The Federal Reserve meets on Wednesday and there's one thing we know for sure: it's going to raise rates by another 25 basis points, lifting the federal funds rate to a range from 2.00 to 2.25%. 

Why are we so confident?  Two reasons.  First, the market in federal funds futures is putting the odds of a September rate hike at 99%.  For the Fed to let those odds get so high without pushing back forcefully with speeches and leaks to friendly reporters means the Fed is fully on board. 

Second, and much more important, it's the right thing to do.  Nominal GDP – real GDP growth plus inflation – is up 5.4% in the past year and up at a 4.6% annual rate in the past two years.  An economy growing at that pace calls for higher short-term rates.

But the meeting is not only about changing the level of short-term rates; it's also about signaling the path of future rate hikes as well as the continued reduction in the size of the Fed's balance sheet, which became bloated during and after the financial crisis a decade ago.

Back in June, the last time the Fed issued economic projections, it forecast that real GDP would be up 2.8% this year and 2.4% next year.  But, given the momentum in the economy, we think the Fed may lift these forecasts.  It may also want to reconsider its projections for inflation now that its favorite measure of inflation – the PCE deflator – is already up 2.3% from a year ago

In turn, that should translate into a more aggressive "dot plot," as well.  In June, the consensus at the Fed – the "median dot" – showed a total of four rate hikes this year, with one more hike in September and a last one in December.  But almost half of the voters at the Fed had the Fed stopping at the third rate hike this year or maybe even stopping at two in June.  That's going to change substantially on Wednesday and we expect a large majority at the Fed projecting a fourth rate hike in December. 

Our best guess is that the median dot will still show three rate hikes in 2019, but that may change in December, by which time the Commerce Department will have reported strong real GDP growth for the third quarter.

In the end, we expect four more rate hikes in 2019.  That would take the federal funds rate to a range of 3.25 to 3.5%.  Right now, that's not what the market expects.  The market is putting the odds of four rate hikes or more next year at 5%.  As the economy continues to impress, look for those odds to soar over the next several months.  In turn, that means long-term Treasury yields keep trending higher, as well.     
 
The Fed may also consider using Wednesday's meeting to change some wording that's been in every Fed statement since December 2015, which was the first time the Fed raised rates after the financial crisis.  The language is "The stance of monetary policy remains accommodative, thereby supporting strong labor market conditions and a sustained return to 2 percent inflation." 

Some at the Fed may think Wednesday's rate hike means monetary policy is no longer accommodative.  That would be a mistake.  But others may want to rightly change the wording because inflation already exceeds 2%.  As a result, the Fed needs to start considering how tight it may eventually have to get to keep inflation from staying above 2%.

Just remember, though, that nothing the Fed does on Wednesday is worthy of obsession.  Just because the financial media dwells on every word from the Fed, doesn't mean investors should.  Instead, focus on profits, which, continue to point to a robust bull market.   

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

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Implications:  After four consecutive months of declines, existing home sales held steady in August, ending the downward momentum.  Sales of previously-owned homes were unchanged at a 5.34 million annual rate in August and are now down 1.5% from a year ago, the sixth consecutive month of year-over-year sales declines.  The biggest problem for existing home sales has been a lack of supply.  The months' supply of existing homes – how long it would take to sell the current inventory at the most recent sales pace – was 4.3 months in August and has been below 5.0 since late 2015 - the level the National Association of Realtors (NAR) considers tight.  That said, inventories look like they may finally be turning a corner, rising on a year-over-year basis for the first time in 38 months.  If sellers really are changing their behavior, a reversal in the steady decline of listings we've seen since mid-2015 would be a welcome reprieve for buyers, boosting supply and sales, as well.  Even with the current lack of choices, demand for existing homes has remained remarkably strong, with 52% of homes sold in August remaining on the market for less than a month.  Higher demand and a shift in the "mix" of homes sold toward more expensive properties has also driven up the median sales price, which has now risen on a year-over-year basis for 78 consecutive months.  Although some analysts will suggest weakness in existing home sales is the result of rising mortgage rates, we doubt that's the case: new home sales, which would be similarly impacted by higher financing costs, have continued to rise at a healthy pace.  Keep in mind that starting next month Hurricane Florence will likely hold back sales just like Harvey and Irma did last year.  Look for a rebound in sales after the initial negative effects work their way through the data.  On the manufacturing front this morning, the Philly Fed Index, a measure of East Coast factory sentiment, jumped to +22.9 in September from +11.9 in August, signaling growing optimism from manufacturers.  Finally, in employment news, initial jobless claims fell 3,000 last week to 201,000, the lowest reading since November 1969.  Meanwhile, continuing claims fell 55,000 to 1.65 million, also marking a multi-decade low. Hurricane Florence will likely push these numbers higher in the weeks ahead, among the many data readings that may be distorted in coming months.  But remember that shifts in activity due to storms are temporary, and we have little doubt the Kevlar Economy will continue higher in the quarters to come.

