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Economic overheating and the risk to the Federal Reserve
Simply Economics - July 27, 2018
By Mark Pender, Senior Editor



GDP came in very strong in the second quarter which raises the unwanted question whether the Federal Reserve may have to increase the pace of rate hikes. And it's more than just GDP's growth rate. Price pressures surged while inventories fell, the former pointing to the risk that the Fed may have already fallen behind the inflation curve and the latter, given the strength of demand and the need to restock inventories, hinting at perhaps stronger GDP growth in the quarters ahead. The Trump administration has already cracked what was once a closed door and jawboned the Fed, and that door could be swinging wide open sooner than later.


The economy

Three percent GDP growth is more or less already here. GDP jumped to a real 4.1 percent annualized rate in the second quarter for the strongest showing in nearly four years and the second strongest since the easy comparisons coming out of the recession. The average over the past five quarters is 2.9 percent. Overheating would appear to be a danger for the economy right now, consistent with the array of regional and private economic data where delivery delays, input costs and even price pass through are at or near record highs.


And these pressures are evident in the GDP price index which shot far beyond expectations, from 2.0 percent in the first quarter to 3.0 percent in the second quarter. This is the strongest price reading of the entire expansion, since shortly before the recession in 2007. Much of this pressure is coming from construction where shortages of labor and high prices of materials have been reported for the past year. High energy prices are also a key factor. And the core, which excludes food and energy prices which have also been high, shows similar pressure, at 2.7 percent vs the first quarter's 2.4 percent. The severity of these headline rates can't be easily ignored by the Federal Reserve especially with oil holding near $70.


The central force driving GDP is the economy's very heart. Consumer spending rose at a very strong 4.0 percent rate and, as tracked in the graph, contributed 2.69 percentage points to the quarter's overall 4.1 percent result. The strength in services shows gains in household consumption spending, health care, as well as food services and accomodations which are both discretionary. Spending is also on the rise for durable goods including vehicles and furniture, again both discretionary, with nondurable goods showing gains for apparel and food as well as fuel.


Net exports, which had been weak, also contributed strongly to the quarter, adding 1.12 points to headline GDP with gains centered in goods. Some of this may be inflation pass through but the jump speaks to the strength of foreign demand. Exports of services have been slowing but still were a positive contributor in the quarter. Further adding to net exports was a slowing in import growth. Note that this calculation is tied to quarterly improvement, not to total net exports which came in at a massive annualized deficit of $849.9 billion but still much better than $902.4 billion in the first quarter.


And the good news continues with another strong showing for business spending as nonresidential fixed business investment added 0.98 points to GDP. Structures are the highilght here, posting back-to-back quarters of 13.3 and 13.9 percent real annualized growth for a 0.39 point contribution to GDP. The gain here further speaks to demand for construction labor and materials. Intellectual property grew at an 8.2 percent rate and added 0.35 points. Equipment rose a comparatively subdued 3.9 percent for a still valuable 0.23 point contribution. Business investment is no doubt getting a boost from this year's corporate tax cut as well as the very high levels of business confidence and expectations for demand growth ahead.


As the tax cut helped business investment, rising levels of government spending are also lifting GDP. Government purchases contributed 0.37 points to the second-quarter's total though the annualized rate is relatively subdued, at 2.1 percent but up from 1.5 percent in in the frist quarter. Natoinal defense is the main factor here, adding 0.21 points to GDP with nondefense offering only a fractional contribution. The breakdown between federal spending and state & local spending shows the former adding 0.22 and the latter adding 0.15.


But the sleeper among the components -- where bad news is good -- is inventories. They fell $27.9 billion for a 1.0 point subtraction from GDP. But this pull lower is actually a very strong positive for the economy, as inventories are too low right now and need to be built up which should be a positive for third-quarter GDP not to mention employment levels as well. When looking at final sales, a key measure of demand that excludes inventories, GDP came in at 5.1 percent rate!


The one weakness in the report comes from residential investment which, however, pulled down GDP only fractionally in the quarter, by minus 0.04 points. The annual rate of growth proved negative for a second straight quarter, at 1.1 percent after a 3.4 percent decline in the first quarter. This is proof positive that the housing sector is not having a good year and that the Spring sales push came up short.


