Rising Wages, Rising Personal Spending, Still Expect The Fed To Cut Interest Rates

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by: Tim Worstall
Summary

A tight labour market is leading to rising wages, as we would expect.

Personal expenditure is rising along with incomes, as we would expect.

However, inflation is well below target so expect the Federal Reserve to loosen rates perhaps twice again this year.

What We're Trying To Achieve In The Macroeconomy

We want wages to be high and rising, obviously, because that means that the people are getting richer. This being the point of having an economy, to make the people richer. However, we also want to limit future inflation, as that makes people poorer again. Thus, our threading of the needle - as much growth as we can get without triggering inflation.

We want therefore personal incomes to be rising, which also means that positive feedback loop of personal spending rising again boosting the economy. But our limitation in allowing this to roll along is that we don't want to set off inflation. As long as that stays low then we can indeed roll along - the Federal Reserve doesn't need to slow things down by raising interest rates.

Further, if it's not happening fast enough then the Fed can lower rates to boost it.

The Old Joke About Central Bankers

The old saying is that it's the central bankers' job to take away the punchbowl just as the party's getting going. Meaning that, just as we're getting significant growth, they should be cooling the economy with interest rate rises.

The part that isn't in the old saying is that when we've not got inflation then they should be spiking the punch with lower rates, which is where the general consensus is that we're at now.

Personal Incomes

Talking about personal incomes going up by 0.1% doesn't sound like very much. None of us are going to be greatly excited by a 0.1% pay rise. But for the economy as a whole, that's pretty good going. For if and as that happens every month, in real terms, then incomes do their trick of doubling every generation, which is what is happening:

Personal income increased $23.9 billion (0.1 percent) in July according to estimates released today by the Bureau of Economic Analysis. Disposable personal income (DPI) increased $44.4 billion (0.3 percent)

Personal income (US personal income from Moody's Analytics)

Note that this is nominal incomes but over time this is higher than inflation.

So, a tight labour market is, as it should raising wages and incomes.

Personal Spending

We would assume that if incomes are rising then spending will as well. As it is. There is one possible confounding factor which is that people save all - or possibly more than all - of their higher incomes. This isn't happening, in fact, the savings rate is going down ever so slightly:

Real consumer spending (PCE), spending adjusted for price changes, increased 0.4 percent in July after increasing 0.2 percent in June. Spending on durable goods increased 1.1 percent in July after showing no change in June.

And:

The personal savings rate slipped from 8% in June to 7.7% in July.

personal expenditure (Personal Expenditure for the US from Moody's Analytics)

So, we've that good feedback loop. People are earning more, they're spending their new earnings plus a bit, this employs more other people who earn more and - we get that desired economic growth. This is the whole point of having an economy, good.

Inflation

This all has to be brought crashing to a halt when inflation rears its ugly head. Basically, and this isn't quite what's in the economics textbooks, when we run out of stuff to make stuff from - no more labour to be had, the existing factories can't produce enough supplies to then convert to what people want - then further demand doesn't show up as growth, we just get rising prices, inflation.

So, we're always on the lookout for that to happen, which is when the Fed raises interest rates to cool off that economy and that rising spiral of higher wages and spending. We're not there yet:

PCE prices increased 0.2 percent in July after increasing 0.1 percent in June. Excluding food and energy, PCE prices increased 0.2 percent in July, the same increase as in June.

There are a number of different inflation rates we can use. CPI (even urban CPI, rural CPI) RPI and so on. The right one to be using in this instance is PCE, personal consumption expenditure. Because we want to talk about the inflation rate being faced by people spending their own money.

Oh, also, this is the one the Fed says that it uses to set its inflation target.

The headline PCE deflator increased 0.2% in July after rising 0.1% in each of the prior two months. The July report includes the revisions to the PCE deflator, but they are consistent with those already released with the government’s second estimate of second quarter GDP.

Now, the actual one we've got to worry about is core PCE, as that's the Fed's real target. That's the normal PCE without food and energy.

PCE (PCE inflation from Moody's Analytics)

The Fed's target for core PCE is 2%. We're at 1.6% over the year and have been for some time. We've been below target for a long time too.

My View

I've been saying for some time now that the American economy is doing just fine domestically. It's only that fuss Donald Trump is making about trade that's even thinking about being a problem. There's nothing here to change that opinion.

The one slight change is that I used to think there wouldn't be any more interest rate cuts. I thought inflation would tick up closer to target and thus monetary policy would be held stable. Inflation isn't ticking up therefore we can expect some more monetary loosening.

The Investor View

Contrary to what we all thought a couple of months back, we can expect further interest rate and monetary loosening this year. As Moody's Analytics says:

U.S. inflation has firmed a little, but it won’t deter the Fed from cutting rates in September and December. The bigger concern for the Fed is the downside risks to the economy from the trade tensions between the U.S. and China.

That seems about right. It's not that we "must" get inflation up to target, it's that the absence of the expected inflation means we can allow the economy to run a little hotter for a little longer.

Interest rate reductions to come.

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.