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Fed Policy Mistake? 3 Reasons the Economy Will Keep Humming

Fed Policy Mistake? 3 Reasons the Economy Will Keep Humming

"I've had a lot of worries in my life, most of which never happened."

— Mark Twain

Chief Investment Strategist

The higher the stock market climbs, the more anxious investors grow. The S&P 500 has reached a new all-time high more than 30 times so far this year. Those records have created a mountain of anxiety. Incendiary headlines and seductive social media feeds further fan the flames of investors’ restlessness.

But as long as the magnificent music is playing, investors feel compelled to keep dancing.

This uneasiness is rarely captured in measures of capital market volatility. Rather, this discomfort is rooted in the cognitive bias of loss aversion which explains why investors feel the pain from losses twice as much as the pleasure from gains. Despite more than 20 months of nearly uninterrupted gains, each new record high amplifies investors’ suffering from the pain of potential future losses.

After all, what goes up, must come down. Or does it?

Building Risks and a Restrictive Fed

At least a half dozen known risks could derail the rally. Not to mention the really scary black swans and unknown unknowns. Of all the visible risks, the increasing likelihood of a policy mistake by the Federal Reserve (Fed) matters most to the economy and investors. The Fed kept its target range for the federal funds rate at 5 ¼% to 5 ½% on June 12. At the post-FOMC meeting press conference, Chairman Powell used the word “restrictive” to describe monetary policy a whopping eight times.

But is Fed policy too restrictive? The top end of the federal funds range is higher than nominal GDP. And according to Strategas Research Partners, holding nominal short-term interest rates above nominal growth has been a recipe for disaster over the past several decades, resulting in economic slowdowns, financial crises, and recessions.

The economy is slowing. First quarter GDP increased at an annual rate of 1.4% compared to 3.4% in the fourth quarter of 2023.1 The labor market is softening. The unemployment rate is headed in the wrong direction, climbing 0.6% over the past 14 months, from 3.4% to 4%.2 May retail sales were weak and consumer confidence measures are treading water.3 Both manufacturing and housing data are struggling under the weight of notably higher interest rates and sticky inflation. The latest Manufacturing ISM Report on Business reveals that the manufacturing sector contracted in May for the second consecutive month and the 18th time in the last 19 months.4 Meanwhile, housing starts plunged 5.5% year-over-year in May.5

The risks are growing that the stubborn Fed gradually and then suddenly puts the economy in recession. But the economy may narrowly escape the dreaded recession outcome for three reasons:

  1. Artificial intelligence is the real deal
  2. Immigration delivers surprising economic benefits
  3. High-end consumers are in great shape

Let’s examine how each of these reasons may help the economy avert catastrophe over the next several quarters.

Rise of the Machines

Stop me if you’ve heard this one before — artificial intelligence (AI) is a game changer. What else can be written about the potential of AI that hasn’t already been said?

Yet, for years, AI promised more than it delivered. Progress on practical uses from self-driving cars to personalized tutoring was painstakingly slow and underwhelming. That changed with the release of OpenAI’s ChatGPT in November 2022.

AI has evolved into a general-purpose technology (coincidentally abbreviated GPT). These once-in-a-lifetime advancements like steam power, electricity, and the internet, impact every industry and every aspect of life. Some AI enthusiasts claim that generative AI might be even bigger. According to McKinsey, generative AI’s impact on productivity could add trillions of dollars in value to the global economy. They estimate that generative AI could add $2.6 to $4.4 trillion annually across 63 different use cases analyzed. That’s about the size of the United Kingdom’s GDP in 2021. This would increase the impact of all AI by 15% to 40%.6

But, because general-purpose technologies require many other technologies to work well together, they are often adopted slowly. For example, the foundation for the internet was developed in the 1960s, but it wasn’t widely accessible until the 1990s. The creation of the web browser, growing infrastructure for high-speed internet, and more affordable computers were needed to fuel greater internet adoption.

This hasn’t been the case for large language models that serve as the backbone for AI products like ChatGPT which have been rapidly adopted by consumers and businesses within just a few years of their invention. ChatGPT reached 100 million users faster than any previous product in history. Free access, widespread availability, and incredible usefulness have accelerated adoption rates.

Ethan Mollick writes in his book, Co-Intelligence: Living and Working with AI, “Where previous technological revolutions often targeted more mechanical and repetitive work, AI works, in many ways, as co-intelligence.” AI strengthens, or potentially replaces, human thinking with startling results. McKinsey’s research suggests that about 75% of the value that generative AI use cases could deliver for businesses fall across four main areas: customer operations, marketing and sales, software engineering, and R&D.7

Recent studies assert that AI can improve productivity across a wide range of jobs by 20% to 80%. That compares favorably to another general-purpose technology, steam power — the catalyst for the Industrial Revolution — which improved productivity by 18% to 22% when it was put into a factory. Remarkably, economists still haven’t found any real long-term positive productivity impact from computers and the internet over the past two decades.

McKinsey claims that generative AI can substantially increase labor productivity across the economy, adding 0.1% to 0.6% annually through 2040. Combining generative AI with all other technologies, McKinsey believes that work automation could add 0.5 to 3.4 percentage points annually to productivity growth.

