Stable gasoline prices could bring headline inflation down very soon.
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By Robert Johnson, CFA | 03-18-17 | 05:00 AM | Email Article

It was a fascinating week as world markets reacted to the third U.S. Federal Reserve rate increase in less than 18 months. Emerging markets soared, gaining 3.9% in a single week, and Europe did about half as well, adding 2.3%. U.S. large-cap stocks pulled up the rear, with the S&P 500 adding just 0.25%.

Robert Johnson, CFA, is the director of economic analysis with Morningstar.

Even bonds did better than U.S. stocks this week, adding 0.5%. This is just about the opposite of what one might have expected. However, the markets had already priced in the news, apparently, as they often do.

The media focus this week was definitely the Fed rate, although it certainly wasn't news. The Fed short- and long-term forecasts were basically unchanged from its prior estimates that anticipated GDP growth rates to stay close to 2% as far as the eye can see. Inflation is also expected to remain close to 2% over the next three years, despite the fact that current data is running a bit higher.

Its expectations are clear: get the Fed Funds Rate to 3% or so by the end of 2018 from the current 0.88% rate with another 0.25% increase every three or four months. Being economic data-dependent, that nice stair-step pattern could be altered if the economy does better or worse than expected.

The increase accomplished a couple of key goals for the Fed. First, it built its credibility because it did what it has been saying it would do over the past month. Second, it will give the Fed a little economic firepower should the economy slow unexpectedly, as it is now three rate moves above the zero mark. Third, it demonstrated that the Fed is cognizant of the recent pickup in inflation. All and all, it was probably a good decision.

However, the economic data was not so great this week, with retail sales looking unusually weak in February, although we would like to think that is partially related to much slower tax refunds this year. Manufacturing and housing data were a bit hard to read, but month-to-month trends have been good in these two sectors for a while, and now even the year-to-year data is showing signs of life. Inflation also cooled a bit too, as month-to-month data has clearly peaked and even the year-over-year data should start moving down next week.

At this point I wouldn't read too much into any of the data being battered by violent weather changes, large seasonal factors in this slow time of the year, and last year's near-panicked first quarter that will continue to provide some easy comparisons.

That said, the mathematical calculation of the first-quarter GDP growth rate, using already available data, looks like its typical first-quarter disaster. GDPNow, the Atlanta Fed-based version of the calculation, shows first-quarter growth of just 0.9%, down from 1.9% in the fourth quarter. While a typical second-quarter bounce is likely in the works, it will make it harder to get to the 2.1% growth rate the Fed is anticipating in 2017.

Headline Inflation Backs off Its Peak: More to Come?
All in, inflation increased just 0.1% in February after increasing a spooky 0.6% in January. Gyrating gasoline prices did some of that, but I suspect the January data was overstated and February understated. Averaging the two months together produces a 0.33% rate that is similar but still a little higher than the rate of the last six months.

Month-to-Month Core Inflation Spike Rolled Back, Too
Core inflation (less food and energy) has shown a more stable pattern than headline inflation, although it showed a January spike and a return to normal in February. The fact that even this measure looks a bit strange suggests some type of temporary data distortion.

Headline Inflation Surpasses Core Inflation on a Year-Over-Year Basis
Energy prices have been suppressing headline inflation for some time. Now gasoline looks more expensive than it did a year ago, lifting total inflation above the core rate. We believe headline inflation is much more useful in assessing the impact of inflation on the all-important consumer.

Unless Wages Move Soon, Consumers Will Take It on the Chin
While there has been a lot of happy talk about higher wages, we note with some concern that headline inflation is not very far behind wage inflation. In fact, on a single-month basis, wage increases are about equal at 2.8% on a year-over-year basis. That is not great news for the consumer, who represents 70% or so of the U.S. economy.

Food and Energy Continue to Shift Roles in the CPI Calculation; Core Remarkably Stable
Over the past year, food inflation has dropped to 0% from 0.8%, helping to blunt at least a part of the big swing in energy prices. Goods are still in a deflationary mode, with autos now also in deflation mode. Services inflation, which is dominated by housing and healthcare, remains stuck at 3.1%.

In the past, high housing inflation has sucked up the inflation reading, as the supply of houses remained limited. However, we now believe housing will potentially keep a lid on further increases and prevent huge declines. Housing prices in general aren't moving up any faster, though they are still high. With affordability still a key issue and new supply coming on the market, we don't see housing inflation getting a lot worse.

Stable Gasoline Prices Could Bring Headline Inflation Down Very Soon
Wild swings in gasoline prices are still the dominant feature of the CPI calculation, even though they represent just 3% or so of consumer spending. You can see that excluding gasoline, inflation has been quite stable at 1.9%. Assuming that the core rate remains stable and gasoline remains at its current seasonally adjusted price, February could represent the 2017 high-water mark for headline inflation at 2.8%. In fact, the CPI could drop back to 2% by the end of the year, without higher gasoline prices or a crop failure.

Retail Sales Lose Some Ground in February on Slow Tax Refunds
Monthly sales data is acting oddly.

And category data confirms widespread issues:

Meanwhile, year-over-year data shows only modest changes in a tight range:

Manufacturing Industrial Production Winning Streak Extends to Six Months

And even year-over-year data is picking up:

But still, the category data is not that reassuring:

New-Orders Data, Without Further Improvement, Suggests Manufacturing Growth Could Hit 2%
That's a nice improvement from current levels.

Housing Data Continues to Bounce Around

And even the year-over-year data is open to some interpretation:

Builder Sentiment Shows a Slightly More Optimistic Picture

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