What a difference a month makes

Bottom Line

The Federal Reserve front loaded interest-rate cuts by a supersized half point on September 18, as the labor market hit a summer air pocket and as inflation appeared to be on a glide path to the Fed’s 2% target. But a month later, the economy has seemingly re-accelerated, the labor market has strengthened and inflation once again looks sticky and persistent.

So, as the Fed approaches its November 7 and December 18 policy-setting meetings—and looks out over the next two years—central bankers may legitimately be data dependent as they gauge their future rate-cutting plans. Instead of more half-point or even quarter-point cuts, for example, Atlanta Fed President Raphael Bostic suggested this week that perhaps skipping November and cutting rates by a more normal quarter-point in December is the right course of action. 

We here at Federated Hermes expect quarter-point cuts in each of the last two FOMC meetings this year, with four quarterly cuts in 2025 and perhaps two more in 2026, which could collectively take the fed funds rate down to a terminal value of about 3% in two years. But there clearly is uncertainty regarding the pace. As a result, benchmark 10-year Treasury yields have surged from 3.6% to 4.1% over the past month. Equity investors, however, appear to have ignored this near-term confusion; the S&P 500 has soared nearly 15% from its August 5 low to this week’s record high of 5,878. 

Inflation persistent The Fed has made solid progress cooling inflation over the past two years. But we have seen a reacceleration in several key metrics in recent months: 

• Core Producer Price Index wholesale inflation has risen from 1.8% year-over-year (y/y) in December 2023 to 2.8% in September 2024. Core measures strip out volatile data, such as food and energy prices, from headline numbers.
• Core Consumer Price Index (CPI) retail inflation has declined from 3.9% y/y in December 2023, but it has stalled at 3.2-3.3% over the past four months through September 2024. The Fed is targeting 2.5%.
• Average hourly earnings declined from 4.4% y/y in January 2024 to 3.6% in July but have rebounded to 4.0% in September. The Fed is targeting 3%. In addition, wages rose by a hotter-than-expected 0.4% month-over-month (m/m) in September (which annualizes to 4.8%). 
• Core Personal Consumption Expenditures (PCE) inflation (the Fed’s preferred measure) declined from 5.6% in February 2022 but has stalled at 2.6-2.7% y/y over the past four months through August 2024. The Fed is targeting 2%.

Labor market rebound The employment picture looked bleak going into the Fed’s September 18 policy-setting meeting. In its annual benchmark revision in August, the Labor Department revised its payroll count down by 818,000 jobs from April 2023 through March 2024, the largest such revision since the Global Financial Crisis in 2009. Nonfarm payroll gains averaged only 116,000 jobs for the trailing three months through August, the slowest pace since early 2020. In addition, the ADP private payroll report in August and the Job Openings & Labor Turnover Survey (JOLTS) in July posted their weakest readings since January 2021. Moreover, through August, the manufacturing sector lost jobs in four of the past seven months, retailers shed jobs in each of the past three months (during the important Back-to-School (BTS) season), and temporary hires (an important leading employment indicator) had lost jobs in 18 of the past 19 months.

In sharp contrast, the September payroll report was surprisingly strong, adding 254,000 nonfarm jobs (consensus at 150,000). In addition, initial weekly jobless claims for the October survey week surprisingly declined by 7% to a much lower-than-expected 241,000, which suggests that consensus expectations for a muted payroll gain of only130,000 in October (to be reported on November 1) may be too conservative. We believe that investors are spooked by the payroll noise associated with Hurricanes Helene and Milton, the short-lived port strike, and the ongoing strike and layoffs at Boeing. This will be the last employment report before the election. 

Mixed consumer picture Nominal consumer spending on goods has slowed, with important BTS results up only 2.2% y/y from June through September 2024, compared with gains of 3.1% in 2023 and 9.0% in 2022. That’s the weakest rate in 15 years (during which time the normalized average annual gain was 4.3%), as stressed low-end consumers are saving more and spending less. The personal savings rate has surged from a 15-year low of 2.0% in June 2022 to 4.8% in August 2024. In sharp contrast, the ISM Services Index hit a 19-month high of 54.9 in September 2024. The ISM Business Activity Index was also strong, rising to a five-month high of 59.9 in August.

Manufacturing remains slow The ISM manufacturing index has been consistently below the 50-contraction level for the past two years, and the six regional Fed indices are weak across the board. Auto sales perked up in September, and while the housing market has been soft, lower mortgage rates point to a better season next spring. Business and consumer confidence metrics remain weak. 

Increasing our GDP growth forecasts The fixed-income, liquidity and equity investment professionals who comprise Federated Hermes’s macroeconomic policy committee met Wednesday to discuss firmer economic growth, sticky inflation, and the Fed’s trajectory of interest rate cuts:

• The Commerce Department left unchanged its second quarter 2024 GDP at a final gain of 3.0%, compared with revised GDP gains of 1.6% in this year’s first quarter and 3.2% and 4.4% in last year’s fourth and third quarters, respectively.
• We raised our estimate for third quarter 2024 GDP, which will be flashed on October 30, from 1.8% to 2.3%, as consumer spending overall appears firmer than expected. The Blue-Chip consensus increased its forecast from 1.9% to 2.3% (within a range of 1.8% to 2.9%). The Atlanta Fed’s GDPNow raised its estimate from 2.5% to 3.4%. 
• The Fed began to cut interest rates last month, with more cuts in the pipeline, which should help to boost economic growth. So, we raised our estimate for fourth quarter 2024 GDP growth from 1.5% to 2.0%. The Blue-Chip consensus raised its from 1.5% to 1.8% (within a range of 1.2% to 2.3%).
• As a result, we ticked up our full-year 2024 estimate from 2.6% to 2.7%. The Blue-Chip consensus similarly raised its from 2.6% to 2.7% (within a very tight range of 2.6% to 2.7%).
• Inflation has been sticky, so we left unchanged our year-end 2024 forecast for core CPI inflation at 3.1% (compared with actual core inflation of 3.3% in September 2024), while the Blue Chip reduced its from 3.0% to 2.9% (within a range of 2.8% to 3.1%). We also left unchanged our year-end 2024 estimate for core PCE inflation at 2.6% (compared with actual core inflation of 2.7% in August 2024), while the Blue Chip left unchanged its at 2.5% (within a range of 2.4% to 2.6%).
• We raised our estimate for first quarter 2025 GDP growth from 1.6% to 1.9%, while the Blue-Chip consensus left its unchanged at 1.7% (within a wide range of 1.0% to 2.3%).
• We increased our forecast for second quarter 2025 growth from 1.8% to 2.0%. The Blue-Chip consensus raised its from 1.8% to 1.9% (within a range of 1.3% to 2.5%).
• We left our estimate unchanged for third quarter 2025 at 1.9%, while the Blue-Chip consensus raised its from 1.9% to 2.0% (within a range of 1.6% to 2.5%).
• We left our forecast unchanged for fourth quarter 2025 at 2.0%, while the Blue-Chip consensus also left its unchanged at 2.1% (within a range of 1.8% to 2.5%).
• Consequently, we raised our full-year 2025 GDP estimate from 1.8% to 2.1%, while the Blue-Chip consensus raised its from 1.8% to 2.0% (within a range of 1.6% to 2.4%). 
• We left unchanged our year-end 2025 forecast for core CPI inflation at 2.7%, while the Blue Chip left unchanged its at 2.2% (within a range of 1.9% to 2.5%). We also left unchanged our year-end 2025 estimate for core PCE inflation at 2.3%, while the Blue-Chip consensus left its at 2.1% (within a range of 1.9% to 2.3%).