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WEEKLY ECONOMIC COMMENTARY -- WEEK OF JUNE 23, 2017

There will be no weekly commentary over the July 4 holiday weekend. The next weekly will be published with the monthly jobs report on July 7.

With the data spotlight focused almost exclusively on housing this week, the disparate opinions about the health of the broader economy continue to be unresolved. No one disputes that growth is rebounding from the first quarter's tepid 1.2 percent pace, but estimates of the pick-up vary far and wide. The two Federal Reserve Banks that run widely-followed, and continuously updated, GDP tracking models - The Federal Reserve Banks of Atlanta and New York - are exceptionally wide apart, with the former pegging second-quarter growth at 2.9 percent and the latter at 1.9 percent. At this juncture, we are closer to the Atlanta estimate of roundly 3 percent, but recognize the downside risks stemming from some disappointing economic reports in recent weeks. Indeed, both Reserve Banks have lowered their growth estimates from those made earlier in the month.

That said, the policy bias of the Federal Reserve hues to the more optimistic camp, underpinning the quarter-point rate hike on June 14 and its plan to continue the process of normalizing interest rates over the next 18 months.. Fed officials expect to lift rates one more time later this year and three more in 2018 and start reducing its $4.5 trillion balance sheet fairly soon. However, the erstwhile data-dependent central bank risks losing its credibility if it follows through with the rate increases without getting cooperation from the data. In particular, inflation continues to run well below the 2 percent target and it is unlikely that the shortfall is due primarily to the "idiosyncratic" factors the Fed believes will unwind over the medium term. Hence, we are less sanguine that it will meet its dual mandate of maximum employment and 2 percent inflation and will proceed more cautiously in the normalization process. We expect that the Fed will start reducing its balance sheet later this year, but will refrain from hiking rates again until 2018 - and then push through only two increases during the year instead of three.

Things could change, of course, in either direction. The Fed is counting on the ever-tightening labor market to belatedly jump-start an acceleration of wage growth, spurring companies to pass on the higher labor costs to consumers by lifting prices. But that time-honored wage-price dynamic has failed to kick in despite a plunging unemployment rate to its current sixteen-year low. Worker earnings are struggling to grow faster than the 2.5 percent annual increases seen in recent years. That, together with 1 percent productivity growth, is consistent with a 1.5 percent inflation rate, which is the most recent reading for the core personal consumption deflator preferred by the Fed. We will get an update on the May figure next week in the personal income and spending report. But prospects for a pickup do not look promising, given the deceleration reported last week in the consumer price index for that month.

No doubt, the low unemployment rate is overstating the tightness in the job market, given the large potential supply of workers not in the labor force that could be lured in under the right conditions. But there is little question that much of the slack in the labor force has been used up and the scarcity of qualified workers is becoming a growing issue across a broad swath of industries. Indeed, job openings are at a record high even as the hiring pace has slackened off a bit in recent months. That reinforces that impression companies are having difficulty filling positions. Still, as the competition for a shrinking supply of labor heats up, worker bargaining power may well increase and belatedly kick-start wage inflation. . But given the lack of response so far with the unemployment rate at a sixteen-year low, the trigger point may not be reached until joblessness falls to under 4 percent, something not seen since December 2000.

Even then, the expected upward pressure on wages may not materialize. In Japan and Germany, for example, wage increases are negligible despite the fact that unemployment rates in those nations are the lowest in decades. Indeed, low inflation is an even stickier issue abroad than it is in the U.S. Not coincidentally, both Germany and Japan share the same problems as the U.S.: low productivity and an aging workforce. These are critical forces restraining wages and inflation. Whether these structural inflation-dampening forces prompt the Fed to slow down the pace of rate increases, as we expect, remains to be seen. But the financial markets are clearly pricing in a shallower upward trajectory. The fed funds futures market is pricing in less than a 45 percent chance of another rate increase before the end of the year and a remote 18 percent chance that an increase will occur at the September policy meeting.

