First, The Pretty Good News
US economic data improved last week, with retail sales being the most notable example: April's numbers exceeded expectations, rising 1.3%. This, in turn, boosted the Atlanta Fed's estimate of second-quarter GDP growth to 2.8% from 2.2%. In addition, consumer sentiment made a significant jump, moving up to 95.8 from 89.0.
And yet, despite this positivity, stocks lost ground last week, and the yield on the 10-year Treasury fell to 1.70%. So, what else was moving the markets?
Now, The Not-So-Rosy News
Clearly, other data points released last week were less than positive. Signs of weakness emerged in employment, which has been a source of real strength for the economy for several years now: initial jobless claims jumped by 20,000 - far worse than expectations. In addition, the Labor Market Conditions Index contracted for the fourth consecutive month, although April's reading was a solid improvement over March. This is notable because, while the Labor Market Conditions Index is relatively obscure, it provides a holistic view of the health of the job market, and Federal Reserve Chair Janet Yellen and other FOMC members keep a close eye on it.
We're also getting mixed readings on inflation, as evidenced by several data points released last week:
- April's Producer Price Index only saw a tepid increase in prices, but that may not last long given higher oil prices and a lower dollar, which is driving up import prices.
- The NFIB Small Business Optimism Index suggests higher future wage growth: The "job openings hard to fill" metric posted a big gain, followed by the "plans to increase employment" metric. Don't forget that in the last jobs report, average hourly earnings showed a solid increase.
- The consumer sentiment reading showed a big drop in one-year inflation expectations on the part of consumers, although one month does not a trend make. We will eagerly watch Tuesday's Consumer Price Index release for signs of inflation, given our view that it will increase materially this year.
Which Forecast Shows Where the Fed Will Go?
With data going in different directions, it's tough to be a voting member of the data-dependent FOMC. Regional Fed banks even show significantly different projections for second-quarter GDP growth: in contrast to the Atlanta Fed's projection of 2.8%, the New York Fed's Nowcast Model of second-quarter GDP growth is just 1.2%. (Interestingly, the two banks also had very different estimates for the first quarter.) Depending on which model proves more predictive, the US economy could be either sputtering along or growing nicely, suggesting at least the possibility of two different policy prescriptions in the short term.
In the coming week, we'll also be privy to the FOMC minutes from the April meeting, which will be released on Wednesday. This may help us make some sense of the Fed's views, although the minutes are somewhat stale when compared with FOMC members' recent speeches. What will be particularly interesting to see is how much emphasis is placed on events outside the US. After all, there's a "Brexit" in the offing in June, and it may be important to the Fed.
The Fed Must Set Expectations
While the Fed might be confused about what to do given the mixed data, the market seems to think it can read the Fed's mind: as of Friday, Fed Funds futures showed only a 4% probability of a June rate hike.
Our view is that a June hike is more likely than the market expects it to be. This could set us up for a possible market disruption if the Fed raises rates in June and takes the markets by surprise. Alternatively, the Fed may decide not to act in June even though it believes conditions warrant it, because market participants don't expect a hike, and the Fed doesn't want to surprise them.
Clearly, as we've said before, if policymakers don't want to surprise the market, and a June rate hike really is on the table, Fed officials need to become more vocal about that possibility.
San Francisco Fed President John Williams certainly helped the cause when he said in an interview last Friday that two or three rate hikes in 2016 make sense, given the strength of the US economy.
However, more FOMC officials will need to speak up as well - and they'll need to be more explicit about their intentions. When it comes to monetary policy, it's difficult to speak softly and then use a big stick.