In this week’s “Three on Thursday,” we delve into the state of Social Security. Originating from the Social Security Act of 1935 as part of President Franklin D. Roosevelt’s New Deal, the program initially provided income to retired workers aged 65 or older. Since then, it has grown to include disability insurance, survivor benefits, and Supplemental Security Income (SSI), becoming a vital support for millions. However, recent projections indicate that Social Security is nearing insolvency, necessitating urgent reforms. 

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Implications:  Industrial production took a breather in April following two months of gains, with the details even weaker than the headline number. The manufacturing sector was the biggest drag on activity in today’s report, falling 0.3%.  Auto production posted a decline of 1.9%, likely the result of a normalization following production surging earlier this year to get back on track following large scale strikes in late 2023. Meanwhile, non-auto manufacturing (which we think of as a “core” version of industrial production) posted a decline of 0.1% in April and is down 0.5% from a year ago. One bright spot in manufacturing in April was the production of high-tech equipment, which jumped 1.0%. This measure is up 9.4% in the past year, the strongest growth of any major category, likely the result of investment in AI as well as the reshoring of semiconductor production. That said, activity here has begun to slow recently signaling that the initial burst due to the CHIPS Act may finally be wearing off.  The mining sector was also a source of weakness in April, with activity falling 0.6%.  Declines in the drilling of new wells and the extraction of other minerals and metals more than offset a gain in the production of oil and gas.  Finally, the utilities sector (which is volatile and largely dependent on weather) was the biggest source of strength in today’s report, rising 2.9% in April. In other news this morning, the Philadelphia Fed Index, a measure of factory sentiment in that region, fell to +4.5 in May from +15.5 in April.

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Implications:  Housing starts rebounded in April but remain below the pace of late 2023.  The main culprit weighing on activity is mortgage rates, which have lingered higher for longer in response to higher inflation reports in recent months.  However, it’s important to keep in mind that many owners of existing homes are hesitant to list their homes and give up fixed sub-3% mortgage rates, so prospective buyers have turned to new builds as their best option. This has boosted demand for developers and should keep a floor under construction activity going forward.  Looking at the details of the report, the gain in April was entirely due to a 30.6% jump in multi-family starts, while single-family starts remained essentially unchanged, down 0.4% from the previous month.  It looks like homebuilders were more focused on completing homes in April versus new builds, as housing completions for single-family homes jumped 15.4%, the second largest monthly gain since 2019. Another recent theme is the split between single-family and multi-family development.  Over the past year, the number of single-family starts is up 17.7% while multi-unit starts are down 33.1%.  Permits for single-family homes are up 11.4% while multi-unit home permits are down 21.9%.  This huge gap in the data is due to the unprecedented nature of the last four years since COVID began.  While we don’t see housing as a major driver of economic growth in the near term, we don’t expect a housing bust like the 2000s on the way, either.  Builders built too few homes in the decade before COVID and that shortage should support home prices in the years ahead.  In other housing news, the NAHB Housing Index, a measure of homebuilder sentiment, fell to 45 in May from 51 in April.  A reading below 50 signals a greater number of builders view conditions as poor versus good.  In other news this morning, initial claims for jobless benefits fell 10,000 last week at 222,000, while continuing claims rose by 13,000 to 1.794 million.  The figures are consistent with continued job gains in May.  Finally, on the trade front, import prices jumped 0.9% in April and export prices increased 0.5%.  In the past year, import prices up 1.1% while export prices are down 1.0%.

