September Employment Report

KEY DATA:  Payrolls: +194,000; Private: +317,000; Public Education: -149,000; Revisions: +169,000; Unemployment Rate: 4.8% (down 0.4 percentage point); Wages: +0.6%; Hours Worked: +0.2 hours

IN A NUTSHELL: “Other than the volatility in the education sector, this was actually a good report, as the labor market continues to firm.”

WHAT IT MEANS: Stop.  Don’t look at the September headline jobs number or you will be totally confused.  Yes, it was disappointing on the surface.  But as I always say, the information is in the details, so let’s look at them.  Start with the payroll numbers.  The private sector added a lot of new workers.  That is critical given the extreme shortage of labor that employers are claiming is out there.  Apparently, firms are finding people to hire, though clearly not as many as they would like.  The low headline number was largely due to the education component, which has apparently lost its past seasonality.  Schools are opening at a different pattern than in the past, so we had seasonally-adjusted 257,000 workers added in July, and a 150,000 cut in September.  Don’t believe either one of those numbers.  However, the rise of 130,000 over the past three months does make sense.  That shows how you really need to follow the 3-month moving average and not focus on one-month worth of data.  Speaking of which, the private sector average monthly job gain over the past three months is 488,000, which shows that hiring continues to be robust.  Finally, revisions to previous reports added a lot of workers not counted previously, so let’s simply accept the fact that that the headline is totally misleading

There are other parts of the employment report that also point to a very strong labor market.  The unemployment rate fell sharply, though not for all the right reasons.  Employment jumped and unemployment declined significantly, which if good.  But the labor market contracted, which was disappointing.  In a normal strong market, the labor force expands.  COVID seems like the obvious explanation.  Still, we are back to the January 2017 unemployment rate.  The labor market is nearing full employment.  As for the ending of the extended unemployment benefits, it may be too soon to see any impact, but for now, it looks like the theory that ending the special pandemic benefits would make workers more available is just that, theory. 

Finally, average hourly wages surged and are up a robust 4.6% over the year.  In addition, hours worked jumped.  Together they point to a large increase in income. 

IMPLICATIONS:The September employment report paints an accurate picture of the labor market.  Firms are hiring like crazy, but with the labor force stagnant, the number of available workers is shrinking.  As a result, the unemployment rate is dropping and with the demand for workers outstripping the supply, wages are soaring.  This has major consequences for the Fed.  First, with income surging, consumer demand should remain solid, so don’t look for any massive slowing in growth.  Second, labor costs are not coming down anytime soon, and when you combine that with the rising input costs from the broken global supply chain and strong demand, the Fed’s hopes for a near-term moderation of inflation are fading.  I think Chair Powell is finally getting to understand that, as he is indicating he thinks high inflation could go into next year.  Now we need the him to start thinking that it could last well into next year.  Until he does, he will be sounding like a clueless politician, rather than a Fed Chair.  Forty miles of ships waiting offshore to unload in California point to a pretty messed up supply chain. Mr. Powell needs to start preparing the markets for the possibility that inflation could last a lot longer than he has been arguing it would.  I suspect that will start at the next FOMC meeting on November 2,3.  Look for the Fed to announce the start of tapering and possibly a larger cut in purchases than is currently expected.  That would indicate the Fed is serious about withdrawing its stimulus and the members recognize the threat that an extended period of high inflation presents for growth and interest rates.

September Manufacturing Activity and Consumer Sentiment, August Income and Spending and Construction

KEY DATA:  ISM (Man.): +1.2 points; Orders: flat/ Sentiment: +2.5 points/ Consumption: +0.8%; Disposable Income: +0.1%; Prices: +0.4%; Ex-Food and Energy: +0.3%

IN A NUTSHELL: “With inflation and Delta running hot, it is beginning to look like we are in for an early deceleration in growth.”

WHAT IT MEANS:  Lots of data and so little space to discuss the meaning.  So, let’s start with the September reports.  Manufacturing activity stayed strong in September.  The Institute for Supply Management’s index rose, and the level is high.  As for the details, they point to more of the same but no acceleration going forward. The order index was flat, the production measure signaled slightly slower growth, backlogs built more slowly, and prices of goods rose faster.  Hiring turned positive but is not strong.  The sector is in good shape and it should remain that way for a while.

