Pity the poor Federal Reserve. In making decisions about interest rates–in this case about whether or not to raise interest rates at its June, July or September meetings–it has to consider the condition of both the real economy and the financial markets.
And right now the two realms are sending out different signals.
The real economy seems to be in good shape, the disappointing 38,000 increase in jobs in May not withstanding. The financial markets not so much so.
You figure out how the Fed is going to split the difference.
In the real economy today’s report from the Commerce Department showed that retail sales in May grew by a better than forecast 0.5%, after a 1.3% increase in April. (The April gain was the biggest in a year.) The means retail sales have now posted their best back-to-back monthly gains in two years. Wall Street analysts have moved today to increase their estimates for annualized growth in household spending to 3.7% from 3.4% (Barclays), and 3.6% from 3.2% (Credit Suisse.) Household spending grew by just an annualized 1.9% in the first quarter.
Absent a surge in job growth, the big increase in retail sales and household spending is coming from wage growth. The economy may not have created many jobs in May, but companies aren’t laying off many people either and they’re paying more to keep their current workers on board.
The Federal Reserve Bank of Atlanta’s wage growth tracker shows wage growth accelerating since October 2015 to a pace not seen since January 2009. The median U.S. worker saw a 3.5% year over year pay increase as of May. That is another indicator that the U.S. economy may be nearing full employment. Anecdotal evidence from individual companies is that finding quality employees is a getting harder with the NFIB Small Business Optimism report for May putting the share of owners unable to fill a job opening at historically high levels.
On the other hand, financial markets struggling. U.S. stocks have pulled back (as expected) from an attempt to set an all time high on the Standard & Poor’s above 2135. More worryingly, the spread between the yield on 10-year U.S. Treasury notes and two-year notes is the narrowest since 2007. Such flattening of the yield curve can signal an impending recession. Deutsche Bank analyst Steven Zeng, for example, now puts the odds of a U.S. recession at 55% within the next 12 months. If that’s a real possibility, the last thing the Federal Reserve would want to do is potentially accelerate the arrival of a recession by raising interest rates. I think there are good reasons to think that the bond market signal is wrong. The big moves along the yield curve are also responding to changes in demand for different maturities of Treasuries because of new financial regulations and worries over the Brexit vote in the United Kingdom on leaving/staying in the European Union. Money is sloshing around seeking safety in a world with major financial uncertainties.
That’s my sense of the signs at the moment. The situation is very fluid. Uncertainty is high. And that in itself is likely to lead the Federal Reserve to wait before making any decision. The Fed’s next rate setting meeting is scheduled for Wednesday June 15.