KEY DATA: Consumption: +0.2%; Income: +0.3%; Prices: +0.4%/ ISM (Manufacturing): +1.7 points; Orders: +4.7 points
IN A NUTSHELL: “It’s nice that manufacturing is accelerating, but it is worrisome that rising prices are wiping out household income gains.”
WHAT IT MEANS: If the consumer is going to lead the way, and household spending kept the economy afloat last year, then incomes better start growing faster because inflation is on the rise. Consumer spending was solid in January as households bought lots of soft-goods but not a lot of durables or services. Indeed, the only category reporting an increase was nondurables and that was due to increasing prices. Actually, the big story in this report was not the jump in spending but the sharp rise in consumer costs. The acceleration in inflation totally wiped out the rise in consumption and that raises questions about the ability of households to keep holding up the economy. Yes, incomes did increase nicely but spending power declined. We need wages and salaries, which rose moderately, to show bigger gains going forward. For the Fed, its preferred measure of inflation is now just a small tick away from its target. The Personal Consumption Expenditure deflator was up 1.9% over the year.
Manufacturers are going to watch the situation with the consumer carefully. The sector has been recovery very nicely and the Institute for Supply Management’s reported that activity accelerated again in February. This was the sixth consecutive month the headline index rose. Demand was strong, production increased and orders swelled. Hiring is still solid but not quite as strong as it had been.
Separately, the U.S. Census Department reported that construction activity fell in January as a large drop in public sector overcame a moderate rise in the private sector.
MARKETS AND FED POLICY IMPLICATIONS: The Fed is meeting in two weeks and we now have everything in position for a rate hike. The Beige Book summary of economic activity indicated that the labor shortages are getting worse and causing wages in some areas to rise faster. The members will be discussing that when they start the meeting on March 14th. Adding to the Fed’s concerns is that inflation is now at its target on likely to go through it in the next month or two. So, its two mandates, full employment and stable (i.e., target) inflation are being met. While last night’s presidential address didn’t provide any usable details about policy, it is clear the President is intent on pushing his agenda of tax cuts and spending increases. To whatever extent that happens, growth should accelerate by year’s end. So, the Fed has no reason to stand pat. Yes, rising prices are curtailing consumer spending power, but the labor market tightness offset some of that. More importantly, the Fed knows it has a long way to go before it hits a neutral or long-term rate and it needs to get going on that process before inflation becomes an issue. Will we get a rate hike in two weeks? The members are trying to get the word out that it is now a real possibility. I had been expecting the move at the following meeting in May, but now I think it is a toss up. Regardless, rates are going up and if the expansionary fiscal policy does get passed, look for them to rise faster than the market currently expects. I a sticking with my 100 basis points – one percentage point – increase this year.