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Implications:   Headline inflation came in a bit softer than expected in April, but it’s still a long way to go before the Fed can declare victory.   Despite today’s moderately good news, it looks clear that the progress against inflation made from mid-2022 to mid-2023 has stalled.  Consumer prices were up 9.1% in the year ending in June 2022.  Then the rapid drop back to 3.0% in the year ending in June 2023 made many believe the end of “temporary” pandemic inflation problems was in sight. Since then, baseline inflation has remained stubbornly sticky above 3%, casting doubt on the Fed’s ability to cut rates in 2024.  Looking at the details, April inflation was boosted by energy prices, which rose 1.1% on the back of higher prices for gasoline and other fuels.  However, it’s important to point out that energy has not been the culprit for the stubbornly high inflation readings over the last year; energy prices are up 2.6% in the same timeframe versus 3.4% for overall prices.  Stripping out energy and its often-volatile counterpart (food) to get “core” prices does not make the inflation picture look any better.  That measure rose 0.3% in April, is up 3.6% in the past year, and up an even faster 4.1% annual rate over the past three months, showing that underlying inflation pressure remains stubbornly high.  While “core” prices did get some help from softer shelter costs in April, that was due to a 0.2% decline in prices for lodging away from home (think hotels). Meanwhile rental inflation – both for actual tenants and the imputed rental value of owner-occupied homes – continues to defy predictions of imminent reversal, rising 0.4% for the month and running at or above a 5% annualized rate over three-, six-, and twelve-month timeframes.  Housing rents have been a key driver of inflation over the last year, and we expect this to continue, as rent makes up a third of the weighting in the overall index and still hasn’t caught up with the rise in home prices in the past four years.  Finally, the most troublesome piece of today’s report for the Federal Reserve came from a subset category of prices that the Fed itself has told investors to watch closely – known as the “Supercore” – which excludes food, energy, other goods, and housing rents, and is a useful gauge of inflation in the service sector.  That measure jumped 0.4% in April, driven by higher prices for motor vehicle insurance (+1.8%) and financial services (+2.5%).  In the last twelve months, this measure is up 4.9% and has been accelerating as of late; up at a 6.3% annualized rate in the last three months.  And while inflation remains stubbornly high, workers are no longer being compensated for it.  Case in point, real average hourly earnings declined 0.2% in April.  These earnings are up only 0.5% in the last year, a headwind for future growth in consumer spending.  Putting this all together, the Fed has little reason at this point to start cutting rates.  How they respond to the incoming economic data in the months ahead could determine whether we repeat the inflationary 1970s.

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Implications:   April producer prices came in hotter than expected, and certainly higher than what the Fed was hoping to see.  Following a breather in March, producer prices rose an outsized 0.5% in April, and have been accelerating of late.  Over the last three months, producer prices have risen at a 4.1% annualized pace, while year-ago comparisons are on the rise and now back above 2.0% for the first time since April of last year.  While tomorrow’s report on consumer prices will garner more attention, it looks unlikely the Fed is going to feel increased confidence that inflation is moving sustainably toward its 2.0% target.  In turn, that means rates are likely to stay higher – for longer – than markets were anticipating earlier this year.   Looking at April itself, service costs lead the index higher, rising 0.6% on the month.  Prices for services less trade, transportation, and warehousing (+0.6% in April) accounted for more than two-thirds of the services cost increase, while margins to wholesalers rose 0.8%.  Goods prices didn’t provide any relief, rising 0.4% in April lead by higher energy costs (+2.0% in April).   That said energy prices – along with food prices – tend to be volatile month-to-month, and April was no exception.  Stripping out these two components shows “core” prices rose 0.5% in April. Core prices dipped below 2.0% on a year-ago basis back in November of last year, but have turned back higher and are now up 2.4% in the past twelve months.  While the Fed can take some solace in that the twelve-month rise in core prices has eased since peaking at 9.7% back in March of 2022, they will be less than enthused about the breach back above 2.0%, nor will they welcome the acceleration over recent months, with core prices up 3.2% annualized in the past three months.   Further back in the supply chain, prices in April rose 0.6% for intermediate demand processed goods and 3.2% for unprocessed goods. Further easing in inflation will come should the Fed have the patience to let a tighter monetary policy do its work.  But inflation risks re-acceleration should the Fed falter and cut rates too quickly.  The question on many minds coming in to 2024 was if the Fed could orchestrate a soft landing, now it’s looking increasingly possible that the Fed may not have clearance to start landing procedures before the year is through.

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One theory making the rounds is that if President Trump gets back into office, inflation is going to surge.  The idea is that if he returns, Trump will raise tariffs, reduce immigration, and jawbone the Federal Reserve to cut interest rates too much, all of which could push inflation higher, maybe even to where it was a couple of years ago when it peaked at 9.1%.

We are certainly not optimistic about the path of inflation in the decade ahead. The Consumer Price Index (CPI) went up at only a 1.8% annual rate in the ten years prior to COVID and we think it’ll be closer to 3.0% per year in the decade ahead.  However, we think that’ll likely be the case regardless of the election results later this year.  At the same time, we don’t expect anything like the COVID surge in inflation in the next few years.

Take the tariff argument, for example.  Yes, tariffs would raise prices for the items being tariffed.  But unless the Fed loosens monetary policy in response, the extra money consumers would have to spend on imported items would have to come from money they’d otherwise use to buy other items, putting downward pressure on prices for those other items and not changing overall inflation.  Remember, Trump raised tariffs during his first term in office and yet inflation was subdued until the Fed ignited it during COVID.

