The Economy Is Slowing Down. What It Means for the Fed.

Text size

For Jerome Powell’s Federal Reserve, the easy part was embarking on an aggressive monetary-policy tightening path to rein in decades-high inflation while the economy was strong. Now, as the economy shows early signs of broad-based softening, the way forward is about to get harder.

Take a look at

FedEx
’s
revenue warning as an example of where things are heading. The company (ticker: FDX) cut its revenue forecast by half a billion dollars on Thursday and warned that volumes were slowing down as “macroeconomic trends significantly worsened.” The news sparked fears of a global recession and sent the company’s stock tumbling more than 20%.

Now consider the flurry of data released this week. Retail sales data for August showed, on the surface, a surprising increase from the month before as falling gasoline prices left more room in household budgets for discretionary purchases and meals out at restaurants. But data for July were revised sharply downward. Taken together, the past two months’ readings have been slightly negative, suggesting that the combination of higher prices and tighter policy is dampening consumer demand.

The manufacturing sector is showing a similar trend. Industrial production fell 0.2% in August, coming in below consensus. While manufacturing output climbed 0.1%, it was also revised downward in July, more than erasing any gains.

Separate surveys from the Federal Reserve Banks of Philadelphia and New York, published on Thursday, both showed negative growth in manufacturing, as well. For Philadelphia, August marked the third contraction in four months; New York notched its second straight contraction and fourth in five months. 

Housing, meanwhile, has “hit a brick wall,” as Comerica Bank chief economist Bill Adams put it this week. Mortgage rates passed 6% for the first time since 2008, Freddie Mac data released Thursday showed, while mortgage applications have plummeted to their lowest level since 1999.

“We’re beginning to observe the lagged impact of past policy hikes by the Fed,” says Joe Brusuelas, chief economist with the economic consulting firm RSM. 

This all could be seen as good news—or at least should be what the Fed expected. The central bank needed to slow things down and cool the economy to tamp down consumer demand and rein in inflation, and the economy is showing the impact of that now.

But the manufacturing slowdown and softening in retail sales are coming even as inflation continues to rage and the labor market remains almost as tight as ever. Initial jobless claims fell again on Thursday for the fifth straight week, and the insured unemployment rate has fallen below 1%.

That means the central bank will have to remain aggressive for longer as inflation turns stickier, or harder to control. It only heightens the challenge for Powell, the Fed’s chair, and opens a new phase in the central bank’s inflation-fighting campaign—one that’s occurring against the backdrop of a stalling economy.

“It is one thing to be raising rates into what everyone agrees is a rip-roaring economy,” says Tim Quinlan, a senior economist with Wells Fargo. “It gets a lot tougher to keep raising rates when you’ve reached some of these main inflection points.”

Despite the broader softening, August CPI data released this week were so hot that they prompted economists at Jefferies and elsewhere to raise expectations for the Fed’s so-called terminal rate to at least 4.5%, up from 4% before the latest monthly data were released. The latest reading also quieted calls that the central bank could achieve a soft landing, dispelling hopes that had risen after price gains stayed flat in July.

The question now becomes just how painful the consequences of the central bank’s rate hikes will be. While Fed officials have seemed to acknowledge that “they need to at least be cognizant of the negative economic impacts of their tightening,” Quinlan says, “there’s nothing about their congressional mandate that suggests that they ought to be paying attention to those deteriorations in the economy.”

“If they’re going to stick with what they’re supposed to stick to,” he says, “then they shouldn’t be discouraged by a deterioration in economic fundamentals.”

Powell has been emphasizing for weeks that the central bank knows its actions will spark a painful fallout but that it won’t be deterred from doing what it must to bring inflation back down to 2%. Not reining in price gains now will only cause more pain in the future, he has said, arguing that the Fed will remain steadfast for as long as it takes.

Making sure investors understand that message is the first step. But following through on it as unemployment soars, small businesses shutter, and the economy contracts would be quite another—one that would require a real test of resolve.

The softening the economy has shown this week is only the beginning.

Write to Megan Cassella at [email protected]