As for consumers, there were two reports that spoke to their attitudes.  First, the University of Michigan’s Consumer Sentiment Index rose a touch in September, but it remains depressed.  Between the virus and inflation, there is not a lot to be happy about.

That sourness in consumer attitudes did not show up in August consumer spending, which surged.  Most of that was from nondurable goods purchases, which was likely driven by rising gasoline prices.  Indeed, the real story in this report was another jump in household’s costs.  That was true even when food and energy were excluded.  With incomes rising modestly, real or inflation-adjusted income actually fell sharply and the rise in consumption was cut in half. 

On the construction front, residential activity was up decently, but that gain was wiped out by a similar decline in nonresidential construction.  These data have been consistently revised upward, so before any judgment is made, let’s see what they look like in a month. 

IMPLICATIONS:Today’s data dump was, for the most part, disappointing.  It was nice to see that the manufacturing sector remains solid, but consumers are not a happy bunch and price increases are eating into their income gains, which is making them even more unhappy.  That doesn’t mean the economy is about to crater.  It’s just that we could see a deceleration toward trend growth occur sooner than expected.  I have growth back to the low 2% range during the second half of next year, but I don’t rule out that happening in the spring, especially if the virus is still with us in earnest.  But the real issue remains inflation and whether it is transitory of more persistent.  The Fed has created the conceptual possibility that it could accept inflation funning in the 2.5% to even 3% range for five years.  For the five and ten years ending 2020, the inflation rate, measured by the personal consumption expenditure deflator, averaged 1.5%. Inflation would have to average 2.5% for the next five or ten years to average out to 2%.  The Fed has built itself a huge cushion when it comes to inflation.It can run hot for an extended period and still meet its stated goal of averaging 2%.  That raises the questions, which I have discussed multiple times before: What happens to inflation expectations if inflation persistently runs above 2%; and is 2% the best inflation goal?  Those are the issues we should be debating, not whether inflation will decelerate from current levels.  It will, but where do we end up?  I continue to believe that trend inflation will be closer to 2.5% than 2% when things ultimately settle down.

August Leading Indicators, Weekly Jobless Claims and FOMC Decision

KEY DATA:  LEI: +0.9%; Claims: +16,000

IN A NUTSHELL: “The Fed is intent on ending its flooding of the markets with liquidity and then raising rates for the simple reason that the economy is in good shape.”

WHAT IT MEANS:  It looks like the only thing about the expected economic slowdown that is slow is the pace at which it is arriving.  If the Conference Board’s Leading Economic Index tells us anything, and it usually does, then we still have some strong growth ahead of us.  The index jumped in August, after a major rise in July.  Only a decline in confidence, which we cannot take for granted, restrained the increase.  The report noted that growth this year could hit 6% and still be 4% next year.  Yes, the slowdown is coming, but it is a way off.

Weekly initial claims for unemployment insurance jumped last week, which was a surprise.  Since hitting its post-recession low on September 4th, the number of people applying for assistance has increased.  These data are volatile because it is impossible to get an accurate seasonal adjustment for weekly data, so don’t read too much into the recent increases. 

Yesterday’s FOMC Decision:  Tapering is coming “soon”, and not much later rate hikes will begin.  Is the sky falling?  Hardly.  It’s the opposite.  The sky is brightening.  Yes, the Delta variant is still a wildfire in many parts of the nation, and that will be the case until it hopefully burns itself out.  That should have happened already, but given the large percentage of the population who will not get vaccinated, there remains plenty of tinder to burn through. Yet the economy continues to move forward, and today’s data don’t point to any major slowdown in the near future.  It was in that light that the Fed, through its statement and more importantly the comments made by Fed Chair Powell at his press conference, determined that the days of extremely easy money need to come to an end.

