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By HaleStewart May 1, 2016 11:03 am
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US Bond Market Week in Review: In Which I Respectfully Disagree with Tim Duy, Edition

     This week the Fed released its latest assessment of the U.S. economy:

Information received since the Federal Open Market Committee met in March indicates that labor market conditions have improved further even as growth in economic activity appears to have slowed. Growth in household spending has moderated, although households' real income has risen at a solid rate and consumer sentiment remains high. Since the beginning of the year, the housing sector has improved further but business fixed investment and net exports have been soft. A range of recent indicators, including strong job gains, points to additional strengthening of the labor market. Inflation has continued to run below the Committee's 2 percent longer-run objective, partly reflecting earlier declines in energy prices and falling prices of non-energy imports. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance, in recent months.

The labor market is in fairly good shape:

The Atlanta Fed’s Employment Spider Chart plots a broad range of current employment data against two benchmarks.  The inner-most light green line is the weakest point of the last recession while the darker blue line is the highest point at the end of the last expansion.  The gold line is the current market.  With the exception of wages and utilization, employment is in as good if not slightly better position than the last expansion.  But despite low unemployment, the three-month rolling average of wage growth is weak:

This explains some of the weakness in spending:

Real retail and food service sales (the blue bars) have contracted in 5 of the last 12 months and have barely grown in 2 others.  Real PCEs have done slightly better.  But the latest Q/Q growth rate was the weakest of the last four quarters.

    Business investment and exports are weak:

Investment has contracted for 3 consecutive quarters.  Total exports declined last quarter and goods exports (not shown) have dropped for two quarters.

     Prices are still contained, as are inflation expectations:

The top chart shows that core inflation is running a little over 2% while overall inflation recently decreased.   Inflation expectations – as measured by the difference between the 5-year CMT and 5-year CMT TIPS – are still below 2%. 

       The Fed offered the following assessment of the next 12-18 months:

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee currently expects that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace and labor market indicators will continue to strengthen. Inflation is expected to remain low in the near term, in part because of earlier declines in energy prices, but to rise to 2 percent over the medium term as the transitory effects of declines in energy and import prices dissipate and the labor market strengthens further. The Committee continues to closely monitor inflation indicators and global economic and financial developments.

This is more or less the same projection they’ve offered over the last few years; moderate growth and weak inflation.  This is also in line with the recent LEIs and CEIs, which argue for slow, grinding expansion.

     What does this mean for Fed policy?  Tim Duy recently argued that we can expect a move to a more hawkish tone, leading to rate hikes.  His argument is well documented.  However, I’m not convinced we’ll see more rate hikes, largely due to weaker data. 

    Consider the above table from the latest BEA report.  The 1Q GDP report only contained two positives: an increase in state and local government spending and a very strong residential investment number.  PCEs are decelerating.  Gross private domestic investment and exports are slowing.  And the breadth of the investment slowdown is increasing.  Finally, two coincident indicators (retail sales and industrial production) are in poor shape:

Retail sales are moving sideways and industrial production is declining.  It’s difficult to see even a 25 basis point increase against this backdrop.

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