Economic Insights: Trying to complete the puzzle

The labor market hasn’t been this strong in half a century, yet inflation continues to be held at bay, which is a conundrum for the Fed

May 08, 2019

The unemployment rate fell to 3.6 percent, the lowest level in half a century.

Fitting the pieces of the economic puzzle together always proves challenging. Last week’s pieces show a dynamic in the economy we rarely see — a continued downtrend in unemployment with the Fed on hold. First, the labor market — employment gains exceeded expectations, registering a strong result of 263,000 net new jobs. So far this year, job gains have averaged slightly below last year’s pace. The unemployment rate fell to 3.6 percent, the lowest level in half a century. Although a declining labor force participation rate propelled the recent drop in the unemployment rate, unemployment is clearly trending downward. In addition, wage gains on a year-over-year basis held steady at 3.2 percent, down slightly from the cyclical high of 3.4 percent in February. Wage growth is accelerating over time as labor scarcity, coupled with increasing demand, forces employers to pay more for workers. If the labor market remains tight, as we expect, wage growth should nudge even higher.

While wages are climbing, inflation is ticking downward. Although that appears to run counter to an economy that continues to grow above trend, temporary factors seem to be distorting the data in recent periods. Chairman Powell referenced these factors in his comments last week, implying that the Fed expects inflation to push past these factors and reaccelerate. His comments sent the markets into a bit of a tizzy because markets anticipated a rate cut this year. We are not sure why markets believed the Fed would cut rates — wishful thinking perhaps? Clearly the markets do not read our weeklies because if they did, they would know our forecast: that while tame inflation stays the Fed’s hand on raising rates, underlying strength in the economy and labor market will keep the Fed from cutting. Consequently, the Fed should still hold steady for the rest of the year barring some idiosyncratic shock. The Fed seems like it is willing to let inflation run above its two percent target if inflation can actually get there. We have noted in recently weeklies that inflation depends upon several factors working together in complex ways.

And therein lies the unusual circumstance that we now face. The Fed sees the risk that once we move past transitory factors inflation could move higher, especially with continued tightness in the labor market. But in the absence of inflation accelerating the Fed does not feel compelled to move rates, even with unemployment still trending downward. Fed officials keep using the expression “data dependent” to describe their current positioning on rates. Yet this current pause comes after years of the Fed leaving rates near zero while unemployment fell and the economy expanded.  

Despite the upside surprise in first quarter GDP growth, the economy is slowing as the impact from fiscal stimulus fades.

Some pieces portend trouble

With the economy growing, labor market humming along, and the Fed on hold for now, it might seem as if things are settling into equilibrium. But some of the pieces portend trouble ahead. Despite the upside surprise in first quarter GDP growth, the economy is slowing as the impact from fiscal stimulus fades. Additionally, both the ISM Manufacturing and Nonmanufacturing indexes for April decline. Manufacturing hit its lowest level since October 2016 and likely reflects the manufacturing weakness observed globally. We caution against complacency in the current environment, although we do not foresee a recession in 2019.

What we are watching this week

This week we are keeping an eye on inflation for any signs of moving past any transitory factors that have softened inflation in recent periods. For the producer price index (PPI) we expect the headline reading to pick up slightly while the core reading slows a bit. For the consumer price index (CPI) we expect both the headline and core reading to accelerate on a year-over-year basis.

What it means for CRE

For commercial real estate (CRE) the macro trends still bode well. Even with underlying economic growth losing momentum, economic indicators still look healthy, particularly in the labor market. With rates on hold for now, the pause gives the market time to make decisions without the potential for a Fed move on rates forcing anyone’s hand. That could theoretically help market participants make more patient decisions than they could in an environment where the treat of a rate hike dangled over the market. CRE valuations will become increasingly important over time. During cycles when rates stay low for a prolonged period, bubbles (across asset classes) tend to emerge. Clearly, valuations have risen markedly during the current economic expansion. We do not yet see signs of a bubble per se, but cap rates across markets, especially primary gateway markets, remain near historically low levels. Can the Fed engineer slower growth without engendering an asset bubble? Usually, it cannot. We will be watching this closely while the Fed remains on hold.

Thought of the week

Every dollar borrowed by a government is a dollar of future tax that will be levied, not including interest charges.

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