Weekly Economic Commentary

Week of October 12, 2018

Two storms buffeted the U.S. this week, leaving a huge amount of human suffering and investor angst in their wake. Residents of the Carolinas were still licking their wounds from the destruction wrought by Hurricane Florence last month as Hurricane Michael struck Florida with an even greater force this week. The stage 4 storm was winding its way up the Southeast as this is written, so the full extent of property damage and loss of life has yet to be measured. As was the case with Florence, Michael's impact is also unfolding during the week that includes the 12th of the month, which is when the Labor Department conducts its employment surveys. So look for more distortions in this key economic report as well as other important indicators for October.

Meanwhile, a hurricane of sorts hit the financial markets this week, as a deep plunge in stock prices and an upsurge in volatility wrought the most havoc since early this year. By itself, the more than 5 percent dive in stock prices on Wednesday and Thursday, wiped out about $2.5 trillion of wealth from equity portfolios. As is customary when the market goes into an abrupt and unexpected nosedive, explanations abound. The most notable came from the White House, where the president put the blame squarely on the Federal Reserve's interest-rate increases, claiming that the Fed is "out of control". Trump took some of the sting out of that remark by stating that he has no intention of firing Fed Chairmen Jay Powell. But the president's ongoing criticism of the Fed only adds to fears that the Central bank's independence may be compromised going forward, something that would likely contribute to more market uncertainty, not less.

To be sure, an upsurge in market volatility has become routine in October, and, true to form, the two-day swan dive reversed course on Friday; by the end of trading, the S&P index moved back above its 200-day moving average, which market technicians view as a critical support level for an existing trend. Whether Friday's rally turns out to be a brief interruption of a nascent correction remains to be seen. Aside from rising interest rates, there is clearly a number of disruptive influences lurking on the horizon to keep investors on edge, including the escalating trade war with China, a weakening Yuan, slowing global growth, rising oil prices and the dicey state of Italian debt. That said, some market experts believe that the setback this week represents a healthy correction that sets the stage for a renewed uptrend, underpinned by improving profits and solid economic fundamentals.

From our lens, the latter that will keep the Fed on a rate-hiking course, notwithstanding the ramped-up criticism it will likely elicit from the Oval Office. Fed officials may well find themselves in a no-win situation in December, when the next decision on rates is expected. Some may view a rate increase - the most likely outcome - as the central bank's way of affirming its independence rather than a response to evolving economic conditions. Conversely, if the Fed finds good reason not to raise rates, some may view this inaction as a concession to political pressure. We don't believe either perspective has merit; Powell has publicly stated that politics will not play a role in the Fed's decision-making process, and there is no reason to doubt his word. Ironically, despite Trump's expressed displeasure with the central bank's moves, his appointments to the Fed have so far been highly regarded by most monetary experts.

The latest batch of economic data solidifies our view that another rate increase is in the cards at the December policy meeting, which would be the fourth this year. Following the robust 4.2 percent growth in the second quarter, the economy is still running well above potential, tracking a growth rate of 3.3 percent in the third quarter. Likewise, job growth continues to outstrip the increase in the adult population, narrowing the slack in the labor market and putting upward pressure on wages. While the annual growth rate of hourly earnings receded a bit in September to 2.8 percent from a decade-high 2.9 percent in August, workers are clearly in a stronger bargaining position than any time since the recovery began. No doubt, there is still some slack in the labor market, as companies are able to fill positions by dipping into a vast pool of workers outside of the labor force. But that pool will soon run dry and finding qualified workers is already hampering operations among a wide swath of businesses, large and small.

