WEEKLY ECONOMIC COMMENTARY -- WEEK OF MARCH 17, 2017
Having prepared the financial markets for weeks that a rate hike was coming, the Federal Reserve followed through this week with its second quarter-point increase in its benchmark federal fund rate in three months. Despite the back-to-back hikes coming out of two consecutive policy meetings, this was only the third rate increase in more than ten years, with the first coming more than a year ago and the second last December. The three moves bring the policy rate up to a range of 0.75%-1.00 %. By any measure, this tightening cycle is progressing more like a turtle than a hare. That said, the pace of rate hikes is poised to accelerate going forward.
Recall that at the December meeting, Fed officials indicated that three rate increases were planned for 2017. While that expected trajectory was met with skepticism in the financial markets, the widespread view was that even if the trifecta occurred, the first increase would not be implemented until June. That timetable, however, was gradually pulled forward as the labor market tightened over the first two months of the year and inflation moved closer to the Fed's 2 percent target. In recent weeks, a number of Fed officials publicly indicated that a rate hike would take place sooner rather than later, cementing the view that an increase at the March 14-15 policy meeting was virtually a done deal.
Ironically, the Fed's quarterly projections of key economic indicators revealed at the latest meeting were virtually the same as the ones put forward at the December meeting. The economy is still expected to grow by 2.1 percent this year and 1.8 percent over the long-run. The unemployment rate is projected to drift down to 4.5 percent by year's end, the same as December, and inflation is pegged at 1.9 percent, also unchanged from the December meeting. Nor were there any changes in the projected path of rate hikes; three increases are still the base forecast for this year, as manifested in the so-called dot plot chart accompanying the forecast. But a slightly more hawkish bias could be detected, as more Fed officials expected three rate increases, both this year and in 2018, at this meeting than was the case last December. There was also a slight upward adjustment in the federal funds rate that is expected to prevail at the end of the tightening cycle.
Hence, nothing has changed that would prompt the Fed to upgrade its economic outlook since the end of last year. But by moving in March instead of waiting until May or June for the first rate increase, as was widely expected a month or so ago, the door is open a bit wider for a fourth rate hike this year should the economy deliver faster growth than expected and/or inflation picks up more than desired. No doubt, the surprising strength in the job market in January and February influenced the Fed's decision to pull forward the rate increase by several months. Indeed, the raft of hawkish comments by Fed officials occurred as evidence of firmer labor conditions evolved. We suspect, however, that two other developments also played a role.
Keep in mind that one objective of removing monetary stimulus is to tighten financial conditions. But since the quarter-point rate increase last December, just the opposite has occurred as financial conditions have actually eased. The stock market shot up right after the announced rate hike and never looked back, posting substantial gains so far this year. And, after spiking to a two-year high of 2.60 percent on December 15, the bellwether 10-year Treasury yield proceeded to drift down to 2.31 percent in late February. The yield rebounded to 2.60 percent in anticipation of the March Fed meeting, but has since slipped to 2.50 percent. What's more, the dollar, which normally strengthens in response to higher U.S. rates, has also flaunted tradition, having fallen by about 3 percent against major currencies since the December 15 rate hike. The financial markets have responded much the same way to the latest rate increase this week. Both the dollar and Treasury yields slipped and stock prices are a tad higher, thanks to a big jump on the day of the announced rate increase.
It's unclear why the atypical easing of financial conditions has taken place in the aftermath of the latest Fed rate hike this week. It may be that investors heaved sigh of relief that the Fed's policy statement and Chair Yellen's comments at the subsequent press conference were not as hawkish as feared. Indeed, Yellen even sounded a dovish note by noting that a temporary inflation spike above the 2 percent target would not be particularly worrisome - or prompt a faster tightening of policy - since inflation has been below 2 percent for so long. We suspect that she is also willing to let the economy run a bit hotter to pull workers on the sidelines back into the labor force, where wage growth is still relatively tame.