Keep in mind, the Fed will be still adding to liquidity until about the middle of next year, it’s just that the amount will be reduced, probably monthly.  As the Fed members have noted in the past, first comes tapering, then come tightening.  And if you look at the infamous “dot plot” of Fed funds forecasts, half the members expect a rate hike by the end of next year.  Barring another variant creating even more havoc, or a massive Chinese meltdown (not expected), that looks like a good bet right now.  Whether the hike comes in the fourth quarter of 2021 or the first quarter of 2022 is irrelevant, it is coming.  The economy should continue to grow solidly next year, though more moderately.  But that should be enough to bring unemployment rates down close enough to 4% for the Committee members to declare victory.  Indeed, 4% is their long-run full employment target.  The only issue is inflation, which is still running well above the 2% target.  The members still say that is transitory.  In, addition, the statement reminded us that “With inflation having run persistently below this longer-run goal, the Committee will aim to achieve inflation moderately above 2 percent for some time so that inflation averages 2 percent over time and longer‑term inflation expectations remain well anchored at 2 percent.”  In other words, the Fed is quite willing to live with high inflation for an extended period.

When you put this all together, it is time to begin planning for rising rates.  Investors should start factoring in not just a lower amount of liquidity flooding the market, but the inevitable move toward the Fed reducing its balance sheet.  Since these actions are coming because the economy is healing and will once again be able to support normal interest rates and a more passive Fed, I will take it. The next FOMC meeting is November 2,3 2021.  Given Mr. Powell’s statement that the announcement on the start of tapering could come as soon as November, expect that to happen.

August Housing Starts and Permits and September Philadelphia Fed NonManufacturing Survey

KEY DATA: Starts: +3.9%; 1-Family: -2.8%; Permits: +6%; 1-Family: +0.6%/ Phila. Fed (NonMan.): -29.5 points; Expectations: -26.8 points

IN A NUTSHELL: “The housing market’s summer construction slump, if there really ever was one, may be over.”

WHAT IT MEANS: While housing prices have been soaring, home construction has been on a major roller coaster ride. Over the first eight months of the year, four times there were declines in housing starts and four months they were up. When you put it all together, so far this year, starts have soared by 21.5% compared to the same period in 2020. In August, they rebounded solidly from the large decline posted in July. The level is high, but largely sustainable. With permit requests continuing to run well above actual construction, we should see the building pace accelerate over the next few months. While starts this year have greatly exceeded last year’s pace, permit requests jumped even more, 25.7%.

The Philadelphia Federal Reserve’s reading of nonmanufacturing activity in the mid-Atlantic region took a nosedive in early September. However, just about every component continued to show that activity is improving. It’s just that the rate of growth slowed. One area where things did improve was hiring. More firms added both full-time and part-time workers. Price pressures remained extremely high, with input costs increasing faster. Firms continued to push through price increases to offset their rising expenses. Looking forward, confidence seems to be flagging, at least a little. The index fell sharply, but over fifty percent of the respondents continue to believe conditions will improve. However, there was a jump in the share that worry that the economy could slow over the next six months.

IMPLICATIONS: Housing construction has been robust, it’s just that it is doing that in fits and starts (pun intended). Given the demand for homes and the paucity of supply, look for the housing sector to add to growth in the third quarter. With retail sales also on the rise, it looks like third quarter growth will be quite strong. So, why are the markets in a tizzy? Sometimes what happens in China doesn’t stay in China. Fears of a meltdown of Evergrande, a huge Chinese developer, brought out concerns that another financial crisis could be coming. One commentator even called it “China’s Lehman Brothers moment”. Yikes. But it isn’t just China. As much as people complain about too much government spending, fears are that gridlock in Congress could cause there to be too little government spending. Let’s not forget that government funds kept millions of small, medium and large businesses from failing and supported millions of unemployed workers and their families. That money is beginning to disappear, and the economy will have to stand on its own. Investors don’t seem that confident the private-sector legs will not be wobbly. Then there is the periodic Congressional brain freeze over the debt limit, or more precisely raising it. I have a suggestion, just let the country default and see what then happens. No don’t. This is just a dumb political game and as I and most other economists have argued for years, simply get rid of the debt limit. Heck, Congress created the mess by passing the spending bills, so pay for them. Finally, there is the not-so-surprising possibility that the investors may be simply taking stock of the fact that prices have soared. A pull back could be nothing more than normal rethinking of things after such as large increase. Ultimately, the economy will prevail and there is little reason to think growth will crater. Slowdown? Of course. Growth at recent levels is just not sustainable, when you consider that roughly two percent is trend growth. The markets need a psychological reset, where anything 2.5% or above is viewed as solid, strong, or even robust, which where it is right now.

