Implications:  Existing home sales surprised to the upside in May, beating the consensus expected pace despite setting the highest median price on record.  Sales of previously-owned homes rose 1.1% in May to a 5.62 million annual rate, and are now up 2.7% from a year ago.  Going forward, it is important to remember home sales are volatile from month to month, but we expect the general upward trend of the past several years to keep going.  That being said, tight supply and rising prices remain headwinds.  Inventories have now fallen on a year-over-year basis for 24 consecutive months and are down 8.4% from a year ago.  This has also affected the months' supply of existing homes – how long it would take to sell the current inventory at the most recent sales pace – which was 4.2 months in May, down from 4.7 months a year ago.  According to the NAR, anything less than 5.0 months is considered tight supply.  The good news is that demand for existing homes was so strong that a typical property only stayed on the market for 27 days in May, the shortest timeframe since the NAR began tracking in 2011.  Higher demand and a shift in the "mix" of homes sold toward more expensive properties has also driven up median prices, which have now risen for 63 consecutive months on a year-over-year basis, and reached a new record high in May.  The more expensive the home the stronger the sales growth has been over the past year, signaling that supply constraints may be disproportionately hitting the lower end of the market.  Further, tough regulations on land use raise the fixed costs of housing, tilting development toward higher end homes.  The NAR suggests that strong demand could also be pushing some properties into higher brackets as multiple offers boost the final sales price.  Although some analysts may be concerned about the impact of higher mortgage rates, it's important to recognize that rates are still low by historical standards, incomes are growing, and the appetite for homeownership is eventually going to move higher again.

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Last week the Federal Reserve hiked the federal funds rate by ¼ of a percentage point for the fourth time since December 2015.  The funds rate is still below the rate of inflation, which means the Fed is still a long way from becoming tight.

The Fed also presented a relatively detailed plan to begin unwinding its balance sheet.  However, this plan means that fully ending QE will take at least a few years, probably more.  In a policy environment where banking rules are (hopefully) moving away from the irrational toughness of the last several years, these reserves have the potential of spurring more economic growth and more inflation even as the Fed raises rates.  In other words, it's hard to see the Fed making monetary policy "tight" anytime soon.

While these slow-motion maneuvers grab all the headlines, the real news is that QE didn't work.  It was very hard to convince anyone of that between 2008 and 2015, but maybe now more people will listen to the evidence.

Yes, the Fed bought bonds. Lots of them. $3.5 trillion of them.  And, yes, the Fed created new money – bank reserves – to pay for them.  Most of those reserves, about 90%, ended up being stored as Excess Reserves – money that exists but is not circulating in the economy.

Those reserves did not boost the money supply.  Those reserves did not boost stock prices.  Those reserves did not boost bond prices.  QE did not work.  How do we know?  Because the Fed stopped Quantitative Easing and the stock market continued to move higher – to record highs.  Because the Fed stopped buying bonds and interest rates have not moved higher.  Because the Fed has now announced that it will reduce its bond holdings and the stock and bond markets yawned.

More specifically, we know QE didn't work because M2 never accelerated when the Fed bought $3.5 trillion in bonds.  Between January 1995 and September 2008, the M2 measure of money – all deposits in all banks – grew 6% at an annual rate.  From September 2008 (the month the Fed started QE) to today, the M2 measure of money has grown at a 6% rate.

Milton Friedman said, "watch M2!"  And the growth rate of M2 has not changed.  What's more important is that economic growth actually slowed.  Between January 1995 and September 2008 (which includes the 2001 recession), real GDP expanded at a 2.9% annual rate.  During the current recovery, in spite of QE, real GDP has grown just 2.1% at an annual rate.

If QE was effective, then real GDP would have accelerated.  Don't be fooled when political economists say the reason real GDP hasn't accelerated is because businesses aren't investing. 

C'mon, think about it.  First, if there wasn't enough investment, there would be shortages of something.  Second, if zero percent interest rates and all the free money in the world can't make people invest more, what can?  And, third, excluding the energy sector, US corporations are earning record profits.  They must be investing, and that investment must be profitable.  But, it's not low interest rates that make them do it, it's the return on high-tech inventions, which get cheaper every day.

