WEEKLY ECONOMIC COMMENTARY -WEEK OF JANUARY 20, 2017
With Trump's cabinet picks traipsing up to Capitol Hill for confirmation hearings and with the inauguration on Friday, politics clearly garnered most of the headlines this week. And with the now-president Trump taking office, the hard work hammering out a fiscal plan as well as the myriad policies regarding trade, immigration, regulations and, of course, the dismantling of Obamacare is set to get underway. It will be weeks, if not months, before a clearer picture of how effectively the new regime gets things done and what ultimately will emerge from negations with Congress comes into view. It's probably fair to say that, despite the ebullient behavior since the election, an air of uncertainty and anxiety is overhanging the financial markets.
Notwithstanding the attention-getting political events, the week was not devoid of economic news. Perhaps the main message conveyed by the recent batch of data is that the economy has not lost as much momentum as thought a month or so ago. To be sure, growth in the fourth quarter is not likely to match the outsized 3.5 percent pace registered in the third quarter. Recall, however, that a soybean-fueled export surge of 14.4 percent accounted for more than 1 percentage point of that growth rate, a temporary boost that has already expired. That said, until recently, the consensus was expecting growth to slow to under 2 percent over the final three months of the year, reflecting a setback in consumer spending that appeared to be underway and ongoing weakness in business investment.
More recently, however, estimates for the fourth quarter have been upgraded. For one, consumers have apparently held their own over the holiday shopping season, belying the retail sales slump in November. Sales rebounded sharply in December, punctuating what now seems to have been a decent quarter overall. And while the monthly data can be volatile, the surge in household confidence over the final two months of the year gives the sales figures some credibility. If this upbeat mood is sustained, it is not unreasonable to expect that consumers will keep their wallets and purses open in January, providing some momentum early in the new year. Clearly, household fundamentals support this notion, as the job market ended the year on a firm note and worker pay staged the biggest annual increase of the recovery.
From our lens, growth in the fourth quarter probably slowed to a 2.4 percent pace from 3.5 percent in the third. That would still be above trend, which the Fed estimates at 1.8 percent, and would yield an average growth rate of roundly 3.0 percent for the second half of the year. Still, the estimated 1.6 percent growth for the year as a whole fell far short of the 2.4 percent median projection made by Fed officials in December 2015. But the second-half pick-up and the ongoing tightening of the labor market provided support for the Fed's decision to pull the rate trigger in December. Nothing since that mid-December decision would seem to undercut that move. Indeed, in a speech at Stanford University on Thursday, Fed Chair Yellen reiterated the rationale for continuing the normalization process begun in December 2015, noting that, "Waiting too long to remove accommodation could cause inflation expectations to begin ratcheting up, driving actual inflation higher and making it harder to control."
The evolving concern over potential inflationary pressures marks the end of the deflation fears that have guided policy decisions during the first five years of the recovery. While there is little in the way of hard data indicating that inflation has once again reared its ugly head, the Fed can justifiably claim that the trend is moving ever-closer to its 2 percent objective. In the latest consumer price report released this week, the annual increase in both the headline CPI and the core CPI exceeded 2 percent for the first time in nearly three years, going back to February 2013. To be sure, the core CPI has been running above that threshold for fourteen consecutive months, paced by housing and medical prices. But owing to the slump in energy prices beginning in the spring of 2014 and sagging commodity prices related to weak global demand, the broader CPI has not hit 2 percent since July 2014.
Significantly, the long disinflationary drag from goods prices seems to have run its course. The main drag, energy prices, has morphed into a modest positive influence over the past year. Crude quotes hit bottom at $37.08/barrel on January 9, 2016 and rebounded to above $50 in June. Since then, oil prices have hovered within $5 around the $50 level, closing on Friday at $52.42. Prices at the pump have followed suit, as has a broad basket of commodity prices. The core producer price index for goods, which excludes food and energy items, increased 1.7 percent from a year earlier in December, the strongest annual increase in more than two years. In contrast, core services prices, which have more than counteracted the deflation in goods prices during the recovery, are now turning into a moderating force, as the increases in shelter and medical costs have been slowing.
With the much larger services component of the CPI moderating the upward pull from goods prices, it will take a while longer for the Federal Reserve's preferred inflation measure - the personal consumption deflator - to reach the 2 percent target. In November, the latest month available, the PCE and core PCE deflators were increasing at annual rates of 1.4 percent and 1.6 percent respectively. That said, both are trending higher and, with worker earnings increasing at the fastest pace of the recovery in December, the Fed understandably has more confidence that inflation is steadily moving towards the 2 percent target. The December figures on the deflators will be released with the figures on personal income and spending later this month.
The bad news, of course, is that as inflation creeps higher, it takes a bigger bite out of worker purchasing power. Indeed, with the latest consumer price information, the sizeable 0.4 percent increase in average hourly earnings workers received in December can now be put into perspective. Adjusted for the 0.3 percent increase in the CPI, the increase in real earnings comes to a paltry 0.1 percent. Compared to a year ago, real earnings are running 0.8 percent ahead of inflation. That's better than what we have seen earlier in the recovery, but not so much over the past year. In December 2015, the year-over-year increase in real worker earnings stood at 1.9 percent. The good news for worker purchasing power is that with the labor market tightening and nineteen states raising the minimum wage at the start of this year, there is every chance that paychecks will expand faster than inflation in coming months.
If that's the case, households should be in good shape to sustain spending at a decent pace, preventing the abrupt setback that dragged down the economy's growth rate in the first quarter of last year. What's more, there were signs towards the end of last year that some missing cylinders of the economy's growth engine are starting to kick in. For one, residential outlays, which have been a drag on growth in both the second and third quarters, appear to have turned the corner. Housing starts surged 11.3 percent in December and while the gain was all in the volatile multi-family sector, building permits for single family units increased to the highest level since October 2007. Overall, housing starts in the fourth quarter increased by more than 6 percent over the third quarter, strongly indicating that residential outlays made a positive contribution to GDP in the fourth quarter. We estimate that such outlays increased by nearly 10 percent.
For another, the long inventory liquidation cycle that has siphoned an average of 0.5 percent from the economy's growth rate from the second quarter of 2015 to the third quarter of last year seems to be over. After seven months of destocking merchandise, companies have brought down their inventory to sales ratio from a cycle peak of 1.41 in February to 1.37 in October. They have since starting restocking shelves, adding to the economy's growth rate in the third quarter for the first time since the first quarter of 2016. With accumulations of $13.1 billion in November - the largest monthly increase since January 2013 - spending on inventories most likely made another positive contribution to growth in the fourth quarter.
Rounding out this week's data, another positive reading on industrial
production suggests that manufacturers are finally pulling out of the doldrums.
True, factory output only increased by 0.2 percent in December, which was below
expectations and boosted primarily by a hefty increase in auto production. But
manufacturing output staged a respectable 0.8 percent increase for the fourth
quarter, the best showing since the third quarter of 2015, and more recent
regional Philly and New York Empire surveys point to stronger gains in January.
The bottom line, as noted earlier, the economy is heading into the new year with
more momentum than thought a month or so ago. Indeed, for the first time since
2012, the Federal Reserve may actually be too conservative in its 2.1 percent
growth forecast for 2017.