Robust US Economic Fundamentals Support Fed’s Gradual Tightening of Monetary Policy

I see little change in US economic fundamentals, despite a modest rise in Treasury yields over the last month, which seemed largely due to a sharp selloff across many other global bond markets, rather than to domestic factors.

The Fed appears to believe the economy’s performance remains robust enough to continue with a gradual tightening of monetary policy and is inclined to downplay stubbornly low inflation data for the time being. With the labor market closing in on full employment, and consumers benefiting from firm housing and stock prices, I would concur with the Fed’s assessment of the health of the underlying economy.

Given such conditions, economic orthodoxy suggests inflation will pick up at some point, and this remains our core view, in the absence of more conclusive evidence that the late period of this cycle could diverge significantly from previous examples in this respect.

US economic data generally followed the mixed pattern seen so far this year. Softer readings included a monthly rise of only 0.1% in consumer spending in May, although much of the weakness was ascribed to low energy prices. More positively, the report contained a healthier monthly gain for spending on services, the largest category.

But retail sales in May and June came in well below consensus expectations, as did some corporate data, notably May orders for durable goods, even when adjusted to exclude the more volatile transportation component of that report. There were also further signs auto sales were continuing to retreat from the record levels reached in 2016, as tighter financing and an increase in the supply of used vehicles increased pressure on new car sales.

The most significant offset to the weaker data was the payroll growth seen in June’s labor report. The 222,000 jobs added were well ahead of consensus forecasts, and upward revisions to previous months’ data left the three-month average for job gains at approximately 194,000, showing little sign of a slowdown in job creation, despite the past tightening of the market.

The service sector was particularly strong, and a rise in temporary hiring suggested employers might be turning to contractors, after struggling to fill permanent positions. The unemployment rate ticked up a tenth to 4.4%, mirroring a similar rise in labor participation, as more people were encouraged to look for work.

However, June’s employment report gave no hint wages were responding to the vibrant pace of payroll growth. Earnings failed to match consensus expectations and rose only 0.2% month-on-month in June, leaving the annual increase at 2.5%, while the equivalent figures for May were revised down to 0.1% and 2.4%.

The lackluster wage growth echoed a similar tone in broader inflation gauges, with the core personal consumption expenditures price index—the Fed’s favored measure of price growth—dropping to an annual rate of 1.4% in May, a third consecutive decline and its lowest level in 18 months.

As the minutes from the Fed’s June meeting showed, most of the committee members were not unduly concerned about this ongoing softness in inflation, putting it down mainly to “idiosyncratic factors” such as cheaper cell phone bills and drugs.

A few, though, did express fears that progress toward the Fed’s 2% inflation target had slowed, and later remarks by Fed Chair Janet Yellen, which emphasized the close attention being paid to whether price pressures were at risk of stagnating, were seen as slightly more dovish than earlier indications.

Similarly, the Fed minutes illustrated differing views among policymakers on the potential implications of the tight labor market, given that the unemployment rate had moved close to or even below most prior definitions of full employment.

Further detail was revealed about discussions related to the unwinding of the Fed’s balance sheet, with the September meeting still a possibility for such a move to be announced. All in all, however, reaction to the release of the Fed’s June discussions appeared fairly muted, and market participants remained divided on whether another rise in US interest rates would take place before the end of the year, as indicated by the Fed’s own projections.

The relatively upbeat sentiment regarding the economy was by no means confined to Fed policymakers. Consensus estimates for second-quarter gross domestic product growth remained in the 2.5%–3.0% range, suggesting a strong pickup from the first quarter’s latest reading of 1.4%, itself a healthy upward revision from the initial figure of 0.7%.

There were further grounds for optimism in the strength of the June Institute for Supply Management purchasing managers’ indexes (PMIs) for manufacturing and services. The surveys pointed to solid levels of employment, new orders, business activity and production, with the manufacturing PMI rising to its highest level since 2014.

Another positive indicator was a quarterly survey of chief executive officers—canvassing their planned investment and hiring as well as projected sales—which hit a three-year high.

The signals coming from the Fed seem to indicate policymakers’ clear desire to gradually normalize monetary policy, so how the pace of this normalization could be affected by domestic data and other factors continues to be the main focus for market participants.

The possibility of future tax legislation and deregulation under the Trump administration and its potential to boost growth remains one of the key unknowns that could significantly impact the Fed’s calculations.

Very good overview of the things with US economy. Basically its aggregation of primary concerns and worries, I’d appreciate if you sauced it with some personal opinions or at least likely scenarios.