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  Fed Tees Up Rate Cuts
Posted Under: Government • Markets • Research Reports • Fed Reserve • Interest Rates • Stocks


The Fed got as dovish as it could get today without actually cutting short-term rates. 

The Fed's next meeting is at the end of July.  If by that time the Trump Administration has made noticeable progress on a trade deal with China (without backsliding on other trade relationships) and inflation has picked up relative to the Fed's expectations, then a rate cut might not happen; otherwise a rate cut is more likely than not in July. 

Right now, the futures market in federal funds puts a stunning 100% likelihood on a July rate cut.  We think that's too high, but a 70% likelihood seems about right.  The reason a rate cut is now more likely than not is that the Fed is focused on bringing its preferred measure of inflation – the deflator for personal consumption expenditures (PCE) – back up to an average of 2.0% versus the current level of 1.5%.

The Fed made an important change to its economic forecast.  It's now projecting a 1.5% increase in PCE prices this year versus 1.8% back in March.  PCE prices are expected to grow 1.9% in 2020 versus a March forecast of 2.0%.  Notably, it's not showing any year with inflation above 2.0%. 

The reason that's significant is that the Fed describes its 2.0% inflation goal as "symmetric," which means it wants to see an average pace of 2.0% inflation over time, with periods of inflation below 2.0% (like we're in now) offset by periods when inflation runs above 2.0%.  The goal of averaging 2.0% inflation means the Fed has given itself room to cut rates based on inflation data alone, even if the US strikes a deal with China.

Superficially, the Fed's "dot plots" suggest no rate cut this year, but that projection dangles by a thread.  Of the seventeen Fed policymakers who made projections, one showed a 25 basis point rate hike and eight showed no change at all.  In other words, the shift of even one more official toward rate cuts would have made a rate cut the median outlook.  Eight policymakers already project a rate cut, with seven of them showing 50 bps in cuts by year end.  Notably, the median forecast for the federal funds rate at the end of 2020 is now 2.125% versus a prior estimate of 2.625%.  The median projection for the longer-run average rate is now 2.50% versus a prior estimate of 2.75%.

The Fed's statement was dovish, as well.  Economic growth was downgraded from "solid" to "moderate" and they noted a decline in "market-based measures of inflation compensation."  Later in the statement, the Fed wrote that "uncertainties...have increased" and that it will "closely monitor" incoming information and "will act as appropriate to sustain the expansion, with a strong labor market and inflation near its symmetric 2 percent (inflation) objective."  The reference in prior statements to being "patient" about deciding on changes to short-term rates was taken out back, shot, and quickly buried in an unmarked grave.  The last key point from today's meeting is that one policymaker, James Bullard from the St. Louis Fed, dissented, voting in favor of a 25 bp rate cut at today's meeting.

The bottom line is that regardless of the likelihood of the Fed cutting rates, we think rate cuts are unnecessary.  Nominal GDP – real GDP growth plus inflation – is up 4.8% in the past two years, which suggest the Fed should be raising rates rather than cutting them. 

Nevertheless, as we stated above, it now looks like the Fed has positioned itself to cut rates in July unless the US reaches a trade deal with China and inflation turns up faster than the Fed now expects.  While the futures market suggests a July rate cut would be 25 bp, we think that if the Fed does cut in July, there is a significant chance that it could be a one and done of 50, or even 75 bps.  Cutting a small amount when the market expects further rate cuts later on creates an incentive for households and businesses to postpone activity.  So, instead, if a rate cut happens, chances are it will be larger than the market now expects.

The current environment is very bullish for equities, which would be cheap even without rate cuts.  In the meantime, holders of long-term bonds may come to regret policies that mean a faster pace of inflation over the long run.  
Brian S. Wesbury, Chief Economist
Robert Stein, Dep. Chief Economist

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Posted on Wednesday, June 19, 2019 @ 4:01 PM • Post Link Share: 
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  Housing Starts Declined 0.9% in May
Posted Under: Data Watch • Home Starts • Housing