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Implications:  Housing starts rebounded sharply in August, recovering from an unusually slow pace of building in June and July.  Most of the recent volatility has been due to multi-family starts, which jumped 29.3% in August after dropping 16.6% in June and then another 3.7% in July.  Meanwhile, single-family housing starts grew a respectable 1.9% in August after a 1.1% gain in July.  Normally, we would highlight comparisons to the same month a year ago, but that was the same month Hurricane Harvey hit Texas (inundating Houston, in particular).  That, plus Hurricane Florence hitting the Carolinas this year as well as Hurricane Irma hitting Florida last September will make next month's report and year-ago comparisons almost useless for the next couple of months.  Expect a big drop in starts for September this year and then a rebound in October.  Instead of year-ago comparisons involving a single month, for the time being the trend is best described by the first eight months of the year compared to the same eight months in 2017.  And that shows single-family starts up 5.7% while overall starts are up 6.6%.  The worst news in today's report is that permits for new construction fell 5.7%, as authorizations for both single-family and multi-unit properties declined.  That said, overall permits are still up 3.6% in the first eight months of 2018 compared to the same period last year.  Expect a rebound in the months ahead, as permits are less influenced by weather.  We still anticipate at least a gradual increase 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.  The problem is that there continue to be some headwinds that may temper growth in home building.  The National Association of Home Builders said 84% of developers cited labor shortages and the rising cost of building materials as their biggest problems in 2018.  And both these issues look set to continue as an increasingly tight labor market keeps the number of job openings in construction elevated and tariffs on lumber, steel, and aluminum drive up input costs.  Cost concerns were echoed in yesterday's NAHB Index, but seem to be stabilizing, as lumber prices continue to decline since reaching a record high in May.  This, paired with strong buyer demand, left the overall NAHB index unchanged at 67 in September.  On the manufacturing front, the Empire State index, a measure of factory sentiment in New York, fell to a still healthy 19.0 in September from 25.6 in August, signaling continued optimism in the region. 

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The U.S. federal government reported last week that it ran a deficit of $214 billion in August, the fifth largest deficit for any single month in US history. 

The Congressional Budget Office thinks these numbers are consistent with a budget deficit of about $800 billion for Fiscal Year 2018, which ends September 30.  If so, that would be the largest annual deficit in raw dollar terms since FY 2012.  This deficit is roughly 4.0% of GDP, which would be the highest since FY 2013.

For many, this growing deficit is a dagger to the heart of the tax cut enacted in late 2017.  They say the tax cut was irresponsible.  However, economic growth has picked up because of the tax cut, and growth is the key to higher fiscal receipts down the road – in fact tax receipts are still hitting record highs.

Between 2010 and 2017, the U.S. passed two large tax hikes, yet the deficit was still $665 billion in FY 2017, which was not exactly a model of fiscal purity.  As a result, we call "politics" on all those now fretting about deficit spending only when a tax cut is involved.

It's important to recognize that the tax cut has, so far, reduced revenue compared to how much the federal government would have collected in the absence of the tax cut.  But, total federal receipts are likely to end the current Fiscal Year up slightly from last year and at a record high.  Next year, according to the CBO, revenue should be up 4.6% and at another record high. 

In other words, the tax cut didn't lead to an outright reduction in revenue, it just slowed the growth of revenue.

Spending is the problem.  Total federal spending will rise about 4% this year and is scheduled to rise about 8% next year.  In spite of an acceleration in economic growth, government spending is rising faster than GDP.

While this is a long-term problem, it will not turn the U.S. into Greece overnight.  No fiscal crisis for the nation is at hand.  Last year, net interest on the federal debt amounted to 1.4% of GDP.  The Congressional Budget Office projects that net interest will hit 2.9% of GDP before some of the tax cuts theoretically expire in the middle of the next decade.

That is a large increase, but net interest relative to GDP hovered between 2.5% and 3.2% from 1982 through 1998.  The U.S. paid this price and the economy still grew more rapidly than it has in the past decade.  The U.S. didn't become Greece.

Compare two economies of equal size.  One spends $500 billion, but with zero taxes, the other spends $2 trillion, but taxes $1.5 trillion.  Both have $500 billion deficits, but the first economy would be more vibrant and could finance the debt more easily.  It's not that deficits don't matter, but deficits alone are not a reason for investors to run for the hills.