As far as the week's other economic numbers go, they pretty much all got wrapped up somewhere in the GDP report. But there is a rush of housing data to look at and, like the residential investment component, they proved weak. The accompanying graph tracks the blue line of single-family new home sales against the green line of single-family existing sales. Three-month averages are used here to help smooth what are often volatile month-to-month performances. And the graph is clear: new home sales, at a 646,000 annualized 3-month rate, have flattened out while resales, at 4.797 million, have long been flat and may now be edging lower. The weakness is a disappointment of course for Realtors and home sellers both and can in part be explained by low supply of both new and existing homes on the market and also perhaps by a lack of fundamental interest for home owners to swap houses. Is this the lingering hangover from the subprime mortgage collapse of the last recession? Or is it a reflection of the strong jobs market and lack of the need to relocate?


One developing result of the sales weakness is a downturn in home-price appreciation. FHFA's house price index managed only a small monthly gain with the yearly rate, as tracked in the blue columns of the graph, slipping 2 tenths to 6.4 percent for the lowest reading since Januay last year. Regional data show cooling conditions in the West where double-digit price bubbles were a concern early in the year but less so now with the Mountain states at 9.1 percent and the Pacific states at 7.6 percent. Weakness in home prices is a negative for household wealth which, however, in an economy that appears to be taking off, is perhaps one less source of excessive growth.


Markets: The Facebook fiasco

The strength of the GDP report and the pressure in prices certainly point to more not less rate hikes ahead which can't be great news for the stock market. And clearly bad news came with Facebook's earnings miss and disappointing outlook, taking shares of the social media bellwether down 20 percent in one single move and making for a weekly decline of 1.1 percent for the Nasdaq. Will we look back at this week as the cyclical peak of the stock market? Another sign of trouble comes from rising interest rates, up 6 basis points for the 2-year Treasury to 2.66 percent and up 7 basis points for the 10-year to 2.96 percent. Even if the Fed doesn't accelerate its rate hike program, the market rise in rates will have a slowing effect of its own.


Markets at a Glance Year-End Week Ended Week Ended Year-To-Date Weekly
2017 20-Jul-18 20-Jul-18 Change Change
DJIA 24,719.22 25,058.12 25,451.06 3.0% 1.6%
S&P 500 2,673.61 2,801.83 2,818.82 5.4% 0.6%
Nasdaq Composite 6,903.39 7,820.20 7,737.42 12.1% -1.1%
Crude Oil, WTI ($/barrel) $60.15 $70.21 $68.89 14.5% -1.9%
Gold (COMEX) ($/ounce) $1,305.50 $1,231.20 $1,232.20 -5.6% 0.1%
Fed Funds Target 1.25 to 1.50% 1.75 to 2.00% 1.75 to 2.00% 50 bp 0 bp
2-Year Treasury Yield 1.89% 2.60% 2.66% 77 bp 6 bp
10-Year Treasury Yield 2.41% 2.89% 2.96% 55 bp 7 bp
Dollar Index 92.29 94.44 94.66 2.6% 0.2%


The bottom line

A rate hike at next week's FOMC could have been justified as a retaliatory assertion of the central bank's independence. But now it could be justified by what looks to be a broad-based pivot higher for the economy, one led by the consumer and fed by tax cuts and higher government spending. The Fed after all does have an institutional ethos, a long tradition of anticipating risks and safeguarding the economy, even when its actions may not be popular. And even if the Fed refrains from action at the upcoming meeting, it will be interesting to see if the unanimous voting block shows any cracks.


Week of July 30 to August 3

An extraordinarily heavy week of economic news will include an FOMC statement at mid-week and an employment report at week's end. The housing sector has been flat and only a modest gain is the expectation for Monday's pending home sales report. With Tuesday's personal income and outlays data already contained in second-quarter GDP, the day's focus will be the quarterly release of the employment cost index and a key reading on wage pressures. Vehicle sales on Wednesday will offer the first solid hints on consumer spending for July with data later in the day to include ISM manufacturing, which has been red hot, and construction spending which has been mixed. But Wednesday's big news will be the mid-afternoon FOMC statement where there are no meaningful expectations for a rate hike. Jobless claims and factory orders will mark time ahead of employment data on Friday with expectations pointing to yet another month of significant strength. The good news when there are so many reports in one week is that the following week is guaranteed to be a lighter!




Pending Home Sales Index for June

Consensus Forecast, Month-to-Month Change: 0.8%

Consensus Range: 0.3% to 1.0%


Pending home sales are expected to increase 0.8 percent in June after falling 0.5 percent rise in May. This index has on trend been accurately forecasting flat to declining results for the existing home sales report.


Dallas Fed General Activity Index for July

Consensus Forecast: 32.0

Consensus Range: 29.0 to 38.5


Dallas has been among the very strongest of the regional surveys, the result of high energy prices which are making for big gains in orders and also confidence in the outlook. Another month of strength is expected for July, at a consensus 32.0 for the general activity index vs June's outsized 36.5.