Implications:  Housing starts surpassed expectations in May, coming in at a 1.269 million annualized pace and signaling continued signs of life in home building in the second quarter.  Yes, today's headline monthly change showed a decline of 0.9%.  But this is only because April's reading was revised up to a 1.281 million annualized pace from a prior reading of 1.235 million.  After the pace of housing construction falling three quarters in a row, it now looks like a rebound is underway, with Q1 2019 posting an increase of 2.4% over the Q4 2018 average.  Barring a major decline in June, Q2 is set to show additional growth as well.  This should help alleviate some negative pressure on real GDP, where weak residential construction has been a drag on growth for five consecutive quarters.  That said, developers continue to face challenges from the increasingly tight labor market, where job openings in construction remain at a record high.  When the National Association of Home Builders recently released their survey of top challenges for builders in 2019, concerns related to the cost and availability of labor were the most prevalent, with 82% of developers surveyed citing them as their biggest challenge in the year ahead.  Despite the headwinds from labor, fundamentals for potential buyers have improved markedly over the past several months.  Mortgage rates have dropped roughly 90 basis points since the peak late last year, and wages are now growing near their fastest pace in a decade, boosting affordability.  Although housing starts are down 4.7% from a year ago, this is largely due to the effects of the unusually strong hurricane season in late 2017, which spurred a surge in building in early 2018.  In other words, it's not surprising – or worrying - that recent starts data looks weak in year-ago comparisons.  The forward-looking data in today's report show that permits for new construction rose 0.3% in May.  Further, the gain was entirely due to single-family permits which rose 3.7%, their first gain of the year.  Overall, our outlook on housing hasn't changed: we anticipate a rising trend in home building in the next few years.  Based on fundamentals – population growth and scrappage – the US needs about 1.5 million new housing units per year, but hasn't built at that pace since 2006.  In other recent housing news, the NAHB index, which measures homebuilder sentiment, declined to 64 in June from 66 in May. The dip was broadly attributed to concerns over rising costs for housing inputs due to tariffs, but the index is still higher than the annual average from 2006-2016.  Finally, the Empire State Index, which measures factory sentiment in the New York region, posted its largest monthly decline on record, falling from 17.8 in May to -8.6 in June.  However, the survey that makes up this index was taken right as the Trump Administration threatened tariffs on Mexico which have since been indefinitely suspended.  This was probably largely to blame for the sudden collapse in sentiment, and now that the issue has been resolved, we expect a strong rebound in July. 

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Posted on Tuesday, June 18, 2019 @ 11:20 AM • Post Link Share: 
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  Better Signs
Posted Under: Bullish • GDP • Government • Monday Morning Outlook • Fed Reserve • Interest Rates

A few key economic reports have taken a turn for the better, boosting expected real GDP growth in the second quarter and pointing to an upward revision to first quarter growth.  

Retail sales grew 0.5% in May, very close to consensus expectations, and were revised up substantially for prior months.  Pairing this data with other recent reports, it now looks like real GDP in Q1 will be revised up to a 3.3% annualized growth rate from the prior estimate of 3.1%.

More important than the Q1 revisions, it now looks like real GDP is growing at a 2.0% annual rate in the second quarter.  That may not sound great, but it's a big improvement from the 0.9% estimate the Atlanta Fed's "GDP Now" model was signaling in early May.  Moreover, this comes despite Q2 growth likely being held down by inventories.  Both our estimate and the Atlanta Fed's estimate of real GDP growth excluding inventories (also known as Final Sales growth) is running 3.0%+ in Q2.  Fed, take note.  With Final Sales this strong, the underlying economy is doing well. 

Moreover, with inventories likely to rebound in months ahead, we expect total real GDP growth will come in near 3.0% in 2019 (Q4/Q4), well above the Fed's consensus projection in March of 2.1%.  In other words, Fed forecasts have been overly pessimistic and will likely affect rate cut thinking.

Despite what the data show, some analysts continue to price in recession, and the bond market seemingly agrees.  The tepid May 75,000 increase in US payrolls bolstered pessimism, but other employment data don't support this fear.  The highest frequency data on jobs are unemployment claims, and those don't signal a problem at all.  Initials claims came in at 222,000 last week, while the four-week moving average was 217,000, both very low levels.  Moreover, the US currently has 1.6 million more job openings than unemployed people. 

It's true that consumer and producer prices increased only 0.1% in May, but in the past three months consumer prices are up at a 3.3% annual rate while producer prices are up at a 3.5% pace.   

At the close on Friday, the futures market in federal funds showed a 21% chance the Fed will cut rates this Wednesday, and an 86% chance of a rate cut by the meeting in late July.  All told, the futures market is pricing in two or three rate cuts for 2019.  We think these expectations are way out of line with the fundamental strength of the economy.  The Fed is not tight.  They don't need to cut rates, and we don't think they will cut rates this week, or even this year.