The decline in prices of high-tech goods are masking an investment boom.  Over the past three years, real (inflation-adjusted) business investment as a percent of overall real GDP is the highest it has ever been.  The benefits of those investments have caused profits to boom.

That's why stocks are up.  Because profits are up.  Not because of QE.  QE didn't work.

There are those who say foreign QE took over when the Fed stopped.  But if this were the case, then US QE would have driven foreign stock markets higher.  It didn't.

So many analysts have been blinded by an obsession with QE that they have missed the forces that are truly driving the underlying economy.  More to the point, by ignoring the great things going on with new technology, and crediting the Fed with causing stock prices to rise, many conservative economists are undermining their own beliefs.

By saying QE, not entrepreneurial success, lifted stocks, they are setting the stage for the Fed to do it all over again in the next recession.  This would be a mistake.  Government interference in the economy causes slow growth and slow recoveries.  Giving credit to the Fed encourages more of it.

Brian S. Wesbury - Chief Economist
Robert Stein, CFA – Deputy Chief Economist  

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Source: St. Louis Federal Reserve FRED Database

Implications:  Housing starts came in much lower than the consensus expected in May, falling 5.5% to a 1.09 million annual rate.  Starts were below even the lowest forecast from any economics group.  However, this does not signal the end of the housing recovery; far from it.  Even though both single-family and multi-unit starts were responsible for the drop in May's headline number, in the past year single-family starts are still up 8.5% while multi-unit starts are down 23%.  The "mix" of construction has been generally shifting toward single-family building and this is a good sign for the overall economy.  When the housing recovery started, multi-family construction led the way. But the share of all housing starts that are multi-family appears to have peaked in 2015, when 35.7% of all starts were multi-family, the largest since the mid-1980s, when the last wave of Baby Boomers was growing up and moving to cities. In May, the multi-family share of starts fell to 27.3%.  The shift toward single-family is a positive sign for the economy because, on average, each single-family home contributes to GDP about twice the amount of a multi-family unit.  Based on population growth and "scrappage," housing starts should eventually rise to about 1.5 million units per year. In other words, much of the recovery in home building is still ahead of us.  The good news in today's report was that housing completions rose 5.6% in May and are now up 14.6% in the past year.  On top of this, the number of homes currently under construction peaked back in February and have been trending down since, signaling that recently builders have been focusing on finishing projects that are already underway before starting new ones.  Expect housing starts to rebound in the months ahead as more unfinished projects are completed.  In other recent housing news, the NAHB index, which measures sentiment among home builders fell to a still elevated 67 in June from 69 in May.  Expect further strength in the housing sector in the year ahead as more jobs, faster wage growth, and, for at least the time being, optimism about more market-friendly policies from a Trump Administration, continue to encourage both prospective home buyers and builders.           

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Implications:  Industrial production took a breather in May, going unchanged overall, after surging in April.  Manufacturing, which excludes mining and utilities, was the main culprit behind today's lackluster headline number, dropping 0.4%, due to both a 2% decline in the auto sector as well as 0.3% drop in what we call "core" industrial production, which is manufacturing excluding autos.  However, this is not the beginning of the end for manufacturing, which is still up 1.4% in the past year.  Auto production is notoriously volatile from month-to-month and core production rose 0.9% in April, the largest monthly gain since 2010, so it's not surprising it took a breather either.  Going forward, we think core production, which is still up 1.2% from a year ago, will continue on an upward trend, in part, due to a lagged effect of the rebound in oil prices, which adds to the production of equipment and materials used in the energy sector.  The bright spot in today's report came from mining which jumped 1.6% in May, and has been accelerating, up at a 15% annual rate the past six months versus 8.3% in the past year.  Oil and gas-well drilling posted its twelfth consecutive gain in May, jumping 3.8%, and is now up a massive 121% at an annual rate in the past three months.  Based on other commodity prices, we think oil prices are below "fair value" range, and with oil companies profitable at current prices mining should stay in recovery after the problems of the past two years.  In other news this morning, two regional measures of the factory sector were both deep in positive territory.  The Empire State index, a measure of manufacturing sentiment in New York, surged to 19.8 in June from -1 in May.  The Philly Fed index, a measure of sentiment among East Coast manufacturers, came in at +27.6 for June.  That's a decline from +38.8 in May, but still very high.  On the employment front, initial jobless claims fell 8,000 to 237,000.  Continuing claims rose 6,000 to 1.94 million.  These figures suggest a rebound in job creation in June.  Finally, on inflation, import prices fell 0.3% in May but are up 2.1% from a year ago.  Export prices fell 0.7% in May, and have increased 1.4% in the past year.  Both figures are a stark contrast to the negative direction of prices in the year ending in May 2016.

