US Weekly Commentary: Tighter financial conditions needed

Last week's report on April employment underscored recent trends in the broad flow of data on the economy: The economy is growing at a gradually slowing pace; labor markets remain unsustainably tight; inflation is falling way too slowly. Bottom line: The Federal Reserve may have still more work to do if things don't change pretty quickly.

Nonfarm payroll employment rose by an unexpectedly strong 253 thousand in April, consistent with a moderately growing economy, but one where growth is clearly slowing. Over the six months ending in April, gains averaged 278 thousand per month. This is down materially from the average gain over the prior six months (388 thousand per month) and even further below the pace from the six months before that (520 thousand per month).

Importantly, however, at a steady labor force participation rate, the pace of job gains likely remains too rapid to prevent further declines in the unemployment rate. This is problematic, as arguably the labor force participation rate has caught up to the pre-pandemic declining trend, suggesting there is little scope for material increases in the participation rate to prevent further declines in the unemployment rate if job gains continue to exceed 100 thousand per month.

Wait, job gains are good, right? Yes, but wage inflation remains above a pace consistent with the Fed's 2% inflation target. If productivity growth averages 1%-1½%, wage inflation of 3%-3½% would be consistent with 2% inflation, roughly speaking. Average hourly earnings (AHE), for example, seem to be stuck growing around 4¼%. Over the three months ending April, AHE rose at a 4.2% annual rate, only slightly lower than its increase over the last 12 months of 4.4%. Like the elevated pace of core consumer price index (CPI) and personal consumption expenditures (PCE) price inflation we saw reported over the prior couple of weeks, this cannot be comforting to the Fed. Demand for workers is on the cusp of outpacing supply, keeping the labor market tight and preventing wage inflation from declining.

Nudging our tracking estimate

Tighter financial conditions are needed to slow spending and employment growth and tip the supply/ demand balance to reduce upward pressure on prices and wages. If financial markets don't deliver that tightening through some combination of weaker stock prices, higher bond yields, or a stronger dollar, and/or if banks do not curtail lending growth sufficiently in the wake of the recent banking turmoil, then the Fed may have to continue to tighten.

Of note, the latest data for the week ending April 29th showed continued growth in bank credit and deposits, so no sharp pullback there yet. Commercial real estate loans were among the classes of loans that expanded. Other data released in the last week were broadly consistent with the latest official report that GDP grew at a 1.1% annualized pace in the first quarter and that GDP will be roughly flat in the second quarter.

We nudged our second-quarter tracking estimate down over the week from +0.2% to a decline of 0.1%. Financial markets weighed "news" of First Republic Bank's closure and sale to JP Morgan, news that the so-called x-date when the US government will run out of cash is even closer upon us, the Fed's decision to hike rates 25 basis points and lighten up on the tightening bias, and a strong employment report that showed no real signs of easing labor-market tightness or of slowing wage gains. In the end, stock prices and bond yields showed surprisingly little movement.

This week's economic releases:

• Consumer price index (May 10): We estimate the overall CPI rose 0.5% in April, while the core CPI, which excludes the direct effects of food and energy prices, rose 0.4%. Consumer price inflation remains stubbornly high and the primary focus of the Fed.
• Produce price index (May 11): We estimate the producer price index for final demand (PPI) rose 0.5% in April, while the core PPI, which excludes the direct effects of changes in prices for food and energy, rose 0.3%.
• University of Michigan Consumer Sentiment Index (May 12): We expect the University of Michigan Consumer Sentiment Index to fall 0.7 point to 62.8 in the preliminary May reading. Inflation, a major source of drag on sentiment, is not easing as quickly as consumers might have hoped.

This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.