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 Federal Reserve’s decision to cut rates by a quarter-of-a-point this month didn’t surprise anyone – but it also did little to satisfy either critics (including two Fed dissenters) who thought the reduction  was unnecessary (and possibly harmful) or President Trump, who has been demanding larger cuts to boost economic growth.

A strong July employment report complicated the Fed’s effort to steer a course that supports the economic recovery (now in a record-breaking 120th month) without igniting inflationary fires.  Employers added 164,000 jobs in July,  short of the 224,000  added in June, but strong enough to indicate that employers remain in a hiring mode, undeterred (as yet) by an escalating trade war with China and evidence that economic growth in the U.S. and worldwide is beginning to slow.

The unemployment rate remained unchanged at 3.7 percent and the job participation rate increased as job openings attracted sidelined workers.  Hourly wages increased by 3.2 percent year-over year –tepid growth compared with past recoveries, but stronger than most analysts had predicted.

Focus on Trade

Looking past the positive employment report in its rate hike decision, the Federal Open Market Committee (FOMC), the Fed’s policy-making arm, targeted growing concern about the impact of the tariffs President Trump has imposed on Chinese goods and the Chinese government’s response to them.  In the most recent economic tit-for-tat, President Trump ordered 10 percent tariffs on $300 million in Chinese goods not yet subject to them, to which China responded by devaluing its currency. 

The FOMC’s official statement cited “the implications of global developments for the economic outlook” and “muted inflation pressures” as the reasons for reducing the Fed’s target rate to between 2 percent and 2.25.  In his post-meeting press conference, Fed Chairman Jerome Powell said he “would love to be more precise” about the economic outlook.  But given the uncertainty about how the trade war will play out, “we have to assess [the forecast] in kind of a new way.”

Although Powell described the July rate reduction as a “mid-cycle adjustment” and not the beginning of a rate-cutting trend, many analysts are predicting that the Fed will slash rates again in September.  Those who have been arguing that the Fed should be tightening monetary policy, not loosening it, are becoming more convinced of that and more concerned that the Fed’s actions will short-circuit the recovery rather than support it. 

Explaining that concern in a research note, Michael Every, senior Asia-Pacific strategist at RaboResearch wrote that the Fed’s rate-cutting decision came “despite ultra-low unemployment, and despite their own general admission that everything is basically awesome." The immediate reaction to the Fed’s decision suggests that it is not having the desired effect, Every said.  “We ended the day with stocks lower, the US yield curve viciously flattening, and the US dollar at a two-year high.  What a mess!” he added.

Housing Market Concerns

While no one is describing the housing market as “a mess,” home sales continue to generate more concern than confidence.  Existing home sales declined again in June – falling 2.2 percent below the year-ago pace.

New home sales recovered from consecutive declines in April and May, primarily because strong sales in the West offset weakness in other regions, pushing the national total 7 percent above the June 2018 level. But new home sales represent only a sliver of the U.S. housing market, and existing sales have now declined year over year for 16 consecutive months, despite lower interest rates and wage gains fueled by a strong labor market. 

Affordability is the primary culprit; 88 consecutive  months of price increases have pushed the national median to $285,700 – an all-time high, according to the National Association of Realtors (NAR).  Housing inventories, meanwhile, remain sparse, especially at the entry-level, where demand has been strong. 

Despite “exceptionally low” mortgage rates, solid employment growth and “a record high” net worth for Americans, “home sales are running at a pace similar to 2015 levels,” Lawrence Yun, the NAR’s chief economist, told DS News. 

“Either a strong pent-up demand will show in the upcoming months,” he predicted, or it will become clear that “a lack of confidence is keeping buyers from this major expenditure.  It’s too soon to know how much of a pullback is related to the reduction in the homeowner tax incentive,” he added. What is clear, Yun said, is that the housing market continues to suffer from an acute shortage of product.

Construction Lagging

There is no evidence that this problem will be resolved any time soon. Housing starts declined by almost 1 percent in June compared with the previous month, falling to a seasonally adjusted annual rate of 1.253 million units.  Building permits – an indicator of future activity – fell by 6.1 percent, the largest monthly decline in more than three years.  Year-over-year the permit total was down by 6.1 percent.

“Lower mortgage rates are not spurring the home building industry to increase construction, as lack of skilled workers, cheaper material costs and land zoned for building continue to hamstring production,” said Robert Frick, corporate economist at Navy Federal Credit Union, explained in a note to clients.

Although home price increases have been moderating this year, appreciation rates continue to outpace modest wage increases. The S&P CoreLogic Case- Shiller national index showed prices up 3.4 percent year-over-year in May.    “The current low mortgage interest rate environment should be getting more buyers off the sidelines,” Robert Diets, chief economist for the National Association of Home Builders, told Housing Wire.  “But they remain hesitant due to affordability concerns.”