August Consumer Prices, Real Earnings and Small Business Optimism

KEY DATA:  CPI: +0.3%; Over-Year: +5.3%; Ex-Food and Energy: +0.1%; Over-Year: +4%/ Real Hourly Wages: +0.4%; Over-Year: -0.9%/ NFIB Optimism: +0.4 point

IN A NUTSHELL: “The inflation rate is moderating, but it is still quite high.”

WHAT IT MEANS:  The Fed Chair has been saying, inflation is coming down, and at least in August it did, at least a little.  The Consumer Price Index rose less than expected, helped along by declines in the costs of used vehicles, medical commodities, and transportation services, which was largely airline fares.  But energy was up sharply, food expenses rose solidly, and new vehicle prices continued to spike.  Still, this was a fairly restrained report.  Key segments, such as shelter and medical services increased at reasonable rates. In addition, the details of the components are starting show some signs of coming off their highs.  While in the past few months, there were very few negative signs in the detailed tables, the number in August rose significantly.  That seems to lead credence to the arguments that inflation will subside.  The questions of at what rate inflation will stabilize and how long it will take to settle down to a more normal level, are still a long way from being answered.

The more moderate rise in inflation helped workers, especially since the tight labor markets are driving up wages sharply.  Hourly earnings soared and even adjusting for inflation, real wages increased solidly.  Unfortunately, they are still down compared to last year.  That is true even if hours worked are added. All that extra money is going to pay for the higher cost of goods, and then some.

According to the National Federation of Independent Business, small businesses remain cautious about the economy and are getting more worried about the future.  It’s Optimism Index edged up in August.  But the percent of respondents expecting business conditions to improve over the next six months dropped sharply for the second consecutive month. The Outlook index hasn’t been this low since January 2013.  Firms are concerned about labor, commodity costs and sales.  They are still trying to hire, but like firms of all sizes, it is a struggle.    

IMPLICATIONS:One month of more moderate inflation pressures is nice to see, but it doesn’t create a trend. We need a few more months of reasonable numbers before we can become comfortable that the declaration in inflation is at hand. The micro-details of the report seem to imply some easing in pressure, but again, we need to wait and see, as there is no letup in the cost of labor and other inputs.  Firms operating expenses are on the rise, and they don’t have the means to address the large increases without raising prices. So, it is hard to argue that inflation will diminish rapidly.  At the same time, the Delta variant continues to punish large parts of the nation and given the battles over vaccines and masks, the likelihood is that it will be with us for quite a while.  And there is no certainty another variant doesn’t appear that creates more issues. If investors are uncertain, they have every good reason to feel that way and we know that uncertainty is rarely good for the markets.  Add to that a FOMC meeting next week where it is unclear what will be said about tapering, and you have the recipe for some real volatility.  The rest of this week is filled with some more important numbers, such as industrial production, import prices, retail sales, and an early reading on September Consumer Sentiment.  It could be a very bumpy week in the markets.

August Producer Prices

KEY DATA:  PPI: +0.7%; Over-Year: +8.3%; Goods: 1%; Goods Ex-Food and Energy: +0.6%; Food: +2.9%; Services: +0.7%

IN A NUTSHELL: “Still no relief from the never-ending rise in producer costs.”

WHAT IT MEANS:  I am sure that Fed Chair Powell truly believes that the inflation pressures we are seeing are only transitory, but as of August, wholesale costs were still soaring.  Both goods and services expenses jumped, and it wasn’t due to energy, which was up moderately (at least for energy).  Indeed, the increases were across all industries.  There are over fifty special categories of the PPI that slice and dice the data in every way possible.  Every single one of them posted an increase.  Even more distressing was the year-over-year numbers: Only one special group rose less than four percent.  For consumers, the food numbers don’t look good.  They were up sharply in August and have risen nearly thirteen percent since August 2020.  While the pathway from producer costs to consumer prices is not direct and frequently ends in a dead end, when it comes to food, those usually wind up being passed through.  As for services prices, they are rising significantly as well, but not quite as massively as goods costs.  That, of course, is faint praise. 

