KEY DATA: GDP: +4.0%; Consumption: +2.5%; Consumer Prices: +2.3%/ADP: 218,000
IN A NUTSHELL: “The strong second quarter growth supports continued solid payroll gains and a further tightening of the labor market.”
WHAT IT MEANS: The Fed is meeting and the members now know that the winter of our discontented economy is past. Economic growth had declined sharply in the first quarter, though the latest estimate of 2.1% was not as ugly as the previous 2.9% guess. Still, that size fall in activity raised questions about the true strength of the economy, an issue that is no longer a concern. Growth rebounded sharply in the spring, led by strong vehicle sales, solid export activity, strong business investment and inventory building and renewed government spending at the state and local government sectors. In other words, only the federal government remains a weight around the economy’s neck. On the inflation front, consumer costs accelerated, rising at the fastest pace in three years. The pace was not great but at 2.3%, it is above the Fed’s target of 2%. Excluding food and energy it was right at the number.
Friday we get the July jobs report and ADP expects it to come in a little lower than the June gain. The economy probably still averaged at least 250,000 new jobs over the past two months and that is strong. The moderation in hiring, if you can call it that, was largely in the small business component. Payrolls rose by about 40,000 less in this component than in June. That doesn’t worry me since Paychex/HIS reported yesterday that small businesses were adding jobs faster, so that slowing may unwind in August. Still, the increases appear to be across all industry segments. Consensus is for about 230,000 new positions which should support a drop in the unemployment rate to 6.0%. I think job gains could be a touch better, closer to 250,000.
MARKETS AND FED POLICY IMPLICATIONS: This report was much higher than most expected (I was at 4.1%). It should also put to rest the questions about the rebound from the winter. The economy came back and even though there may have been a little extra inventory building that could moderate third quarter growth, solid activity was so widespread that you cannot call this number an aberration. We are likely to see growth in the 3.5% to 4% range during the second half of the year. With job gains strong and the labor marketing tightening, income should begin rising faster, powering better consumer spending. Chair Yellen is focusing on wages, but that is a lagging indicator which may lag even more because of business intransigence on raising compensation. That is, when broad wage increases start showing up, it will be late in the process to begin dealing with the rising cost pressures. That is a warning to both the Fed and business executives. Either have plans in place soon to deal with the inevitable workings of supply and demand in the labor market or play catch up. That is why I think the first rate hike comes in the first quarter of next year. It is also time the bond markets begin focusing on the increasing likelihood that growth will be closer to my forecast, which is well above consensus, and as a consequence prices will accelerate faster than expected. We are not talking high inflation, but inflation that exceeds Fed targets.