The same goes for immigration, which was slower in the Trump Administration than it had been under President Obama, without causing a spike in inflation.  By contrast, immigration has soared under President Biden while the CPI has averaged 5.6% per year.  If immigration was some sort of magic that kept inflation low, why wasn’t inflation much higher during Trump and why hasn’t it been lower under President Biden?

We think this is ultimately because it’s monetary policy that determines inflation, not tariffs or immigration.  Which brings us to the last argument suggesting Trump will bring back high inflation, that he will put political loyalists in charge of the Fed who will loosen policy much more than economic conditions suggest, leading to a spurt in inflation.

It is true that Trump would have the chance to put loyalists at the Fed, but the terms of Fed policymakers turn over gradually.  Also, every nominee would need confirmation by the Senate.  None of these people, not the nominee or nominators, would want to be blamed for causing a surge in inflation.

We are guessing Trump would appoint either Kevin Warsh or Kevin Hassett as Fed chairman to succeed Jerome Powell, neither of whom would want to go down in history as the second coming of the failed Arthur Burns of the 1970s.  Moreover, many of the votes on monetary policy come from regional bank presidents not appointed directly by the president.  The Fed is full of checks and balances, and part of a new Fed regime’s task will be to fix the inflationary tilt of policy since 2008.

Again, we are not saying inflation won’t be a problem in the years ahead; it likely will be.  But it’s likely to be a problem no matter who wins this November.  

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist 

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In this week’s “Three on Thursday,” we look at the state of natural gas in the United States. Natural gas has become a cornerstone of the U.S. energy landscape, providing a dependable and adaptable energy source that bolsters economic growth and enhances energy security. Its plentiful supply has fueled unprecedented consumption levels, underscoring its critical role in the national energy portfolio.

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If the financial markets have a religion, we think we know what it is: a deep and abiding faith in the ability of an omniscient Federal Reserve to ride to the rescue if and when the economic weather turns bad.

It’s hard to tell exactly where the economy is right now, but it’s very unlikely to be in a recession or need a rescue yet.  The Atlanta Fed’s GDP Now model is tracking 3.3% annualized growth in the second quarter, while our models suggest a growth rate of 2.5%.  Both of these are above the 20-year average growth rate of 2.0%.

However, not all the economic signs are as positive.  The ISM Services index came in at 49.4 in April, the first reading below 50.0 since December 2022.  The business activity component, at 50.9, was the lowest since the onset of COVID in 2020.  This is important to us because readings below 50 signal contraction.  The ISM Manufacturing index came in at 49.2, the seventeenth month below 50.0 in the past eighteen months.

During COVID, services were locked down in many states for a long time, with many of those workers receiving checks from the government, which they in turn spent on goods.  Since opening up, goods have been weak, while services have recovered.  That process appears complete now, and the dip in services could signal problems.

It could also be why the labor market lost at least a little bit of luster in April, with slower job growth, slower wage growth, and fewer hours worked.  Nonfarm payrolls grew 175,000 for the month, less than the 225,000 the consensus expected.

We like to follow payrolls excluding government (because it's not the private sector), education & health services (because it rises for structural and demographic reasons, and usually doesn’t decline even in recession years), and leisure & hospitality (which is still recovering from COVID Lockdowns).  That “core” measure of payrolls rose a modest 67,000 in April, the slowest pace so far this year.

There are two measures of total jobs.  One survey (which gave us the data we just mentioned for nonfarm payrolls) looks at existing establishments.  The other measures civilian employment by talking directly to workers.  It will catch self-employment and small-business start-ups.  Last month this measure increased a weak 25,000 (and unemployment rose to 3.9%).  Over the past year civilian employment is up 500,000 versus 2.8 million new jobs counted by the payroll survey.  This divergence has happened before, but it is still slightly worrisome.

Nothing in the April jobs report suggest a recession, but it’s certainly a move in a more tepid direction versus the prior path of the labor market.

In the meantime, the Fed, as well as market expectations of what the Fed will do, keep bouncing around.  On Wednesday the Fed made it clear that, in response to a string of relatively high inflation readings, the bar to cutting rates anytime soon (at least until July) is very high.  Why? Consumer prices are up 3.5% in the year ending March, an acceleration from the 3.0% in the year ending in June 2023.  Lack of progress on inflation makes it difficult for the Fed to justify rate cuts.

