Portfolio Strategy Analyst
The U.S. economy regained its footing over the second quarter. Driven by stronger consumer spending and a reviving housing sector, economic growth expanded at a 2.3% annual rate over the past three months. Once again it appears that the slowdown in growth seen at the start of the year was more an anomaly related to temporary factors than an indication of significant weakness (Figure 1). While hardly exceptional by historical standards, growth is improving where it matters in private domestic spending and investment, suggesting that the U.S. economy is strengthening despite continued signs of global weakness.
The bright spot in the economy has been the consumer. Since the second quarter of 2014, spending growth has averaged 3.3%, and the conditions facing households continue to improve substantially. The economy has added more than three million jobs over the past 12 months, and the outlook for real income growth is the best in nearly a decade. With gas prices still more than 20.0% lower than a year ago, overall inflation muted, and the strong dollar supporting purchasing power, consumers can be expected to spend a bit more freely in the quarters ahead.
Meanwhile, economic growth continues to get a lift from housing. Home sales have rebounded sharply to post-recession highs, exceeding even the 2009 and 2010 home-buyer credit spikes, while builder confidence, permit applications, and building starts also have all picked up pace in recent months. What is particularly encouraging is that growth in sales (after stagnating for two years) is becoming more organic and sustainable, with gradual but steady rotation towards first-time home-buyers and away from investor-driven demand.
Housing itself is a relatively small part of the economy as a whole, but it plays an out-sized role in overall economic activity. Appreciating property values help to stimulate growth because, for many people, their home is their largest, most valuable asset, and when this asset appreciates, confidence and spending tends to increase as well.
At the same time, increased home building supports not only the construction industry, but numerous other housing-related industries, from furniture retailers to insurance sales. These developments should help further boost consumption and the jobs outlook, off-setting weaker demand overseas, and should provide a decent base for economic growth in the second half of the year.
All of these circumstances backs the Fed’s more upbeat tone on economic conditions recently, and suggest that the economy may soon be ready to cope with higher interest rates. Fed Chair Yellen has been clear that the timing of its first interest rate increase in nearly a decade will be data dependent. Unlike in previous business cycles, the Fed is under no pressure to rein in unsustainable growth or curb mounting inflation.
In addition, there are still plenty of risks apparent, most notably overseas. China’s economy continues to cool, and although the latest data suggest that the Greek crisis has not derailed the Eurozone recovery, growth seems to be slowing as the boosts from earlier falls in oil prices and the euro exchange rate fade.
Nevertheless, after a temporary blip, the U.S. economy appears in large part to be shaking off the global trouble surrounding it, and indicators point to further improvement ahead. Manufacturing is likely to continue to struggle because of the strength of the dollar, but a continued strengthening in domestic demand should help offset the headwinds from the stronger dollar and foreign economic weakness.
Meanwhile, the much larger services sector is set to see further gains as both household and business spending accelerates. As inflation continues moving slowly in the upward direction that policymakers want to see, providing reassurance that disinflationary pressures are fading, there appears to be good reason for the Fed’s increasing comfort with economic progress, and the start to a gradual tightening cycle should be expected sooner rather than later.
Will they? Won’t they? The next meeting of the Federal Open Market Committee (the monetary policy-making arm of the Federal Reserve Bank) will occur in mid-September. The big question is “Will the Fed increase the federal funds rate at that meeting?” If so, this will be the first rate increase since 2006. The federal funds rate has been at the low level of 0% to 0.25% since December 2008.
In mid-July, Fed Chair Yellen gave congressional testimony on monetary policy. She was very concise as she put forward an upbeat scenario of the domestic economy. She did make reference to some of the foreign “hot spots,” namely Greece and China, but did not think those countries’ events would have a significant impact on the U.S. economy.
In regard to inflation, she stated, “my colleagues and I continue to expect that…inflation will move gradually back toward our 2.0% objective over the medium term.” Inflation has been lower than the Fed’s target rate recently due to “transient” reasons, such as low oil prices and a strong dollar, which have helped to drive down import prices.
The decision to raise interest rates in September is dependent upon the economic data released between now and then. However, with the positive second-quarter GDP report, continued improvements in the labor market, global financial stresses dissipating, and the expectation that inflation will move back toward 2.0%, we think there is a high probability of the Fed acting in September.
The unemployment rate fell to 5.3%, the lowest level in seven years, and about one-half of the peak level of 10.0% reached during the lowest point of the recession in October 2009. Hiring has been strong, as reflected in the monthly change in payrolls, which have been increasing for the past 57 months. More importantly, total payrolls over the past year have increased around 2.0% (Figure 2). This should help to bring down the unemployment rate, since the working age population is growing at just about 1.0% per year.
Despite the steady increase in workers being added to the payrolls, there has not been a significant change in the hourly earnings rate (currently $24.95 per hour). The year-over- year change of this proxy of demand for workers is at 2.0%, which is roughly in line with what it has been since the current expansion began. Now that the labor market is approaching full employment (which the Fed currently defines to be in the range of 5.0% to 5.2%), the belief is that wage growth will start to move up. This, in turn, will likely help drive inflation up toward the Fed’s target level of 2.0%.
There is concern that the recent rout in commodity prices (Bloomberg commodity prices have fallen 11.4% in the past three months) will cause downward pressure on inflation (Figure 3). Since inflation is an important factor in the Fed’s decision to increase the interest rate, this disturbance is somewhat of a concern to the Fed. Despite this, the Fed has downplayed the recent weak inflation readings, which were due to weakness in oil prices, and stated that oil prices, like other commodities, are transient. This has been an important trend over the past few years. The goods portion of the Consumer Price Index (CPI) has been very volatile and is currently down 2.9% over the past year, whereas the service portion of the index has been holding steady for about three years and has increased 2.2% over the past year (Figure 4).
Fed policymakers have been very clear to the financial markets that inflation does not have to be at its target rate of 2.0% for the Fed to initiate the raising of the federal funds rate. Additionally, the Fed has stated that it must be “reasonably confident” that inflation will move toward its 2.0% goal over the medium term.
The data for housing has been moving on an upward momentum in recent months. Combined new and existing home sales are at their highest level since 2007 (Figure 5). While the last few months make up the heart of the home-buying season, we believe there are strong fundamental factors behind this growth, which should help to keep sales thriving into the future. Demand has been robust this year as more households are being formed and, with the strengthening economy, are now looking for a place to live. Mortgage rates are still near historically low levels, and housing affordability, which has moved up slightly over the past few months, is also near a historically low level. Labor market conditions continue to improve, and wage inflation is starting to increase, albeit modestly. Nothing drives demand like home price appreciation, which is up 4.9% over the past year. The main drag on the housing market is access to credit, as mortgage standards remain tight. Builders have been busy creating the supply to meet the increasing demand.
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