The Fed’s waiting game: is the US economy finally starting to crack?

In the 16 years that Mike Zaffaroni has helmed Liberty Landscape Supply in north-east Florida, no stretch proved quite as difficult as last year. 

Soaring costs, supply chain bottlenecks and an acute worker shortage mounted a challenge for the lawn and garden centre, which Zaffaroni said was even worse than the early days of the Great Recession more than a decade ago and the mass shutdowns stemming from the global pandemic in 2020.

But despite these hardships — made all the more potent by rapid interest rate increases from the Federal Reserve — customers continued to flock to his outlets. Revenue jumped 16 per cent in 2022 compared to the year prior and just this month the company opened another location.

Florida’s economy stands out as one of the country’s strongest. The state has seen a huge influx of new residents in recent years — drawn, in part, by balmy weather and no income tax — and now leads the nation in terms of net income migration. Business applications have also boomed, making it one of the most popular places to open up shop. That has helped to keep the unemployment rate at 2.6 per cent, well below the national average of 3.7 per cent.

While Florida enjoys unique tailwinds, the durability of its economy exemplifies a national trend that has flummoxed policymakers seeking to damp demand to stamp out elevated inflation. But with the collective weight of the US central bank’s forceful monetary tightening efforts to date and the ongoing retreat by regional lenders across the country in the wake of a string of bank failures, there is growing apprehension that the US economy’s resilience is finally beginning to crack.

As a small-business owner, Zaffaroni said he is “always worried” about the future and warned that the second half of 2023 could become tenuous.

“We are not a sexy tech company from San Francisco that is living off of the fumes of private equity or venture capital. We are a real, tangible, boring business that relies on capital in order for us to continue to invest in infrastructure, equipment, inventory and people,” says Zaffaroni. “So the cost of capital going up will cause us to grow slower for an undetermined amount of time. That’s just the reality of it.”

Liberty Landscape Supply in north-east Florida has had a jump in revenues and expanded but its owner, Mike Zaffaroni, worries the second half of 2023 could become tenuous © Colby Smith/FT

Whether the economy buckles enough to tip into a recession is an issue that has tormented officials at the Fed since they began aggressively lifting interest rates in March 2022. In just over a year, the Fed has raised its benchmark rate over 5 percentage points to the highest level since 2007, changes that take time to affect the economy.

Now Jay Powell, the Fed chair, faces the arduous task of forging consensus across a Federal Open Market Committee that holds fractured views about the speed at which inflation will moderate from here, the impact of the recent banking stress and just how close the economy is to a cliff edge.

“We’re getting to the real hard part here of how we assess trade-offs,” Loretta Mester, president of the Cleveland Fed, told the Financial Times earlier this month.

Progress on getting inflation down has been slow, but the central bank is now considering a more patient approach. That is widely expected to mean foregoing additional tightening at its policy meeting this week while keeping the door open to fresh increases if warranted. Cuts are not being considered until 2024. Powell himself has said the Fed can “afford” to look at the data and make “careful assessments”.

For Charles Evans, who retired from the Fed in January after serving 15 years as president of its Chicago bank, the upcoming debates boil down to one question: “What kind of policy mistake are you most comfortable making?”

Where cracks are forming

Nestled just below Michigan in northern Indiana sits the RV capital of the world. The city of Elkhart earned that moniker for the dominant role it plays in the production of recreational vehicles, with nearly 90 per cent of all units in the US and Canada manufactured there or in the surrounding area, according to the RV Industry Association.

RV enthusiasts are not the only ones keeping close tabs on Elkhart, which boasts a Hall of Fame dedicated to the industry. Economists do too. That is because the RV is the “classic disposable income and interest rate sensitive item”, Michael Hicks, an economics professor at Indiana’s Ball State University, says. 

A discretionary purchase that is typically financed with borrowed money, demand for RVs is acutely sensitive to business cycles, meaning that more often than not a cooling off typically augurs a weaker economic backdrop. Hicks has even gone so far as to say that RV sales are superior to economists for forecasting recessions. Right now, he says it is a close call over whether there will be a downturn. 