IMPLICATIONS: The next FOMC meeting is on September 21, 22 and I truly wish I was a fly on the wall.  You have the Fed Chair who wants to go slow when it comes to tapering asset purchases.  There is also the “weak” August employment report, that I think has been totally misread.  It really wasn’t weak, but the Committee will not have the September report before they meet, so they only have what has already been released.  On the other side are a number of Reserve Bank presidents who feel inflation is a growing issue and the economy has recovered enough that continued massive additions of liquidity could create more inflation problems.  They want to at least announce the Fed’s intention to taper.  So, what will the Fed do?  The members will probably find wording that says they are watching the economy and inflation carefully and at the suitable time, will announce that that the need for aggressive actions will be coming to an end.  In other words, they will say close to nothing.  And that makes sense.  The economy doesn’t need as much stimulus as the Fed is putting into the system, but timing matters and the “weak” employment report is the 800-pound gorilla in the Eccles Boardroom.  As for investors, they need to chill. The economy is just fine, though growth is moderating because most of the reopening process has been completed and too many people refuse to get vaccinated, so the virus resurgence is affecting confidence and restraining activity in a number of industries.  That is correctable without a sharp slowdown occurring. And inflation, even if it persists at an above 2% pace, may not be that bad.  There is nothing magical about 2% inflation.  For many businesses, it locks them into sub-2% price increases and places major pressures on controlling operating costs, which sometimes is out of their control. The equity markets have risen massively, and it would not be a surprise if there was pull-back, especially if more normal growth has yet to be priced into the markets.  But the economy shows no signs of faltering, and that too should be a factor in investor decision making.   

August Employment Report

KEY DATA:  Payrolls: +235,000; Private: +243,000; +134,000; Unemployment Rate: 5.2% (down 0.2 percentage point)

IN A NUTSHELL: “Don’t jump to conclusions over one less than expected report, the economy is still creating lots of jobs.”

WHAT IT MEANS: Wow, did economists blow this one.  Total payrolls rose by almost half a million less than expected.  I had one of the lowest estimates, but I was off by 150,000, which is still pretty bad.  So, has the economy slowed sharply? Is the Delta variant having a major impact on job growth?  I don’t think so, though it is too early to tell.  First of all, the July and August gains were revised upward sharply, and the three-month average is 750,000.  This is massive.  Almost 62% of the sectors posted payroll increases in August and that is really good.  The real surprise was leisure and hospitality – it created zero jobs.  That said, the sector is now at ninety percent of the job total it was in February 2020.  It is still 1.9 million below its peak, but everything considered, that is not that bad.  There was a decline in retail, though it is hard to know what is going on there.  Finally, state education, not local education, payrolls fell.  Local school districts added workers.  So don’t read too much into the government decline.

Maybe more importantly, the unemployment rate declined again, which was a very positive development.  The fall was driven by all the right reasons: Unemployment fell sharply, the number of employed skyrocketed and the labor force rose, though only moderately.  Once the rate gets below 5%, and we are closing in on that, the issue of full employment will be raised.  We are in a drum-tight labor market already, and unless we see the labor force start growing much more rapidly, the shortages will persist for an extended period.

IMPLICATIONS:  I have little doubt that those who focus on one month of data will start saying the economy is slowing, the Delta variant is bashing growth, and woe is me.  But I will repeat what I have said for decades, don’t let a single number define economic conditions.  The past three months the economy added 2.25 millionThe unemployment rate has fallen by 0.6 percentage point, despite a small rise in June.  That is quite large given the level of the rate.  The number of job openings exceeds the number of unemployed workers.  This report may have been disappointing, but only because economists were unrealistic on the ability of the economy to create huge numbers of new positions every single month.