Personal Income for June

Consensus Forecast, Month-to-Month Change: 0.4%

Consensus Range: 0.3% to 0.4%


Consumer Spending

Consensus Forecast, Month-to-Month Change: 0.4%

Consensus Range: 0.4% to 0.5%


PCE Price Index

Consensus Forecast, Month-to-Month Change: 0.1%

Consensus Range: 0.1% to 0.2%


PCE Price Index

Consensus Forecast, Year-on-Year Change: 2.3%

Consensus Range: 2.3% to 2.4%


Core PCE Price Index

Consensus Forecast, Month-to-Month Change: 0.2%

Consensus Range: 0.1% to 0.6%


Core PCE Price Index

Consensus Forecast, Year-on-Year Change: 2.0%

Consensus Range: 1.9% to 2.2%


Both personal income and consumer spending are seen rising a moderate-to-solid 0.4 percent in June. Note that the data will unbundle June's contribution from last week's second-quarter GDP report. The core PCE price index, which excludes both food and energy, is seen posting a 0.2 percent monthly rise for a year-on-year gain of 2.0 percent. This index, which is the most closely watched of all inflation readings, first hit the Fed's 2 percent goal in the May report.  The consensus for the overall price index is for a 0.1 percent monthly gain and a year-on-year rate of 2.3 percent.


Employment Cost Index for 2nd Quarter

Consensus Forecast, Quarter-to-Quarter Change: 0.7%

Consensus Range: 0.6% to 1.0%


Slightly easing pressure is expected for the employment cost index with Econoday's consensus at a 0.7 percent rise in the second quarter compared to 0.8 percent in the first quarter. The year-on-year rate in the first quarter, at 2.7 percent, was the highest in 10 years in what was a strong signal of wage pressures in the labor market.


Case-Shiller, 20-City Adjusted Index for May

Consensus Forecast, Month-to-Month Change: 0.4%

Consensus Range: 0.2% to 0.6%


Case-Shiller, 20-City Unadjusted Index

Consensus Forecast, Month-to-Month Change: 0.8%

Consensus Range: 0.7% to 0.9%


Case-Shiller, 20-City Unadjusted Index

Consensus Forecast, Year-on-Year Change: 6.6%

Consensus Range: 6.4% to 6.9%


Home-price appreciation appears to have tangibly slowed during the Spring selling season. FHFA house prices have been flat while Case-Shiller data slowed in April. But noticeable strength is the call for Case-Shiller data in May where the consensus gain for the 20-city adjusted index is 0.4 percent vs only 0.2 percent in April with the unadjusted year-on-year rate seen holding at April's 6.6 percent. The consensus for unadjusted monthly growth, reflecting the relative price strength of May compared with other months of the year, is 0.8 percent.


Chicago PMI for July

Consensus Forecast: 62.0

Consensus Range: 57.3 to 64.8 


Easing strength at a very high level is the call for the Chicago PMI with the July consensus at 62.0 vs an overheated 64.1 in a June report when delivery delays hit a 14-year high and input costs a 7-year high.


Consumer Confidence Index for July

Consensus Forecast: 126.9

Consensus Range: 126.0 to 127.5


Econoday's consensus, at 126.9 in July, is calling for steady strength in the consumer confidence index which came in at 126.4 in June. Job assessments, especially the closely watched jobs-hard-to-get subcomponent, have been extraordinarily strong.




Total Unit Vehicle Sales for July

Consensus Forecast, Annualized Rate: 17.1 million

Consensus Range: 16.6 to 17.3 million


Domestic-made Unit Vehicle Sales

Consensus Forecast, Annualized Rate: 12.9 million

Consensus Range: 12.9 to 13.2 million


A 17.1 million annualized rate is the consensus for total unit vehicle sales in July, a solid outcome that, however, would compare with a 17.5 million pace in June which easily topped Econoday's consensus range. Though July's rate is expected to be strong, the month-to-month comparison with June's strength could point to weakness for the motor vehicle component of the retail sales report. Domestic-made vehicles are expected to sale at a 12.9 million vs May's 13.6 million.


ADP, Private Payrolls for July

Consensus Forecast: 172,000

Consensus Range: 150,000 to 198,000


Econoday's consensus for ADP's private payroll estimate in July is 172,000 which would compare with 177,000 in ADP's June estimate and against 202,000 in the government's data for June. ADP is always hit or miss and has underestimated the strength of the last two employment reports.


PMI Manufacturing for July, Final

Consensus Forecast: 55.5

Consensus Range: 55.5 to 55.8


The PMI manufacturing index is expected to come in at a final 55.5 in July, unchanged from the mid-month flash. Orders in the flash report were very strong, reversing what was a warning signal of tariff-related slowing in the June report.


