The key question for the US economy in 2024
Why is it so difficult to calculate the R* or natural rate of interest for the economy to maintain long-term equilibrium?
The future ain’t what it used to be. At the Fed’s FOMC meeting last week, Chairman Jay Powell said, “We’re not looking for inflation to tap the 2% base once…we are looking for it to be sustained below 2%.” Given that US headline CPI inflation has remained stubbornly above 3% since last July, the market rapidly started to price out chances of a March rate cut.
Mr Powell’s apparent hawkishness in January contrasts to his ‘dovish pivot’ at the December 2023 FOMC press conference when he said, “The reason you wouldn’t wait to get to 2% to cut rates is that would be too late…you don’t overshoot.”
While the Fed claims to be data dependent, especially with respect to employment, clearly there seems to be some doubt about how to respond to inflation trends. With the Fed Funds rate at its highest level in a decade and a half, the consequences for the economy are huge, especially given the apparently schizophrenic nature of much of the economic data at the moment.
The debate about how many rate cuts will happen in 2024 is really a debate about the correct natural rate of interest - the R-star (R*) rate in central-banking terminology. This is the rate at which full employment matches stable inflation, the latter currently targeted at 2% by common central bank agreement.
The market has generally wanted more cuts than the Fed has so far indicated from its dot-plots, and has been walking back its dovishness in the face of apparent Fed hawkishness, sticky wage growth and other creeping worries about inflation, not least tension in the middle east and how that will affect supply chains.
We know rate cuts are coming, but the question is when and how many. The equity market appears to be acting as though not only has a soft landing or a no-landing been achieved, but rate cuts have already happened. Given how critical stock prices are to corporate activity in the US (when markets fall, CEOs stop investing in capex projects and start laying off workers), the stakes for getting the natural rate right have never been higher, especially in an election year.
The Fed’s favoured measure of inflation, the core Personal Consumption Expenditures (PCE) index, was at 2.93% in December 2023 (see graph above), but is falling, with estimates for 2024 around 2.2%. US GDP printed 2.5% in 2023 and is expected to fall in 2024. With falling inflation and lower real GDP growth, rate cuts are certain. The question is how many, and this is where the natural rate of interest becomes such an important question.
If the economy were to grow at around 2 to 2.5% in the long-term, and with a 2% medium-term inflation target, the R* or natural rate of interest should be somewhere between 0% and 0.5%. Keeping real rates (headline interest rates less inflation) too high, and especially too high for too long, risks transforming a battle to curb inflation into a journey towards a hard landing, something which a highly leveraged economy like the US can ill afford to do.
With the Fed Funds rate at 5.25-5.50% at present, 2.2% PCE inflation in 2024 gives you a real rate (Fed Funds less inflation) of around 3% (slightly restrictive for 2.5% GDP growth, very restrictive for lower levels of economic activity). With the Fed Funds rate restrictive to tame inflation, the debate for the correct number of rate cuts becomes one about the level of GDP growth this year. The problem is even last year’s GDP numbers are causing consternation.
A large gap has opened up between US gross domestic product (GDP) and gross domestic income (GDI) as can be seen from the graph below. This difference between what America spends (GDP) and what it earns (GDI) tends to even-out over time, but may well suggest GDP is at present overstated, which would in turn suggest interest rates may need to be cut further to avoid over-tightening leading to a hard economic landing.
The next problem the Fed has is unemployment, a factor which Mr Powell suggested at Wednesday’s FOMC meeting and again in Sunday night’s 60 Minutes interview would be a key vector in forthcoming rate decisions. The headline January non-farm payrolls (NFP) number out on Friday showed the Establishment survey at a strong +353k while the Household survey showed a fall of 31k. The difference between the two, according to the Bureau of Labour Statistics (BLS), is that the latter includes agricultural and self-employed workers while the method of data gathering also differs.
The gap between the two has been building for some time. Leaving aside a debate about the politicisation of labour data in an election year, the difference between the two sets of stats at the very least creates some doubt about the real strength of the US labour market. The January NFP numbers also showed a fall in hours worked versus the prior month (34.1 Jan vs 34.3 Dec), a small but notable change given the likely reluctance of employers to commit to layoffs given hiring difficulties over the past few years - the first step in a business slowdown is to reduce hours worked. The more draconian move of sacking comes later.
While Friday’s NFP data saw the December employment data revised higher, the trend in 2023 had very much been about revising prior employment data lower. The participation rate remains stuck at a low 62.5%, and there are suggestions that the quality of new jobs has been low, with more people looking to take on part-time work while full-time employment has been falling. The government sector has been a key contributor to 2023 employment growth.
Economic growth comes from a combination of work done in an economy and how efficient that work is. Short of a productivity miracle (AI needs to do this right now..), then overstating the strength of the labour market may well mean overstating potential GDP growth.
With GDP growth and employment data questionable, the issue of the appropriate natural rate of interest then turns to the US fiscal position. The graph above shows the extraordinary situation of the US deficit - $1.7 trillion in 2023, and with Q1 fiscal year 2024 already clocking $500 billion, the deficit is nearing double digits even with unemployment at a historic low.
The question of the right rate of interest for the economy is therefore being complicated by the spiralling cost of interest payments on the Federal debt, a problem exacerbated by US Treasury sleight of hand in 2023 in favouring shorter-dated bill issuance over longer-dated maturities. This has been great for managing the yield curve and market liquidity, but adds to the government’s funding costs as short-dated interest rates are currently higher than long-dated ones.
The graph above shows the rapid increase in the annual cost of servicing US Federal debt, now over $1 trillion per annum and likely to rise if the Fed stays higher for longer as seems to be the case. Deficits always rise during slow-downs and recessions as tax revenues fall and the automatic stabilisers of unemployment benefits kick in. A hard landing in the US would likely see a double-digit US Federal deficit.
A growing number of economists and market commentators are highlighting the risk of the government sector crowding out the private sector through ‘fiscal dominance’, and it worth noting that the strong US GDP data in Q4 (3.1% annualised growth) came with the US having to run a 7-8% annual fiscal deficit. While the bond market is still functional, the numbers are starting to raise eyebrows - and this is in the good times.
However it pans out, 2024 is going to be a key year for markets. The stock market (or parts of it) are acting like it’s a boom. The oil market is looking like it’s a recession. Inflation is sticky, and geopolitics aren’t helping. The labour market is ostensibly tight, but there are real questions about what’s going on under the hood. There are ongoing rumblings in the US banking sector, particularly with respect to commercial real estate. 2024 is going to be a year of real uncertainty - not least in divining what the right rate of interest is this year and in the coming ones. Good luck, Mr Powell.