Main Street Macro: The self-love theory of economics

As we enter the third week of July, upcoming data releases are all about economic incentives.  While insights about supply, demand, and equilibrium often make the headlines, a crucial but rarely discussed pillar of economics is the importance of incentives to macroeconomic outcomes.

Financial incentives, whether good or bad, guide individual behavior. And a big, new financial incentive is looming, one that could change the trajectory of certain economic indicators: The possibility of Federal Reserve rate cut.

Adam Smith, the philosophical architect of modern economics, succinctly described the critical necessity of incentives in economics in his 1776 treatise, “An Inquiry into the Nature and Causes of the Wealth of Nations.”

“It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own self-interest,” Smith wrote. “We address ourselves not to their humanity but to their self-love, and never talk to them of our own necessities, but of their advantages.” 

In other words, there is no free lunch in economics.

Now is the perfect time to brush up on the theory of rational self-interest because the prospects of pending interest rate cuts and a slowing job market are set to play a major role in incentivizing consumers, workers, investors, and business owners in the second half of the year. 

Last week, data showed that consumer inflation slowed to 3 percent in June from a year earlier. Core inflation, which omits volatile food and energy prices, slowed to 3.3 percent.

Inflation continues to make progress towards the Fed’s 2 percent target.  Once that zone is reached to their satisfaction, central bank policymakers are prepared to start cutting interest rates from their two-decade high.

Main Street is incentivized to wait on those pending rate cuts, and that incentive will show up in three key areas of the economy that are highly exposed to the Fed’s rate decision.  

The labor market

In 2022, strong demand for workers encouraged people to jump to new jobs to boost their pay. Since then, job opportunities have begun to dry up, with new postings on the decline. Diminishing labor market incentives mean that workers are staying on their jobs longer even as wage growth at their current employers slows.

ADP payroll data shows that turnover at U.S. employers-–the percentage of workers leaving their current jobs–-has fallen from a high of 6.8 percent in August of 2022 to less than 5 percent as of May 2024.

The housing market

Housing plays an important role in the path of inflation. Shelter costs, based on a combination of rental prices and imputed home values, are up 5.2 percent in June from a year earlier. But inflation in shelter slowed to just 0.2 percent in June from the previous month, the slowest pace of growth in more than three years.

High mortgage rates are putting the brakes on sales, as would-be homebuyers hold out for cheaper borrowing and more inventory. 

Small business loans

Small businesses have been heavily affected by current interest rates. Over the last year, demand for small business loans has decreased substantially. Growth in small business loans swelled in early 2023, jumping 8 percent year over year. As interest rates have risen and held at higher levels, year-over-year growth in small business loans outstanding was less than 1 percent in May.

This slowdown in loan demand might signal that small businesses are delaying hiring and investment until they can secure cheaper financing.

My take

The theory of economic incentives, like most of economics, provides a useful heuristic to abstract the role of human traits that are hard to forecast, such as emotions, laziness, or generosity.

Whether it’s waiting for the perfect time to trade in a leased car, finance a big purchase, or secure a business loan, individual economic decisions hew closely to Federal Reserve decisions to cut rates, and by how much.

The incentive to wait will become much stronger the closer inflation gets to the Fed’s comfort zone. Main Street’s patience means that growth could slow in the second and third quarter, as people and businesses delay their spending and investment decisions in hopes of a rate cut this fall. 

The week ahead

Tuesday: Retail sales and business inventories data from the Department of Commerce will tell us whether consumers are pulling back on spending at higher prices. Worth watching is durable goods sales, because those items tend to me more expensive and tied more directly to borrowing costs.  A buildup in inventories also could signal softening demand.

Wednesday: The Census Bureau will release data on residential construction, including housing starts and new permits. Interest rates have slowed both the supply and the demand for new homes. This data will reveal whether homebuilders are revving up plans for new construction as the likelihood of a Fed rate cut increases.

Thursday:  Weekly initial jobless claims from the Department of Labor will get even more than the usual attention as economists look for more evidence of a cooling job market.