November Consumer Prices, Real Earnings and December Philadelphia and New York Manufacturing Activity

KEY DATA: CPI: +0.2%; (Over-Year): +1.7%; Excluding Food and Energy: +0.2%/ Earnings: -0.4%/ Phil. Fed: +13.9 points/ Empire State: +7.5 points

IN A NUTSHELL: “Inflation is edging up and that is cutting into consumer spending power.”

WHAT IT MEANS: Yesterday, Fed Chair Yellen seemed to indicate the Fed had done its job as the labor market was pretty much at full employment and inflation was near where the Fed wanted it to be. It looks like she was right on target. The Consumer Price Index rose moderately in November, even excluding volatile food and energy. Food costs were flat but energy prices did jump. Importantly, over the year, inflation continues to move toward the Fed’s 2% target. The details, however, don’t point to any major acceleration in inflation as few components posted large gains. Even health care, especially health care commodities, was well contained. The cost of services, which is the largest component of consumer spending, continues to rise faster than commodities, though the days of declining goods prices should be over soon.

With inflation up moderately but wages oddly falling, household purchasing power declined sharply in November. I cannot explain the drop in the wage measure so I will simply report the data. This is a relatively new series so we really don’t have a good handle on what moves the numbers. Still, flat or down spending power is not positive for the economy.

Two Fed regional banks, New York and Philadelphia, reported that manufacturing activity in their regions improved markedly in December. Orders rose solidly in both districts but while Philadelphia reported improved hiring, New York indicated it softened. Most heartening was a surge in optimism in both regions.

Unemployment claims fell last week and we continue to run at historically low levels, when adjusted for the size of the labor force. Is there really any question that the labor market is pretty much out of slack?

MARKETS AND FED POLICY IMPLICATIONS: Rightfully so, the Fed Chair is proud of the work the Fed has done and she showed it at her press conference. The Fed did all the heavy lifting over the past eight years as fiscal policy restrained growth. But the reality is that interest rates are well below long-term trend levels and that is something that must be corrected before anyone can claim victory. So, what should we expect out of the Fed in 2017? Once the recent rise in energy costs is transmitted through the economy, inflation should exceed 2% for the overall index and core index. That could happen within the next couple of months. While it is likely the unemployment rate will tick up in December (the November drop was too large), it is clear from other indicators that the labor market is tight. But the Fed, especially Chair Yellen, will not believe that is the case until wage gains accelerate. The closely watched Atlanta Fed Wage Tracker is beginning to get into a more normal, strong economy range but we are still not seeing that in my preferred measure, the Employment Cost Index. It will be interesting to see what those numbers look like in the fourth quarter, which comes out on January 31, 2017. That is critical because the Fed Chair has made it clear that the members are waiting to see what the stimulus package looks like before they commit to any course of action. They are likely building some expansionary fiscal policy to be passed, which may be why they think rates will go up three times next year. But an aggressive package would change that. I think four hikes (or 100 basis points) next year would be likely with any decent-sized stimulus program.