Mollick sums up neatly the potential of AI, “We have invented technologies, from axes to helicopters, that boost our physical capabilities; and others, like spreadsheets, which automate complex tasks; but we have never built a generally acceptable technology that can boost our intelligence.” That is until now.

AI’s incredibly powerful economic benefits are one reason investors shouldn’t worry so much about a Fed policy mistake. Now, let’s explore another reason to leave those worries behind.

Immigration's Positive Economic Impacts

Immigration is a political football. It’s become one of the most divisive issues of the looming US presidential election. Regrettably, many people underappreciate the role that increasing immigration has played in stabilizing the post-pandemic labor market without further flattering inflationary pressures.

Last year over 2.5 million immigrants entered the US, and this year is on a similar pace. Typically, about a million immigrants enter the US each year. During the Trump administration, that number dipped to about 750,000. That lower immigration figure combined with the post-pandemic challenges contributed to extreme supply/demand imbalances in the labor market in 2021.

The rise in immigration over the past couple of years has helped the labor market achieve greater equilibrium without stoking wage inflation. Empirical Research Partners says this is particularly true for low-skill service positions where wage growth peaked at 8.5% and is now 4.2%. In fact, foreign-born workers accounted for 60% of the growth in the labor force last year, three times their share of the base — and 2024 figures will be comparable.8

Foreign-born workers’ notable contribution to labor force growth is at least partly driven by a decline in the native-born population from aging demographics and lower fertility rates. The pace of immigration increases over the past couple of years is consistent with past economic expansions. And, with job openings remaining elevated in immigrant-dependent service industries, participation rates are likely to increase over the next two years, further boosting the labor market.

The US has added roughly 3 million jobs over the past 12 months and the unemployment rate has stayed at or below 4%. At the same time, wage growth has slowed from 4.7% to 3.9%, a level that’s less likely to put upward pressure on inflation. This outcome has been driven largely by an increase in foreign-born workers. Conditions have improved considerably, but the labor market remains moderately tight.

This gradual return to labor market equilibrium has enabled the Fed to stay higher-for-longer while also confirming the economy’s ability to withstand higher interest rates. Despite some of the senseless fear mongering, positive economic impacts from increased immigration start from gainful employment but rapidly extend to greater entrepreneurship, innovation, consumption, and fiscal contributions.

Immigration’s underappreciated positive economic impacts may be another reason investors shouldn’t worry too much about a Fed policy mistake. Let’s delve into the third and final reason investors shouldn’t waste too much time worrying about recession in the next few quarters.

Hey, Big Spender

The top 20% of the income distribution, people earning $150,000 or more, are in good shape. In a late June report, Empirical Research Partners forecast that this group could potentially lift discretionary spending by 8% this year. That matches the average from 2015 to 2019 and last year’s result. Continued employment growth, increasing small business confidence, and falling inflation would likely further bolster confidence and spending from the top 20% of earners.9

There’s a growing list of economists and market commentators that believe that top earners have actually benefitted from higher interest rates over the past 18 months. This group owns most of the financial assets held by households. According to Empirical Research Partners, they own 85% of stocks, 80% of bonds, and two-thirds of liquid assets. Yet, they only makeup about one-third of consumer credit card balances.10

In a departure from past periods, higher stock and home prices combined with a significant increase in their interest income has enabled top earners to spend solidly throughout this tighter monetary policy cycle. In fact, the top quintile of the income distribution is responsible for 40% of US consumer spending. That’s roughly equal to the bottom three quintiles combined.11

Capital gains, business income, bonuses and stock awards have allowed high earners, particularly those in the top 1% of the distribution, to capture an increasing share of the income pie. Labor market tightness coming out of the pandemic, led to larger wage gains from the bottom 60% of the income distribution. Now, as the labor market normalizes, at least partly driven by a surge in immigration over the past couple of years, consumer earnings in the highest-paying industries have climbed 4.5%, matching the 2023 result and outpacing inflation.12

Top quintile incomes are expected to grow 5% this year. Higher debt service and nondiscretionary costs will trim spending a little bit, but the wealth effects from stocks, bonds, and homes will easily outpace those increased expenses. All of this resulted in Empirical Research Partners’ prediction that discretionary spending would get an 8% boost this year.13

Top earners’ rising incomes and increased spending will likely continue to support the economy. This should allay investors’ fears of a lurking recession in the next few quarters.

Just Dance

With the S&P 500 rising more than 15% and touching new all-time highs more than 30 times so far this year, it’s been a solid six months for stocks. But the cognitive bias of loss aversion nags at investors, fueling growing fears of imminent future losses.

Of the many risks that could disrupt the bull market rally in the second half of the year, a Fed policy mistake is the most visible. Holding short-term nominal interest rates above nominal economic growth — where we find ourselves now — has historically resulted in economic slowdowns, financial crises, and recessions.

But a restrictive Fed won’t stop the music this time around because the economy’s moving to a new rhythm. AI and its use cases are ushering in a prolonged and unprecedented productivity miracle. The surge in immigration over the past couple of years has helped normalize the labor market without increasing inflationary pressures — and those benefits will likely continue. And the top 20% of income earners could boost discretionary spending by 8% or more this year.

Given the S&P 500’s incredibly strong rally over the past 18 months, investors are right to be cautious and constantly weighing potential risks. But they should put those worries aside temporarily and appreciate that AI, immigration, and high-end consumers will keep the music playing for a little while longer.

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