MainStreet Macro: Running Hot and Cold

In the month of March, it’s hard to know which coat to wear. Will the weather be on the warm side or the cool side? That question also can be asked of the economy right now. As Main Street transitions from a pandemic-oppressed winter to a vaccine-liberated spring, is the economy running hot or cold?

The answer is both.

Last week, the Federal Reserve Board confirmed that the economy writ large is running much hotter than it thought when it last met in December. The Fed boosted its 2021 projection of GDP growth to 6.5% from 4.2% and lowered its forecast of the unemployment rate to 4.5% from 5%.

Inflation is coming in hotter too, ending the year at 2.2% versus 1.8%. This projection is particularly significant because it’s hotter than the Fed’s self-imposed 2% target yet will be allowed to float high “for some time”, the board said.

At the same time, the Fed acknowledged that hard-hit sectors are still feeling the chill of COVID-19. So in a very real way the economy is running hot and cold, depending on where you look. To get a feel for the country’s temperature, let’s pull out our figurative thermometer to measure five areas of the economy.

1. Housing

Housing has been running hot since summer, with median home sales up 27.3% at the start of this year compared to a year ago, according to the National Association of Realtors. But there are signs the market is starting to cool. Residential construction pulled back 10% in February from the previous month, according to Census data, with builders stymied by higher costs for lumber and other materials. Construction permits also dropped by 10%.

A record shortage of homes for sale, a slowdown in building, higher prices, and an uptick in mortgage rates could cool the white-hot home buyer demand that has defined the pandemic housing market.

This week will give us fresh data on existing home sales, which could confirm the spring cool-down.

Source: St. Louis Federal Reserve Economic Research

1. Stocks

Stocks had a speedy recovery from their pandemic plunge last March. Major indices have rebounded sharply and have even hit record highs. While the economy reeled from lockdowns, stocks benefited from super-low interest rates and super-high government spending. The S&P 500 index is more than 10% above its pre-pandemic peak.

Share prices are likely to maintain their warming trend, with occasional swings. Wall Street continues to test the market as it watches whether the Fed will keep easy and cheap money flowing to large companies even as the economy improves.

2. Business Investment

The latest read on business investment shows a warming to above pre-pandemic levels. Investment in hard assets like physical plants and technology was up 3% in the fourth quarter compared to a year ago according to the Federal Reserve.

That’s significant for two reasons. One, while consumer spending makes up the bulk of the U.S. economy, capital expenditures by companies can amplify economic growth.

Second, business investment isn’t a sure thing even in an expanding economy. Going into last year, interest rates were low, corporate balance sheets were strong and Congress had just approved a corporate tax cut. But business investment still was lackluster, with fourth-quarter capex spending by non-financial companies down more than 2% from the previous year before the pandemic hit.

If we start to see stronger spending, it could signal that businesses are more confident about future earnings opportunities. A warmer business climate could be the hot trend for the spring season. 

4. Labor

With 9.5 million workers still sidelined by the pandemic, no part of the economy is colder than the labor market. After two months of hiring declines, last month we saw a burst of job creation by restaurants and bars. The hope is that this is the start of a long hot spring–and summer–for hiring.

For now, a real-time measure of labor market health shows the economy is still being buffeted by the headwinds of job loss. After trending down, the number of people applying for unemployment benefits reversed last week, rising to 770,000 from an upwardly revised 725,000 the week before.

It’s been 11 months since weekly jobless claims hit an astronomical record 6.9 million, but the weekly average now is settling into a rate more than 100,000 higher than the peak of the Great Recession.

5. Inflation

The Federal Reserve has two mandates: Full employment and stable prices. But there’s been a sea change in monetary policy post-Covid, and the Fed is willing to loosen its grip on inflation to better support jobs. Last week, even as the Fed acknowledged stronger economic growth, it recommitted to ultra-easy monetary policy to give a boost to hiring.

Doing otherwise would risk another jobless recovery like the one we saw after the Great Recession, when the economy accelerated while unemployment stalled above 8% for years.

Inflation is moderate for now and is likely to warm up considerably as the economy improves (we’ll get another temperature check Friday). But a surge in inflation is unlikely while the labor market is cool and wage growth is modest.

My Take

Taken as a whole, the economy is warming, but we should brace for cold spells. Industries are still wrestling with the lingering after-effects of the lockdown, such as supply shortages and curtailed consumer spending on services.

Post-pandemic growth is consistent with a K-shaped recovery, in which the fortunes of some industries and Main Streeters accelerate, while others plod along. That’s precisely why local temperatures matter.