

Consumers, however, are now tapped out (delinquencies rising and banks denying requests for higher credit limits). Layoffs are climbing, hiring and quit rates are fading, and job openings have fallen.

Nearly 70% of GDP is consumption. So, the fall in the growth of GDP in Q1 to 1.6% from 3.4% in Q4 is quite telling. The slowdown appears to be due to the exhaustion of the cash gifts, and the impact of a restrictive monetary policy. We think the slowdown will continue.

Only the financial markets, equities in particular, appear to be immune to the economic slowdown, despite the results from, and comments by, the major retailers. Equity markets had an episode in April’s first half with the Dow, for example, falling -5.2%. But they have since risen back and now threaten to set new highs. The question is, can they sustain themselves as the economy continues to fade? They never have in the past.

Robert Barone, Ph.D.

(Joshua Barone and Eugene Hoover contributed to this blog.)


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