Financial market volatility has picked up notably in the past few weeks, with equity and bond markets adjusting to stronger economic growth and increased inflationary expectations and to the impacts that this will have on future monetary policy. Indeed, there have been solid improvements in the outlook in manufacturing and other sectors, with healthy gains in demand, production and employment. In the minutes to the January 30–31 Federal Open Market Committee (FOMC) meeting, participants cited the strengthening economy and tighter labor market. While the Federal Reserve did not hike short-term rates at that meeting, the FOMC “expected that economic conditions would evolve in a manner that would warrant further gradual increases in the federal funds rate. They judged that a gradual approach to raising the target range would sustain the economic expansion and balance the risks to the outlook for inflation and unemployment.”
The bottom line is that financial markets now anticipate three to four increases in the federal funds rate in 2018, which is up from an expectation of two or three hikes just a few months ago, with the next increase likely coming at the March 20–21 FOMC meeting. The brighter economic outlook—which has been boosted by passage of tax reform—has not only strengthened growth prospects but also increased forecasts for accelerated prices and wages. Along those lines, a number of recent business sentiment reports have reflected elevated input cost expectations over the next six months. This included two surveys out last week—a national one from IHS Markit and a regional analysis from the Kansas City Federal Reserve Bank—which found that raw material prices should grow over the coming months at rates not seen in at least five years.
To be fair, as the FOMC minutes note, core inflation remains modest and largely under control for now despite those increased expectations. Manufacturers will get a new reading for the core personal consumption expenditure (PCE) deflator—the Federal Reserve’s preferred measure—on March 1, but in December, it increased just 1.5 percent year-over-year. This illustrates the Federal Reserve’s case that overall inflation remains below its 2 percent target. Nonetheless, the strengthened outlook for growth (and the prospects of more federal funds rate increases) has sent interest rates higher, including 10-year Treasury bond yields, which have soared to four-year highs, approaching 3 percent.
Encouragingly, the beforementioned surveys continue to show strong growth in manufacturing activity. For instance, the IHS Markit Flash U.S. Manufacturing PMI registered the best reading since October 2014, and the index for future output was just shy of December’s reading, which was nearly a two-year high. Likewise, the Kansas City Federal Reserve’s composite index of general business conditions increased to a four-month high, building on solid growth over the past year. More importantly, the forward-looking measure of activity for the next six months soared from 29 to 38, an all-time high in the survey’s 17-year history. More than 60 percent of respondents anticipate higher new orders, production and shipments in the coming months, with 46 percent and 48 percent seeing more employment and capital spending, respectively.
Meanwhile, existing home sales decelerated for the second straight month, down 3.2 percent in January. Sales of existing homes declined from 5.56 million units at the annual rate in December to 5.38 million units in January, the slowest pace since September. Despite some easing in the past two months, the good news is that existing home sales remain not far from November’s rate, which was the fastest since February 2007. There were 3.4 months of supply in January, up from 3.2 months in December but down from 4.2 months in September. As such, supplies have trended generally lower, helping to raise list prices. The median existing home sales price was $240,500 in January, up 5.8 percent from one year ago.
There will be a number of important data releases this week for financial markets to process. On Tuesdayand Wednesday, new Federal Reserve Chairman Jay Powell will give his first monetary policy testimony before Congress, likely touching on the topics discussed above. Markets will be watching his words carefully for clues about the pace of policy changes in 2018 and beyond. In addition, on Wednesday, there will be a first revision for fourth-quarter growth in real GDP, which was estimated originally to be 2.6 percent. That prior estimate included large drags from inventories and net exports, which were likely overstated, and as such, there may be an upward revision of that figure to something closer to 3 percent.
Moreover, there will be several reports on the health of the manufacturing sector, including the latest surveys from the Institute for Supply Management and the Dallas and Richmond Federal Reserve Banks, which should reflect continued strong growth. Other highlights this week include updates on construction spending, consumer confidence, durable goods orders and shipments, the international trade in goods, personal income and spending and new home sales.
Chad Moutray, Ph.D., CBE
National Association of Manufacturers