Economic Insights: Playing the bounce
When economic growth is better than expected, what happens to inflation, and is a recession still a possibility?
Tepid inflation likely keeps the Fed from raising rates further.
The U.S. economy gained momentum as the first quarter unfolded. While we still expect somewhat muted growth in the first three months of the year, the outlook is not as bleak as we expected. Over time, confidence has returned, and economic activity has increased, reflected most prominently in the retail sales data. Retail sales sagged during the holiday season as shoppers fretted about the federal government shutdown and the correction in the equity market. That loss of momentum rolled into the new year through February, which saw retail sales decline on a month-to-month basis. But by March, with the shutdown over and the equity market swinging up again, consumers opened their wallets and retail sales — both headline and core, exceeded expectations. In addition, the most recent inventory data and international trade data indicate rebounding growth in the first quarter. The trade data, of course, reflects a reacceleration in economic growth around the world. This has helped to alleviate recession fears, which surged in March after the yield curve briefly inverted. The improving economic outlook has pushed up yields at the long end of the curve.
Inflation (and interest rates) going nowhere
Yet none of this looks likely to rekindle inflation, at least not in the short run. No shortage of suspects for tepid inflation exists, but no clear culprit has emerged. Globalization, technology, and limited inflation expectations have all played a role in this mystery. A long-term decline in the labor share of income has also contributed. And in recent periods, rising productivity growth likely limited the ability of rising wages to filter through to inflation. That puts the Fed in a position where it will probably not take much, if any, action. Tepid inflation likely keeps the Fed from raising rates further. Meanwhile an improvement also keeps them from cutting rates. Therefore, we anticipate little movement at the short end of the yield curve. At the long end, any volatility will come from changing investor sentiment — an outcome quite difficult to predict.
What it means for CRE
A key facet of the current economic expansion concerns asset price inflation in the absence of meaningful general price inflation. Many have argued that the inflation that would have otherwise gone into the general price level in the economy has simply gone into asset price levels. That assumes a unique divergence that has not previously occurred, possibly due to incredibly low interest rates during the current cycle. But a look at the historical relationship between asset returns and core inflation shows an inconsistent relationship between the two series. When we examine asset price inflation, measured by the appreciation return in NCREIF’s office index, and inflation, measured by the core personal consumption expenditures (PCE) index, we see that the two series behave differently together from cycle to cycle. During the 1990s following the Savings and Loan Crisis, core PCE decelerated significantly while office appreciation returns accelerated meaningfully. The two series correlate very negatively during this period. During the 2000s following the dot-com implosion office appreciation returns and core inflation correlate better, with a relatively strong positive relationship. During the current cycle the correlation scores positive again, but only slightly weaker than during the 2000s. We are not saying that one explicitly influences the other (correlation is not causation) nor are we saying that one should necessarily influence the other (although that’s possible). We are simply saying that an examination of the historical data shows an inconsistent relationship between asset inflation/appreciation and overall price inflation and that the current environment does not strike us as very unusual.
But what about the argument concerning very low rates? That needs to be taken in context. During the first half of the 1990s the Fed cut rates by roughly 500 basis points to stimulate the economy. During the early 2000s the Fed also cut rates by roughly 500 basis points. During the current cycle? Again, the Fed cut rates by roughly 500 basis points. Yes, the terminal levels differed, but this is reflected in asset returns as well. Whatever is going on with tepid inflation, it seems more involved than just a shunting of it into asset prices. Yet it appears by keeping rates low to perpetuate the current economic cycle the Fed is willing to risk another asset bubble, like the previous two cycles which experienced significant asset bubbles. That could ultimately make the next downturn more severe, with a greater pullback in asset prices, than would otherwise occur. Several members of the Fed have noted this risk.
What we are watching this week
This week, we will get our first look at first quarter GDP growth, which we expect to land in the low two percent range. Existing home sales for March appear set to decline while new home sales should surprise on the upside. Both have recently trended upward, so this looks more like a blip than a problem. We expect durable goods orders to increase in March following a decline in February. Finally, we expect the final reading on consumer sentiment for April to edge slightly higher with consumers moving past the short-term disruptions earlier in the year.
Thought of the week
Labor’s share of income has fallen from roughly 62 percent in the 1990s, bottoming around 56 percent in 2013, before rising slightly to roughly 57 percent in 2018. Despite fluctuations, the trend is downward over time.