Election year dissonance: Midyear economic outlook

June 10 , 2024

A recent KPMG poll revealed that consumers assess their own financial situations as better than prospects for the overall economy. Some of that dissonance reflects the divisiveness of our politics. Republicans assess the economy as worse when the White House is occupied by a Democrat and vice versa.

However, the gap we are seeing is more than one of political allegiance alone. Recent research reveals that people who reside in states that are Republican strongholds experienced the highest inflation and were the largest beneficiaries of in-migration.

Those wealthy newcomers bid up costs, notably of shelter, making it harder for existing residents to make ends meet. Some of that migration was due to the arbitrage that cheaper, second-tier cities offered, including lower income taxes. Many of those same enclaves are now among the most expensive, with inflation outpacing other parts of the country.

The KPMG survey reveals that CEOs are less confident about their companies’ performance but more confident in prospects for the overall economy. That is the reverse of how consumers perceive the economy, another seeming anomaly or dissonance in the data.

Some of that discrepancy can be explained by the source of our news. Those who get their news from social media or word of mouth tend to assess the economy much more harshly than those who listen to mainstream or business news. It is not a stretch to assume that CEOs tune in to mainstream and business news.

The gap between consumers’ and CEOs’ individual situations gets to the frictions we are seeing emerge. Higher interest rates have hit a tipping point. Loans are repricing, especially for mid-sized and small firms, while consumers are pushing back on price hikes, especially on goods. 

This is at the same time that the overall economy is slowing under the weight of higher rates. The shift into low fixed rate debt delayed but did not derail the effects of higher rates on consumer and corporate balance sheets.

There is an asymmetry between how people experience economic trade-offs. They see the surge in wages as a reflection of their skills, not a rapid recovery but inflation is more nefarious. They blame it on the government and corporate greed. Many of the same factors that spurred wages also stoked inflation. That has opened the door to populist rhetoric, which fuels public anger, rather than provides effective solutions to inflation.

This edition of Economic Compass provides a deep dive into the outlook, the implications for inflation, decisions on interest rates by the Federal Reserve and the trajectory of bond yields. Special attention will be paid to the election and how it could influence the economy. Our divisive politics have consequences. Policy uncertainty acts as a tax on the economy and prompts firms and households to delay big spending decisions.

Election uncertainty jumped to the second greatest threat in the Fed’s Spring 2024 Financial Stability Report; 60% of respondents cited it, up from 24% in Fall 2023. Another KPMG survey revealed similar concerns, with 62% of CEOs saying they would delay investment until after the election. Our analysis suggests that the consequences of policy uncertainty can linger, especially if an election is contested.

Constrained rebound in housing

Home buying and building surged at the start of the year after mortgage rates dropped in anticipation of rate cuts. Home values accelerated as the market picked up. A rebound in rates has locked first-time buyers out of the market and put a damper on overall activity.

Home buying sentiment has hit a new low, while the number of those who think it is a good time to sell has softened but remains elevated. Listings are up along with inventories of new homes on the market but supply shortages persist.

Reports of price cuts have picked up. However, it is unclear whether that is just a slowdown in the pace at which home values are appreciating, which jumped in recent months, or an actual cooling. The difference matters for inflation.

Housing affordability is at the lowest level since the mid-1980s. Those measures do not include the rise in other housing-related costs, from insurance to maintenance and repairs; all have surged.

Home builders have moved downscale and offered mortgage discounts to tap the pent-up demand by millennial buyers. However, builder discounts are not as aggressive as they once were, given the upward pressure on materials costs due to the surge in weather-related damages and waning hopes of a rate cut this year. Costs of inputs to construction are 39% higher than early 2020, even as many items have come off record highs.

Those who can’t buy are renting. That is helping to absorb the excess supply of apartments in the hottest post-pandemic markets and placing a floor under rents. 

The rebound in housing activity once mortgage rates start to fall is expected to be solid but not spectacular. Millennials now represent the largest generation of thirty-somethings we have ever seen. That is the median age of first time buyers, fueling demand amidst supply constraints.

Many sellers remain locked into ultra low rates and are reluctant to list, while baby boomers continue to age in place. That is limiting the stock of existing homes for sale, while builders are struggling with shortages of workers, materials and land for development. Water shortages and the stress on the electrical grid are additional hurdles.

Another wild card is weather. An increase in severe storms could compound the damages to property we have already seen, keep materials costs high and trigger construction activity later in the year and into the start of 2025.

Business investment softens

Business investment accelerated at the start of the year, buoyed by subsidies for chip plants and the surge in demand for data warehousing. Intellectual property investments are catching up after last year’s writers’ strike and investment in AI.

Investments in generative AI (GenAI) are rising from a low base. Recent surveys by the Census Bureau suggest they follow a U-shape and are concentrated in large firms and startups. The insatiable demand for energy created by data warehousing and GenAI is stressing energy grids. That has focused Silicon Valley’s attention on renewables and cheaper non-carbon sources of energy, including nuclear.

