Bill Wood: 'Soft landing' for overall economy, not manufacturing

If you are like me at this time of year, then you increasingly focus more of your attention on holiday-related festivities and travel-related weather reports than you do on the daily news stream. To my chagrin, I find this is especially true about economics news. But before we in the business media lose you completely for the year, allow me one last opportunity to share a situation that has developed over the past few quarters and that I believe will become a major talking point in 2024.

I am referring to the divergence in the recent performance of the U.S. services sector compared with that of the U.S. manufacturing sector and what this divergence means for policy decisions pertaining to the timing and magnitude of cuts (or hikes) in interest rates in the coming year.

The service sector is by far the largest segment of the U.S. economy. Spending on services accounts for about two-thirds of total consumer spending in America, and consumer spending accounts for about two-thirds of the entire economy. When you include all of the services purchased by all levels of government, then it seems fair to say we are a service-based economy.

The pandemic was far more disruptive to the services sector than it was to the goods sector. The unavailability of many types of services during the shutdown created a huge amount of pent-up demand that has yet to be fully sated. Subsequently, the pandemic-induced spike in the demand for services has had an unpredictably large impact on the labor market.

At the risk of oversimplifying all of this, I will summarize our current situation: The government pumped trillions of dollars of relief money into the system, and a disproportionate share of that money has gone toward the purchase of services. This sharp increase in demand for services has in turn pushed wages for workers across the board much higher, and these higher wages are also being disproportionately spent on more services. And this increase in spending on services keeps upward pressure on the overall rate of inflation.

As evidence of this, I first offer the latest employment report. The headline number showed a solid gain in the number of jobs created in the U.S. in November. The good news is it also indicated the trend in job growth is moderating.

For the proponents of the "soft landing" narrative, this is the perfect scenario. It indicates the labor market is cooling, but it is not falling off a cliff. A cooling labor market is necessary for lower inflation because it relieves upward pressure on wages.

This is exactly the trend the Federal Reserve wants to see because it is walking a tightrope. On one side, it needs lower wage pressures in order to quell inflation. On the other side, it wants to keep everybody employed. Looking at just the headline numbers, it appears to be succeeding, at least so far.

But if you dig deeper into the employment data, you discover the bulk of the job gains in recent months have been in the services sector. This is especially true in the November report.

Accounting for the one-time adjustment caused by the auto workers' strike, the prevailing trend in the jobs data for the goods-producing sector is flat to down.

An analogous situation is emerging in the Consumer Price Index. The headline numbers have come down nicely this year, and though the overall rate is still higher than the target rate of 2 percent, we are making good overall progress to be sure.

Yet here again there is a widening gap between the underlying trends in the prices for goods and services. In fact, the prices for many types of goods have actually declined recently.

By comparison, price increases for many types of services are significantly higher than 2 percent. These are the "sticky" prices you may have heard about. As a general rule of thumb, the prices paid for these services tend to be less sensitive to changes in interest rates, but they are responsive to trends in wages. In fact, they may even be the cause of higher wages. This is what it means to be in the throes of the dreaded "wage-price spiral."

This is why the Fed cannot rule out entirely the need for future rate hikes, and it is also why it cannot start cutting the interest rate sooner rather than later—because rising employment levels result in higher wages and higher wages cause higher inflation. As of November, employment levels are still rising.

This is a complicated dynamic, and the Fed only has blunt instruments at its disposal that they can use to address any imbalances. To its credit, the overall trends are progressing in a positive direction and a soft landing still seems achievable. In other words, we may yet get the overall rate of inflation down to a sustainable level of 2 percent without a recession in the overall economy. But the operative word in that statement is "overall."

It is increasingly clear to me that the goods-producing sector of the economy has already landed. For some industries, it may well come to pass that this landing will not be soft. On the chart I have graphed the rate of change curves for the after-tax profit data for the U.S. manufacturing sector. This data is compiled and reported each quarter by the U.S. Census Bureau.

The chart shows after-tax profit for the entire manufacturing sector are down from a year ago. To be clear, this does not mean profit is negative. The total manufacturing sector is still making money; it is just not making as much as it was a year ago. The same can be said about the plastics industry: As of the third quarter of this year, the overall industry remains profitable, but margins are shrinking at an accelerating pace.

The chart indicates total profit for the plastics industry is down 28 percent when compared with the same four quarters a year earlier. That is a weaker performance than the overall manufacturing sector, and as I said the line is still aimed downward, which means the pace of decline is accelerating.

It is not yet clear when this line will hit bottom, but it is probable it will not start to turn upward until the first half of 2024. And that landing, when it finally happens, may not be that soft for many manufacturers.

Obviously, I will have much more to say about all of this in the coming months. In the coming weeks, please celebrate the things other than numbers that truly matter in your lives. The darkness will recede, and the light will return, and we will have time to address all of this further in the New Year.