Economic Growth is Stagnating as Inflation Continues to Run Hot, Prompting Tighter Monetary Policy
- At its July 26-27 meeting, the Federal Open Market Committee (FOMC) voted unanimously to raise the target rate for the federal funds rate by 75 basis points to a range of 2.25-2.5 percent, the second consecutive hike of this magnitude. The range is now equal to its 2019 peak. In addition, the FOMC is continuing with its previously outlined plan to reduce the size of the Federal Reserve’s balance sheet. In his press conference, Chairman Powell stated the federal funds rate is now at or close to its neutral level and that future hikes will likely come with less forward guidance.
- Gross domestic product (GDP), adjusted for inflation, declined at a 0.9 percent seasonally adjusted annualized rate (SAAR) in Q2 2022, following a 1.6 percent decline in Q1, according to the Bureau of Economic Analysis (BEA). Personal consumption expenditures, the largest portion of GDP, grew at an annualized rate of 1.0 percent, a slowdown of eight-tenths from Q1. An increase in real services consumption more than offset a decline in real goods spending. Inventory investment dragged a full 2 percentage points on GDP, while net exports added 1.4 percentage points following a weak Q1. Residential fixed investment dropped at an annualized rate of 14.0 percent, subtracting seven-tenths of a percentage point from GDP. Business fixed investment declined at an annualized rate of 0.1 percent, and direct government expenditures declined at an annualized rate of 1.9 percent.
- Personal income, adjusted for inflation, declined 0.3 percent in June, according to the BEA. Real disposable personal income and real personal income less transfer payments, which is used in officially dating a recession, also both declined 0.3 percent. The PCE price index rose 1.0 percent over the month and was up 6.8 percent on an annual basis, a new near-term peak. Core PCE rose 0.6 percent over the month and 4.8 percent over the year, a slight acceleration from May but still below its recent 5.3 percent peak in February.
- The Employment Cost Index (ECI), a measure of labor compensation, increased 1.3 percent in Q2 2022, a deceleration of one-tenth from Q1. On an annual basis, civilian labor compensation rose 5.0 percent, an acceleration of five-tenths of a percentage point from Q1 and the highest reading since 1990.
- The National Association of REALTORS® Pending Home Sales Index, which records contract signings of existing homes and typically leads closings by one to two months, dropped 8.6 percent in June.
- New single-family home sales declined 8.1 percent to a SAAR of 590,000, the slowest sales pace since December 2018 when excluding the spring 2020 COVID-induced drop, according to the Census Bureau. Additionally, the April and May figures were revised downward. Year to date, new home sales are down 13.4 percent. The months’ supply increased nine-tenths to 9.3, the highest since May 2010, though a large percentage of these remain homes not yet started or completed.
- The FHFA Purchase-Only House Price Index increased 18.3 percent from a year ago in May, a deceleration of six-tenths from April and the third consecutive month of deceleration in annual price growth.
The GDP print was modestly above our Q2 expectations due in part to better-than-expected net exports, business investment, and government expenditures, while consumer spending was a bit weaker than forecast. While there continue to be caveats to this second consecutive negative GDP print, such as ongoing COVID-related disruptions affecting inventory investment from quarter to quarter, we believe this GDP report is supportive of our view that economic growth is stagnating and will likely operate below its long-term trend for the rest of the year. In fact, final sales to private domestic purchasers, which strips out recently volatile categories such as inventory investment and government spending, was flat in Q2 after growing at a 3.0 percent annualized rate in Q1. We currently do not believe a recession has yet begun in the first half of the year per the metrics used by the National Bureau of Economic Research to officially date downturns. This is in part due to payroll employment continuing to suggest a strong labor market, though we continue to believe the economy is weakening. At this time, our baseline forecast continues to see the economy entering a modest recession in Q1 2023.
Of course, our outlook will continue to be influenced by a number of factors that are subject to change. With another 75-basis point hike, the federal funds rate is now close to its theoretical neutral rate. Considering the Fed is simultaneously reducing the size of its balance sheet, we think monetary policy at large is in modestly restrictive territory but will need to go further to get inflation under control. Considering core PCE accelerated slightly on an annual basis in June and the ECI, which adjusts for labor force composition, continued to show wages growing at a rate that is inconsistent with 2-percent inflation, we think the Fed will continue to tighten policy even as economic data weakens.
Still, the housing sector has already slowed significantly given the sector’s sensitivity to interest rate changes. Residential fixed investment in Q2 was a significant drag, new home sales were below our expectations and will likely lead to a downgrade to our near-term forecast, and pending home sales dropped further, pointing to continued declines in existing home sales in Q3. We continue to believe home sales will slow further through the end of the year as a combination of past home price growth and high mortgage rates weigh on affordability.
Economic and Strategic Research Group
July 29, 2022
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