So, why were we wrong?  First of all, we didn’t believe what the markets were telling us.  The huge labor shortage should have been a major warning sign that the lack of workers is restraining hiring and until the supply increases, there are only so many people that can be hired.  Second, we really are giving little value to the simple realities that it took a decade of moderate growth to get to the 2020 economy and returning to that level may take a really long time.  You don’t collapse and recover everything quickly. 

Finally, we didn’t consider the problem I have talked about before: The seasonal factors may be screwed up because of the nonseasonal job changes last year created by the reopening of the economy.  When nonseasonal issues persist for an extended period, as they did last year, the monthly seasonal adjustments can expect job changes that are not likely to be repeated.  Mathematically, the “mistakes” wash out over the course of the year, but for any individual month, they can create weird numbers.  We need to look at the three month-moving averages to smooth out the misses.  Three-quarters of a million jobs a month is fantastic and that’s where we were for the past three months. 

The problems of misplaced expectations and technical issues create real problems for the Fed, which seems to be leaning toward starting to taper its asset purchases.  Traders are rarely long-term thinkers, and economic commentators don’t usually have the time or space to get into the details of the issues, so they go with the current.  The result is a perception that the economy may be slowing.  I am not arguing that everything is beautiful.  It isn’t.  The Delta variant is bringing back uncertainty about going into stores and restaurants.  It is keeping some workers out of the labor market because of health fears or childcare issues. It is causing consumers to spend more cautiously.  It is slowing the reopening of offices, which impacts businesses in densely populated areas and extends the changes in demand for goods and services on the part of those working from home.  And going forward, there is the impact of ending the supplemental unemployment payments.  Together, these imply the economy could post slower growth over the second half of the year than expected. 

The Fed knows it needs to pull back its massive liquidity add.  But timing matters, so today’s report could push back the announcement a little.  But it is coming, unless Delta or another variant creates even more massive problems that we are currently experiencing.   

August Consumer Confidence and June Housing Prices

KEY DATA:  Confidence: -11.3 points; Current: -9.9 points; Expectations: -12.4 points/ Case-Shiller National Prices: +2.2%; Over-Year: +18.6%/ FHFA Prices: +1.6%; Over-Year: +18.8%

IN A NUTSHELL: “Confidence is faltering and that raises some questions about the strength of the recovery going forward.”

WHAT IT MEANS:  What me worry?  Well, yes.  That seems to be the verdict, as the Conference Board’s Consumer Confidence Index tumbled in a sharp manner that mirrors what we saw in the University of Michigan’s Consumer Sentiment report.  The difference is that there the Michigan Sentiment number was even lower than the pandemic bottom reached in April 2020, while the Confidence Board’s Confidence level was still well above the low.  As was the case with the Michigan report, both the current conditions and expectations indices tanked.  In addition, household views about both the business situation and the labor markets, in the present and the future, were off solidly.  Household concern is rising sharply and if those worries persist, we could see some scaling back of spending.

On the housing front, prices seem to know no upper bound.  Both the Case-Shiller and Federal Housing Finance Agency home price indices rose sharply in June.  Over-the-year, both surged over 18.5%, an enormous increase, and the price gains are accelerating.  Is that sustainable?  Do you think that increases of 29.3% in Phoenix, 27.1% in San Diego and 25% in Seattle are sustainable?  Only three of the twenty large metro areas in the report posted over-the-year increases less than sixteen percent while eleven had price gains in over nineteen percent.  Can you say bubble?  If not, I will.

IMPLICATIONS: Confidence is falling, despite strong gains in jobs, solid increases in wages, and large declines in the unemployment rate.So, why are households feeling so uncertain?  The only logical reason is the rapid spread of the Delta variant and the worries that a major slowdown could occur.  That raises questions about using the confidence data to forecast consumer spending.  Usually, spending changes follow confidence changes when the source of the disturbance is related to economic factors.  While the Conference Boards measure about current and future jobs and business activity did decline in August, their levels are not signaling any major slowdown.  But the reports do raise the warning flag that if the pandemic worsens, and given the continued unwillingness of many to get vaccinated that is a real possibility, we could see people stashing away funds just in case.  That would mean at least a short-term easing in demand.  In addition, there’s the housing bubble.  The National Association of Realtors Housing Affordability Index is down nearly 16% over the year.  It is not just new buyers who are being priced out of the market, but current owners as well.  Those high prices may not be sustained.  Residential investment was a drag on the economy in the spring and it could continue slowing growth for some quarters to come.  If the pandemic leads not only to a drop in confidence, but also an unwillingness to go into stores and restaurants again, then consumption could falter as well.  We could see growth moderate faster than expected.  Which raises the question: When it comes to tapering, is the Fed behind the curve?  If you believe Chair Powell, the answer is no.  If you believe several the Fed Bank presidents, the answer is yes.Today’s numbers only confound the issue as they imply a slowdown in the future, which doesn’t help a data-dependent Fed.The next FOMC meeting on September 21,22 could be very interesting.