The smaller firms are particularly hard-pressed to fill staffing needs. According to the latest NFIB survey, a record-tying 38 percent share of small companies had at least one job slot in September that could not be filled due to a lack of qualified applicants. The survey also demonstrates how companies are responding to this shortage - by offering better pay packages, both to retain existing workers and to attract new ones. In September, a record 37 percent share of small companies planned to increase worker compensation, up from 32 percent in August and 25 percent a year earlier. Needless to say, these companies remain highly optimistic, as the NFIB Small Business Optimism Index hovers near the highest level in its 45-year history. Importantly, the time-honored response of small firms to worker shortages indicates that the working of the Phillips Curve is not dead, only that the trade-off between wages and unemployment took longer to gain traction following the deepest recession since Great Depression.

The question is how will rising labor costs filter through to the economy? If companies can pass on the higher costs in the form of higher prices, inflation would clearly accelerate. Conversely, if companies lack the pricing power to pass through labor costs, profits would suffer unless productivity growth picks up. Clearly, the Fed would much prefer the latter to the former, as tamer inflation would ease pressures to speed up rate hikes. At this juncture, the Fed should feel little pressure to step more forcefully on the monetary brakes, despite the recent pick-up in wage growth. The Fed has set its inflation target at 2 percent, which together with productivity growth at just over 1 percent over the past year indicates that wages could increase by slightly over 3 percent without penetrating the Fed's target. By this yardstick, the need to control wage inflation is not a pressing concern.

Nor for that matter, are companies showing they have the muscle to easily lift prices. If anything, the latest consumer price reports suggest that just the opposite is the case. In September, the consumer price index increased by a tame 0.1 percent, slower than the consensus forecast of a 0.2 percent advance. The core CPI, which excludes volatile food and energy costs, also came in softer than expected, rising by just 0.1 percent as well. Thanks to the slower monthly gains, the annual inflation rate took a step back from its steady upward climb. After hitting a multi-year high of 2.9 percent in July, the year-over-year increase in the overall CPI has since receded markedly, slowing to 2.7 percent in August and to 2.3 percent in September. The increase in the core CPI remained steady at 2.2 percent in August and September, but slowed from the 2.4 percent cycle high reached in July.

Importantly, inflation expectations, which the Fed closely monitors, remain well anchored. According to the latest University of Michigan Sentiment survey, household inflation expectations over the next five years fell to 2.3 percent in early October, matching the lowest reading on record, from 2.5 percent in September. Nor are the financial markets pricing in higher inflation. Both the 5-year and 10- year breakeven inflation rates, at 2.04 percent and 2.16 percent are below the levels of six months ago. Meanwhile, the 10-year Treasury yield, after climbing to a four-year high of 3.26 percent last week retreated to 3.13 percent on Thursday. No doubt, the yield decline responded more to the stock meltdown that sent investors scurrying for safe assets than to a decline in inflation expectations. It is noteworthy, however, that the 10-year yield remained at that nearby low on Friday, despite the sharp rebound in stock prices.

Still, it would be a mistake to extrapolate the recent easing of inflation measures into the future, or to assume that it would prompt the Federal Reserve to halt its rate-hiking strategy. At some point, probably late next year when rates are up to a neutral level, the Fed may pause to see what impact the cumulative rate increases is having on the economy. Keep in mind that the tailwinds that have driven growth this year, particularly the fiscal boost from tax cuts and increased government spending, will fade even as supply constraints in the product and labor markets will be kicking in. But over the medium term, the economy should retain considerable momentum, thanks to the ongoing robust job market, high confidence among households and businesses and the solid fundamentals behind consumer spending, the economy's main growth driver.

Indeed, one positive byproduct of the unexpected softness in consumer prices last month is that it provided households with a nice boost in purchasing power. Real average hourly earnings increased 0.5 percent in September from a year earlier, the strongest annual increase in 10 months. While prices are likely to resume their faster climb in coming months, so too will wages as the job market continues to tighten and bolster the bargaining power of workers. Meanwhile, household balance sheets are in decent shape; the personal savings rate is at a relatively lofty 6.6 percent, the debt-servicing burden is historically low, ever-rising property values has restored all the home equity that was lost during the financial crisis and housing collapse, and net worth is at an all-time high as a share of disposable income.