As the summer goes on, we expect evidence will continue to show that the economy isn't slipping into recession.  Why? We think the Trump Administration is either (a) going to forge a trade deal with China or, (b) in the absence of a deal with China, move toward freer trade with other countries and regions (Japan, South Korea, the EU,...etc.) to help organize an effort to get China to conform to normal trade rules.     

Our best guess is that the "dot plot" from the Fed, which shows the projected path of short-term interest rates, will look much different than it did in March.  Back then, it showed about one-third of policymakers thought rates would be higher by year end, while none thought rates would be lower.  Look Wednesday for a dot plot showing some policymakers forecasting higher rates by year end, some lower, but most showing no change at all.  That's what we think will actually happen in 2019, too.

For all the issues the US economy faces, it has some pretty strong winds at is back.  Corporate tax rates have been cut, boosting incentives for investment.  The federal funds rate is still well below nominal GDP growth, and the Fed still has $1.4 trillion in excess reserves in the banking system.  In other words, monetary policy is not an impediment to entrepreneurs or businesses.  Finally, the federal government is reducing regulation, not increasing it. 

Meanwhile, home building has plenty of room for further growth, and households have both low debts relative to assets and low debt service relative to incomes.  Banks are in strong financial shape, while the rest of Corporate America has debts that are below normal relative to assets.    

None of this means the US economy will grow forever.  It won't.  But too many analysts and investors are needlessly fearful of a recession starting soon.  We don't see one this year or in 2020.  Beyond that, forecasts are merely guessing.  Appetite for risk should improve from here.  Smart investors should get in front of it.

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

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Posted on Monday, June 17, 2019 @ 11:26 AM • Post Link Share: 
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  M2 and C&I Loan Growth
Posted Under: Government • Fed Reserve


Source: St. Louis Federal Reserve FRED Database

Posted on Monday, June 17, 2019 @ 8:45 AM • Post Link Share: 
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  Retail Sales Rose 0.5% in May


Implications: Retail sales saw healthy growth in May, in addition to significant upward revisions to prior months.  Sales for April were originally reported down 0.2% but were revised to a gain of 0.3%.  When you pair the upward revision for April with the 0.5% rise in sales in May, retail sales are up a combined 1.1% from prior estimates.  Revisions like those are one reason we focus on the trend rather than monthly figures.  Remember last December when retails sales declined 1.2% (later revised even lower to -1.6%) and the recession calls rang from the rafters?  Then the trend in rising sales returned in the first quarter and has picked up pace in Q2.  In fact, since December, retail sales are up at a 7.6% annual rate versus the 3.2% gain in the past year. These numbers are nowhere close to recessionary.  For May itself, eleven of the thirteen major categories had higher sales, led by internet & mail order retailers and autos, which rose 1.4% and 0.7%, respectively.  Gasoline stations sales moved 0.3% higher as prices at the pump rose in May.  "Core" sales, which exclude autos, building materials, and gas stations (the most volatile sectors) were up 0.5% in May, are up at an 8.9% annual rate over the past three months, and are up 3.5% from a year ago.  Even if these sales are completely unchanged in June, they'll be up at a strong 6.0% annual rate in Q2 versus the Q1 average.  While the Q2 real (inflation adjusted) GDP reading is likely to come in near 2.0%, a deceleration from Q1, this is not reason for concern. Volatility is perfectly normal from quarter-to-quarter, and the trend in growth remains healthy.  Jobs and wages are moving up, companies and consumers continue to benefit from the tax cuts, consumer balance sheets look healthy, and serious (90+ day) debt delinquencies are down substantially from post-recession highs.  For these reasons, expect solid gains in retail sales over the coming months.  In recent employment news, initial jobless claims rose 3,000 last week to 222,000.  Continuing claims rose 2,000 to 1.695 million.  These readings suggest solid jobs growth in June after the lull in May.  On the inflation front, import prices fell 0.3% and export prices declined 0.2% in May. In the past year, import prices are down 1.5%, while export prices are down 0.7%.  Expect higher year-ago comparisons later in 2019 due to the rebound in energy prices.

