Inflation in the Wind

The US economic cycle is heating up and so is summer uncertainty. The Federal Reserve Bank (Fed) has been primarily focused on containing inflation, but now they may have to get ahead of it. Manufacturing and industrial data coming out of various Fed districts are all pointing to the same general theme. Manufacturers are facing increased costs for inputs and they are experiencing significant capacity constraints. The net effect will be higher prices for finished goods.

March’s tariffs on primary metals are believed to be one reason for rising input prices. As a result, durable goods sales have been on a steady decline since peaking last March when the tariffs on steel and aluminum went into place. On the flip-side, imports are now steadily declining since the tariffs. That has helped lower the consumer trade gap, which is seen as a positive for second-quarter output growth. However, a lot still rides on consumer spending trends, since consumption represents over two-thirds of US growth.

Unfortunately, the latest consumer spending report turned up another soft consumption figure, contrary to what the Fed was inclined to believe at their last FOMC meeting in June where they raised the key interest rate another twenty-five basis points. Additionally, construction spending has cooled despite data supporting more new housing starts. Home builders are said to be challenged by labor and equipment shortages as they encounter their own capacity constraints.

Second-quarter economic growth was expected to be rosy, possibly coming in between 3% to 5%. However, based on the latest data and economic frictions, consumption and residential expenditure may actually drag second-quarter growth below the most optimistic scenario. In fact, first-quarter was recently notched back down to 2% in June.

Rising oil prices and tariffs as well as a tight labor market are perpetuating several economic complications. Prices should only continue to gain momentum. The price of West Texas Intermediate oil has already surged 23% this year. Price acceleration recently showed up in the personal consumption expenditure (PCE) index, which is the Fed’s preferred inflation index.

"The Federal Reserve Bank has been primarily focused on containing inflation, but now they may have to get ahead of it."

The core PCE, which strips out food and energy prices, reached 2% in May’s report after two gradual increases in the prior two months’ reports. The 2% milestone is significant, because that is the Fed’s preferred benchmark for inflation in a healthy economy. Anything above and beyond 2% may show that the Fed was actually behind the policy curve for containing inflation. Adding back in the effects for food and energy reveals that prices on personal consumption have risen 2.3% in one year’s time.

Inflationary data is certainly starting to catch up to annual wage growth trends. Currently, average hourly earnings are growing at about a 2.5% annual rate. Should inflation catch wages and pass them, households could see their net-worth diminish. That would force labor market participants to ask for raises, which would increase the cost of business and cause some businesses to scale back.

Today’s US government bond rates certainly have something to say about the existing cycle. Two-year borrowing costs on government debt have risen steadily as one might expect in an environment of Fed tightening and rising prices. The two-year yield now trades around 2.5%. The ten-year yield on US debt, however, sunk back down from a mid-May high of 3.1% to about 2.85%. The difference between the ten-year and two-year yield has gotten narrower.

Government yields provide a window into short-term expectations versus long-term expectations. The short-yield communicates an expanding economy that may actually start to overutilize resources. Remember what the Fed manufacturing district reports are saying. Longer yields are indicating less robustness, hence, the flattening of the yield-curve.

Still, financial markets are hanging in there, especially the US stock market. US trade and international policy certainly appears to be helping US stocks at the detriment of international stocks. Tariffs may actually end up as a positive for US small business, which could be currently reflected in the existing performance of US small capitalization stocks.