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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The big economic news for this month is the much stronger than expected employment report; the big question is, why in the face of strong labor market, consumer spending (reflected in retail sales) has been trending steadily downward.

Starting with the good news: Employers added 313,000 jobs in February, representing the largest monthly increase in nearly two years. Positive labor reports and increasing confidence in the economic outlook lured more than 800,000 workers off the sidelines, holding the unemployment rate at 4.1 percent for the fifth consecutive month.

The increase in the labor pool – the largest since 1983 ─ provided further evidence of economic strength, but it also countered pressure on employers to increase wages. The 2.6 percent year-over-year wage increase reported for February was lower than analysts had expected after January’s initial report of a nearly 3 percent annual jump. But January’s preliminary report was also revised downward. The result: bad news for workers, who saw a slim 0.1 percent wage increase over January; but good news for investors, who had feared a rapid jump in wages would prompt the Federal Reserve to increase interest rates more aggressively than expected.

“A strong jobs report with less wage inflation tells the market that current concern about the wage issue is overblown,” Jonathan Golub, chief United States equity strategist at Credit Suisse, told the New York Times. “The market has to think that is terrific,” he added.

Unenthusiastic Consumers

Consumers, apparently, were less enthralled. Retail sales fell for the third consecutive month in February, as extra dollars in consumers’ pockets did not match the boost they had expected from the combination of a strong labor market and the tax cuts that took effect in January. As a result, purchases of everything from cars and furniture to groceries, health products and electronics fell, as did consumer prices, which declined by 0.2 percent on a seasonal basis. The price index to personal consumption expenditures, which the Fed uses as an inflation marker, also increased by only 0.4 percent, remaining stuck well below the Fed’s 2 percent inflation target.

Although consumer spending is lagging analysts’ expectations, consumer confidence levels have rebounded after flagging earlier this year. The University of Michigan’s consumer sentiment index jumped to 99.9 in February from 95.7 the previous month, reaching the highest level since last October.

Andrew Hunter, an economist at Capital Economics, thinks the increase “may be the first sign of the boost to consumers from lower taxes.” Even if consumption growth slows in the first quarter, he told clients in a recent note, it is likely that “spending will continue to grow at a solid rate over 2018 as a whole.”

Upbeat Economists

The consensus economic view also remains upbeat, despite recent stock market turbulence and sluggish wage growth. Economists responding to the Wall Street Journal’s monthly survey predicted an economic growth rate of nearly 3 percent for this year, ensuring at least three and possibly four interest rate hikes by an increasingly confident Federal Reserve. Economists also boosted their assessment of recession risks slightly – from 13 percent to a still very low 14 percent.

“The tax-cut stimulus and faster wage and salary growth are the garlic to the vampire of recession,” Sean Snaith, director of the University of Central Florida’s Institute for Economic Competitiveness, told the Journal.

Interest Rate Outlook

Fed officials have made clear their intention to boost interest rates multiple times this year, although Jerome Powell, the newly installed Fed Chair, said recently that policy makers will “remain alert to any developing risks to financial stability.”

Increases in the Fed’s target rate will bring higher mortgage rates, raising obvious concerns about the impact on the housing market. The 30-year fixed rate, which has been rising steadily since the beginning of the year, is now hovering around 4.5 percent – its highest level in three years, according to Freddie Mac.

Although home buyers aren’t happy about the higher rates, “they can still make it work,” a mortgage broker told Bloomberg News. “But as we get closer to 5 percent,” this industry executive predicted, “that’s when [buyers] will start thinking about it.”

Aaron Terrazas, a senior economist at Zillow, echoed that warning. “For nearly a decade now, homebuyers have been buoyed by historically low mortgage rates that made buying a home more affordable than it was for prior generations, but tomorrow's buyers may not be so lucky," he told Bloomberg. Discretionary buyers, who aren’t forced by life circumstances (a job change or a growing family) to buy a home, and who have locked in a lower mortgage rate, “may look to alternatives like renovating their current home, instead of becoming a buyer in a stressful, competitive market when higher rates would limit their buying power below what it was when they bought their current home," Terrazas suggested.

Inventory Issues

At least for now, it is scarce inventories more than rising rates, that are driving housing market trends. Hamstrung by limited choices for buyers, existing sales fell again in January, to a seasonally adjusted rate of 5.38 million units – down 3.6 percent year-over-year. That represents the slowest pace since last September and the largest annual decline in more than three years.

Although Realtors have been reporting steady foot traffic, those boots on the ground at open houses haven’t translated into closed sales, as rising interest rates, rising prices (up 6.6 percent year-over-year in January, according to CoreLogic), and scarce inventories have taken a toll.

“I still think we will see the job market and demographics overcome the rise in mortgage rates and give some upward movement in home sales, but much less than in the past because the number of homes for sale is so small,” David Berson, chief economist at Nationwide Insurance, told the Wall Street Journal.

Lawrence Yun, chief economist for the National Association of Realtors, continues to blame the “glaring” inventory shortage for the disconnect between a strong economy and lagging home sales.

“It's very clear that too many markets right now are becoming less affordable and desperately need more new listings to calm the speedy price growth…. The underproduction of single-family homes over the last decade has played a predominant role in the current inventory crisis that is weighing on affordability," he said in a press statement.

But Yun also sees some indicators that “the tide is finally turning,” reflected in what he termed a “nice jump” in new home construction in January and the rising confidence of home builders. “These two factors will hopefully lay the foundation for the building industry to meaningfully ramp up production as this year progresses," he predicts.

Housing starts did increase in January, to a one-year high, and building permits, an indicator of future construction, reached their highest level since 2007. But in both cases, the increases were attributable primarily to gains in the multi-family sector. Single-family starts increased by 3.7 percent over the January level, compared with a gain of nearly 20 percent in multi-family starts. While permits for multifamily construction were up by 25.4 percent, single family permits declined by 1.7 percent.