From our lens, there is also a more fundamental reason behind the atypical easing of financial conditions since the latest rate hike. With a nod to that old Wendy's commercial, we would like to know, "Where's the beef?" No doubt, the economy is on a strong-enough footing to withstand a quarter point increase in interest rates. But by pulling forward the increase from later in the spring, the underlying assumption is that the economy is outperforming expectations. Nothing could be further from the truth. With two months of data now in hand, growth in the first quarter is tracking a tepid 1 percent pace, which is slower than the 1.9 percent registered in the fourth quarter of last year. Underpinning this slowdown, the economy's main growth driver, consumer spending, is showing signs of fatigue.
After posting a solid 3.0 percent growth rate in both the third and fourth quarters of last year, real personal consumption will be hard put to advance by half that pace in the current quarter. As noted last week, spending actually fell in January to a level that is roughly even with the fourth quarter average. Granted, the figure stands a good chance of being revised higher, as this week's retail sales report for February included a substantial upward revision to January retail spending, some of which should bleed into real consumption. Retail sales for January are now reported to be up by a respectable 0.6 percent compared to the previously reported 0.4 percent gain. Excluding volatile auto sales, the upward revision was even larger, from 0.8 percent to 1.2 percent. But it is hard to get too excited over this better reading, as there was little follow-through in February
According to this week's report, retail sales eked out a very modest 0.1 percent increase in February, with auto sales falling for the second consecutive month and the third out of the last four. But excluding autos, retail sales only advanced by a modest 0.2 percent, considerably slower than the 1.2 percent gain registered in January. The components of retail sales that feed into personal consumption in the GDP accounts - the so-called control group - showed no gain. But that followed a sturdy 0.9 percent increase in January, which does yield a decent average increase for the first two months of the year. Still, the February reading is notable for its lack of breadth as much as for its lack of strength. Only four of the thirteen key categories showed increased revenues - building materials and garden supplies, home furnishings, health and personal care and nonstore retailers, mostly online sales. The latter continued to eat into sales at brick and mortar establishments, surging by 1.2 percent in February. Indeed, while total retail sales increased by $377 million in February, nonstore retailers saw a $610 increase in revenues. As a result, nonstore retailers now account for a record 10.53 percent of total retail sales, up nearly a full percentage point in slightly over a year.
Simply put, while households are still keeping their wallets and purses open, their spending behavior belies the exuberance shown in consumer confidence surveys. Both the University of Michigan and the Conference Board's measures show that households are more optimistic than any time in more than a decade, with the Conference Board's February reading the highest since 2001. Both measures spiked following the election, reflecting heightened expectations that the Trump administration's tax, spending and regulatory policies will jump-start jobs and income growth. However, the yawning gap that has opened up between household expectations and actual behavior is not sustainable. It may well be that "animal spirits" unleashed since the election are pumping up spending more than otherwise, but unless the heightened expectations of households are met, the slowdown in consumption now underway will continue and put a lid on the economy's growth prospects.
Make no mistake; there are some bright spots in the economic landscape that are shining through in the first quarter. Homebuilding activity is accelerating, as housing starts were up 6.2 percent in February from a year ago, paced by single-family construction. Building permits for single-family units surged 13.5 percent over the year-earlier level, indicating that residential construction will make a meaningful contribution to overall growth this quarter. We are looking for a double-digit increase in residential outlays during the period. And while the housing market is no doubt getting a helping hand from the mild weather this winter - which may lead to some payback in the spring - the manufacturing sector is flexing muscles on its own. On Friday, the Federal Reserve reported that manufacturing output increased 0.5 percent in February for the second consecutive month, the strongest back-to-back increases since November/December 2012. Importantly, the gains reflect renewed strength in business equipment output, which rose for the second time in three months in February, lifting it 1.5 percent above the year-earlier level. That's the strongest annual increase since April 2015 and suggests that capital spending may finally be coming out of the doldrums.
The emergence of housing and capital spending as sources of strength will probably not be enough to offset the slowdown in consumer spending, but it does underpin the sustainability of the expansion and validates the Fed's desire to normalize policy, particularly with inflation already hugging the 2 percent target and the economy on the doorstep of full employment. That said, expectations continue to run ahead of fundamentals in our view, and it remains to be seen how that gap will close over the balance of the year.