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Posted on Friday, June 14, 2019 @ 11:21 AM • Post Link Share: 
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  Industrial Production Increased 0.4% in May


Implications:  Industrial production surprised to the upside in May, beating consensus expectations and posting the largest monthly increase so far in 2019.  That said, the details of today's report were not quite as strong as the headline suggested.  Nearly all the month's gain was due to utilities and auto manufacturing, which rose 2.1% and 2.4%, respectively.  However, these two series are very volatile from month to month.  Meanwhile, manufacturing outside the auto sector (which represents the majority of activity) remained unchanged. Putting the two series together shows overall manufacturing rose 0.2% in May and is now up 0.7% in the past year.  On the bright side, even though non-auto manufacturing is only up a tepid 0.3% in the past year, the various capital goods production indices continue to show healthy growth.  For example, over the past twelve months business equipment is up 3%, high-tech equipment is up 6.6%, and durable goods more generally are up 2.3%. By contrast non-durable goods production is down 0.6%, demonstrating that the ongoing weakness in non-auto manufacturing growth isn't signaling the death of business investment.  Year-over-year growth rates peaked for both manufacturing and headline industrial production in September 2018 and have since declined, as the above chart shows. Some will suggest that the Trump administration's tariffs on an additional $200 billion in Chinese goods are responsible, and this is something to think about, but other indicators like the ISM Manufacturing data continue to show a healthier picture. It's also important to keep in mind that manufacturing is only responsible for about 11% of GDP and is much more sensitive to global demand than other sectors of the economy.  Finally, mining activity posted a 0.1% increase in May, hitting a new record high.  In the past year mining is up 10%, showing the fastest year-over-year growth of any major category.

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Posted on Friday, June 14, 2019 @ 11:10 AM • Post Link Share: 
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  The Consumer Price Index Rose 0.1% in May
Posted Under: CPI • Data Watch • Inflation


Implications:  Consumer prices rose 0.1% in May and are up 1.8% in the past year, while "core" prices – a more reliable gauge of inflation that strips out the typically volatile food and energy components – rose 0.1% in May and are up 2.0% in the past twelve months. Given the Fed's 2% inflation target, that should be a signal that everything is looking A-OK. Not too fast, not too slow, just right. So when we see headlines that core inflation readings "[Bolster] the Case for Fed Rate Cuts", we can't help but wonder if we are looking at the same report.  A look at the details of today's report makes the fear of low inflation even more confusing.  Headline inflation is up 1.8% in the past year, but up at a 1.9% annualized rate over the past six months, and a 3.3% annualized rate in the past three months.  In other words, broad-based inflation is already near 2% and rising.  In addition, the Cleveland Fed's median CPI series, which adjusts for both upside and downside outliers, shows inflation up 2.7% in the past year. No matter how you cut it, inflation is in-line with Fed targets, and shows no signs of the economic paralysis that bond markets are pricing in.  Medical care and housing costs – up 0.3% and 0.1%, respectively, in May - continue to be key drivers pushing "core" prices higher, while higher prices for airfares, education, and new vehicles more than offset declining costs for used cars and trucks as well as car insurance.  We believe these data, as well as strength in trend inflation (which is far more important than single month readings) don't support the case for rate cuts.  Moreover, unemployment is 3.6%, initial claims are near historic lows and there are 1.6 million more job openings than unemployed people.  That's not to say some dovish Fed members won't alter down their forecasts for rates through 2019 and into 2020, but the data, if anything, suggests higher rates would be the more appropriate path based on economic fundamentals alone.  As the year progresses and worst-case scenarios aren't realized, possibly catalyzed by resolution of trade tensions, we expect a return of confidence to the financial markets and a shift back towards a more "risk on" environment, putting upward pressure on longer-term interest rates.  Among the best news in today's report was that real average hourly earnings rose 0.2% in May and are up 1.3% in the past year.  With the strength in the labor market noted above, we believe that the trend higher will continue in the months ahead.  Healthy consumer balance sheets, a strong job market, inflation in-line with Fed targets, and the continued tail winds from improved tax and regulatory policy, all reinforce our belief that the economy is on very solid ground. 

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Posted on Wednesday, June 12, 2019 @ 12:27 PM • Post Link Share: 
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  The Producer Price Index Increased 0.1% in May
Posted Under: Data Watch • Inflation • PPI


