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Here Comes the Rate Hike

Labor market signals go for rate hike

The last batch of labor market data provided no evidence that would prevent the Fed from hiking interest rates again this week. Payrolls grew by 228,000 net new jobs which exceeded expectations and the recent trend in job creation. But the long-term trend reinforces our view that a lack of qualified people to fill jobs remains the largest problem in the labor market. The number of people unemployed exceeds the number of open but unfilled positions by only about 500,000. Mismatches in skills, geography, and other factors prevent the unemployed from filling these openings. With each passing month, the labor market tightens further. The unemployment rate remained at its post-recession low of 4.1 percent while the number of net new jobs per month continues to decline. The labor market would need to generate roughly 322,000 net new jobs (between December figures and prior months' revisions) to equal 2016's job creation total. Barring some idiosyncratic late-year surge in hiring, job growth (on an absolute basis) will decline for the third consecutive year in 2017 after peaking in 2014. We forecast that this trend will continue in 2018.

A continuously tightening labor market has not yet translated into consistent upward pressure on wages. Over the last two calendar years, wage growth accelerated toward 3 percent three times, only to quickly fall back toward 2.5 percent or so. Frequent readers of this weekly know that productivity and inflation drive wage growth in the long run. Weakness from both stymied wage growth during the current expansion. But with productivity growth and inflation firming, ongoing tightness in the labor market could finally push wage growth above that 3 percent threshold in 2018. 


Last rate hike hurdle cleared

Friday's employment report should not deter the Fed from raising rates by 25 basis points at this week's meeting. Given recent guidance, the Fed has more than enough evidence to believe that the economy can digest a third rate hike for 2017. And the market currently anticipates the probability of a rate hike at 100 percent so the Fed would substantially harm markets and its own credibility if it did not follow through. 

The Fed will likely hike rates three times in 2018. 

The Fed found sufficient evidence to hike three times in 2017 and 2018 should bring stronger wage growth and inflation, especially with tax reform likely to boost economic growth next year. This presents a tug of war between late-cycle fiscal stimulus and continued rate increases. Interest rates remain low enough to be stimulative. But if the Fed hikes three times next year as we anticipate then it will push the target fed funds rate into a range of 200-225 basis points. Such increases would bring the fed funds rate closer to the neutral short-term rate (which is not simulative or contractionary) and increase the risk of moving past the neutral rate in 2019 which could slow economic growth.

What it means for CRE

In the short run, these developments in the economy bode well for CRE. A fiscal stimulus boost to the economy from tax reform benefits virtually all CRE property types. Continued improvement in the labor market also supports demand for most property types. But slowing job growth over time limits demand for office space, which is already contending with modest supply increases. The importance of wage growth to retail is increasing as the number of net new jobs declines over time. Adding new workers not only increases the number of people spending, but workers entering or returning to employment often have a higher propensity to consume on a variety of goods and services including new work-appropriate clothing, cars, and apartments.  Notably, continued employment gains among young adults, coupled with the strongest entry-level wage growth in the last five years, should provide firm demand for apartments in the face of significant new supply increases. And all of the above drives demand for warehouse/distribution space which will need these drivers to help net absorption outpace increasing supply growth. Overall, economic data continues to support demand for virtually all property types, but to varying degrees.

What else happened last week?

Congress passed a stop-gap measure to keep the federal government funded for two weeks, once again kicking the can down the road. Unlike tax reform (which continues to progress through the reconciliation process and remains likely to be settled by Christmas) Republicans will need Democratic support to pass a budget for fiscal year 2018. We do not believe that a shutdown is likely, but it is not an impossibility.

What we are watching this week

In addition to the Fed's announcement on Wednesday, inflation and sales data will feature prominently this week. The producer price index (PPI) for November should show its fastest increase in roughly six years, although producer price increases have not been fully passed on to consumers. We see evidence of that in the consumer price index (CPI): although both headline and core CPI likely accelerated in November, both trail the data from the PPI by a wide margin. If core CPI increased as expected it would mark the second consecutive month of modest acceleration after core CPI decelerated throughout much of 2017. Both headline and core retail sales likely grew in November with core sales growth continuing to reflect healthy consumer spending at the start of the holiday shopping season.

Thought of the week

The unemployment rate for those with a high school diploma or less declined by 270 basis points between November 2016 and November 2017.





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