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The economy’s forward momentum slowed sharply in the first quarter and raised questions about the underlying strength of the U.S. expansion. In particular, bullish employment data were not consistent with modest gains in consumer spending. These doubts have been put to rest, for the most part, as incoming data suggest that the weakness of the first quarter is beginning to fade.
Solid employment numbers, impressive auto sales and strong non-auto retail sales are a few examples of improving economic conditions. A reduction in inventories and a drop in oil industry investment spending are likely to trim real gross domestic product (GDP) growth somewhat in the second quarter, but business momentum in the second half of the year should continue at a decent clip.
Key Economic Indicators
Key Elements of Forecast:
- Real consumer spending was flat in April, reflecting a reduction in goods outlays and an increase in service expenditures. The April-May non-auto retail sales data, combined with strong auto sales, point to much stronger growth in real consumer spending than the 1.8% increase in the first quarter.
- Home sales (existing and new) and housing starts advanced following a lull in the winter months. Earlier in the year, Fannie Mae and Freddie Mac decided to purchase mortgages with loan-to-value ratios of up to 97%, and the Federal Housing Authority reduced mortgage insurance premiums; both of these steps bode positively for the housing market. These easier financing terms and improving labor market conditions support expectations of a positive contribution from residential investment spending going forward.
- Shipments of non-defense capital goods (the input for capital spending in the GDP report) rose in April and set a positive tone for the second quarter. The lingering impact of oil-related investment declines will partially offset positive contributions from other components of investment spending in the second quarter. The oil price recovery is predicted to enable a reversal of this trend in the second half of the year.
- The 280,000 increase in payrolls during May, low weekly jobless claims, the jump in job openings and early signs of wage pressures suggest that full employment is within reach. Wage gains should accelerate through the remainder of 2015 as labor market slack shrinks further.
- The Federal Open Market Committee’s (FOMC) meeting next week is widely expected to end without any change in policy. The full employment mandate is within reach, but inflation data continue to come in short of the 2.0% target.
There are essentially two camps in the Fed – one that is willing to raise the policy rate based on expectations and the other that would prefer to wait until higher inflation data are printed. The dollar rally has weakened considerably (import prices excluding fuel held steady in May), and rental costs are moving up. These developments raise expectations of higher inflation down the road. The Fed’s view on this subject will be available when its new forecasts are published next week.
- The port strike held back exports in the first quarter and led to an artificial widening of the trade deficit. A smaller trade deficit in the second quarter is nearly certain, as the strike has been resolved. Looking ahead, the nearly 10% year-to-year increase in the trade-weighted dollar will cast a shadow on export growth in the near term due to lags, while imports should continue to advance, given the strengthening of the U.S. economy.
- The 10-year U.S. Treasury note is now trading at 2.45%, reflecting the impact of a string of bullish economic reports – payrolls, auto sales, non-auto retail sales, construction spending and an increase in job openings. Projections of U.S. economic growth suggest that modestly higher bond yields should follow.
- Headwinds from China remain on the radar screen. Growth there is decelerating, and debt is increasing. The threat of deflation in the eurozone has been reduced, and growth in the region has improved. But solutions for Greece’s economic woes remain elusive, leaving the potential for a tail event.
- The probability of a rate hike at the September FOMC meeting has risen following the nature of recent data that show acceleration in both wage and core inflation. Markets are awaiting Fed Chair Janet Yellen’s press conference next week for hints about near-term monetary policy.