Orlando's Outlook: Inflation stalls


Bottom Line It appears as if the pickup in inflation from pre-election troughs to much firmer levels earlier this year has stalled, at least temporarily. The disappointing first-quarter flash of only 0.7% for GDP is an obvious culprit. But the Department of Commerce continues to experience seasonality problems with the first quarter, which we believe will be revised higher anyway due to the positive revision for March retail sales “control” results. In addition, the delayed tax refunds, winter storm Stella and the late Easter, which collectively hurt first-quarter economic growth, will be rear-view mirror fodder when we get to second-quarter GDP, which we expect will be a much stronger 2.6%.

Perhaps it’s Washington, then. The early post-election surge in a dozen different confidence metrics has moderated recently, with the Beltway apoplectic over the firing of FBI director James Comey, the appointment of a special prosecutor to investigate Russia’s alleged involvement in the presidential election and the possibility of impeachment for President Trump. The latter has the associated risk that structural fiscal policy reform will be derailed, an event on which we place low odds.

Consequently, over the past two months, benchmark 10-year Treasury yields have fallen from 2.63% to an overbought 2.25% in a flight-to-safety rally, while the VIX spiked this week from 10 to an overbought 16 and the S&P 500 slipped 2% from a record high of almost 2,406 to an oversold 2,352. The bounce we’ve enjoyed over the past two days is sustainable, in our view, as we tune out the noise from Washington and focus on the stuff that actually matters: like the best quarterly earnings in five years in the nearly completed first quarter, with economically sensitive categories such as energy, technology, financials and materials leading the charge.

Whither the Fed? We do not believe that the Federal Reserve will be distracted by the slowdown in inflation or Washington-related noise when it convenes next on June 14, as it will look past those issues. The Fed hiked interest rates by a quarter point at its mid-March 2017 policy-setting meeting, the second such hike in three months’ time. It also marked the third hike this cycle since ending zero-bound policy in December 2015. We continue to believe the Fed is likely to hike rates twice more in 2017—certainly in June and perhaps again in September—and then slowly begin to unwind its $4.5 trillion balance sheet in December. But if the aforementioned slowdown in inflation continues deeper into the summer, perhaps the Fed adopts a more dovish second-half pace.

To that point, let’s take a deeper dive into some of the key inflation metrics the Fed is likely to be watching closely this summer:

Core personal consumption expenditures (PCE) index The Fed’s preferred measure of inflation fell to 1.6% in March 2017 on an annualized year-over-year (y/y) basis. That was down from 1.8% in both February and January, the highest level since October 2012 (a more than 4-year high). Core PCE inflation had troughed at 1.3% in July 2015, and it remains below the Fed’s oft-stated 2% inflation target. On a month-over-month (m/m) basis, the core PCE inflation declined 0.1% in March, down from gains of 0.2% in February and 0.3% in January.

Core consumer price index (CPI) This retail inflation measure that strips out volatile food and energy prices slipped a tick in April 2017 to 1.9% y/y, down from 2.3% in January 2017, which matched its highest reading in five years (April 2012). The CPI had troughed at 1.6% in December 2014.

Core producer price index (PPI) This wholesale inflation metric, which strips out volatile food, energy and trade prices, surprisingly leapt 2.1% y/y, a new cycle high, in April 2017 from 1.7% in March. This important measure of pipeline inflation had troughed at a deflationary annual reading of only 0.2% in November 2015, gradually rising to 1.8% in February 2017, a 2½-year high that matched similar peaks in November 2016 and August 2014 (when this data series was first introduced). So while wholesale inflation has improved sharply over the last 17 months to a new high, this is a relatively new and unseasoned index, so patience is warranted.

Average hourly earnings (AHE) Wage growth slipped a tick to a y/y gain of 2.5% in April 2017, down from a 2.9% increase in December 2016, the healthiest pace of wage inflation since June 2009, when the Great Recession was ending. Wage growth had troughed at a 1.5% increase on a y/y basis in October 2012, and was sitting at a 1.9% rate in December 2014. Despite the declining trend over the past four months, we continue to expect wages will grind higher over time, rising to perhaps 4% y/y by the end of 2018.

Employment cost index (ECI) This quarterly measure of wage growth soared 0.8% to a more than 9-year high in the first quarter of 2017, compared with a more muted 0.5% gain in the fourth quarter of 2016. The cycle trough of a 0.2% quarter-over-quarter gain was registered in the second quarter of 2015, so wage growth has clearly accelerated over the past two years.

Crude oil prices Energy prices had plunged 75% from $108 per 42-gallon barrel as measured by West Texas intermediate (WTI) in June 2014 to a 12-year low of $26 in February 2016. Since that time, crude more than doubled to $54 per barrel in January 2017, due to an historic OPEC and non-OPEC accord to cut 1.8 million barrels a day from production starting at the beginning of this year. But over the first five months of this year, crude prices inexplicably plunged nearly 20% to an oversold level of $44 per barrel. Over the past week, they have rebounded almost 15% to $50 per barrel. We continue to believe that a trading range of perhaps $40-60 per barrel is appropriate over the balance of 2017.

Currency The U.S. dollar rallied more than 25% versus the euro, from 1.40 in May 2014 to 1.03 in January 2017. But amid the political concerns in Washington and the questions about economic growth and inflation, the dollar has retraced more than 8% so far this year, to 1.12.

Housing prices peaking? Home prices in the 20 largest U.S. cities rose 5.85% y/y in February 2017, the fastest pace since July 2014, according to the lagging Case-Shiller index, which calculates housing prices on a rolling 3-month average. That’s up from a y/y pace of 4.95% in October 2016, so the growth rate of this metric has been accelerating. But the m/m gains tell a more cautionary story. After a 0.6% m/m gain last October grew to a 0.9% increase in December, the pace of growth has slowed sequentially to a 0.86% monthly increase in January 2017 and to a 0.69% gain in February. That nascent decelerating trend may begin to manifest itself shortly in the rolling y/y metrics.

Autos braking Annualized unit sales peaked at 18.29 million in December 2016, lapping the cycle trough of 9 million units at the bottom of the Great Recession in 2009. But over the last four months, unit sales have declined 8% to an annual run rate of 16.81 million. At the same time, dollar sales for vehicles have actually fallen on a m/m basis in four of the past six months.