An often-overlooked economic metric signals serious trouble ahead

Employees work at the BMW manufacturing plant in Greer, South Carolina on October 19, 2022.

Bob Strong | Reuters

The economy sent a muted signal on Thursday that a recession is looming — and that the Federal Reserve could be making a policy mistake by continuing to try to slow things down.

According to the Conference Board’s Leading Economic Indicators Index, conditions deteriorated in September, with the indicator down 0.4% from the previous month and 2.8% for the six-month period.

“The US LEI fell again in September and its persistent downward trajectory in recent months suggests that a recession is increasingly likely before the end of the year,” said Ataman Ozyildirim, senior director of economics at the Conference Board. Ozyildrim noted that the index’s weakness was “widespread” as high inflation, a decelerating jobs picture and tighter credit conditions put pressure on the economy.

The index looks to the future using 10 metrics that include manufacturing hours worked, unemployment insurance claims, building permits, stock indexes and credit spreads.

Normally the LEI is not considered a major data point. It’s not necessarily that the measure isn’t a good snapshot of the economy, but more that the data points that go into the index are already known, so there isn’t much new information.

A reverse trend for the Fed

However, under current conditions, the index is of greater significance as it comes at a time when the Federal Reserve is seeking to further tighten the screw on growth in an effort to curb runaway inflation.

This goes against a general historical pattern where the Fed typically eases policy when the outlook darkens. However, Fed officials point out that they are far from done when it comes to raising rates.

“We went from a Fed that was far too easy to be irresponsible,” said Joseph LaVorgna, chief U.S. economist at SMBC Capital Markets and former senior economic adviser to then-President Donald Trump. “When this basket signals the weakness it’s showing, what the Fed typically doesn’t do is raise rates. But in this case, it’s not just raising rates. aggressively, but with a commitment to continue to aggressively raise rates.”

LaVorgna’s research shows that during previous declines in leading indicators, the Fed was always cutting rates or was on pause at the same time. This was the case at the start of 2020, the financial crisis in 2008 and the recession at the start of the 21st century – among multiple other economic contractions.

He fears that the Fed’s insistence on tightening policy will have even worse results to come.

“Delays in policy mean the full effects of the Fed’s actions have yet to be fully felt. Worryingly, the Fed is not done,” LaVorgna said in a client note.

LaVorgna isn’t alone in believing the Fed is overdoing its efforts to rein in inflation, which continues to hover around its highest levels since the early 1980s.

In a recent interview with CNBC, Starwood Capital Group CEO Barry Sternlicht said the central bank faces “incredible calamities if it continues its action, and not just here, anywhere in the world.” Goldman Sachs CEO David Solomon, JPMorgan Chase In recent days, CEO Jamie Dimon and Amazon founder Jeff Bezos have all expressed concern about a coming recession, though they did not single out Fed actions.

Disappointment on inflation

However, Philadelphia Fed President Patrick Harker said on Thursday he believed the central bank still had work to do before it could relax, as he said he had seen a “disappointing lack of progress” in the fight against inflation.

“What we really need is a sustained decline in a number of inflation indicators before we ease monetary policy tightening,” said the central bank official, who is a member non-voting Federal Open Market Committee responsible for setting rates.

So far, inflation data has indeed not been on the side of the Fed.

In addition to typical general measures such as the Consumer Price Index and the Fed’s Preferred Personal Consumption Expenditures Price Index, the Atlanta Fed’s “sticky price” CPI rose 8, 5% on an annualized basis in September, compared to 7.7% in August. The measure covers items such as rent, cost of food outside the home and leisure costs.

Services inflation has been particularly nagging, rising 7.4% in September on a 12-month basis, from 6.8% in August, according to Trading Economics. It came as the economy shifted back to services after strong demand for goods through much of the Covid era.

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Critics, however, say the Fed is tracking too many historical data points. But policymakers are also waging a battle against inflation expectations which, although falling now, could rise, especially now that gasoline prices are rising again.

“The challenge for the Fed is that we haven’t seen the real leading indicators moving in the direction that inflation has remained consistently elevated against those leading indicators that would suggest otherwise,” said Jeffrey Roach, chief economist for LPL Financial. .

In Roach’s view, the only silver lining is that financial markets may be on the verge of assessing all the damage from rising rates and inflation. Moreover, the continued decline in the LEI could at least give the Fed a reason to slow the pace of its rate hikes. Roach expects the Fed to rise 0.75 percentage points in November and then slow to 0.5 points in December, which is not the market’s expectation.

“In a nutshell, this report probably won’t change anything for the November meeting,” Roach said. “However, you could argue that makes a case for a December downgrade.”

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