July 29, 30 ’14 FOMC Meeting

In a Nutshell: “…a range of labor market indicators suggests that there remains significant underutilization of labor resources.”

Rate Decision: Fed funds rate maintained at a range between 0% and 0.25%

Quantitative Easing Decision: Bond purchases reduced by $10 billion to $25 billion

The latest FOMC two-day meeting was not expected to create any major change in the messages that the Fed members have been trying to send, and it didn’t.  But there were still some interesting takeaways from the statement.

If it is all about the labor market and wage pressures, then the Committee did elevate its thinking about the potential for rising compensation to the top of the discussion.  That said, the members then decided to downgrade the threat by indicating there was “significant underutilization of labor resources”.  There is still belief that the labor market will improve, but right now they seem to be saying potential wage pressures are not a threat.  The statement seemed to be a little more cautious about inflation, which has accelerated recently.  The comment was that “Inflation has moved somewhat closer to the Committee’s longer-run objective” rather than just being below target. I am not exactly sure how much worry that shows given the lack of concern about wages, but at least there was recognition that the rate is moving upward.

Otherwise, everything was expected.  The Committee knew that growth had rebounded in the spring and said so.  With growth back on track, it was easy to continue the reduction in asset purchases by another $10 billion.  It is likely that quantitative easing will be a thing of the past as of the October meeting.  But other than indicating that all funds would be reinvested, there was no indication of what will happen to the Fed’s balance sheet after asset purchases end.  As for the funds rate, it was repeated that “it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends”.  Since considerable time is about six months – per Janet Yellen – and the program should end in October, that gets us to April.  I think the March meeting is still a good possibility.

Okay, what does this all mean?  There seems to be a growing discontinuity between the firming labor market data, excluding wages, the upward trend in consumer costs and the Fed’s lack of concern about future inflation.  Indeed, it is unclear why the Fed believes that wages will not start rising faster by year’s end.  Keep in mind, the Fed has been so easy for so long that it will take at least two years or longer to unwind everything.  If they are using wages, which is a lagging indicator of a lagging indicator, to signal inflation pressures, then they are taking a fascinating gamble.  While I am not an inflation hawk by any means, it is time for the Fed to explain how it will know when labor market conditions are becoming tight.  My view is simple: If you wait until you see that wage pressures are building, it will be very late in the process to begin dealing with the rising cost pressures.  That is true for both businesses and the Fed.

Second Quarter GDP and July ADP Jobs Forecast

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.

May Case-Shiller Home Prices and July Paychex Small Business Hiring

KEY DATA: Case Shiller (Monthly): -0.3%; Annual: +9.3%/Paychex: up 0.3%

IN A NUTSHELL:  “Small businesses are hiring but the improving labor market conditions are not translating into booming home sales or prices.”

WHAT IT MEANS:  Another day, another sign that economic conditions are improving but not across the board.  Today’s fun numbers spoke about housing prices and small business hiring.  In May, home prices took a step backward, according to the S&P/Case-Shiller home price measure.  The seasonally adjusted 20-city index fell between April and May with fourteen of the twenty cities posting declines.  In April, only four cities saw home prices fade.  Looking over the year, prices are still up strongly, but the rate of gain is decelerating sharply.  It had peaked in November 2013 at 13.7%, so the increase is off one-third.  That said, the increases are still impressive with only New York, Charlotte and Cleveland having home costs increase by less than five percent.

While housing seems to be in a lull, hiring is not.  The Paychex/IHS Small Business Hiring Index rebounded from a spring thaw and is closing back in on the record high it posted in April.  Except for the West South Central, which includes Texas, all regions were up nicely over the year.  The Mountain and Midwestern regions led the way with somewhat more modest gains being recorded along the East Coast.

MARKETS AND FED POLICY IMPLICATIONS: It just seems that when it comes to breaking out of its slow growth pattern, if it isn’t one thing that restrains activity it is another.  When manufacturing came around, housing and the labor market lagged.  Then housing started to rebound, but jobs and incomes were not growing rapidly.  Now that firms are hiring, the housing market is starting to stumble.  Will we ever get things going all at once?  Maybe, but not right away.  Still, the key remains wages and with small business hiring picking up, that bodes well for income growth.  As for the housing situation, I differ from many of my colleagues.  While others bemoan the rising prices as a problem for first-time buyers, I cheer rising prices because they are lifting people out of the negative equity/minimal equity trap.  Without enough equity to buy another home, families are basically “home bound”.  The normal churn in the market, where current owners move around, is limited.  The more prices rise, the more households can move.  I think adding to equity is a more important factor in getting the housing market back to normal than keeping prices low so new buyers can enter.  But that is just me.  Anyway, it is still earnings season and with geopolitical concerns lurking, these reports are not likely to move the markets much.  And let’s not forget that the Fed has started its two-day meeting.  Not much news is expected tomorrow, when the FOMC meeting ends, but it still hangs over the markets.

