HIGHLIGHTS OF THE WEEK
- Last week’s market sell-off came to a halt this week. U.S. equities staged a decent recovery, looking past January reports that pointed to higher-than-expected inflation and worse-than-expected retail sales.
- Price gains in the CPI report were broad-based, with core inflation rising by a hearty 0.3% m/m. Unfavorable base-year effects anchored the core pace at 1.8% in y/y terms, but this dynamic should turn more favorable in the months ahead.
- Despite a pullback in retail sales, Q1 consumer spending is still tracking a decent 2% (ann.). This pegs our tracking for Q1 GDP growth above 2%. Decent economic momentum and rising inflation bolster the case for a March hike.
Inflation Heats Up on Valentine’s Day
Last week’s equity and bond sell-off halted this week as risk sentiment made a comeback and volatility receded. The much-awaited Valentine’s Day reports failed to deliver as retail sales sharply disappointed while prices rose more than expected. The inflation report pushed Treasury yields higher, with the 10-year rising to a 4-year high. Inflation hedging benefited gold, but the trade-weighted US dollar pulled lower on strengthening global growth and expectation of higher U.S. deficits. Overall, the rebound in equities continued unperturbed (Chart 1).
After the wage-data inspired sell-off, it was encouraging to see that markets took the CPI report in stride. Headline CPI jumped a hefty 0.5% m/m in January (2.1% y/y), boosted by a sharp gain in energy prices. But it wasn’t all energy, with price gains broad-based. In fact, core inflation also rose by a robust 0.3% m/m. While base-year effects anchored the core pace at 1.8% in y/y terms, this dynamic should turn more favorable in the months ahead. In fact, even small monthly gains could take core CPI above target in the coming months. Ultimately, inflation should continue to firm, with this narrative reinforced by a robust gain of 0.4% in the January producer price index, along with a higher share of small businesses raising (and planning to raise) worker compensation (Chart 2).
Future wage gains will be essential in sustaining the momentum in consumer spending. This is particularly important after a disappointing couple of months. Retail sales not only declined by 0.3% in January, but December’s value was also revised down, wiping out the 0.4% advance estimate. Having said that, last month’s print was weighed down by autos and building materials – categories which may be retreating after receiving a boost in the aftermath of hurricanes Harvey and Irma. Coupled with good performance in the many discretionary spending categories, this indicates that the pullback is likely transitory. All told, the recent developments suggest that first quarter consumer spending is now tracking 2% (ann.) – providing slightly less support to growth than previously anticipated.
The boost from residential investment is also looking increasingly frail at the beginning of 2018. While housing starts picked up to just below their post-recession high in January, the concentration in lower value-added apartments and condos has reduced its overall GDP boost. Despite these developments, first quarter GDP is still tracking above 2% – a number that is enough to reduce economic slack. The consumer and housing sectors are likely to remain supported by a continually improving labor market, despite some headwinds ahead related to recent policy changes and rising rates. Housing should also benefit from tight inventories of existing homes for sale, with the near-term trend supported by permitting activity which reached a new post-recession high.
All in all, economic momentum remains decent and price pressures are rising – both themes that lend support for a March rate hike. Moreover, the risk that possible signs of ‘overheating’ may compel the Fed to step with a more rapid pace of hikes – a move that could stress vulnerabilities in sub-sectors of household and corporate credit (see report) – remains well in place.
Admir Kolaj, Economist
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