Economy: Strong income and jobs welcome September rate hike

By Larry StewartAugust 31, 2022

Revisions reduced second-quarter GDP shrinkage to 0.6% from 0.9%, gross domestic income gained 1.4% in the same period and weekly jobless claims dropping 2,000 to 243,000 not only challenge assumptions of recession, but also provide the Fed with reason to continue raising interest rates to fight inflation.

Power in income

U.S. Department of Commerce measures of the economy from the income side – an important factor in defining recession – show the economy growing steadily in 2022. It’s part of the mystery in this pandemic economy. Gross domestic income (GDI) rarely rises as much while production is contracting. Economic strength underlying GDP matches other recent upbeat readings on the labor market, retail sales and industrial production.

The unusual gap between gross domestic income (blue) and gross domestic product (red) shows an economy that is growing in all measures except production. (Graph: St. Louis Fed)

The National Bureau of Economic Research, the organization that officially decides when the United States is in recession, assesses conditions using several indicators, including the labor market, consumer and business spending, industrial production, and incomes. All of those indicators except one pointed towards expansion, albeit with slight gains, in June, the last month of the second quarter.

Outsized impact of inventory

The pandemic interjected an important anomaly into current economic dynamics most obvious today in the outsized role of inventories on the economy. Supply chain disruptions have left unfinished products on factory floors or at shipping docks. These products cannot be included in GDP until they go into inventories.

Inventories rose at a $83.9 billion annual rate last quarter after increasing at a $188.5 billion pace in the first quarter of 2022. They subtracted 1.83 percentage points from GDP. Meanwhile, consumer spending grew at a 1.5% pace, revised up from the previously reported 1.0% rate.

An alternate measure of economic growth, GDI, increased at a 1.4% rate in the second quarter and 1.8% in the first quarter. Calculated using corporate profits, compensation and proprietors’ income data, its 2022 performance is boosted by profits that were 11.9% higher than one year ago, and wage gains amid a tight labor market.

The average of GDP and GDI, referred to as gross domestic output and considered a better measure of economic activity than GDP alone, increased at a 0.4% rate in the second quarter, up from Q1’s 0.1% growth pace.

Strength cuts both ways

Appreciation for actual U.S. economic strength is a double-edged sword, though: it disproves assumptions of recession and it is the reason the Federal Reserve is committed to continuing its aggressive campaign against inflation.

The U.S. central bank has raised the federal funds rate 225 basis points since March. Interest-rate-sensitive industries like housing and technology may be laying off workers, but broad-based job cuts have yet to materialize, leaving the overall labor market tight.

The most-recent Department of Labor report showed initial claims for state unemployment benefits fell 2,000 to a seasonally adjusted 243,000 for the week ended Aug. 20. The jobless rate fell to a pre-pandemic low of 3.5% in July from 3.6% in June.

Fighting inflation hurts

Fed Chair Jerome Powell’s address at the annual global central banking conference in Jackson Hole, Wyo., confirmed that the Federal Open Market Committee is watching the economy carefully, but the fight against inflation will bring some pain, and change will come slowly.

“Without price stability, the economy does not work for anyone. In particular, without price stability, we will not achieve a sustained period of strong labor market conditions that benefit all,” Powell said, according to a prepared text. “The burdens of high inflation fall heaviest on those who are least able to bear them.

“Reducing inflation is likely to require a sustained period of below-trend growth. Moreover, there will very likely be some softening of labor market conditions.

“While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation.

“Restoring price stability will likely require maintaining a restrictive policy stance for some time. The historical record cautions strongly against prematurely loosening policy.”

Interest rate outlook

Some indicators have pointed to inflation receding in the coming months, as commodity prices have fallen, supply-chain strains improve, and earlier Fed rate increases hammer the housing market and other sectors. But continued tightness in the job market will support inflationary wage increases.

July data showed price growth slowing, and the Fed will get the August inflation report before its September policy meeting. The FOMC officials are expected to approve a rate increase of either 50 or 75 basis points.

CNBC.com reports Cleveland Federal Reserve President Loretta Mester, a voting member this year of the rate-setting FOMC, said she expects benchmark rates rising above 4% in the coming months. That’s well above the current target range of 2.25% to 2.5% for the federal funds rate.

“My current view is that it will be necessary to move the fed funds rate up to somewhat above 4 percent by early next year and hold it there,” she said in prepared remarks for a speech in Dayton. “I do not anticipate the Fed cutting the fed funds rate target next year.”

Markets are pricing in a third consecutive 0.75 percentage-point increase at the Fed’s September meeting and looking for rate cuts to start in the fall of 2023.

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