June Durable Goods Orders

KEY DATA: Durables: +0.7%; Excluding Transportation: +0.8%; Non-Defense, Non-Aircraft Capital Spending: +1.4%

IN A NUTSHELL:  “Corporations are investing in big-ticket items, a clear indication that business conditions are improving.”

WHAT IT MEANS: Durable goods orders, the poster-child for volatile data, showed once again that if you don’t like the numbers one month, wait thirty days and they will change.  Demand for big-ticket purchases plummeted in May, setting off concerns that the economy was not picking up steam.  Well, not to worry.  Orders rebounded in June and the increases were in a variety of industries.  Yes, aircraft, both Boeing and Pentagon, was up.  But it wasn’t just sales of airliners and fighters that moved the needle.  Demand for machinery, electronic products and primary metals rose.  While vehicle orders fell, demand is so strong that it is likely that sector will be posting gains going forward.  As for corporate capital spending, the key measure – non-defense, non-aircraft orders – jumped.  They had been soft and this may be a sign of improving confidence.  Looking toward the future, backlogs built in almost every major sector.  That implies production should accelerate in the months to come.      

MARKETS AND FED POLICY IMPLICATIONS: Just as I cautioned that we shouldn’t read too much in a decline in durable goods orders, so should be we careful not to jump to conclusions when demand rises.  The data are just way too volatile to assume one or even two months of numbers mean a whole lot.  With that said, the rise in orders in June means that durable goods demand has increased for four of the past five months.  That is really the story.  If big-ticket purchases are growing on a fairly consistent basis, then economic activity should be improving.  With the labor market tightening and loan demand picking up, about the only place where there seems to be problems is housing, and that is more in new homes than existing homes.  The existing market seems to have righted itself after the winter slump.  Neither is strong, but it is hard to get a mortgage with income growth weak and with many homes still either under water or with limited equity, owners just don’t have the down payments.  Next week the Fed is meeting on Tuesday and Wednesday, before the employment report is released.  They will have second quarter GDP but regardless of the rebound from the first quarter decline, it is still all about labor compensation.  The July payroll and unemployment numbers should be good, though with businesses adamant about not raising wages, don’t expect hourly earnings to pop.  It will take real labor shortages before firms get the picture that to fill open slots, they will have to pay more.  But as I keep saying, the longer the pressure builds, the bigger the explosion.  When wages start to rise, they could really pop. The Fed has some time to watch and wait, but their flexibility may come to an end sooner than expected.  As for investors, they should like this report.  But it is earnings season and with orders bouncing around so much, don’t expect this report to drive the markets.

June New Home Sales and Weekly Jobless Claims

KEY DATA: Sales: down 8.1%; Jobless Claims: 284,000 (down 19,000)

IN A NUTSHELL:  “The labor market may be getting better but wage gains are not and until that happens, families will not be buying new homes at any great pace.”

WHAT IT MEANS: When it comes to economic numbers, today’s data were the best of times and the worst of times.  First the good news.  Jobless claims dropped to their lowest level in over eight years.  And when you adjust for the size of the labor force, you have to go back to 1999.  Clearly, the labor market is tightening, but we have to be a little cautious about the July claims numbers.  The vehicle makers don’t close plants in the same pattern that they used to when July was standard changeover to new model time.  Thus, the seasonal adjustments may be a little out of whack and it wouldn’t be surprising if the number gaps upward next week.  It will still be low, but not as eye-catching as today’s number.

While the job market may be getting better, the housing market is not, at least when it comes to new home sales.  Builders saw demand plummet in June and the decline was across the entire nation.  The largest fall off was in the East, where sales plummeted 20% while the West saw demand decline by just under 2%.  The supply of homes for sale is continuing to rise and that growing inventory could lead to improving sales as buyers have more options to choose from.

