Industrial Production Supports Fed President Williams: Fed Not Cutting Soon

The Industrial Production and Capacity Utilization Report, corresponding to activity during the month of November 2023, was published by the US Federal Reserve on December 15, 2023, at 9:15 AM. This report is widely considered to furnish some of the best indicators of the production of goods in the US economy, that are available at a monthly frequency.

In this article, we will walk our readers through an in-depth analysis of the data in the Industrial Production and Capacity Utilization Report, and then proceed to converse potential implications for the U.S. economy and financial markets.

Summary Data and Analysis

We begin our analysis of the Industrial Production and Capacity Utilization report by reviewing the summary information in Figure 1.

Figure 1: Change, Acceleration, Expectations, and Surprise

Total Industrial Production grew by 0.24% which ranks in the 51st percentile. Represents an acceleration of 1.13% compared to last month’s growth of -0.89% (revised down from -0.63%). The reported growth in November was a downside surprise compared to the median forecast of 0.30%. The manufacturing component of industrial production grew by 0.34%, compared to -0.82% the previous month. This was also below the consensus forecast of 0.40%.

We will now proceed to our detailed analysis of the Industrial Production data.

Analysis of Growth Rates By Component Categories

Industrial Production data can be broken down in three different ways: by Industry Group, Market Group, and by Stages. In Figure 2 we take these breakdowns and display their annualized growth rates and respective historical percentile ranks over various time frames (1m, 3m, 6m, and 12m). The objective of this analysis is to differentiate the growth rates of different components and to differentiate growth rates across different time frames.

Figure 2: Annualized Growth Rates of Key Components

Industry Breakdown

Market Breakdown

Stage Breakdown

There are a few important things to highlight. First, durable manufacturing growth was very strong this past month due to the restart of auto manufacturing, after the strike. Such strong growth will not be sustained. Second, nondurable and other manufacturing are weak. Third, overall, manufacturing growth is running well below trend on a 3-month annualized basis. Fourth — and this is the most important point — the rate of growth in the past 3 months, although below trend, is not significantly lower compared to growth in the past 12 months.

Decomposition Analysis: Contributions to Change and Acceleration

In Figure 3, we perform a decomposition analysis of the MoM growth in Industrial Production, according to three different ways of breaking down the data into different economic categories.

Figure 3: Contributions of Components to Change and Acceleration

Industry Breakdown

Market Breakdown

Stage Breakdown

Manufacturing accounted for nearly all the change in Industrial Production for this month. Specifically, Durable Manufacturing contributed strongly to both positive change and positive acceleration in Industrial Production while Nondurable Manufacturing contributed negatively. Outside of Durable Manufacturing, mining was also a major positive contributor to acceleration. In the Market breakdown, Materials were a disproportionately positive contribution to both change and acceleration. Consumer Goods were also a notable positive contributor to the acceleration in the Industrial Production total index.

Implications for the Economy

The manufacturing data, outside the auto sector, look soft. The data imply that the U.S. economy is cooling moderately. But there does not appear to be any major reject in manufacturing growth during the last 3 months, relative to growth in the past 12 months, that would raise concerns about recession. The U.S. economy grew by over 5.0% in Q3 2023, despite the same type of sub-trend growth in manufacturing that we are seeing now. Therefore, unless manufacturing activity contracts more significantly than it has in the past 3 months, there is little cause for the market, or the Fed, to be concerned. Arguably, the Fed should be concerned that its interest rate hikes have not had more of an impact on the manufacturing sector than they have.

The Fed would admire to see demand for manufactured goods growing at a below-average pace. However, In our article on Retail Sales yesterday, we highlighted the fact that, in real terms, demand for manufactured goods is quite strong. Thus, the moderate weakness in manufacturing production, reflected in this report, appears to be indicative of a slight inventory correction, as opposed to being a signal of any significant or sustained overall economic weakness.

Implications for Financial Markets

The industrial production data are supportive of a “soft landing” narrative. However, in our view, the weakness in industrial Production is not sufficient to uphold widespread market expectations for a Fed rate cut in March. This is because the manufacturing sector is not much weaker than it was when GDP grew by over 5% in the third quarter of 2023. In other words, Fed interest rate hikes have not been sufficiently high and/or been in place long enough.

Taken together with the Retail Sales report from yesterday, we believe the data imply that the Fed Funds rate will probably remain “higher for longer,” than the market currently expects. Federal Reserve Bank of New York President John Williams hinted at this earlier this morning.

Conclusion

It is our view that market participants have gotten ahead of themselves in anticipation of a “pivot.” We believe that the pivot narrative is both misguided and premature. Fed Governor Williams’ comments today propose – in our interpretation of them – that any rate cuts in 2024 will probably come significantly later than the market currently expects.

When Williams said that the Fed members “aren’t really talking about cutting interest rates right now,” what he is really saying is that the Fed is not talking about cutting interest rates in the same way that the market is talking about this subject right now- particularly with regard to the timing of interest rate cuts. Williams is acknowledging that the market is expecting rate cuts starting in March 2024, and he is saying that the Fed is not talking about cutting rates in March. And we think investors should believe him.

Furthermore, the economic data simply are not supportive of Fed rate cuts any time soon. Unemployment is well below the non-accelerating inflation rate (NAIRU), wages are growing (5%+) well above levels compatible with 2% inflation, CPI core services ex housing (the indicator considered to be most important by the Fed) is growing at over 5% – to name only a few factors.

Therefore, markets may face some disappointments in the months ahead regarding the timing and extent of interest rate cuts. Our view is that Fed rate cuts in 2024, if they occur at all, will not occur until the second half.

However, it is also our view that the probabilities of a soft landing have probably increased. Ironically, this is partly due to the easing of financial conditions that the market itself has engineered due to overly optimistic expectations about the timing and extent of Fed rate cuts.

At Successful Portfolio Strategy, we are positioning our portfolios accordingly. Our view is that risk is badly mispriced, as seen most clearly in the extremely low level of the VIX. However, cyclical growth is probably also currently mispriced – particularly in relative terms.