The Fed thinks the stance of monetary policy is already tight enough to eventually bring PCE inflation (its preferred measure) down to its 2.0% target, it’s just taking longer than previously expected.

In fact, the Fed must believe it is making progress on inflation because it announced that it would soon slow the pace of Quantitative Tightening.  It will now reduce its portfolio of Treasury securities by $25 billion per month starting in June, less than half the previous rate of $60 billion per month since mid-2022.  The Fed didn’t change the rate of reduction in mortgage-related securities, holding that target to “up to $35 billion per month,” which makes sense because paydowns have slowed with higher mortgage rates.

In effect, the Fed is moving toward a loosening of monetary policy, even as the Fed claims to be determined to fight inflation.   No wonder the expectations surrounding shifts in short-term interest rates this year have bounced around so much, with the Fed thinking of its balance sheet, the money supply, and short-term rates as separate and distinct tools. 

Ultimately, if the Fed is going to be successful on inflation, it’s going to need a monetary policy that’s tight enough to hurt real economic growth, as well.  That should scare the stock market, and yet the stock market as a whole remains lofty relative to interest rates and profits.  This only makes sense if investors believe the Fed will be able to react quickly to economic weakness once it kicks in, without reigniting inflation.  Count us skeptical.  

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Implications:  The ISM Services index missed consensus expectations and fell into contraction territory for the first time in sixteen months.  Although the service sector has not matched the same weakness as the manufacturing sector (which has posted readings below 50 in seventeen of the last eighteen months), activity has been softening lately.  Looking at the details of the report, twelve major service industries reported growth in April while six reported contraction.  The drop in the overall index was a result of slower growth in business activity and new orders, with those indices declining to 50.9 and 52.2, respectively.  Survey comments noted tempered activity coming in part from slowing markets and soft business activity, and in part from concerns over inflation and geopolitical impacts on supply chains.  Hiring activity also looks to be cooling, as the index moved deeper into contraction territory in April, now below 50 for four out of the last five months.  Although labor tightness remains a key issue for hiring (and with short supply, labor costs have been reported higher for 41 consecutive months), only five major industries reported an increase in employment in April versus ten industries reporting a decline.  Inflation remains a major problem.  Prices continued to rise in the service sector and the pace accelerated in April.  Although the index, which currently sits at 59.2, is below the back-breaking pace from 2021-22, fourteen industries reported paying higher prices in April and not one reported paying lower prices.  What do we expect this year?  Continued weakening in services activity as the economic morphine from COVID wears off and the impact of the recent reductions in the M2 measure of the money supply make their way through the economy.  The service sector was a lifeline for growth in 2023.  Further deterioration in this sector could be a harbinger for tougher economic times ahead.  

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Implications:  The labor market fell short of consensus expectations in April, with slower job growth, slower wage growth, and fewer hours worked.  This will not get the Federal Reserve back on track for rate cuts this Summer but could, if followed up with a few months of softer inflation readings, put the Fed in position for a potential rate cut this Fall.  Nonfarm payrolls grew 175,000, below the consensus expected 225,000 and the slowest pace for any month so far in 2024.  We like to follow payrolls excluding government (because it's not the private sector), education & health services (because it rises for structural and demographic reasons, and usually doesn’t decline even in recession years), and leisure & hospitality (which is still recovering from COVID Lockdowns).  That “core” measure of payrolls rose a modest 67,000 in April, also the slowest pace so far this year.  Meanwhile civilian employment, an alternative measure of jobs that includes small-business start-ups, increased a modest 25,000.  As a result, the unemployment rate ticked up to 3.9% for the month.  Much has been written lately about whether the immigration surge at the border is a force behind solid continued job growth.  If so, you’d expect job growth in the payroll survey to beat the growth of civilian employment (which is based on a survey of households that probably fails to measure illegal immigrants).  That’s consistent with the past year, as payrolls have grown 2.8 million while the employment measure is up only about 500,000.  The alternative reason for the general trend of slower employment growth is that this is what sometimes happens when the economy is at a turning point toward a recession.  Other tepid news on the job market included a 0.1% decline in total hours worked, and a modest 0.2% increase in average hourly earnings, which are now up 3.9% versus a year ago, the smallest gain since 2021.  The Fed will welcome slower growth in wages.  The problem for workers is that inflation is running hotter than 0.2% per month, so the most recent gain in wages likely means declining inflation-adjusted purchasing power.

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