MARKETS AND FED POLICY IMPLICATIONS:  While the declining housing sales are troubling, they really didn’t make a lot of sense.  It is hard to believe that builder confidence is jumping, as we saw with the jump in the Home Builders’ index, while sales are falling.  So I am a little suspect about these data.  Meanwhile, the jobs numbers are just getting better and better and for me it is all about the labor market.  Not to sound too much like the broken record that I am, the missing link in this recovery continues to be solidly growing worker income.  We saw this week that in June, earnings were flat again and adjusting for inflation, they declined.  It is hard to make a commitment to buy a house when you don’t have increasing funds.  But that is likely to change.  The low levels of claims points to another solid jobs report and we could see the unemployment rate decline to 6% or even lower when the July data are released next Friday.  Now there are many who simply do not believe that worker compensation will accelerate any time soon.  But unless the law of supply and demand has been repealed for the labor market, the tightening of conditions will force firms to start bidding for workers.  There may be resistance to doing that and the appearance of wage pressures may take longer to show up as a result, but it is coming and probably sooner than most think.  When household incomes start rising, they will be better able to qualify for mortgages while the resulting increase in confidence will likely also encourage more home purchases.  The Fed will likely wait to until wages are actually rising before any decision to increase rates is made.  The old saying that “if you wait to see the whites of inflation’s eyes before tightening you have waited too long” seems to have been discarded by the Yellen Fed.  As for investors and business owners, they dismiss the warning signs about growing wage pressures at their own peril.

June Housing Starts and Weekly Jobless Claims

KEY DATA: Starts: -9.3%; 1-Family: -9%; Permits: -4.2%/Claims: 302,000 (down 3,000)

IN A NUTSHELL:  “We thought that home construction would surge this spring but instead it has fizzled, despite improving labor market conditions.”

WHAT IT MEANS: I know this will probably date me but does anyone remember the Vanguard rockets that were supposed to launch our satellites into space?  No?  Not surprising, since most of them went up and the fell back right to earth.  Well, the home construction sector, which was supposed to rocket us into stronger growth looks more like a Vanguard than the Atlas V that successfully sent our men to the moon.  Yes, I miss the space program. Housing starts posted a second consecutive big decline in June.  After rebounding sharply in April from the winter weather, builders seem to be getting more cautious.  This is a real surprise.  First of all, permits, while down in June as well, have been running about five percent above starts for the last two months.  Builders are not paying for permits unless they expect to build those units.  The number of homes authorized but not started also jumped.  And finally, builder confidence soared in June, according to the National Association of Home Builders.  So what is going on?  I am not certain but the nearly thirty percent decline in starts in the South has to be suspect.  I could understand it if there was just a huge decline in the volatile multi-family sector, but the single-family component also dropped sharply.  In the rest of the country, activity was up.  So let’s wait a while before we jump to any conclusions about the state of the housing market.

The good news today was the drop in jobless claims.  We are looking at levels not seen since 2007 and when you adjust for the size of the labor force, we are approaching record lows.  The monthly surge in the number of jobs being created and the continuous drop in the unemployment rate is no fluke.  The July jobs report is setting up to be another really good one.

MARKETS AND FED POLICY IMPLICATIONS: Home construction is a critical component of any strong economy and right now, activity seems to be faltering.  But I just don’t believe that the headline number is telling the whole story.  The huge fall off in the South makes no sense, especially given that starts rose everywhere else and other indicators point to rising activity.  So my suggestion is that we feel disappointed by the report but don’t get too worked up about it.  What I think investors should focus on is the jobless claims data.  The labor market is tightening.  Firms are not cutting workers and people are finding jobs.  Don’t be surprised if the unemployment rate dips below 6% by the fall and with full employment at around 5.5%, it is hard to believe that labor shortages will not start appearing across industries, occupations and regions.  The real question is: When will businesses feel compelled to raise wages to attract workers?  I have said this before and I will keep saying it, that time is coming, likely before the end of the year, and once the wage dam breaks, retention issues will arise and compensation costs will become the main topic of discussion at the Fed.  But Fed Chair Yellen is content to wait until she actually sees that happen so rate hikes are still well into the future.

June Producer Price Index and Industrial Production

KEY DATA: PPI: +0.4%; Goods: +0.5%; Goods less Food and Energy: +0.1%; Services: +0.3%/IP: +0.2%; Manufacturing: +0.1%

IN A NUTSHELL:  “The rise in wholesale consumer product costs may not lead to a large rise in inflation, but the upward trend needs to be watched.”

