This week, the Federal Reserve surprised no one and disappointed everyone when it cut the overnight rate by 25 basis points (0.25%). Investors had fully expected it. They had NOT expected the relatively hawkish tone of the Fed’s analysis and Chairman Powell’s subsequent comments.
Instead of an open-ended, easy monetary policy in 2025, the Fed telegraphed only 50 basis points more in additional cuts. While that wasn’t terribly far from consensus estimates, you would have thought the Fed had announced it intended to take first-born sons across the country. As I type this at 11:15 am CDT two days later, I am still puzzled by the markets’ extremely negative reaction(s) to whatever was so surprising in the comments and commentary.
Everything seemed pretty straight forward to me.
The Fed isn’t done with this easing cycle, which should continue well into 2026. However, it would like to “see” more meaningful improvement in the official inflation data before going crazy slashing rates and throwing a bunch of money around. With the inflation gauges being what they are, lower but not low enough, the Fed’s stance shouldn’t have flummoxed anyone. However, it did.
The market rout this week was almost as bewildering as the rally immediately after the Presidential election. Has that much really changed in such a short period of time? Perhaps it is time to set some realistic expectations moving forward.
Let me start with the Federal Reserve. As you probably know, it has a so-called dual mandate:
- Price stability
- Full employment
If prices are too high and the economy is adding jobs, the Fed isn’t going to cut the overnight rate. The inverse is also true. So where are we?
Admittedly, consumer prices remain stubbornly high on many items. However, has the level of prices increases moderated for most? According to the official data, the answer to that question is mostly yes. This is evidenced by the most recent 12-month Consumer Price Index (CPI) reading of 2.7%, GDP Price Index of 1.9% and November’s reading for the PCE Price Index of 2.4%. The 30-year average for each of these series is 2.5%, 1.9% and 2.1% respectively.
As such, you could reasonably argue that inflation, at least how the government calculates it, is within a reasonable variance from the norm. What’s more, there is nothing in the proverbial crystal ball to suggest it will trend significantly higher without an exogenous shock to the system. Obviously, tariffs could play a role in higher prices moving forward, but that doesn’t mean the U.S. consumer will blithely pay for them.
Simply put, if companies could easily pass along their price increases to consumers, companies would never go out of business. We know that is not the case.
But why am I so seemingly cavalier about inflation? Hey, I am not. The prices for many items I used to buy have gotten to the point where I no longer purchase them. For instance, absent a BOGO, I am simply not going to pay what Frito-Lay is asking for its completely elastic products. I don’t need them in any event, and neither does anyone else.
However, the labor markets are simply not as strong as the Bureau of Labor Statistics (BLS) has been leading us to believe. Period. As I have written in this newsletter on numerous occasions this year, the significant gap between the Household and Establishment data sets is simply too great to ignore. Further, most independent employment surveys align more closely with the Household data, which reflects sluggish job growth at best. Finally, on December 12th, the Philadelphia Federal Reserve released its own analysis suggesting the BLS’ payroll data was significantly inflated, and the true numbers were in keeping with the Household series.
You can find the report here.
If you follow the link, you will see that the previously tight correlation between the Fed’s data and the BLS’ started falling in September of 2023. Through the first 3 quarters of 2024, there was an 0.8% difference between the Fed and the BLS. That might not sound like much, but it means the Fed is suggesting that payroll growth was about half what the BLS initially reported before massive revisions, and is still one-third higher even after those adjustments.
The Math
In case you were wondering, back of the envelope math suggests the official payroll data for the 3 quarters ending on June 30, 2024, might still be overstated by close to 630K jobs (non-annualized), or roughly 70K per month. What’s more, during 2Q 2024 alone, the discrepancy between the two data sets was around 1.7%, and the Fed projected it was going to get worse during 3Q.
As a result, I fully expect the BLS to make a negative revision of at least 800K to previously announced (and revised) payroll growth when it does so in March 2025. The range of estimates will likely range between 700K to 1.4MM. That isn’t insignificant.
Then there is the issue of the personal savings rate, or apparent lack thereof. While not anywhere close to the three decade low we reached in July 2005 at 1.4%, last month’s observation of 4.4% is well under the 30-year average of 5.7%. What’s more, it has been trending steadily downward since January, when it reached it’s 2024 high of 5.7%.
Couple all of this with a money supply, as defined by M2, which is over $400 billion less than it was in April 2022, and it raises questions about how much “dry powder” the U.S. consumer really has in its collective arsenal. Recently announced closures of once-popular retailers (of cheap economically elastic stuff) Big Lots and Party City, as well as an untold number of restaurants, would suggest “not much.”
Hey, this is just realism. Shoot, the Village Tavern in the SouthPark area of Charlotte recently closed after being open for roughly 35 years. Would you have seen that coming 3 years ago? In Nashville, how about Varallo’s Chili Parlor at 8th and Church Street closing its doors after 117 years?
All of this is to say, realistic expectations for 2025 are:
- Continued moderate inflation, which remains stuck just slightly higher than the Fed’s 2.0% goal, but is still reasonably well-contained.
- A slightly softer labor market which isn’t creating the paychecks, also known as new consumers, we would hope for.
- Negative revisions, potentially significant, to the official labor market data.
- Negative revisions to previously announced Gross Domestic Product (GDP) estimates. These won’t be catastrophic.
- For all his bluster and threats, President Trump will not be able to accomplish miracles during the first half of 2025. He won’t be able to “drain the swamp,” make a permanent (and meaningful) dent in the regulatory bureaucracy. Similarly, Elon Musk isn’t going to be able to trim anywhere close $2 trillion out of the Federal budget if Social Security, Medicare and debt service aren’t on the table. After all, aircraft carriers don’t stop on a dime.
- Corporate earnings have to catch up with stock valuations. This doesn’t mean the markets are poised to fall off a cliff. They aren’t. However, investors shouldn’t expect similar massive returns in 2025.
- By the end of 2Q 2025, the Fed will likely have enough data to cut more than 50 basis points during the year. Whether it wants to do so is another issue.
In the end and if nothing else, the markets’ sharp reactions this week to the Federal Reserve’s relatively “to be expected” comments shows that everyone needs to chill out a little bit. Don’t have the extra cup of coffee, and quit looking at balances every hour. Everything is going to be okay, as it almost always is.
Have a great weekend, Merry Christmas and Happy Holidays.
Thank you for your continued support. As always, I hope this newsletter finds you and your family well. May your blessings outweigh your sorrows on this and every day. Also, please be sure to tune into our podcast, Trading Perspectives, which is available on every platform.
John Norris
Chief Economist
Please note, nothing in this newsletter should be considered or otherwise construed as an offer to buy or sell investment services or securities of any type. Any individual action you might take from reading this newsletter is at your own risk. My opinion, as well as those of our Investment Committee, is subject to change without notice. Finally, the opinions expressed herein are not necessarily those of the rest of the associates and/or shareholders of Oakworth Capital Bank or the official position of the company itself.