Everyone loves a good comeback story. Well, most everyone.
When the economy provided us with a comeback story last week, just in time for this week’s meeting of the Federal Reserve, only the stock market took the news as bad.
The central bank’s Board of Governors will gather once again to decide what to do with interest rates. Two of three options seem equally likely: Governors either will deliver a modest rake hike or leave rates where they are, which is 5 percentage points higher than they were before the Fed started raising rates in March 2022.
The third option, lowering the federal funds rate, likely is off the table for now given the economy’s growth spurt.
U.S. economic growth accelerated from July through September to an annual rate of 4.9 percent, more than double the rate of the previous three months, according to a preliminary estimate from the Bureau of Economic Analysis.
This economic vigor flies in the face of higher interest rates, which are supposed to crimp growth. Historically, when the Fed has increased rates at a rapid clip, the economy tended to slow down, sometimes even sliding into recession. That’s not happening this time.
The economy is behaving abnormally. The third quarter’s surprise turnaround will have an enormous impact on what the Fed decides to do next.
The economy seems untethered from the restrictive effects of higher borrowing costs.
The housing market, for example, has slowed to a near standstill as mortgage rates hover around 8 percent. But depressed home sales seem to be driven more by lack of inventory than too-high financing costs.
For proof, look at new home sales, which surged more than 12 percent in September from the previous year, according to the U.S. Census Bureau. Over the same time period, mortgage rates have increased almost a full percentage point. When it comes to housing, if you build it they will buy it, even at higher rates.
It’s not just houses. Sellers of other goods, too, seem to believe that buyers are out there. One reason the economy just grew so fast in the third quarter is that retailers and manufacturers loaded up on inventory to sell. This stockpiling added a percentage point of growth to the economy.
The true hero of the third quarter was the consumer.
Personal consumption grew at a 4 percent annualized rate in the third quarter, a more than fourfold increase from the second quarter’s 0.8 percent growth. This suggests that households are well-placed to cope with Fed rate hikes. Consumers are drawing down on savings, they’re using credit, but they’re still spending at a rapid clip.
The problem for the Fed is that this momentum in spending might be at odds with their efforts to slow the economy and rein in inflation.
The Fed’s preferred inflation measure, the personal consumption expenditure index, or PCE,, suggests that inflation is enduring.
The core PCE price index, which omits volatile food and energy prices, grew by 3.7 percent in September from the previous year, barely down from the 3.8 percent rate recorded in August.
Continued strength in consumer spending could slow or even upend Fed plans to push inflation back toward 2 percent.
The job market
The third driver of the economy’s comeback is my favorite, the job market. It’s solid. Last week, Bureau of Labor Statistics data showed that initial jobless claims, an indicator of layoffs, are still very, very low compared to historical averages.
Labor force participation for workers ages 25 to 54 is higher than it was before the pandemic. The economy continues to add jobs at a solid pace. And the unemployment rate is less than 4 percent.
The job market is healthy. That’s a prime reason consumer spending has been resilient to rising interest rates.
I’m a big believer that good news is good news. This is true even when, like last week, good news on the economy is seen as bad news by the stock market, where traders view a strong economy as a harbinger to additional Fed rate hikes.
A resilient consumer and steady job market potentially could help the Fed pull off one of the greatest comebacks of all times – an economy that grows and reduces inflation.