WHAT IT MEANS: As long as inflation remains well contained, the Federal Reserve can provide unlimited support to the economy.  We have seen a steady, but slow, upward drift in the inflation rate and the June data on wholesale costs indicate that the trend will likely continue.  The Producer Price Index rose sharply but much of that came from a jump in energy costs.  We already know that the upsurge in petroleum prices has already unwound so the headline rise in July will likely be lower.  But as usual, the real information is in the details and they tell a somewhat different story.  Costs at the finished goods levels are beginning to show some real signs of rising inflation.  Finished consumer goods prices have increased by over 3% during the past year even when you exclude energy.  Finished consumer food costs have jumped nearly 5%.  While not all of those increases make their way into retail prices, a lot do and that argues for additional pressure on consumers.  Services costs, though, have been more contained, increasing just under 2% over the year.

On the manufacturing front, output rose modestly in June, but that doesn’t tell the whole story.  The industrial sector rebounded from a terrible January, posting strong gains over the next four months.  Even with the limited increase in June, manufacturing production increased at a nearly 7% pace during the second quarter.  Despite a weather-restricted 1.4% first quarter increase, manufacturing output is rising at a better than 4% pace this year and that is an indication the economy is picking up steam.  Construction activity was solid in June and the output numbers were backed up by a jump in the National Association of Homebuilders’ Index which hit its highest level since January.  The winter is finally over as far as builders are concerned.

MARKETS AND FED POLICY IMPLICATIONS:  It is hard to get worked up over any producer price report as the pathway from wholesale to retail is hardly direct and frequently goes nowhere.  But the increases in finished goods costs are a warning that the days of putting inflation in the back of our minds may be coming to an end.  We are not talking about high inflation, just rising inflation.  We have seen that in the both the Consumer Price Index and Personal Consumption Expenditure Price Index.  The CPI is now over 2% while the PCE is closing in at that level, though excluding food and energy they are still below the Fed’s target.  The Fed probably wouldn’t mind a little acceleration in inflation. It is a lot higher that they worry about.  Right now there is little reason to fret but that may not be the case in by the end of the year.  Investors will probably not think much about today’s data as they are really non-threatening.

June Retail Sales and Import Prices

KEY DATA: Retail Sales: +0.2%; Excluding Vehicles: +0.4%/Import Prices: +0.1%; Excluding Fuel: -0.1%

IN A NUTSHELL:  “Consumer exuberance remains restrained and that raises questions about how strong the economy can or will grow.”

WHAT IT MEANS: The winter or our consumer discontent continued into the spring of our shopping boredom.  Most economists assumed that the weather drove down spending in the first part of the year but that would change dramatically as we got to the summer.  Well, spending is up but not nearly as robustly as forecast.  Retail Sales increased less than expected in June.  Strangely, vehicle sales fell.  I say strangely because unit sales hit their highest level in eight years in June.  After going crazy at the Home Depots of the world in April and May, demand for building supplies collapsed in June.   And since we weren’t shopping like crazy, we didn’t eat out a whole lot either.  But there were positive signs in the data.  Sales of food, clothing, sporting goods, health care products and appliances and electronics were up.  We shopped online and at general merchandise stores, so we really did spend some money.  These are the products that show up in the consumption component of GDP so we could see a decent spending number when the second quarter growth rate comes out on July 30th, the same day the next FOMC meeting ends.

Consumers can continue to buy lots of things, even with limited incomes, since inflation is well restrained.  We saw that again with the import price numbers.  The cost of foreign products rose minimally in June but most of the gains came from a jump in energy costs.  Food prices fell while the costs of consumer goods, capital equipment and vehicles were flat.  In other words, consumer purchasing power, at least when it comes to most imported products, is holding up.  On the export side, a similar pattern was observed as prices fell pretty much across the board.

MARKETS AND FED POLICY IMPLICATIONS: I keep saying we cannot get strong growth until we get strong income growth and so far we don’t have either.  Part of the problem with the expected rebound in spending is that some of the demand was lost forever.  If we didn’t go out to eat in February, we were not going to make up for that in June.  But another, longer-term change may be in the wind: The long-lasting, slow recovery may be eroding the “shop ‘till you drop” mentality.  People may be discovering they really can live without all the things they used to think were necessary.  Doing without for a short time may cause only temporary reductions in demand but cutting back for an extended period could change habits.  We will see what happens when income growth gets back toward decent levels, but we have to consider that the Great Recession and the Not-So-Great Recovery have modified spending patterns. With the Fed worried about disappointing growth, the decline in non-fuel import prices provides further cover to keep rates low for an even longer period of time.  Inflation is hardly a threat right now.  As for the markets, the focus of attention is where it should be, on earnings.

