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Raising rates to curb inflation

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Weak retail sales will weigh on economic growth

Headline retail sales disappointed again, with sales declining for the third consecutive month.  Core retail sales, though positive, also came in below expectations. Weak sales occurred despite the combination of tax refund payouts from 2017 tax returns plus lower taxes paid in 2018 because of the Tax Cuts and Jobs Act.

We do not anticipate that weak sales will persist – after-tax
incomes are increasing and last week consumer sentiment
reached its highest level since January 2004.

But they will likely drag on economic growth during a first quarter in which the hard economic data has trailed the soft sentiment data. This will continue the pattern from recent years - economic growth begins the year slowly only to accelerate in later quarters. We have not yet revised our growth expectations downward, but disappointing first quarter growth and increasing trade protectionism are pushing the risks to our forecast to the downside.

Inflation stabilizes, poised to increase

The headline consumer price index (CPI) for February matched expectations and increased slightly, growing 2.2 percent on a year-over-year basis, up from 2.1 percent in January. Meanwhile the core CPI remained at 1.8 percent year-over-year, also in line with expectations. Although we didn't believe that the CPI could maintain its fast acceleration from January, we are not surprised to see inflation firming up.

Over the last few years, inflation has generally been increasing.

But weakness in inflation in 2017 hung around for a while (as we predicted) and disrupted the trend. Weak inflation will start to fall out of the index in the coming months. As it does, inflation will accelerate, continuing the trend of the last few years. Recent readings support this: inflation over the last half year measures 2.5 percent on an annualized rate and year-to-date measures 3.2 percent. Also the headline and core produce price index (PPI) accelerated on a year-over-year basis, following its continued trajectory. Although the relationship between the CPI and PPI has broken down over time, if producer prices continue to rise companies will try to determine if they can pass those increases onto consumers.

Fed has enough evidence

Weak retail performance in recent months should not be enough to deter the Fed from raising rates by 25 basis points this week. The Fed has been signaling this increase and the futures market currently projects a roughly 94 percent chance that the Fed will raise. That would mark the sixth increase since tightening began in December 2015 and raise the target rate to a range of 150-175 basis points. This range will remain below the estimated neutral rate and continue to stimulate economic activity. We have not yet revised our forecast of three hikes this year, but with economic growth set to accelerate, the risk to more increases lie on the upside.

Labor shortage worsens, reaches all-time high

The number of open but unfilled positions reached an all-time high in January of roughly 6.312 million. The rate at which jobs are opening matched a record high. We anticipated that the tax cuts could spur an increase in job openings and it could be that companies are creating openings in advance of the tax cuts because of the widespread difficulty in hiring. Although job creation has accelerated in recent months, it has failed to keep pace with openings.

The labor shortage in the U.S. will likely worsen before it
improves, even if a tight labor market incentivizes some
workers to reenter the labor force.



What it means for CRE

We believe that the weakness in the first quarter, particularly on the part of the consumer, will not last and that economic growth will accelerate in later quarters. We are not revising our forecast for economic growth for 2018 and continue to believe that resurgent growth will support fundamental space markets and capital markets for commercial real estate (CRE) even at what appear to be relatively late stages of the cycle for most property types. The next rate hike should not have much, if any, impact on CRE overall – the rate remains low enough to stimulate the economy, financial conditions continue to loosen, and with fiscal policy set to boost economic growth tailwinds for CRE remain strong. The labor shortage poses a larger problem. So many open but unfilled positions produce suboptimal economic results. While this shortage impacts all property types, it most directly affects the office market. If all of the open office-using positions were filled, we estimate that would increase office net absorption by roughly 450 million square feet. The represents roughly 11 percent of overall office inventory and roughly 73 percent of all vacant office space. Of course, openings and vacancy are not identically distributed throughout markets in the U.S. and job growth of this magnitude would spur greater office construction. But this analysis demonstrates the significant impact that filling these openings would have on the office market.

What we are watching this week

In addition the announcement by the Fed, housing sales data features prominently this week. After falling in December and January, we expect new and existing home sales to rebound in February. Although we do not anticipate a huge bounce back, the underlying data looks positive. Durable goods orders from February should also rebound relative to January's disappointing result.

Thought of the week

The weakening of the dollar, despite rising interest rates and a stronger economic outlook, suggests increasing concerns over economic policy in the U.S.

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