Implications:  Hold off on the details of the today's PPI report for a moment and let's talk about what today's report should mean to the Fed.   Producer prices are up 1.8% in the past year (very near the Fed's 2% inflation target) and are up at a faster 3.5% annualized rate in the past three months.  "Core" prices - which strip out the ever-volatile food and energy components and are a better measure of trend inflation - are up 2.3% in the past year, above the Fed's target.  And when you add in the 3.6% unemployment rate and average job gains of 196,000 a month over the past year, there is no reason for the Fed to cut rates.  That's not to say some dovish Fed members won't alter down their forecasts for rates through 2019 and into 2020, but the data, if anything, suggests higher rates would be the more appropriate path based on economic fundamentals alone.  Fed rant over, now to the details of today's PPI report.  Following a 0.6% surge in March and 0.2% increase in April, producer prices continued to rise in May, up 0.1%.   But unlike the prior two months, where higher energy costs led the way, May's rise came despite a 1.0% drop in energy prices.  Striping out food and energy shows core prices rose 0.2% in May, led by prices for services.  As noted above, core prices have been rising faster than the Fed's 2% inflation target, and we should note that core prices have now exceeded the 2% target for twenty-two consecutive months.  Within core prices, prices for services less trade, transportation, and warehousing (so think costs for things like health care, lodging, and banking) rose 0.5% in May, with guestroom rental prices in particular jumping 10.1% on the month.  It's also notable that private capital equipment prices are up 2.6% in the past year, the fastest year-over-year growth of any major category, signaling continued demand for business investment.  Given these readings, we think many investors are severely mistaken in their belief that the Fed's path should be lower in the months ahead. The actual data – for employment, wages, inflation, and GDP growth – are not flashing signals of tight monetary policy. 

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Posted on Tuesday, June 11, 2019 @ 11:28 AM • Post Link Share: 
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  No Need for Rate Cuts
Posted Under: Employment • Government • Markets • Monday Morning Outlook • Productivity • Trade • Fed Reserve • Stocks

At the Friday close the market consensus was that the Federal Reserve would cut short-term interest rates by 50 - 75 basis points in 2019, with another 25 basis point cut in 2020.  We think this is nuts.

The US economy doesn't need rate cuts.  At present, we are projecting that real GDP is growing at about a 1.5% pace in the second quarter.  That's slower than the recent trend but largely held down by a return to a more normal pace of inventory accumulation, which is a temporary phenomenon.  Excluding inventories, real GDP is growing at a 2.5 – 3.0% annual rate.     

Some analysts and investors are worried about the relatively slow pace of payroll growth in May, which came in at 75,000.  But there's nothing awful about this pace of job creation.  The bond market is convinced this means rate cuts are necessary to avert a recession; but the stock market has surged, suggesting it's not worried about growth.

Since the business-cycle peak in 2001, the labor force has grown 0.7% per year.  At that trend, we need about 90,000 jobs per month to keep the unemployment rate steady, not far from where we were in May.  So rather than seeing the May payroll gain as a reason to cry, we should instead have seen the prior trend as a reason to celebrate.  In fact, while low unemployment rates may lead to smaller monthly gains in jobs, we're not convinced it will anytime soon.   

Nor does potentially slower job growth mean the economy has to grow more slowly, as well.  Productivity growth has picked up in the past couple of years due to deregulation and lower taxes on corporate profits and investment.  As a result, the economy's growth potential has improved, and a smaller share of growth can come from increasing the number of hours worked.

This weekend brought good news: that the Trump Administration and Mexico reached a deal to avert higher tariffs.  As we explained in last week's MMO, a potential trade war with Mexico on immigration was a legitimate concern and we are very relieved the threat has passed.  We also hope the G20 meeting later this month leads to a trade deal with China.  If so, this news along with better economic data, should propel longer-term Treasury yields significantly higher.   Risk appetites in the financial sector should recover.

As a result, we expect the Fed to "punt" at the June meeting, leaving rates unchanged, although the new "dot plot" will likely show some policymakers projecting rate cuts later this year.  Our view is that better news will cut the rate reductions off at the pass, and the Fed will end up leaving rates unchanged this year.     

Does anyone seriously believe short-term rates at 2.375% are an obstacle to economic growth, that it is preventing some entrepreneur from embarking on some venture or a firm from putting some equipment into place? 

Instead, we think policymakers who are interested in promoting economic growth would be better served by turning the focus toward government spending.  In the background of all the recent news, the long-term fiscal problems embedded into Social Security, Medicare, and Medicaid keep getting worse.

The federal government spent 20.3% of GDP in the four quarters ending in March, far higher than the 17.7% it spent in 2000.  Finding ways to reduce spending now and in the future would boost our growth potential even higher.

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

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Posted on Monday, June 10, 2019 @ 11:22 AM • Post Link Share: 
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  M2 and C&I Loan Growth
Posted Under: Government • Fed Reserve


Source: St. Louis Federal Reserve FRED Database

Posted on Monday, June 10, 2019 @ 8:29 AM • Post Link Share: 
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