July Consumer Spending and Income, August Consumer Sentiment and Fed Chair Powell’s Jackson Hole Speech

KEY DATA:  Consumption: +0.3%; Disposable Income: +1.1%; PCE Inflation: +0.4%; Ex-Food and Energy: +0.3%/ Sentiment: -10.9 points

IN A NUTSHELL: “The Fed should start slowly tapering its stimulus sometime this year, but rate hikes are well into the future.”

WHAT IT MEANS: Before Fed Chair Powell’s greatly anticipated Jackson Hole speech is dissected, it is worthwhile understanding the condition of the economy from which he is operating.  The state of the economy is strong, though the expected moderation is at hand.  Consumption rose moderately in July, led by a robust gain in services demand. Goods spending, though, was down.  The microchip shortage continues to restrain vehicle sales and durable goods consumption tanked.  While the headline number was decent, the rise in spending was more than offset by another sharp increase in inflation.  Adjusting for the price increases, real spending declined.  That could change, though.  Led by the massive July job gain, which powered a jump in wages and salaries, after-tax (disposable) income skyrocketed.  Given the more moderate increase in consumption, the savings rate ticked up.  So far this year, it has averaged 14.7%.  Households have built up a nest egg to spend when the stimulus money runs out. 

Normally, when incomes rise, confidence follows.  That is not the case right now.  The University of Michigan’s Consumer Sentiment Index plummeted in August.  The final number was similar to the mid-month result, so there may some stability setting in – though at a level that is below the bottom hit on April 2020.  That says a lot.

Powell Speaks:  Strong job gains and continued government stimulus funding, including the Biden child tax credit, is supporting the economy.  Covid-19, though, continues to suppress confidence and especially expectations.  The battle between the two was a key point made today in Fed Chair Powell’s speech to the Kansas City Fed’s Jackson Hole Conference (held virtually).  The short story here is that some new ground was plowed, but what the Fed Chair said was pretty much expected.  The markets were looking for hints on when the Fed would start reducing (tapering) its purchases of assets.  This is the monetary policy equivalent of the open-checkbook policy being run by the federal government.  Not surprisingly, he didn’t say the taper was about to begin, but by commenting that “the substantial further progress” test has been met for inflation, as well as “There has also been clear progress toward maximum employment”, the stage has been set for the Fed to announce that they will start to cut back purchases of assets.  Barring a setback in the jobs situation, that could come most likely in the November or December FOMC meeting statement. 

To ward off another “taper tantrum” in the markets, as occurred in 2013, Mr. Powell spent most of his time explaining why he believes that inflation is coming back down to more normal levels.  He has been making the argument that the factors driving the surge in inflation were transitory for a while now, but his defense today was as strong as it gets.  I almost believe him.  Almost.  I am still concerned about what the longer-term trend in inflation winds up as and think it could wind up higher than the current Fed target of an average of 2% over time.  It might take another two years before we have a good idea if 2% holds, so it gives economists a lot of time to argue over the issue.  The fact that he made it clear that it would be a long time before the Fed’s balance sheet declines, adds to the belief that the Fed will allow inflation to run hot for the foreseeable future. 