Sales and shipments have both recently declined and Elkhart employment recorded the largest year-over-year drop among the biggest US counties as of the fourth quarter of 2022. 

Distortions tied to Covid have muddied the signals slightly, however. Sales exploded during the pandemic as people sought alternative ways to travel, so the recent softening could simply represent a reversion to a more normal trend.

However, Hicks expects the US economy to at best grow at an annualised rate of 0.5 per cent this year and warns it could even register a 0.5 per cent contraction.

What has kept the economy afloat and out of the grips of a recession so far is the labour market, which roared back from the depths of the pandemic and has shown surprising strength as worker shortages have fuelled intense competition among employers. Despite waves of lay-offs in Silicon Valley and Wall Street, companies across a wide range of industries are still hiring in droves, vacancies are rising again after a recent dip and the rate at which Americans are quitting remains elevated.

“People’s confidence and their willingness to spend are most importantly determined by how they feel about their job situation, and right now people are feeling very secure in their employment,” said Kristin Forbes, a former Bank of England official who now teaches at the Massachusetts Institute for Technology’s Sloan School of Management. 

Beneath the surface though, some of the labour market’s momentum has faded. Over the past three months, job gains have averaged about 280,000 positions, a robust monthly pace but well below the roughly 400,000 increase registered the same time last year. And while still historically low, the unemployment rate edged up in May, jumping 0.3 percentage points to a seven-month high of 3.7 per cent.

Across the country, well over a dozen states are flashing warning signals, triggering the so-called Sahm rule, which links the start of a recession to when the three-month moving average of the unemployment rate rises at least half a percentage point above its low over the past 12 months.

The Sahm rule traditionally applies to national unemployment — not state-level data, which can be distorted by small sample sizes — but the trend across the country suggests labour market conditions have softened. Still, the weakness is not yet broad-based and would need to intensify for the worst prognoses to be realised.

Wage gains have cooled in tandem, offering relief to policymakers concerned that rapidly rising pay is pressuring companies to themselves raise prices.

For the time being, however, consumers continue to spend, buoyed by stockpiles of savings accrued early on in the pandemic as the federal government injected $5tn to bolster household balance sheets. Americans have run down those nest eggs, but economists at the San Francisco Fed estimate there are still some $500bn in aggregate excess savings in the economy that will support consumer spending at least until the end of 2023. 

Some sectors initially battered by the Fed’s rapid rate rises have already begun to stabilise, including the housing market.

Demand for services-related activities like travel or entertainment have seen little let-up, too. That has kept upward pressure on “core” inflation, which strips out volatile food and energy costs, frustrating the Fed’s attempts to get this key metric back to its 2 per cent target.

In a sign that businesses are tentative about the future, however, orders placed with US factories for machinery and other “core capital goods”, which exclude aircraft and military hardware, have dipped below shipments on a three-month moving average basis.

In preparation for a downturn, Matt Hirsch, president of Primus, which builds cold-storage facilities and just broken ground on a new warehouse in Jacksonville, says he is now focused on lining up three years’ worth of projects.

“We have a backlog larger than we’ve ever had before and it’s easy to sit back and say, ‘let’s just execute,’” he says. “I can’t let that happen, I have to fill the bucket again because I do believe sales are going to soften.”

Delinquencies are also rising as more people fall behind on payments. By the end of 2022, fewer Americans had already reported being able to cover an unexpected $400 expense using cash, savings or a credit card that could be immediately paid off. 

As president of Feeding Northeast Florida food bank, Susan King is already seeing this pressure first hand. Families living pay cheque-to-pay cheque who once needed assistance on an emergency basis now need it “very consistently”.

“It is always in the back of our mind that a recession is looming,” she says.

Banking woes

Officials at the Fed and its staff have long contended that there is a narrow path to get inflation down without causing a painful economic downturn. For staffers at the Fed, that changed following Silicon Valley Bank’s collapse.