The hurdle is high interest rates and the maze of regulations surrounding government loans for and permitting of renewables. This is before the losses associated with office leases repricing in 2024 and 2025. Much of what was due to reprice in 2023 was delayed until rates were expected to fall. It is unclear how many more of those payments can be deferred. Unrealized losses in the financial system have increased in recent years.

The Fed has flagged private credit markets, which have expanded, as a place to watch. They are opaque; officials have no way of knowing how systemic the risks of a large failure in that market might be for the overall economy.

The uncertainty surrounding the election and its outcome could further surpress investment. There is considerable uncertainty regarding the fate of expiring tax cuts; corporate tax cuts could now lapse under both candidates due to a broad lack of trust in corporate America. Small businesses are viewed much more favorably than large businesses.

Both party leads favor more protectionist policies, although those favored by the former president are more extreme when it comes to tariffs and immigration. The United-States-Mexico-Canada-Agreement (USMCA) is unique in that it was negotiated with a sunset clause; that is suppressing investment in all three countries as it removes the certainty of avoiding tariffs.

The trade agreement is up for renegotiation in 2026. The US has the largest sway in the review process, which makes who the president is sitting at the negotiating table crucial. The former president was much more critical of the trade pact than the current president, hence the escape clause.

Why do we care? Because a failure in the review process could set off a chain of events that boosts tariffs and creates more hurdles to trade within North America more broadly. The literature on tariffs is split on whether consumers or firms in the country that enacts them pay the greater costs; either way, they are a tax.

Inventories are replenished

One of the few bright spots in the economy is the drawdown in inventories we saw in late 2023 and early 2024. That sets the stage for some rebuilding during the Spring and Summer. The cost of carrying inventories has risen with the jump in bond yields since the start of the year. That could delay a full rebuilding of inventories until rates come down in 2025.

Government spending posts short-term gains

The resolution of federal budget battles earlier in the year means that much of what is left of the budget will need to be spent before the end of the fiscal year, which ends October 1. The biggest obstacle for 2025 is the fiscal cliff; 25 tax cuts associated with the 2017 Tax Cuts and Jobs Act (TCJA) are slated to expire by the end of the year.

The chances of getting a deal on the TCJA early in the year are slim, which pushes most of the economic consequences into 2026. Our baseline forecast has tax cuts for corporations lapsing at year-end, but not for households. Both parties favor keeping at least a portion of the individual tax cuts, which covered more than half of all households.

Spending by state and local governments is expected to hold up better, as earlier stimulus is still being spent. Many states have shored up their rainy-day funds. However, revenues have begun to slacken, which suggests a larger headwind for spending in fiscal 2025, beginning over the summer for many states.

Fiscal policy is expected to be a drag on growth in 2025. Federal deficits are expected to continue to mount, as Congress debates where and how to raise revenues or reduce spending; neither party has a recent record of achieving either, while the upward pressure due to aging demographics mounts.

Estimates on potential deficits are large and rising under both candidates but the figures are all over the place due to the uncertainty of outcomes, including immigration policy. In the absence of immigration the overall population is projected to contract by 2040.

The latitude of state and local governments, which make up the lion’s share of spending, is limited. They cannot rely upon deficit spending the same way that the federal government can. Their revenues are expected to continue to slow as they enter fiscal 2025.

The drag from trade dissipates

The US continues to outperform many of its trading partners, even as its economy slows. That has put upward pressure on imports relative to exports. The push by businesses to get under the wire before new tariffs go into effect has further fueled imports. Those shifts will front-load the widening of the trade deficit.

A slower glide path by the Fed is another hurdle, as it has triggered a widespread strengthening in the dollar against the currencies of all our major trading partners. That makes imports cheaper and our exports more expensive. The lags on the dollar suggest that the largest effects of those moves will hit late this year and early 2025.

The Fed will release new forecasts for its trajectory on rate cuts in June. We expect most participants at the June meeting to forecast two or fewer rate cuts for the year and a slow glide path on cuts in 2025.

The Fed has made clear it does not want to repeat the mistakes of the past and cut prematurely. That would risk stoking a more persistent inflation, or worse, stagflation.

Hence, the Fed wants to be sure that inflation is coming down “convincingly” before it cuts. That is not likely to happen until late in the year, given our forecast for inflation. The first cut in rates is expected in December.

Another six cuts are forecast in 2025, which would bring the fed funds rate down from its current 5.25% to 5.5% range today to a 3.5% to 3.75% range at the end of 2025. The fed funds rate is expected to hit a terminal rate of 2.75% to 3% in 2026, which is still well above the 1.5% to 1.75% in February 2020.

What would prompt the Fed to cut more aggressively? A much more abrupt weakening of labor market conditions. The Fed’s most recent Beige Book report highlighted a slowdown in hiring, but that has yet to show up in the payroll data.

The election poses an existential threat to the Fed. The former president made his dislike for the Fed Chairman, whom he appointed, well known. Some in his campaign have pledged to curb the Fed’s independence by picking leaders more loyal to the president. History is littered with central banks that succumbed to political pressures. That is what helped stoke the stagflation of the 1970s.

Lower short-term rate risks. The Fed is “data-dependent” but data on the economy lags. That ups the risk that the Fed overtightens and adds to the policy uncertainty surrounding the election.