So, what does this all mean?  The Fed is likely to announce that it is slowing, not ending, its purchases of Treasuries and Mortgage Backed Securities (MBS) sometime by the end of this year.  It will likely take all next year to taper the level of purchases and only then would it consider reducing its balance sheet and start raising interest rates.  The timing is unknown, but that seems like a logical one, as of now.  One final comment.  Jerome Powell has been a steady hand during the pandemic crisis.  He has taken a stand on Fed stimulus and has backed it up with strong economic arguments.  Yes, he seems to believe that supporting high and rising markets is one of the three Fed mandates, in addition to legislatively mandated maximum employment and price stability. That has caused the markets to depend upon and therefore demand continued Fed easy money.  That is a major concern going forward.  He was appointed by Trump, but I don’t think that will stop Biden from reappointing him.  His record is solid and not surprisingly, stories have it that Treasury Secretary Clinton supports him.  His term ends at the end of January, and he deserves to be reappointed. I suspect that announcement will be made later this year.

August Philadelphia Fed Manufacturing Survey, July Leading Indicators and Weekly Unemployment Claims

KEY DATA:  Phila. Fed (Manufacturing): -2.5 points; Orders: +5.8 points/ LEI: +0.9%/ Claims: -29,000

IN A NUTSHELL: “If the economy is softening, you cannot see it yet in the labor market, which remains drum-tight.”

WHAT IT MEANS:  Another day, another set of economic numbers that should drive investors crazy.  First, there was the Philadelphia Fed’s survey of manufacturers.  The index eased back in the first part of August, which was hardly a surprise.  Not because the index was anywhere close to the near-record high it reached in April, but because this index is crazy volatile.  So, ups and downs are taken as a given and when the change is as small as it was in August, then you have to say that conditions didn’t change much.  Indeed, the manufacturing sector in the Mid-Atlantic region is in pretty good shape.  New orders grew much faster, hiring remained robust and pricing power improved solidly.  If there was a warning in this data, it came from the special question section.  Respondents expect that they will have to raise compensation by 4% over the next year but will be able to offset that by an even faster 5% increase in prices.  These results are similar to the ones found in the May survey, except firms now think national inflation will run at a 5% pace over the next year rather than 4%.  That seems to point to rising inflation expectations, something the Fed should be worried about.  

If the Fed is going to start tapering, it should time it when the economy is still improving and it looks like we are in for more strong growth.  The Conference Board’s Leading Economic Index rose sharply in July, as every component added to the gain.  That is about as broad based as you can get.  Given how much the index has risen this year, the Conference Board expects “real GDP growth for 2021 to reach 6.0 percent year-over-year”.  It even thinks that 4% is likely in 2022.  That hardly looks like much of a slowdown. 

As for the labor market, new claims for unemployment insurance declined to a level that is very consistent with a strong economy and an unemployment rate at the current 5.4%.  That is, the market churn, (hires versus fires, quits, retirements etc.) that determines initial claims is pretty normal.   

IMPLICATIONS:Is the economy in good shape? Yes,but it is also true that it is not too hot, not too cold, and not just right.  Forget Goldilocks, bring on confusionSome of the data, including the housing and retail spending reports, have not been great.  But the labor market data have been really great.  And then there are the inflation numbers, which show no signs of subsiding.  The reality is that the economy is in transition and that is the way it is going to be for quite a while. So, expect some volatility in the data, especially when we get to the fall, which is when the labor markets will be moving from government manipulation to private sector actions. For investors, uncertainty is never a good thing, so don’t be surprised if we get some big ups and downs. And that may be in part because the Fed continues to find itself in a tough spot. Clearly, the economy is better than the members expected it to be, while inflation is worse.  That should mean it is a layup that tapering would begin this fall.  But the weak housing and consumption reports, which might just turn out to be temporary aberrations, means that investors are getting worried about the sustainability to strong growth.  If the Fed only had a dual mandate, maximum employment and stable inflation, then there would be no issue.  But the Fed continues to operate under its self-imposed, but never stated, triple mandate, where stable and/or rising markets are also a major factor in its decision making.  Chair Powell doesn’t want to spook the markets (i.e., investors), so he must get his timing right.  Yet when all is said and done, the Fed is likely to start cutting back on its liquidity adds sometime in the next six months.  The issue is not whether but how quickly, so the best thing is to assume it is going to happen and act accordingly.

Linking the Economic Environment to Your Business Strategy