Economy: On Solid Footing as 2018 Began
January 2018 saw December’s trend of above-consensus economic reports taper off, though the data suggests strong underlying fundamentals in the U.S. economy, supported by solid consumer spending. Fourth quarter growth in real gross domestic product (GDP) of 2.6% fell short of the more optimistic 3.0% forecast by Bloomberg-surveyed consensus, dragged down largely by inventories and trade (faster growth in exports than imports). Both economic factors contributed heavily to the growth rate of GDP in the third quarter of 2017, which speaks more toward disruptions from hurricanes than a fundamental decline in momentum. Consumer spending was the standout contributor to the GDP report, corroborated by upbeat consumer confidence reports, supported by tax cuts and the drop in the household savings rate.
Consumer-oriented data for the fourth quarter of 2017 outlined a significant acceleration relative to the third quarter. Retail sales data excluding autos were in line with expectations and the strongest since 2010. The strength, which has the potential to be inflated given post-hurricane spending, may continue in light of tax cuts and improving economic growth. Job growth (+148K) slowed and missed expectations in December (reported in January) but appeared to be dragged down by temporary factors. Wage growth at 2.5% year over year strengthened modestly. Consumers remained confident, as the University of Michigan Consumer Sentiment Index topped expectations and remains elevated.
Jobless claims posted a drop in January, though this is made less significant given the usual volatility around seasonal layoffs and construction shut-ins. The ADP National Employment Report exceeded consensus, keeping pace with December’s reading and indicative of tightening labor market. Bloomberg economists expect that the unemployment rate will fall below 4% by year-end. The Employment Cost Index, which outlines the cost of labor for U.S. businesses, continued upward, confirming a tight labor market and increasing wage pressures.
Consumer inflation, detailed in the Consumer Price Index (CPI), was under scrutiny given the potential for accelerating inflation to lead to a faster pace of Federal Reserve (Fed) rate hikes. Though Core CPI, which excludes food and energy, surprised to the upside at 1.8% year over year, the core goods category pickup is viewed as unlikely to be sustained. Headline CPI (including all items) came in at +2.1% year over year, meeting expectations. Inflation may become a bigger concern should the U.S. dollar weaken further, pushing up import prices.
Productivity contracted 0.1% in the fourth quarter, though this was largely attributed to weather disruptions and is expected to normalize in the first quarter of 2018. Productivity has seen slow gains over the last few years due largely to demographic headwinds as the labor force ages, but may accelerate due to rising wage pressures and increasing labor scarcity.
Business investment continued to pick up in the fourth quarter, increasing 6.8% from the third quarter. Manufacturing surveys for December, released in January, largely came in ahead of expectations. The ISM Manufacturing Index reading for December, at 59.7, exceeded expectations. A reading above 50 indicates economic expansion.
Regional surveys showed strength as well: Dallas, Chicago, and Kansas City beat expectations though Richmond and Philadelphia surveys fell short. Businesses remain confident based on strength in the NFIB Small Business Optimism Index.
Fed Chair Janet Yellen presided over her last Federal Reserve Open Market Committee meeting as markets prepared for the transition to incoming Fed Chair Jerome Powell. As expected, the Fed left monetary policy unchanged, keeping the fed funds target rate between 1.25% and 1.50%, while allowing Treasuries and mortgage-backed securities to roll off its balance sheet. The central bank also upgraded its economic assessments, noting solid gains in employment, household spending, and business fixed investment, while taking a more hawkish stance on inflation. Markets continued to price in a very high likelihood of a March rate hike at the conclusion of the meeting.
Turning to other central banks, as expected, the European Central Bank (ECB) made no changes to interest rates or forward guidance on its quantitative easing program. The ECB is still expected to begin tapering bond purchases in September but remains flexible. The strong euro currency remained a focus for its potential risk to European exports.
The Bank of Japan (BOJ) left policy unchanged on January 23. Markets had been pricing in a slight chance of a near term taper in the BOJ’s asset purchase program, following reports early in the month that it adjusted purchases of intermediate- and long-term bonds. That move was more operational in nature.
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