ISM Manufacturing Index for July

Consensus Forecast: 59.4

Consensus Range: 58.0 to 60.4


Near record delivery delays and a plus 75 reading for input costs headlined ISM's overheated manufacturing report in June. Forecasters see the composite index easing only slightly from June's 60.2, at a consensus 59.4.


Construction Spending for June

Consensus Forecast, Month-to-Month Change: 0.3% 

Consensus Range: -0.3% to 1.1%


A modest rate of monthly growth is the Econoday consensus for June construction spending, at a 0.3 percent gain vs May's 0.4 percent rise. May's report was led by multi-unit housing, offsetting another choppy performance for the non-residential side of the report.


Federal Funds Target for July 31 & August 1 Meeting

Consensus Forecast, Midpoint: 1.875%

Consensus Range: 1.75% to 2.00%


There are no expectations that the FOMC will respond to the very strong second-quarter GDP report or will launch a retaliatory rate hike to assert its independence following the administration's calls for policy adjustment to go slow. All of Econoday's panel see the federal funds target holding at a 1.875 percent midpoint within a 1.75 to 2.00 percent range. There is no press conference or economic forecasts to go along with this meeting's statement where updates on consumer spending, the labor market and inflation, should they prove hawkish, could raise the number of future rate hikes that are expected.




Initial Jobless Claims for July 28 week

Consensus Forecast: 218,000

Consensus Range: 216,000 to 225,000


Initial claims are expected to come in at 218,000 in the July 28 week vs 217,000 in the prior week. All readings in this report are at or near historic lows and consistent with strong demand for labor.


Factory Orders for June

Consensus Forecast, Month-to-Month Change: 0.8%

Consensus Range: 0.2% to 2.5%


Durable goods orders for June were helped, but much less than expected, by aircraft orders. Orders excluding transportation equipment proved moderate while orders for core capital goods proved solid. Forecasters see factory orders in May, a report that will include fresh data on non-durable goods, rising 0.8 percent.




Nonfarm Payrolls for July

Consensus Forecast: 188,000

Consensus Range: 150,000 to 205,000


Unemployment Rate

Consensus Forecast: 3.9%

Consensus Range: 3.8% to 4.0%


Private Payrolls 

Consensus Forecast: 184,000

Consensus Range: 148,000 to 204,000


Manufacturing Payrolls 

Consensus Forecast: 15,000

Consensus Range: 11,000 to 22,000


Participation Rate

Consensus Forecast: 62.8%

Consensus Range: 62.7% to 62.8%


Average Hourly Earnings

Consensus Forecast, Month-to-Month Change: 0.3%

Consensus Range: 0.2% to 0.4%


Average Hourly Earnings

Consensus Forecast, Year-on-Year Change: 2.7%

Consensus Range: 2.6% to 2.8%


Average Workweek

Consensus Forecast: 34.5 hours

Consensus Range: 34.4 to 34.5 hours


Following a very strong May and June, nonfarm payrolls are expected to extend their strength to July where Econoday's consensus is calling for a 188,000 rise. The unemployment rate, at a July consensus of 3.9 percent, rose 2 tenths in June to 4.0 percent in what was a good sign as more people began to look for work. Despite all the strength, wages were flat in June and mixed results are expected for July with the monthly gain for average hourly earnings at a moderate at 0.3 percent consensus, not enough however to lift the year-on-year rate which is expected to hold at 2.7 percent. Private payrolls are seen rising 184,000 with manufacturing payrolls expected to show another solid increase at 15,000. The workweek is seen unchanged at 34.5 hours with the labor participation rate down 1 tenth to 62.8 percent.


International Trade Balance for June

Consensus Forecast: -$45.6 billion

Consensus Range: -$48.0 to -$41.0 billion


The international trade deficit for goods and services is expected to widen in June to $45.6 billion vs May's deficit of $43.1 billion. The goods side of this report has already been released and showed sizable widening as exports fell and import growth held steady.


PMI Services for July, Final

Consensus Forecast: 56.2

Consensus Range: 56.2 to 56.3


PMI services held steady and strong in the flash report for July on what was described as "robust" strength in new orders. The index is expected to hold at the 56.2 flash reading.


ISM Non-Manufacturing Index for July

Consensus Forecast: 58.8

Consensus Range: 57.9 to 59.0


A standout showing of 63.2 in June's new order index points squarely at another month of exceptional strength for the ISM non-manufacturing index in July where the consensus is 58.8. A plus in the June report was a slight cooling in delivery times, input costs, and order backlogs.


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