Inflation Pressures Are Easing but Rate Cut Forecast Remains Uncertain

The New Year is beginning where the old one ended -- with uncertainty about when – or whether – the Federal Reserve will begin cutting interest rates.

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Although Fed Chair Janet Yellen admits that policy makers are baffled by persistently low inflation, they are undeterred by the failure to meet the 2 percent target they have set as the indicator that higher interest rates are in order, and still on track to boost interest rates once more this year.

They remain convinced that the declining unemployment rate – now near a 16-year low – will begin to stoke inflation pressures, although it hasn’t done so yet.

As the economy has strengthened steadily, albeit slowly, the Fed has levied four, quarter-point rate hikes since late 2015, pushing its target range from zero to between 1 percent and 1.25 percent. But Fed officials have been struggling for most of this year with competing concerns that failure to raise rates soon enough could trigger an economy bashing inflationary spiral, while hiking rates too much too soon could tip the economy back into a recession.

Talking to reporters following the Federal Open Market Committee’s (FOMC’s) September meeting (at which the committee left rates unchanged), Yellen attributed the below-trend inflation rate to temporary factors that, Fed officials believe, will soon give way to more normal patterns.

Reiterating that point in a subsequent speech to business economists, Yellen said “significant uncertainties” about the inflation trend “[strengthen] the case for a gradual pace of adjustments. It would be imprudent to keep monetary policy on hold until inflation is back to 2 percent,” she added.

No Need to Rush

Although most members of the policy-setting FOMC apparently share that view, some disagree. “The Fed should be under no pressure to raise rates. We have time to let inflation climb back to target,” Neel Kashkari, president of the Federal Reserve Bank of Minneapolis, told reporters. “When I look at the economy, I don’t see any signs the economy is close to overheating,” he added. “I see no need to tap the brakes” and attempt to moderate the economy with higher short-term rates.

Charles Evans, president of the Chicago Fed, and Fed Governor Lael Brainard have expressed similar concerns. Speaking recently at the Economic Club of New York, Brainard said, “We have been falling short of our inflation objective not just in the past year, but over a longer period as well. My own view is that we should be cautious about tightening policy further until we are confident inflation is on track to achieve our target,”

The persistently low inflation rate isn’t the only concern as Fed policy-makers eye another interest rate increase. The labor picture dimmed in September, as the hurricanes that bashed Houston and Florida battered the employment statistics as well.

The economy lost 33,000 jobs last month, the first monthly decline in seven years. Average hourly wages increased by a modest 0.45 percent, for a year-over-year gain of 2.9 percent. Adding a disappointing footnote to the report, revisions shaved 38,000 jobs from the July and August totals.

Although Fed officials had expected – and hoped for – a stronger labor report, they are expected to dismiss it as an aberration attributable to the early fall hurricanes and not a reflection of underlying weakness in the economy. There is some support for that view.

The economic growth rate topped three percent in the second quarter, more than doubling the first quarter’s anemic pace. Increases in consumer spending, nonresidential investment, exports and federal government spending fueled the increase, reported by the U.S. Bureau of Economic Analysis; declines in residential investment and state and local spending partly tempered the gains. A rise in imports also sapped some of the second quarter strength.

The key question now is how much the combined impacts of Hurricanes Harvey, Irma and Maria will dent the economy, and on that point, analysts are divided. Some expect the economy to take a major hit in the third quarter, but others think the momentum reflected in the second quarter will continue. Paul Ashworth, chief economist for Capital Economics, lines up with the optimists. Although the hurricanes “did cause some temporary disruption,” he predicts that third quarter growth will still fall in a healthy 2.5 percent to 3 percent range.

 Housing Indicators Mixed

Housing market indicators have been mixed – tilting toward the negative. The highs and lows:

  • Existing home sales slid in August by 1.7 percent, the third consecutive monthly decline. The annual rate of 5.35 million units was the slowest pace this year.
  • Pending sales also slipped by 2.6 percent for the month. The 106.3 reading in the National Association of Realtors’ Pending Sales Index was the lowest since January of 2016.The index has posted a year-over-year decline in four of the past five months.
  • New home sales declined by 3.4 percent from the July total and by 1.2 percent year-over-year. The annualized rate of 556,000 units reported by the U.S. Census Bureau and HUD was a low point for the year.
  • Housing starts and completions both declined, but permits, an indicator of future activity, jumped by 5.7 percent – a welcome bright spot in the report, tempered because the gain was concentrated in the multifamily sector; permits for single-family homes actually declined by 1.5 percent.

Fannie Mae’s Home Purchase Sentiment Index in August increased by 1.2 points over the previous month, nearly reaching the record high set in June. But the gap between how buyers and sellers view the market widened. The number of sellers who think this is a good time to sell jumped by 21 percentage points year-over-year to 36 percent, while the number of buyers who see conditions as favorable to them fell to 1 16 percent, 5 points below the July level and a year-over-year decline of 16 percentage points. Analysts say rising prices and skimpy inventories are primarily to blame for buyers’ souring mood.

“In the early stages of the economic expansion, home selling sentiment trailed home buying sentiment by a significant margin. The reverse is true today,” Doug Duncan, senior vice president and chief economist at Fannie Mae, said in a press statement. “Such a sizable gap between selling and buying sentiment, if it persists, could weigh on the housing market through the rest of the year,” he warned.

Lawrence Yun, the NAR’s chief economist, thinks the housing market is “in a funk” resulting from the combined effects of rising prices and shrinking inventories. "The pace of new home construction has not meaningfully broken out this year, and not enough homeowners at this point have followed through with their belief that now is a good time to sell. As a result, home shoppers have seen limited options, stiff competition and weakening affordability conditions." He’s predicting that sales totals for the year will fall below the 2016 level.

Semaj Gudell, chief economist for Zillow, also sees cause for concern. “We had high hopes beginning the year,” she told reporters, “but those have been smashed with a steel-toed boot.” The discouraging reality, she said, is that the country is not producing enough new housing to satisfy the demand.

“Buying conditions, in theory, are great right now,” she noted. “Jobs and incomes are growing, and rock-bottom mortgage interest rates are helping keep financing costs low. What’s missing from the equation is a lack of homes actually available to buy at a price point that’s reasonable for most buyers.”

A surge in new construction would provide the boost the market needs, Gudell said. Recent statistics suggest that if this surge is coming, it’s not coming anytime soon.