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Watch for a rate hike this week

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Watch for a rate hike this week

Last week contained relatively few important data points. But the data revealed a continued pickup in economic activity that should not prevent the Fed from raising rates again this week.  The ISM Nonmanufacturing index for May effectively reversed its decline from April. Business demand is growing: the key risk remains limited inputs to production, notably labor.

The trade deficit for goods and services in April fell compared to March. The general trade environment remained intact: relatively strong demand for U.S. exports, fueled by international demand and a weaker dollar on the one side and relatively robust domestic demand for foreign imports, driven by fiscal stimulus, continued employment growth, and wage gains. Exports increased to a record high in April while imports fell slightly. If this trend persists in May and June it would modestly boost economic growth.

The labor market continued its strong performance. Weekly unemployment claims have held steady at low levels, keeping the four-week moving average (which smooths out random week-to-week volatility) near historically low levels.

This level of strength should keep the unemployment rate trending down, even
though it is already well below the Fed's estimation of the long-run normal level. 

Wages should also continue pushing upward. Such robust results across the economy reaffirm our view of an acceleration in economic growth during the second quarter. 

Trade risk looking worse, not better

The key short-term risk remains trade policy, which took a turn for the worse after last week's G7 meeting. The president further strained trade relations with many key trading partners. Although the announced measures remain relatively minor which will limit the impact on the economy, the chance of restrictions becoming more widespread is clearly rising.

An escalating trade war could undo much of the benefit of the fiscal
stimulus implemented by the administration over the last 6 months. 

These risks are rising at a time the economy is gaining momentum, clouding the outlook.

Look for a hike of 25 basis points

Against that economic backdrop, we see no reason why the Fed should not hike rates another 25 basis points at this week's meeting. The futures market is pricing in near certainty of such a hike. Although the Fed will surely take account of rising trade risks, the underlying fundamental trends in the economy remain strong enough. Unemployment continues to trend down, wage growth continues to slowly increase over time, and inflation is slowly but surely accelerating across a wide variety of measures. A 25 basis point hike will take the target Fed funds rate to a range of 175-200 basis points. With core inflation lurking near 2 percent, the era of borrowing at negative short-term interest rates is nearing its end.

We continue to forecast three rate hikes this year. But as we mentioned when the Fed last raised rates in March, the projection fell just one vote shy of the median forecast rising to four rate hikes this year. We expect little change to the Fed's statement and projections so the three-versus-four hikes question should remain in doubt. We do not anticipate any series changes to the Fed's forecast for the economy as the committee members continue to look to the data for cues on how to proceed. Although the trends in the underlying data (such as wage growth and inflation) remain slow but steady, chances of an acceleration are increasing input markets tighten. Risks to monetary policy have become more hawkish than dovish.

What it means for CRE

We remain firm in our position that individual rate hikes only have little to no impact on commercial real estate (CRE). The Fed has been tightening since December 2015 and the empirical evidence suggests that our view holds correct. But, our main concern remains the long-term impact that cumulative rate hikes will have on the economy and ultimately CRE. Even here, we are not primarily concerned about direct impacts through rising rates. We expect that yield curve to continue to flatten which means smaller movements at the long end of the curve and less direct impact on CRE lending rates. We continue to focus on the secondary impact of a slowing economy over time due to continued rate increases, particularly as the impact of fiscal stimulus fades over the next couple of years. The combination of higher rates and slowing economic growth would likely drag on CRE fundamentals which would reverberate throughout the CRE markets. But that scenario remains a more distant concern. 

What else are we watching this week?

Most eyes will be fixed on the Trump-Kim summit in Singapore, though that meeting should hold little direct consequence for the economy. More importantly, a slew of important economic events in addition to the Fed meeting will occur this week. Inflation, measured by the producer price index (PPI) and the consumer price index (CPI) for May should all show slow, but continued acceleration. We expect both the core and the headline readings for both indexes to tick up on a year-over-year basis. Import prices for May should also show an increase, largely due to rising energy prices. Similar to our stance on interest rates, our caution predominantly concerns the impact of cumulative acceleration over time rather than the impact of a sudden spike (though that can't be ruled out over the next couple of years). Retail sales for May, both headline and core, should show firm increases following healthy data from April. Preliminary consumer sentiment for June should nudge up slightly versus May's reading. All of these releases support our belief of stronger economic growth in the second quarter.

Thought of the week

Working mothers now have the highest birth rates in the U.S. This effectively places them in the position of leading businesses while driving population growth, a heavy burden.

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