KEY DATA: Phila. Fed: +28.7 points; Orders: +27.5 points; Expectations: +22.1 points/ LEI: +0.2%/ Claims: +45,000
IN A NUTSHELL: “The future is not what it used to be.”
WHAT IT MEANS: My, how things can change quickly. We saw that on the downside a year ago and now with state and local governments easing if not eliminating restrictions, it is happening on the upside. The latest sign of how much the economy is coming back is the March Philadelphia Fed’s Business Outlook Survey of manufacturers. The index skyrocketed to levels not seen since spring 1973. I am trying to remember what was going on then, but it eludes me. The details were just as robust. Fewer than ten percent of the respondents said that economic activity, orders and hiring declined. That is amazingly low. Demand soared and firms had to hire more workers. But it is difficult to do that as respondents are finding that there is a growing labor and skills shortage. That is forcing them to raise wages, which nearly fifty-four percent of the firms said they had to do to overcome the lack of workers. That is just one sign that inflation may be accelerating. Over seventy-seven percent said they paid more for their inputs while nearly thirty-five percent indicated they were able to raise prices. These are signs that inflation just may hit levels higher than the Fed is expecting. As for the future, optimism is on the rise as well, as nearly seventy percent of the respondents expect activity to pick up in the next six months. The index hit its highest level in nearly twenty-eight years.
The Conference Board’s Leading Economic Index rose a bit more slowly than expected in February. However, it was February and the weather was a real problem, so don’t read too much into that. The increase in the measure over the last few months still point to solid growth going forward. As the report noted, “The Conference Board now expects the pace of growth to improve even further this year, with the U.S. economy expanding by 5.5 percent in 2021.”
On the labor market front, firms in the Mid-Atlantic region may be suffering from labor shortages, but layoffs around the country remain way too high. New unemployment claims shot up last week. That may be a delayed effect of the February weather or, more likely, it is just a continuation of the two-steps forward, one and half steps back we have seen for the last five months. The number of people receiving assistance fell sharply, but it is still over eighteen million. That number has bounced around like crazy but the level remains nine times what it was just before the pandemic hit. That is another indicator of the extent to which the government is supporting demand in this country.
IMPLICATIONS: The Fed Chair channeled his best Alfred E. Neuman pose yesterday, making it clear that inflation would rise but it would be due to temporary factors that would dissipate over time. The key is not simply the rate of inflation, but as Mr. Powell, it is inflation expectations. As long as they are anchored around 2%, he really doesn’t have to worry. But the 6.5% growth this year that the Fed is looking for is well beyond any we have seen since 1984. The economy was rebounding from the back-to-back recessions and surged by 7.2% that year. The highest growth rate since then was 4.7% in 1999, the peak in the dot.com and Y2K investment boom era. Firms are going to have pricing power unlike anything they have seen in decades and I would be surprised if they didn’t take advantage of it. With wage and goods prices likely on the rise as well, businesses will have the ability to offset those rising costs and increase margins. That doesn’t mean we are in for a long period of high inflation. But it calls into question the ability of the Fed to moor inflation to 2%, especially since it is also indicating it is not going to raise rates for at least the next two years. It looks like the Fed will get its wish that inflation averages 2%. That means an extended period of 2.5% to 3% inflation in order to make up for the two years of below 2% inflation. The outlook for inflation is already showing up in mid- and longer-term rates. The 10-year note is back above 1.70%, which it hasn’t seen since January 2020. That makes sense. There should be a premium above inflation, but that wasn’t the case in 2020. If the 10-year returns a reasonable real rate of 100 to 125 basis points, then it should average 3.00% to 3.25%, which means there is a long way to go. Investors are likely to start factoring in the possibility of rates rising significantly further over the next year.