Mediocre To Solid Data Flow, But Weak Inflation Still Key, by Tim Duy: The data flow is generally supportive of additional Fed action, surely enough to allow the Fed to move forward with balance sheet action later this month. But what about another rate hike? That remains an open question as low inflation remains an obstacle to further rate hikes for a sizable faction within the Fed.
The employment report disappointed with job growth of 156k, shy of expectations for 180k. Previous months were revised downward. Looking through the monthly volatility, the report does little to change the basic story that job growth continues the slow downward trend that began in 2015:
Mediocre, but not disastrous. A key issue for the Fed is where does this slowdown stop? If they were reasonably confident job growth would soon stabilize around 100k a month, then the pressure for additional rate hikes would ease substantially. For the Fed that figure would be sufficient to bring stability to the unemployment rate. For now, though, it looks like the current pace of job growth is likely to bring further declines in the unemployment rate:
In other words, the recent stability in unemployment around 4.3-4.4% is only temporary. A significant faction of the Fed will worry that additional declines in unemployment will signal that the economy is operating beyond full employment, placing inflation stability at risk. Hence that faction will press for additional pre-emptive tightening.
That said, tepid wage growth calls into question the Fed's current estimates of full employment:
I think that going forward the Fed will essentially split the difference by edging down estimates of full employment while remaining concerned that the pace of job growth still exceeds that required for inflation stability over the medium-term. On net, that leaves December still open for a rate hike. More on that later.
In the meantime, it looks like the manufacturing sector continues to shake off the 2015-6 doldrums. The latest ISM report was strong:
To be sure, a slowdown in auto sales will weigh on manufacturing in the months ahead. That said, Hurricane Harvey wiped out a half a million vehicles in Texas, so that throws some needed support to that sector going forward.
Overall, consumer spending looks solid, continuing to hold the pace of the last 18 months:
Not the best of the cycle, but not the worst either. Something that might be expected in a more mature phase of the cycle, which is probably about right. And within a reasonable margin of error of what might be expected given consumer sentiment numbers:
And then there is inflation. Or, more accurately there isn't inflation, at least any to be concerned about:
It is fairly clear that the disinflation this year is more persistent than the Fed would like to believe. It seems like too many one-sided errors to be just coincidence. Truth be told, looking at that chart makes me think that inflation expectations are anchored around 1.75% rather than the Fed's target of 2%. I don't think the Fed thinks that, but I also don't think it is an unreasonable idea either.
Bottom Line: So where does this leave us? The Fed continues to be caught between the push of the generally positive momentum of the US economy and the pull of the surprise weakness on the wage/inflation front. Luckily for them, they don't need to decide between the two until December. Their next move is to start reducing the balance sheet - they want to have that process underway before any leadership changes next year. Moreover, they would like to ensure the process begins smoothly before returning to the issue of rate hikes. My expectations about December are, not surprisingly, data dependent. If the current mix of activity continues - generally upward momentum suggestive of actual or forecasted declines in unemployment, coupled with what the Fed will view as fairly easy financial conditions (watch the dollar!) - the Fed will hike in December even if inflation remains tepid. I think the Fed will need to see more evidence of slowing in the real economy before they cease rate hikes - I suspect they will see the economy as operating to close to full employment to risk the potential inflationary consequences of delaying additional rate hikes.