And when deficits are partly caused by more federal spending on interest payments you know who will hate it the most?  The politicians.

Here's why.  Politicians like to deliver things their constituents are grateful for, things that make voters more likely to vote for them rather than someone else.  Tax cuts help politicians get more votes, at least from those who actually pay taxes.  Government programs can also help incumbents corral votes.  Pass out government checks and you can get more votes, too.  But bondholders have no gratitude for politicians when they receive the interest they're owed on Treasury securities.

Higher net interest payments will eventually "crowd out" future tax cuts and government programs, making it tougher for incumbents to get re-elected.  As net interest payments rise, more politicians will start obsessing about the deficit again, just like in the 1980s and 1990s.                    

The true threat to long-term fiscal health is spending.  If left unreformed, entitlement programs like Social Security, Medicare, and Medicaid will take a ceaselessly higher share of GDP, leading to a larger and larger share of American production being allocated according to political gamesmanship rather than individual initiative, in turn eroding the character of the American people.

Unless we change the path of spending, last year's tax cuts - and the boost to economic growth they've already provided -  risk getting overwhelmed in the long run.  But, for investors, this isn't an immediate problem.  After all, deficit fears have been around for decades and equities still rose.  Stay bullish, for now.           

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

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Source: St. Louis Federal Reserve FRED Database

Implications:  Industrial production extended its gains in August, posting its third consecutive month of growth to set a new record high.  Industrial production data counts "units" of output, and is therefore a proxy for "real" growth.  Taken as a whole, the August data suggests the recent strength in real GDP growth is sustainable.  Looking closer at the details of today's report shows that manufacturing, which makes up the largest part of overall production, rose 0.2% in August.  However, the gain was entirely due to a 4.1% jump in the volatile auto production series.  Excluding autos, manufacturing growth would have been flat, according to the Federal Reserve.  That said, in the past year manufacturing activity is up 3.2%, while manufacturing ex-autos is up 2.8%, both of which represent the fastest 12-month increase since 2012 for their respective series.  This demonstrates that the strength in overall manufacturing isn't just about the recent surge in auto production.  Meanwhile, mining grew for the seventh month in a row to eclipse its prior peak in 2014, before a decline in oil prices reduced activity.  Mining is now up 14.2% from a year ago, its largest 12 month gain since 1959!  This comes as new information from the EIA shows the United States has just surpassed Russia and Saudi Arabia as the largest producer of crude oil in the world.  Notably, this is all being done with roughly half the number of drilling rigs as before the 2014-2015 oil price crash, demonstrating the massive improvements in productivity that have occurred in just a few years.  

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Implications:  Retail sales grew for the seventh consecutive month, rising 0.1% in August. You may think 0.1% is nothing to write home about, but that came on top of upward revisions for July. And the gains in August were broad-based, with nine of thirteen major categories showing rising sales, led by sales at gas stations and non-store retailers (internet & mail order sales). Non-store retailers now make up 11.3% of overall retail sales, a new record high, and are up 10.4% over the past year. Overall retail sales are up a strong 6.6% from a year ago (and up an even stronger 7.3% excluding auto sales).  After plugging in the retail numbers along with other data out today, real consumer spending in the third quarter looks to be growing at around a 3% annualized rate, supporting our projection of 4.0% real GDP growth for Q3. Given the tailwinds from deregulation and tax cuts, we expect an average real GDP growth rate of 3%+ in both 2018 and 2019, a pace we haven't seen since 2005.  Jobs and wages are moving up, tax cuts have taken effect, consumer balance sheets look healthy, and serious (90+ day) debt delinquencies are down substantially from post-recession highs. Some may point to household debt at a record high as reason to doubt that consumption growth can continue.  But household assets are at a record high, as well.  Relative to assets, household debt levels are the lowest in more than 30 years.  In other words, there's plenty of room for consumer spending – and retail sales – to continue to trend higher in the months to come, but don't be surprised if the series becomes a little more volatile over the short term as Hurricane Florence may skew the numbers in both directions over the following months.  On the inflation front, import prices declined 0.6% in August, while export prices declined 0.1%.  The large decline in import prices was due to a 3.9% drop in fuel prices. The drop in export prices was due to lower prices for nonagricultural exports more than offsetting higher agricultural prices.  However, the trend in import and export prices is still upward.  Import prices are up 3.7% in the past year, versus a 2.0% gain the year ending August 2017; export prices are up 3.6% in the past year versus a 2.3% increase in the year ending August 2017.  Cutting through recent gyrations, more inflation is on the way.

