Did the Fed Wait Too Long?

Tighter monetary policy and higher interest rates finally had their intended effects, slowing growth and reducing inflation. The question now is whether the Federal Reserve waited too long to reverse policies.

While most analysts focus on Fed policies, productivity and an expanding labor force are the unsung heroes of the last couple of years. They are key reasons why inflation declined without a recession.

Nonfarm labor productivity surged after the second quarter of 2022. Recent productivity growth has been about twice the long-term trend.

Higher productivity allows businesses to produce more with the same amount of labor, lowering costs to consumers and increasing profit margins.

Short-term bursts in productivity occur regularly. The issue now is how long this higher productivity will be sustained. It’s possible that developments in technology, such as artificial intelligence, are behind the productivity increase and make it long lasting.

But if this has been another cyclical fluctuation in productivity and it then falls, it will be difficult to maintain the current combination of solid growth, falling inflation and high profit margins.

At the same time productivity surged, the labor supply increased, primarily due to higher immigration.

Labor supply growth allowed businesses to hire and retain workers without continuing the extreme wage increases of the pandemic. To be sure, wage increases remain above the long-term average, but they are lower than in the last few years.

Lower compensation increases are a boon to businesses and help maintain solid growth and profit margins while inflation declines.

As with the productivity increase, a key issue for the economy is whether the increase in the labor force is a lasting trend or a short-term fluctuation. If labor force growth doesn’t continue, businesses could have to compete aggressively for workers again, reducing productivity and profit margins.

Consumer spending growth tells us a lot about the state of the economy and what’s likely to happen next.

Household spending growth is a major reason economic growth remains positive. Despite higher interest rates, businesses aren’t laying off workers in large numbers.

Wage increases have been high enough to keep consumers spending even as government stimulus faded. Also supporting spending are a reduction in the savings rate and an increase in household debt levels as interest rates declined.

The result is personal consumption expenditures, after adjusting for inflation, continue to increase at a steady rate.

But in recent months, we’ve seen the first signs of weakness in the labor market.

The pace of hiring is slower, as is the rate at which workers voluntarily quit jobs. The number of open jobs has been falling from the record highs of the pandemic.

There have been layoffs in technology, retail and manufacturing. The question is whether layoffs spread to other sectors and become widespread in the economy.

Stock markets are fragile because of their high valuations and the extremely strong returns of the last few years.

It wouldn’t take much bad news to trigger selling by investors that spreads, cascading into broad declines through the markets.

The pieces are in place for higher investment prices: lower inflation, solid growth, easier monetary policy and more. Plus, history shows that the years after the Fed begins cutting interest rates are good for many types of assets, especially stocks.

But this cycle has been different from typical cycles in many ways. We shouldn’t be complacent because the Fed shifted its policy.

Remain balanced and diversified and have solid margins of safety.