May 1, 2015
Following the weak first quarter GDP report most economists postponed the first Fed rate hike until September. We are not convinced. We continue to expect the Fed to raise rates at the conclusion of its June 16-17 meeting. The flow of data during the next six weeks will determine the outcome.
The first quarter GDP data were surprisingly weak with a reported increase of just 0.2%. We can identify several causes of the anemic growth.
First, the dock workers slowdown on the West Coast crushed the trade component. Exports declined 7.5% in that quarter while imports rose 1.8%. That combination caused the trade gap to widen by $50 billion and subtract 1.3% from GDP growth. Goods sat at the dock much longer than normal. Retailers could not get the goods they needed to sell. Producers could not get the supplies they needed to sustain production. But the strike has now ended and the backlog of goods sitting on the dock and on ships in the harbor will be reduced in the coming months.
Second, bitter cold weather in much of the country caused consumers to stay indoors during February. Consumer spending rose 1.9% in the first quarter compared to 4.4% in the fourth quarter of last year. Given the arrival of spring weather consumer spending should rebound in Q2.
Third, falling oil prices hammered oil drilling activity. The structures component of investment spending plunged 23.1% as oil rigs were shuttered. Now that oil prices have risen somewhat the drop in this category should be arrested, but it will plateau at a lower level. Unlike the other two causes of slower growth in Q1 we should not expect a rebound in Q2.
The Fed seems to have a similar view. In the statement released at the end of this week’s FOMC meeting the Fed said that recent data suggest that “growth slowed in the winter months in part reflecting transitory factors.” That statement seems reasonably consistent with the causes described above. The statement also seems to suggest that the Fed’s decision regarding the upcoming increase in the funds rate will not be unduly influenced by the weak first quarter. It expects growth to rebound for all of the reasons noted above.
The Fed has told us that two factors will be crucial to its decision. Yellen has said that it will not begin to raise rates until the labor market reaches full employment. It should be very close by June. The Fed will receive two more employment reports between now and the June FOMC meeting. Next Friday they will get the employment report for April. Following the modest increase of 126 thousand in March, we expect to see a snapback to an increase of 280 thousand in April and a 0.1% drop in the unemployment rate to 5.4%. Initial unemployment claims (which are a measure of layoffs) dropped to a 15 year low of 262 thousand in late April. Admittedly, it is for a single week but it is suggestive of another strong jobs report for May.
If the unemployment rate declines to 5.4% in April the economy is rapidly approaching full employment. We will know when that point has been reached because wage pressures will intensify. Indeed, that already seems to be happening. The employment cost index for the first quarter rose at an annual rate of 2.6% which is actually the fourth consecutive gain of roughly that magnitude. Last year labor costs were rising at a rate of 1.8%. As the unemployment rate has fallen the labor market has steadily tightened and in the past year the employment cost index has accelerated to a 2.6% pace. The Fed will worry that this more rapid increase in labor costs will translate into higher consumer prices.
The Fed has also said it will not begin to raise rates until the inflation rate stops falling and begins to turn upwards towards its 2.0% target. That, too, seems to be happening. Given the recent upward movement in oil prices the overall price index rose 0.2% in both February and March. Furthermore, the rise in gasoline prices continued its ascent in April and is still climbing in early May which should boost pump prices to $2.75 or so within a couple of weeks and boost the CPI in both April and May
More importantly, the so-called “core” CPI (the CPI excluding the volatile food and energy components) has risen 0.2% in each of the past three months. That is an annualized increase of 2.4% compared to a 1.7% increase last year. The faster increase in the core rate may well be attributable to the higher labor costs described above. We also know that the tightness in housing, the rental market in particular, is boosting rents which represent one-third of the overall CPI. So while the year-over-year increase in the core CPI has only edged upwards thus far it appears to be headed higher.
In addition to the two upcoming employment/unemployment and CPI reports pay attention to the other statistics. The housing market seems to be advancing rapidly. New home sales have been surprisingly robust in recent months. Pending home sales have also been climbing rapidly which suggests that existing home sales will be heading upwards in the months ahead. It could be that the sudden big increase in household formation is leading to a much faster-than-expected increase in home sales.
The point is that whether the Fed raises rates in June or not will depend crucially upon the data it seems in the next six weeks. We think they will be sufficiently strong that the Fed will choose to begin the long, gradual increase towards higher interest rates at that time. We’ll see.
Stephen Slifer
NumberNomics
Charleston, SC
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