This Is Why The Fed's Next Move Is A Rate Hike

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by: Lawrence Fuller
Summary

Real wage growth is at an expansion-high and accelerating.

An increase in real consumer spending growth typically follows.

This portends an increase in the core rate of inflation that already stands at 2.2%.

The Fed will have to stem this increase with additional rate hikes.

Investors are obsessed with the Federal Reserve’s next policy move, and for good reason, since the stock market has become seemingly dependent on the monetary stimulus it has provided since the Great Recession. At the same time, the Fed has jumped to stem every meaningful decline in the stock market in what has become a clear co-dependency. Yet we must remember that the Fed’s dual mandate has nothing to do with the stock market. Instead, it is tasked with maximum employment and stable prices.

In his latest co-dependent act, Chairman Powell softened his hawkish tone last December following the 19% correction in the S&P 500 (SPY). Investors interpreted his comments to mean that there would be far fewer interest rate increases, if any at all, in 2019. Some are even conjecturing that the next move by the Fed will be to cut interest rates.

I am becoming increasingly convinced that the Fed’s next move will be to increase interest rates, because it will be forced to combat a rise in the rate of inflation to levels well above its 2% target.

Wage growth has been anemic during what will be the longest expansion on record by this summer, but it has started to pick up significantly over the past 12 months.

In the latest employment report, we learned that average hourly earnings increased 3.2% on a year-over-year basis in January 2019 to what is an expansion-high. This increase in wages is obviously due to tight labor market conditions and the low unemployment rate. What will put further upward pressure on wage growth are the new minimum wage requirements that are taking effect in 20 states and approximately two dozen cities, boosting pay for millions of workers.

The Consumer Price Index report, which was released on Wednesday, showed that the year-over-year increase in the rate of inflation was 1.6%. The rate has declined with the slide in crude oil prices from a high of more than $75 per barrel last October to a low of approximately $45 in December. The price has recovered to approximately $54. Yet the most valuable piece of data in this report, which receives virtually no attention, is the resulting change in real (inflation-adjusted) wages. Real average hourly earnings is the most effective single leading indicator of consumer spending, and consumer spending is what fuels our rate of economic growth.

Note at the very bottom of the table below that when we account for the rate of inflation and the increase in the length of the workweek, real average hourly earnings increased 2.4% in January on a year-over-year basis for production and non-supervisory employees. The year-over-year increase in January 2018 was just 0.3%. This is a huge increase in real earnings, and it looks to be on an upward trajectory.

I focus on real wage gains because the rate of economic growth is reported in real terms, and the largest contributor to that growth is real consumer spending. Changes in the rate of real average hourly earnings, which have historically fluctuated between -2% and +3%, lead changes in real consumer spending. Therefore, the increase in real wages over the past year suggests that we should see an increase in the rate of real consumer spending growth, which portends a further increase in the core rate of inflation.

The conundrum facing the Fed is that the core rate of inflation is already at 2.2% when its stated target is 2.0%. As recently as last October it was planning on raising short-term interest rates three more times this year and once in 2020. It has since catered to the whims of investors by leading them to believe that further rate hikes are off the table. Meanwhile, the seeds of inflationary pressures have taken root. I think that the next move by the Fed will be another rate increase, which will require it to break its co-dependency with the stock market.

In my next writing I will discuss the implications of this forecast, including another out-of-consensus call – rising long-term interest rates. I think the bond bull market has long ended.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Lawrence Fuller is the Managing Director of Fuller Asset Management, a Registered Investment Adviser. This post is for informational purposes only. There are risks involved with investing including loss of principal. Lawrence Fuller makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by him or Fuller Asset Management. There is no guarantee that the goals of the strategies discussed will be met. Information or opinions expressed may change without notice, and should not be considered recommendations to buy or sell any particular security.