Meanwhile the bond market remains downright bearish on rate-hiking prospects, reflecting a downbeat view on the economy and, in particular, inflation. The slope of the yield curve is a reliable barometer of the bond market's assessment of economic prospects. A flattening curve is seen as a bearish bet on growth and a steepening slope suggests stronger growth. With long-term rates sliding since this year's first Fed rate increase in March, the spread between long and short-term rates has narrowed sharply. As of Friday, the spread between 10-year Treasury yields and the federal funds rate is the narrowest in nearly a decade, just before the onset of the Great Recession.

Indeed, should the Treasury yield remain at the current 2.15 percent, four more quarter-point increases in the federal funds rate, which the Fed projects by the end of the 2018, would result in an inverted yield curve, something that has occurred before every recession. To be fair, not every inversion led to recessions, as bond yields respond to many influences besides growth prospects. For example, rates in most other developed nations are much lower than in the U.S. so yield-seeking foreign investors are still attracted to U.S. Treasuries. What's more, the supply of safe assets has been shrinking dramatically in recent years, thanks in good part to the massive buildup of sovereign debt holdings by central banks pursuing easier monetary policies. And while the U.S. Fed is removing monetary stimulus, the ECB and other central banks are still in an accommodative mode.

That said, if bond investors thought the U.S. economy was stronger and inflation poised to accelerate - thus validating the Fed's rate-hiking campaign - they would be driving up long-term interest rates, notwithstanding offsetting external influences. Hence, the flattening of the yield curve does reflect market expectations of a weaker economy than the Fed perceives. Similarly, the market is far from convinced that the Fed will meet its 2 percent inflation target over the medium term. Just as the slope of the yield curve is a barometer of growth expectations, the spread between nominal interest rates and inflation-indexed rates is a yardstick of inflation expectations. The trend in this so-called "break-even" rate has been falling dramatically this year, with the current spread indicating that market participants expect inflation to average 1.7 percent over the next ten years. Notice in the chart how the markets have fully unwound the reflation trade following the November elections.

What's more, the market has an even greater downward inflation bias over the medium term, expecting inflation to average about 1.2 percent over the next two years, based on the two-year break-even rate. Shorter-term inflation expectations are more heavily influenced by volatile oil prices, which have fallen from about $50/barrel to under $44 over the past month amid a supply glut. But agricultural and industrial metal prices have also been on a strong downtrend, punctuating the deflation in goods that has shown up in the consumer price index in every month this year. With inflation in services also moderating, it is hard to see how the Fed will meet its 2 percent inflation target over the medium term. The good news is that the stubbornly low inflation rate should keep the Fed from hiking interest rates too aggressively, which might stifle growth and risk sending the economy into a recession.

No sector derives more benefit from low rates than the housing market. Accordingly, with mortgages rates following the Treasury market down in recent months, home sales have perked up. As noted at the outset, the housing reports were the only indicators of note to be released this week, but they were unambiguously favorable. Both new and existing home sales exceeded expectations in May, with the former increasing by 2.9 percent and the latter by 1.1 percent. Transactions are running comfortably ahead of last year, with sales of new homes up an impressive 8.9 percent. Importantly, with a sturdy pace of job growth and rising incomes, the outlook is promising as reflected in the high level of confidence among builders and realtors.

That said, the sales outlook would be brighter if the supply of homes for sale were larger. The inventory of existing homes, for example, has been declining on a year-over-year basis for 24 consecutive months. According to the National Association of Realtors, the average time a home remains on the market is 27 days, which is the shortest since it started tracking this series six years ago. The supply is also historically light in the new home market, but at least it has been gently rising in recent months. With the demand for homes strong and inventories tight, the ingredients for sharply rising home prices are firmly in place. Hence, median prices in both the new and existing markets rose to record highs in May. Unless this trajectory is curbed, first-time homebuyers will be shut out of the market, something that is already a growing problem in an industry that has a critical influence on U.S. growth prospects.