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The Federal Reserve did what almost everyone expected today, raising the target range for the federal funds rate by 25 basis points to 1.00% - 1.25%.   

Here are the key takeaways from today's statement from the Fed, its updated forecasts, its plan on reducing the balance sheet, as well as Fed Chief Yellen's press conference. 

First, although the market consensus is that the Fed isn't going to raise rates again until 2018, the Fed thinks we still have one more hike in 2017, with the odds of two hikes equal to the odds of none at all. 
 
Second, the Fed has a concrete plan to start reducing the size of its bloated balance sheet, a plan it is likely to start later this year.  Once implemented, for the first three months, the Fed will reduce its balance sheet by $10 billion per month ($6 billion in Treasury securities, $4 billion in mortgage-related securities).  Then, every three months, the amount of monthly balance sheet reduction will rise by $10 billion (w/ the same 60/40 proportion between Treasury securities and mortgage-related securities).  That escalation will continue until the Fed is cutting its balance sheet by $50 billion per month. 

Third, compared to three months ago, the Fed is expecting a little more economic growth this year, less unemployment, and less inflation.  However, projections for economic growth and inflation remain unchanged beyond this year.  The only significant change in the forecast was that the Fed now thinks the jobless rate will average 4.2% in 2018-19 instead of 4.5%.  In addition, the Fed thinks the long run average rate for unemployment is 4.6% versus a prior estimate of 4.7%.      

Fourth, the Fed is not impressed by the recent softness in inflation and does not think that softness is a reason to change the projected path of monetary policy.  Although the Fed acknowledges inflation has receded back below its 2% target and is "monitoring inflation developments closely," it thinks inflation will head back to 2% in the medium term. 

Fifth, the Fed is no longer as concerned about the potential negative influence of foreign events, having removed language saying it was closely monitoring "global economic and financial developments." 

We still think the most likely path is that the Fed makes no policy changes in July but then uses the September meeting to make its last interest rate hike of the year while also announcing balance sheet reductions will start October 1.  This is our interpretation of Yellen saying the balance sheet reductions would start "relatively soon."  A less loose monetary policy than the market consensus believes is, in part, why we think long-term Treasury yields will be moving up significantly later this year, with a 3.00% target for the 10-year Treasury Note by the end of the year.

The most disheartening part of the today's Fed releases was that the plan for reducing the balance sheet noted that the Fed stands ready to use quantitative easing again in the future when the economy gets weak.  We don't think QE helped the economy and had been hoping the Fed had learned that lesson.  Apparently not.

Overall, however, we are pleased the Fed raised rates today and look forward to another rate hike and the beginning of balance sheet reductions later in 2017.  Neither of these will hurt the economy and will help prevent future problems that could.      

