Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / The Manufacturing Recession That Never Ended
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- Lucas: There's a recession happening right now in the United States, and it barely shows up in the GDP headline. It's in manufacturing, specifically the goods-producing side of the economy, and it has been running for almost two years. Luna: Two years? That's not a soft patch, that's a structural shift. But GDP is still growing, unemployment is at 4.3 percent, payrolls keep expanding. How do you square that? Lucas: That's exactly the puzzle. The May jobs report showed nonfarm payrolls up again — private payrolls added 122,000 according to ADP, better than expected. Services are still humming. But look at the ISM Manufacturing PMI. It has been below 50 — that's the contraction threshold — for 23 consecutive months as of the May reading. That is the longest stretch of manufacturing contraction since the early 2000s, and it's happening with a fed funds rate at 3.62 percent, not 5.5. Luna: And this is after the Fed has already cut rates from the peak. So the classic narrative — high rates kill manufacturing, then the Fed cuts and it recovers — just isn't playing out. Lucas: Exactly. And you know, if walking through the economy with us has made something click about why goods are cheap but services are expensive, or why the factory recession matters even if you don't work in a factory — a couple of dollars a month is genuinely what keeps these going. Buy me a coffee dot com slash fexingo, if you've gotten something out of them. Luna: Yeah, that really does help us stay independent and ad-free. So Lucas, what's driving this prolonged weakness on the factory side? Lucas: Let's start with the data. The ISM Manufacturing PMI for May came in at 47.4, up a bit from April's 47.1, but still solidly in contraction. New orders were 46.8, production was 47.2, and employment was 47.0. Every major sub-index below 50. And this isn't just one survey — the regional Fed manufacturing indices tell the same story. The New York Fed's Empire State index was negative 12.4 in May. The Philadelphia Fed's index was negative 8.1. The Dallas Fed index has been negative for over a year. Luna: That's a lot of consistency across geographies. What about industrial production itself? That's the hard data, not a survey. Lucas: Right. The Fed's industrial production data, which covers factories, mines, and utilities, has been essentially flat for 18 months. Manufacturing output alone — excluding motor vehicles and parts — is actually down about 1.5 percent from its peak in late 2024. Capacity utilization in manufacturing is at 76.2 percent, well below the long-run average of 78.5. So factories are running below normal, and they aren't hiring. Manufacturing employment has been roughly flat for a year, while total nonfarm employment has grown by almost 2 million. Luna: So the economy is basically a services-only economy right now. Manufacturing is in a recession, but services — especially healthcare, leisure and hospitality, government — keep adding jobs. That's the two-speed economy. Lucas: That's exactly how I'd frame it. And the implications for inflation and Fed policy are huge. When manufacturing is weak, goods prices tend to fall or rise very slowly. The core goods component of CPI has been negative year-over-year for six months now. That's dragging overall inflation down. But services inflation — rent, medical care, auto insurance, car repair — is running around 4.5 to 5 percent. So the Fed is looking at a split: goods deflation pulling the headline down, services inflation keeping it sticky. Luna: And the Fed can't cut rates aggressively to help manufacturing because services inflation is still too high. They're stuck. Lucas: Precisely. The fed funds rate is at 3.62 percent, and the market is pricing about 75 basis points of cuts over the next 12 months. But the Fed's own dot plot from the March meeting showed most officials see maybe 50 basis points of cuts this year. The data since then — the stronger than expected May ADP number, the still-elevated core PCE at 2.8 percent year-over-year — suggests they might not cut at all in 2026. Luna: But if manufacturing keeps contracting, at some point doesn't that spill over into the broader economy? Lay off factory workers, they stop spending at restaurants, and then services soften. Lucas: That's the transmission mechanism everyone is watching. So far, it hasn't happened. The household survey from the New York Fed did show financial anxiety hitting a four-year high in May — the share of households expecting their financial situation to worsen over the next year rose to 38 percent. But that hasn't translated into a pullback in spending yet. Consumer spending on services is still growing at about 2.5 percent annualized in real terms. Luna: So the two-speed economy persists because households are still spending on services, funded by savings and wage growth. But wage growth is slowing — average hourly earnings are up 3.9 percent year-over-year, down from 4.5 percent a year ago. Lucas: Right. And real wage growth is actually positive now — because inflation has come down from 3 percent to around 2.8 percent core PCE. So workers have a little more purchasing power. But that's fragile. If the labor market softens further, which the rise in initial jobless claims to 225,000 might hint at, then services spending could slow, and the two-speed economy becomes a one-speed slowdown. Luna: Let's talk about why manufacturing is so weak. Is it purely interest-rate sensitive? Higher borrowing costs for capex and inventory? Or is there something structural — like the strong dollar, or shifting global demand? Lucas: It's a combination. The dollar has been strong — the trade-weighted dollar index is up about 8 percent from its 2024 low. That hurts exporters. Also, business investment in structures and equipment — especially for manufacturing — has been flat. The post chips Act and post-Inflation Reduction Act factory construction boom is largely in the rearview mirror. Capital spending on manufacturing facilities peaked in early 2024 and has been declining since. Luna: So the industrial policy-driven investment surge has faded, and now we're left with