June 19, 2018
On Wednesday, the Federal Open Market Committee (FOMC) raised key interest rates a quarter-point, which was widely telegraphed and anticipated. The FOMC statement, as I expected, was decidedly dovish, which helped to excite financial markets. Specifically, Fed Chairman Jerome Powell said, “If you raise rates too quickly, you are just increasing the likelihood of recession.” He added that “we’ve been very, very careful not to tighten too quickly … We had a lot of encouragement to go much faster and I’m really glad we didn’t.” This refreshingly clear statement caused the 10-year Treasury bond yields to decline significantly, signaling that the bond market does not expect too many additional rate hikes.
The FOMC remains divided on whether the Fed should raise key interest rates one or two more times in the rest of 2018 due to a lack of consensus on how high inflation will rise and how high the Fed can raise rates before hindering economic growth. I must add that Fed Chairman Powell is very direct, pragmatic, and does not use confusing “Fedspeak” like his predecessors, which is very good for market confidence.
The news on the inflation front last week was mixed. On Tuesday, the Labor Department reported that the Consumer Price Index (CPI) rose 0.2% in May, in line with the economists’ consensus estimate. The core CPI, excluding food and energy, also rose 0.2%. Gasoline prices rose 1.6% and medical commodities rose 1.3% but excluding those items, there was scant evidence of any significant inflation in May.
On Wednesday, however, the Labor Department reported that the Producer Price Index (PPI) rose 0.5% in May, due predominantly to soaring crude oil prices. Economists were expecting 0.3%, so this was a big surprise; but excluding food, energy, and trade, the core PPI rose only 0.1% in May, significantly lower than economists’ consensus expectation of a 0.2% rise, so the bottom line is that wholesale inflation is tied predominantly to crude oil prices, which have moderated in June due to rising crude oil inventories.
It is important to note that the recent energy-related inflation is merely seasonal in nature, since crude oil demand rises in the spring and ebbs in the fall simply because there are more people in the Northern Hemisphere than the Southern Hemisphere. Both Saudi Arabia and Russia have recently boosted their crude oil production ahead of this month’s OPEC meeting. Furthermore, now that the U.S. is the largest producer of crude oil, thanks to the fracking boom, the incremental U.S. production has offset the supply disruptions caused by Venezuela. There is now a growing surplus of crude oil being stored in oil tankers around the world so, if anything, the worldwide crude oil supply seems to be finding equilibrium and stabilizing at a high enough price level to be favorable for most major energy producers.
I should add that all that fracking in West Texas has resulted in a natural gas glut. The natural gas market remains very weather-sensitive, so only a hot and miserable summer or a freezing cold winter can reduce the current natural gas glut. The other glut in the energy patch is in heavy-to-intermediate (WTI) crude oil grades compared to light sweet (Brent) crude oil, which means that the refiners are poised to continue to post very strong earnings as long as the spreads remain wide. Energy prices should decline in the coming months, which will help inflation to moderate and cause the Fed to raise rates at a slower pace.
Consumers and Small Business Owners are Buoyant
Back in 1984, Ronald Reagan campaigned on the slogan, “It’s Morning in America,” and he was re-elected in a landslide. Small business owners have never felt better than they did that year – until now.
On Tuesday, the National Federation of Independent Business announced that their small business optimism index surged to 107.8 in May, up from 104.8 in April, reaching its highest level in 34 years. Since small businesses create most jobs in the U.S., this bodes well for second-quarter GDP growth.
Consumers feel just as good. On Thursday, the Commerce Department announced that retail sales soared 0.8% in May, substantially higher (double) the economists’ consensus estimate of a 0.4% increase. Retail sales for March and April were also revised substantially higher to increases of 0.7% (from unchanged) and 0.4% (from 0.2%), respectively. Excluding autos, gasoline, building materials, and food services, core retail sales rose an impressive 0.5% in May. In the past 12 months, retail sales have risen by 5.9%. Due to May’s strong retail sales as well as strong upward revisions, GDP growth in the second quarter is on track to grow at over a 4% annual pace, perhaps up to the 4.8% rate predicted by the Atlanta Fed.
Finally, on Friday, we learned that the University of Michigan’s preliminary consumer sentiment index rose to 99.3 in June, substantially higher than the economists’ consensus estimate of 98.5. The current conditions component soared to 117.9 in June, up from 111.8 in May, which is a good omen for continued strong retail sales and second-quarter GDP growth, which will be released in late July.