In March, they updated their forecast to a “mild” recession later this year, before the economy staged a recovery in 2024. Concerns stemmed from the immediate retreat expected by small and midsized banks, which account for 40 per cent of all outstanding loans and leases, as they confronted rapid deposit outflows, plunging share prices and the spectre of harsher regulatory scrutiny as more banks failed.

Lending standards have since tightened, extending a trend that was already under way as the Fed raised borrowing costs. Powell has warned that tighter credit conditions could dent economic activity, hiring and inflation. It could well mean the Fed does not need to raise interest rates as much as initially expected to reach its inflation goal, he has also said

But there is considerable debate about just how much pain the banking turbulence will inflict.

Former Chicago Fed president Evans is sympathetic to the view that it could have little impact on the economy. “If I were a policymaker, I’d be nervous that the credit distress channel isn’t nearly as powerful [as was first predicted],” he says, especially in light of the sheer strength of the labour market. “The banks seem to be making their way through it.”

Torsten Slok, chief economist at Apollo Global Management, is among those to consider the banking crisis a “substantial event”, warning that over the next several quarters it will have a “significant negative impact” on the economy. Small businesses are already finding it more difficult to access financing and he reckons the banking stress is akin to roughly 0.75 percentage points of Fed tightening.

Coupled with his concerns that inflation will prove more difficult for the Fed to tame and require the central bank to tighten more, Slok is now worried about a recession taking hold that is much deeper and more drawn out than expected.

“We are waiting for Godot, and I do believe Godot will eventually arrive,” says Slok.

Fed fears

Against this backdrop, the policy decisions confronting the central bank are becoming far more fraught.

For the bulk of the monetary tightening campaign, officials have hesitated little about the appropriate path forward for policy. Having been late to react to inflation, the Fed has moved with unanimity at nearly all of its meetings since last year, repeatedly relying on jumbo half-point and three-quarter-point increases to catch up.

That cohesion now risks being eroded as different policymakers draw different conclusions about when the full effects of the Fed’s actions so far will be felt and how much more to squeeze the economy — divisions that Alan Blinder, a former Fed vice-chair, said are not only “natural” at this stage but also a “problem” for Powell.

“A chair likes to get as close to unanimity as he or she can,” he said.

For at least the next gathering, top leadership at the Fed appear to have forged a compromise: omit an increase this week but keep in play the prospects of a later move. Waiting would give officials more time to learn how economic activity and credit conditions are evolving, Christopher Waller, a governor, said in a May speech, as he laid out the options.

Waller adds that there needs to be “clear evidence” that inflation is moving down to the desired level before he would be comfortable stopping rate rises. Individual projections from officials of the peak policy rate this year, due to be published this week, could indicate broad support for at least one more quarter-point rate rise. Economists polled in a recent FT survey reckon the Fed will eventually implement a minimum of two.

Pausing rate rises prematurely and finding out in a couple of months’ time that the Fed has not done enough would be “very disappointing”, says Evans. “You can just see the regret in that kind of commentary.”

Unnecessarily crushing demand and throwing an excessive number of people out of work comes with its own costs, though.

“The problem is when we get to the point where the interest rate does change behaviour, if the Fed has done too much too fast, it’ll be too late,” says Claudia Sahm, a former economist at the US central bank, who developed the Sahm rule.

“People on the margins will be hit first, whether it’s a minority-owned business or its Black or Hispanic workers, who typically have been on the sidelines but have jobs right now.”

In terms of what the Fed could more easily correct, however, economists seem confident in the central bank redressing having overtightened.

“The biggest risk now is that inflation does not come down as quickly as expected,” says Forbes. “If you hike too much today and growth slows too much, you can quickly lower rates. That’s an easier problem to fix.”

An even more pernicious problem would be a stagflation scenario taking hold, in which the economy is hobbled by both an extended period of slow growth as well as stubbornly high inflation. That is increasingly a concern for Nela Richardson, chief economist at ADP, a payroll processor, who warns that it would severely limit the Fed’s latitude to respond in either direction.

“It definitely means they have to sleep with one eye open.”

Additional reporting by Oliver Roeder in New York