Brian S. Wesbury, Chief Economist
Robert Stein, Dep. Chief Economist

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Implications:   Retail sales were soft in May, but shouldn't prevent the Fed from raising short-term interest rates later today.  Although retail sales declined 0.3% in May, coming in below the consensus expected no change, most of the decline was due to lower sales at gasoline stations, the result of a drop in gas prices at the pump.  Usually, gas prices rise in May as people start taking longer trips in the better weather.  However, this year headline gas prices fell slightly in May, making seasonally-adjusted prices and gas sales even weaker.  Plugging this morning's data into our models, it looks like "real" (inflation-adjusted) consumer spending will be up at about a 3% annual rate in the second quarter.  Some analysts will use today's data as a reason to stoke fears about the overall state of the consumer and will emphasize recent news about weakness and store closings among traditional brick and mortar retailers.  But, on a year-ago comparison basis, the growth in overall retail sales is still outstripping the growth of consumer prices.  Consumers are just spending their money differently than in the past, buying more items via the internet.  Non-store retailers made up 10.9% of retail sales in May, the largest portion ever and that will keep growing in the years ahead.  A decade ago, nonstore retailers accounted for 6.8% of retail sales.  And if you adjust for the areas where the internet has not had a dramatic effect, taking out autos, building materials and gas stations, non-store retailers now make up 16.3%.  "Core" sales, which exclude autos, building materials, and gas, were unchanged in May, but were up 0.2% including revisions to prior months.  Core sales are up 2.8% from a year ago but are accelerating, up 3.4% annualized over the past six months and 4.4% over the past three months.  The fundamental trends that drive growth in consumer spending continue to look good, including healthy job growth, faster wage growth, and very low consumer financial obligations relative to historical norms. The consumer is alive and well.

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Implications:  Consumer prices fell 0.1% in May, but the decline should do little to sway the Fed's decision to raise rates by 0.25% later today.  Consumer prices are up 1.9% in the past year, compared to a 1.0% increase in the twelve months ending May 2016 and no change for the period ending May 2015.  In other words, inflation is still in a rising trend.  Energy prices led the index lower in May, falling 2.7%, while rising costs for nonalcholoic beverages, meats, and poultry pushed food prices up 0.2%.  Stripping out the volatile food and energy components, the "core" CPI rose 0.1% in May and is up 1.7% in the past year.  Housing led "core" prices higher in May, gaining 0.2%, more than offsetting declines in medical and apparel costs.  The best news in today's report is that real average hourly earnings rose 0.3% in May.  These earnings are up a modest 0.6% over the past year, but they're up at a 0.9% annual rate over the past six months and a 2.6% annual rate over the past three.  This acceleration signals that a loose monetary policy has led to a tighter labor market.  Because the Fed believes in the Phillips Curve, the trend of accelerating price and wage gains should have Fed officials focusing more on the potential for inflation to rise faster than desired as the jobless rate continues to fall below their long-term target.  That's why we expect the Fed to raise rates twice more in 2017, once today and again in September.  Then, in the fourth quarter, we expect the Fed to start unwinding the bloated Fed balance sheet that ballooned during early episodes of quantitative easing.

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Implications:  In spite of no change in producer prices in May, the Fed is still poised to raise short-term interest rates by another quarter of a percentage point tomorrow.  The reason overall producer prices were unchanged in May was because energy prices fell 3% while food prices – led by falling costs for fruits, vegetables and eggs - declined 0.2%.  Take out these two volatile sectors, and you are left with "core" prices, which rose 0.3% in May (following a 0.4% rise in April), and have now risen 2.1% in the past twelve months. That's the first move above 2% since 2014.  With both headline and "core" producer prices above the Fed's 2% inflation target, there can be little doubt that a rate hike is warranted.  The increase in core prices in May was led by margins to wholesalers, which increased 1.1% and pushed prices for services up 0.3%.  Goods prices were pulled lower by food and energy, but rose 0.1% in May when excluding those sectors.  A look further back in the pipeline shows that prices for intermediate demand are also rising.  Intermediate unprocessed goods prices declined 3.0% in May but are up 7.5% in the past year.  Meanwhile prices for intermediate processed goods rose 0.1% in May and are up 4.7% over the last twelve months.  The Fed will keep these prices, which give a hint to the direction final demand prices will follow in future months, in mind as they plan the path for monetary policy.  We expect the Fed to raise rates one more time this year, after tomorrow's hike, while also starting the process of unwinding its bloated balance sheet later this year.  The pouting pundits may paint a pessimistic picture of the Fed becoming tight, but as we noted in yesterday's MMO, the Fed has plenty of room for further rate hikes before risking recession or a bear market.  If anything, the Fed should be concerned about staying too loose for too long.

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