The Service Sector Is Still Too Hot for the Fed

Chief Economist Eugenio J. Alemán discusses current economic conditions.

The Federal Reserve (Fed) still has a very tough job ahead to bring inflation down to its 2% target over the long run while facing pressures from markets, which have a very different timetable than the Fed. At least, this is what transpired from the Fed’s June Federal Open Market Committee meeting (FOMC) Summary of Economic Projections (SEP) and dot plot.

Furthermore, the Fed is facing a highly unsynchronized business cycle in the U.S. economy. Normally, economic cycles are synchronized, that is, they go up and down in a relatively synchronized fashion even though one sector is, typically, the culprit for generating the cycle in the first place.

A typical monetary tightening cycle starts as the Fed increases interest rates, that is, tightens credit, and the most interest-rate sensitive sectors of the economy, particularly residential investment, take a plunge. Clearly, this was happening just before the COVID-19 pandemic, as the Fed’s tightening campaign started in 2016. However, as the COVID-19 pandemic commenced, the Fed relaxed monetary policy once again and the housing market, that is, residential investment, took off again. But that cycle ended once the Fed started increasing interest rates last year due to the strong increase in inflation.

Residential investment has fallen for eight consecutive quarters, on a quarter-over-quarter, annualized basis, and while it was still negative during the first quarter of the year, the decline wasn’t as large as in the previous seven quarters, which is another sign that the housing market has stabilized somewhat from the fall experienced during 2022.

But as the graph below shows, this time has been different, so far, as the large decline in residential investment has not been followed/accompanied by a decline in construction employment. And we don’t buy into the argument that the reason for not seeing a decline in construction employment is because firms are ‘hoarding’ workers.

Construction Employment and Real Residential Investment