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Implications:  Consumer prices continue to march higher, rising 0.2% in August and, at 2.7%, have now shown a 12-month increase of 2% or more for twelve consecutive months.  To put all of this in a longer-term perspective, consumer prices increased 1.9% for the twelve-months ending August 2017, 1.1% for the twelve-months ending August 2016, and 0.2% for the twelve-months ending August 2015.  Put simply, after five years of running below the Fed's inflation target, the question has shifted from "will the Fed wait on raising rates?" to "can the Fed really wait on raising rates?" Runaway inflation this is not, but with the federal funds rate well below the pace of nominal GDP growth, the odds of higher inflation should be enough to keep the Fed on track for slow-but steady hikes through at least the end of 2019 (think two more this year, and four next year).  Energy prices led the way higher in August, rising 1.9% on the back of higher gasoline prices.  "Core" consumer prices – which exclude both food and energy costs – rose a tepid 0.1% in August but are up 2.2% in the past year.  Taking a deeper dig into today's report shows the 0.1% increase in core prices was once again led by owners' equivalent rent (the amount an owner would need to pay in order to rent their home on the open market).  Meanwhile, a 1.6% drop in apparel prices – the steepest decline for any month since 1949 – as well as declines in prices for medical services and commodities held down the overall increase in core prices.  On the wages front, real average hourly earnings rose 0.1% in August and are up 0.2% in the past year.  These inflation-adjusted hourly earnings have been stubbornly slow to move, however this earnings data does not include irregular bonuses – like the ones paid by companies after the tax cut or to attract new hires, and also don't include the value of benefits.  It's an imperfect measure, to say the least, but that said we still expect a visible pickup in wage pressures in the year ahead.  In employment news this morning, initial jobless claims fell 1,000 last week to 204,000, the lowest reading since December 1969.  Meanwhile, continuing claims fell 15,000 to 1.70 million, also marking a multi-decade low. Hurricane Florence will likely push these numbers higher in the weeks ahead, among the many data readings that may be distorted in coming months but remember that shifts in activity due to storms are temporary, and we have little doubt the Kevlar economy will continue higher in the quarters to come. To those in the path of the storm, stay safe, our thoughts and prayers are with you.     

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Friday's jobs report finally included what appears to be evidence of the long-awaited acceleration in wage growth.

Average hourly earnings grew 0.4% in August, which meant they were up 2.9% from a year ago, the largest 12-month increase since the economic recovery started in mid-2009.  By contrast, these wages were up 2.6% in the 12-months ending in August 2017.  Moreover, this measure of wages doesn't include extra earnings from irregular bonuses and commissions, like those paid out since the tax cut was passed late last year.    

Total wages, which factors in both average hourly earnings as well as the total number of hours worked, are up 5.1% in the past year, meaning consumers have plenty of earnings to keep increasing spending.

Nonetheless, many still argue that the 2018 corporate tax cut didn't help workers.  Nothing could be further from the truth.  In December 2017, figures on average weekly earnings as well as private payrolls suggested private-sector workers were earning wages at a $6.0 trillion annual rate.  In August, those total wages had increased to a $6.2 trillion annual rate – a boost of $200 billion per year.  By contrast, corporate profits - which have also grown rapidly - were up by just $100 billion annualized from the end of 2017 through the second quarter.  Workers have taken home two times more than companies!

When hit with this data, the anti-tax cutters argue that this increase in wages has been concentrated at the top of the pay-scale.  The rich are getting richer and the tax cuts haven't helped lower to middle income workers.  Guess what?  This isn't true, either. 
 
Usual earnings for the median full-time wage & salary worker grew 2.0% in the year ending in the second quarter this year.  But these earnings grew 3.9% for workers at the bottom 10th percentile, while workers at the top 10th percentile had their usual earnings grow only 1.2%.  Usual earnings for people who never finished high school are up 7.6% in the past year, faster growth than for any other educational category.

Put it all together and we have a labor market that is already tight and set to get tighter.  Back in June, the Federal Reserve projected an average unemployment rate of 3.6% in the fourth quarter of this year and 3.5% in the fourth quarter of 2019 and 2020.  The projection for this year sounds about right, but we're forecasting a jobless rate of 3.2% by the end of 2019 and 3.0% in 2020.  Either way, wages are likely to keep growing at an accelerating pace in the next few years. 

That means the Fed will likely remain more aggressive with their rate hikes than the market is now projecting, but don't fret.  Even with our more aggressive forecasted path of two more 25 bps rate hikes this year and four next year, the Fed will still not be "tight."

Tax cuts and deregulation have turned the Plow Horse Economy into a Kevlar Economy for the foreseeable future.  And if we get trade deals that reduce tariffs along with some real focus on limiting government spending, the strength of this economy could make Superman jealous.

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

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Source: St. Louis Federal Reserve FRED Database