07 Feb Economic Equilibrium

The year started with markets convinced that the Fed would start cutting its key interest rates as soon as March, giving a probability of 97.5% to such an outcome on January 1st. However, following solid macroeconomic data throughout the month and a less dovish Fed, markets were far less sure at the end of the month, with this probability down to 35% on January 31st. It is true that the December Services ISM disappointed sharply, falling from 52.7 to 50.6, its weakest in 7 months, with a large decline in the employment component from 50.7 to 43.3, lowest since 2020. Manufacturing picked up to 47.4 but remains in contraction for the 14th month with soft demand. However, the job market is still very tight, with persistently low initial jobless claims, a sustained pace of jobs’ creation (353k in Jan.), a low unemployment rate (3.7%) and wage growth rising (4.5% y/y in Jan.)

It is true that the December Services ISM disappointed sharply, falling from 52.7 to 50.6, its weakest in 7 months, with a large decline in the employment component from 50.7 to 43.3,lowest since 2020. Manufacturing picked up to 47.4 but remains in contraction for the 14th month with soft demand.

However, the job market is still very tight, with persistently low initial jobless claims, a sustained pace of jobs’ creation (353k in Jan.), a low unemployment rate (3.7%) and wage growth rising (4.5% y/y in Jan.).

The December CPI may also have created some uneasiness at the Fed, as the core fell just one tenth from 4.0% to 3.9% (3.8% exp), while the headline picked up more than expected, from 3.1% to 3.4%. That said, core PCE, the Fed’s preferred inflation gauge, sent a softer message, with the core year-over-year measure falling to 2.9%, below 3% for the first time since March 2021.

In fact, for central bankers, data looked quite immaculate overall, with the economy approaching a Goldilocks’ state of strong – but not overheated – growth and stable inflation, with the advanced estimate for GDP in the 4th quarter of last year and the quarterly growth in core PCE at 3.3% and 2% annualized respectively. Meanwhile, preliminary Jan. PMIs took the economy further away from recession, with manufacturing unexpectedly back in expansion (50.3), while services also surprised higher (52.9).

The risk seems to have shifted from recession a year ago to “too good to be true?” today, and the January FOMC meeting showed a bit more cautiousness regarding rate cuts.

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