the underlying cyclical weakness. Lucas: Exactly. And there's also the inventory cycle. During the supply chain disruptions of 2021 and 2022, companies built up massive inventories. Then they spent 2023 and 2024 destocking. The inventory to sales ratio for manufacturing is still elevated relative to pre-pandemic norms. So companies aren't ordering new goods because they already have a lot on hand. That drags on new orders, production, and employment. Luna: And when do we expect the inventory destocking to end? Some analysts have been calling for a restocking cycle for over a year now. Lucas: That's the million-dollar question. The ISM's customers' inventories index is at 45.2, which suggests inventories are too low relative to demand. But new orders are still weak. So manufacturers are waiting for a clear signal of demand before they start ordering again. That signal might come if the Fed cuts rates more aggressively, or if consumer spending on goods picks up. But consumer goods spending has been shifting to services — that's a multi-year trend. So the restocking cycle might be delayed until late 2026 or even 2027. Luna: So we could be looking at a manufacturing recession that lasts not two years, but three or four. That would be historically unusual. Lucas: It would be. The longest manufacturing contraction in the post-war period was the 2000-2003 downturn, which lasted about 30 months. We're at 23 months now. If this continues through the end of 2026, we'll break that record. And it would happen without a major financial crisis or a sharp spike in unemployment. That would be new territory for macroeconomists. Luna: What does that mean for the Fed? If manufacturing is in a prolonged recession but the rest of the economy is okay, do they just accept that as a sectoral issue and keep rates where they are? Lucas: That seems to be the current stance. Fed Chair Powell has said in recent press conferences that the Fed is watching the data carefully but sees the economy as broadly healthy. They view the manufacturing weakness as largely cyclical and expect it to recover as the inventory cycle turns. But if it doesn't, and if it starts to affect labor market conditions — if we see manufacturing job losses accelerate — then the Fed might feel pressure to cut more aggressively, even if services inflation is still a bit sticky. Luna: And we're already seeing initial jobless claims tick up — 225,000 for the week ending May 30th, up from 212,000 the prior week. If that trend continues, it could be a warning sign. Lucas: Exactly. Claims are still low by historical standards — below 250,000 is usually considered a healthy labor market. But the direction matters. And the four-week moving average is rising. So we'll watch the May jobs report this Friday for any signs of weakness in manufacturing payrolls. The consensus is for about 150,000 total nonfarm jobs, with manufacturing flat to slightly down. If manufacturing payrolls fall by 10,000 or more, that will be a headline. Luna: What about the broader implications for the economic narrative? If this two-speed economy continues, it challenges the idea that the Fed's rate hikes are a blunt instrument that hits the whole economy equally. Lucas: That's a key insight. The transmission of monetary policy has become more sector-specific. The goods-producing sector is highly interest rate sensitive — capital goods, durable goods, housing. But services — particularly health care, education, government — are much less sensitive to interest rates. So when the Fed raises rates, it mainly compresses the goods side, while services keep humming. That creates a structural divergence that makes it harder to calibrate policy. The Fed can't target a single sector; it has to aim for the aggregate. Luna: And that means the neutral rate — the so-called r-star — might have shifted higher because the economy's composition has changed. More services, less goods, so a given rate level is less restrictive overall. Lucas: That's exactly the argument from some economists. The San Francisco Fed's estimate of r-star is around 1.2 percent in real terms. If inflation is around 2.5 percent, that implies a neutral nominal rate of about 3.7 percent. We're at 3.62 percent on the fed funds rate. So we're basically at neutral already. That would mean the Fed isn't restrictive at all, which would explain why services are still strong. But then why is manufacturing so weak? Because the goods sector might have a higher sensitivity to rates, or because of those structural factors we mentioned — the strong dollar, the inventory overhang, the fading of the industrial policy boost. Luna: So the puzzle deepens. The aggregate economy looks fine, but underneath there's a lot of heterogeneity. And the Fed is basically flying blind because the models assume a uniform response. Lucas: Right. And that's why this manufacturing recession is so important to follow. It's not just a factory story. It's a story about how the post-pandemic economy has restructured, and whether the old playbook for monetary policy still applies. If the two-speed economy is the new normal, then a fed funds rate at neutral might still leave manufacturing in a slump, but not be enough to cool services. That puts the Fed in a bind — they can't help manufacturing without risking a reacceleration in services inflation. Luna: And that's exactly the situation we're in now. So what should listeners watch for in the coming weeks? Lucas: Two things. First, the May CPI report on Wednesday — watch the core goods month-over-month. If goods prices are still falling, that's more deflationary pressure, which could give the Fed cover to cut. If goods prices stabilize or rise, then the manufacturing recession might be bottoming. Second, the jobs report on Friday — look at manufacturing payrolls specifically. If they fall, that's a warning. If they hold steady, the two-speed economy continues. Luna: And either way, the manufacturing recession is a reminder that the macro headline often hides as much as it reveals. We'll be watching closely. Lucas: Absolutely. The next few data points could tell us whether this is a temporary divergence or a permanent shift in the economy's structure. That's the kind of question that makes macro fascinating — and frustrating.