May Job Openings and Labor Turnover Survey

KEY DATA: Openings: +171,000; Hiring: -52,000; Quits: +60,000

IN A NUTSHELL:  “Rising openings and increasing labor turnover is another sign that the labor market is improving rapidly.”

WHAT IT MEANS: Despite the robust June jobs report, skepticism about the strength of the labor market remains.  And the basis for that uncertainty is valid: Wages continue to rise minimally.  That more work needs to be done before firms are forced to start bidding for workers is clear, but that time may not be far off.  The monthly reading on job opening and labor turnover was a pretty good one.  Jobs openings jumped.  Since May 2013, they are up a nearly 20%.  Hiring has clearly not kept pace, in part because business leaders are not raising compensation so workers are not coming out of the woodworks to take the jobs.  But changes are in the air as the number of people quitting is rising.  Given all the uncertainty about the labor market, it takes a lot of guts to leave a job and since last May, there has been a nearly 15% increase in the number of people willingly leaving their jobs.

MARKETS AND FED POLICY IMPLICATIONS: The JOLTS data are my favorite non-payroll numbers and members of the Fed, including Fed Chair Yellen, also watch them closely.  I like the quits data the most as it really gets to the heart of the uncertainty that workers have been facing: The inability to get another job.  In this world, job security, as I have noted many times before, can be defined as “the ability to walk across the street and get another job”.  That is still not readily possible, but the rise in people quitting and the jump in openings provide the basis for my belief that turnover rates could start to increase rapidly over the next six months.  Businesses, though, don’t believe that is likely.  They still complain about a lack of qualified workers but refuse to raise offers.  I call that the Einstein Insanity Defense: They continue to do the same thing, not raising wages, and keep getting the same results, no qualified workers at the prevailing wage.  It is as if there is only one curve in the labor market: the demand curve.  Business demand workers and workers are supposed to appear magically.  But there is a supply curve as well and that means that wages need to rise to attract the needed workers.  We will see how long it takes for businesses to recognize that fact.  But when they do, wages will jump and those that were slow in seeing that happening, as well the Fed, will have to scramble to catch up.

June Supply Managers’ Non-Manufacturing Index and Weekly Jobless Claims

KEY DATA: ISM (Non-Manufacturing): -0.2 points: Orders: +0.7 point: Hiring: +2 points/Claims: 315,000 (up 2,000)

IN A NUTSHELL:  “The service sector remained solid in June and with orders strong, that should continue.”

WHAT IT MEANS: Normally, the Institute for Supply Management’s surveys take center stage, but on a day where we got a huge employment report, this is probably a tree falling in the forest: It makes noise but few hear it.  The service sector grew in June but not quite as strongly as it had been over the previous few months.  Still, two key components of the index, new orders and employment, rose solidly.  Indeed, the orders index is quite high, indicating that not only has there been no slowdown in demand, but activity should accelerate in the months to come.  Firms are gearing up for that as their hiring is increasing.  We saw that in the payrolls number.  This bodes well for job gains going forward.  But this was not a uniformly strong report.  Business activity eased and backlogs grew more slowly, so we may not be seeing a rapid pick up in activity.

Also lost in the employment report was the weekly jobless numbers.  Claims inched upward but the level is still consistent with payroll increases in the 225,000 to 250,000 range.  I suspect we will stay at that job gain pace during the summer and accelerate in the fall and winter.

MARKETS AND FED POLICY IMPLICATIONS:  It was a good day for economic numbers.  The economy is indeed as strong as I have been arguing but not as strong as we want.  But that time is coming and sooner rather than later.  The equity markets should be focusing on the better growth not the coming jump in interest rates, but rationality and efficiency are two vastly different things.  Markets are efficient, not necessarily rational.  That said, we have been sent into the July 4th weekend with lots of things to celebrate, so let me end by simply saying:

Have a Great July 4th Weekend!

Linking the Economic Environment to Your Business Strategy