Look for a tug of-war between those worried about disinflation and those hoping to taper as we move into summer. The Fed is also trying to juggle the out-sized role it is playing in the purchases of both Treasury bonds and MBS, especially as the federal deficit is now declining. (The Treasury is not going to have to issue as much debt as was previously forecast, which in and of itself could justify some tapering by the Fed.)
Our forecast that the Fed begins to taper in September holds. It is critical to remember that tapering will be gradual, barring a major surge in economic growth, and that the Fed’s policy remains extremely accommodative. The bond market appears to be overreacting to prospects for growth and inflation. Indeed, if the Fed’s forecast for inflation is realized, lower bond yields may be justified.

With regard to normalizing policy, Federal Reserve Chairman Ben Bernanke emphasized that the Fed is not about to stop stimulating the economy, particularly the housing market. The Committee has decided that the Fed will NOT sell MBS when it starts to normalize monetary policy.  This is an admission by the Fed that ongoing support for the mortgage market is critical for the recovery to become more self-sustaining. It also underscores how long the Fed’s balance sheet will remain elevated (years, not quarters), and that even after the Fed starts to raise interest rates (not until 2015 according to the current forecast), it will be a gradual, even glacial process.

Bernanke emphasized that the Fed could taper later this year and gradually reduce its purchases into mid-2014. He clarified that the FOMC would like to see the unemployment rate come down to 7% before it stops its asset purchase program. He also emphasized that the Fed could alter its decision by increasing or reducing its purchases as economic conditions evolve.

Bottom Line: The FOMC remains highly accommodative and will remain so for some time to come. Policy shifts will remain data-driven; nothing is predetermined.

The one notable exception was a 0.3% increase in shelter costs; rents have been rising in response to short supply. The problem is earnings, which can’t continue to support rapid rent increases. Average hourly earnings dropped 0.2% in May, after adjusting for inflation.

Separately, housing starts rebounded to a 914,000 unit rate in May, which was a bit of a disappointment given the sharp decline in April. Building permits continued to outpace starts by a substantial margin, which along with optimism among builders, suggests that unusually wet weather was a bigger factor holding back construction activity than demand was. Look for some catch-up in activity over the summer, particularly in the single-family home market.

Bottom Line: Inflation remains tepid, wages constrained and housing continues to heal but unevenly. The Federal Reserve will stand behind quantitative easing when it releases its statement tomorrow and reassure markets it is not going anywhere anytime soon. Fed Chairman Ben Bernanke is likely to spend some time underscoring the risks associated with fiscal drag; spending cuts from sequestration are starting to bite, which is forcing the Fed’s hand on stimulus.

Bernanke will also have to waste a lot of time talking about on his tenure at the Fed, after President Barack Obama confirmed what we already knew; Bernanke will  leave when his tenure expires in January. The question is who will replace him; the best bet is Janet Yellen.

Capacity utilization, which is a factor in determining inflation, edged down slightly to 77.6%. Capacity utilization has remained below the long-term average since the onset of the Great Recession. This is despite widespread plant closures and efforts by industry to match production capacity to underlying demand.

Bottom Line: The recovery remains uneven and has lost some steam since the start of the year. We will weather the slowdown, but not without additional help from the Federal Reserve. We are past the point of possibly stalling out but continue to hit speed bumps, which can have long-term consequences, especially for the ranks of the long-term unemployed.

The deceleration in underlying inflation is something that the Fed is watching extremely closely. Deflation is exponentially worse for overall economic performance than accelerating prices, as people and firms wait for prices to fall before they pull the trigger and buy and/or produce.

Bottom Line: Overall inflation remains tame, despite the volatility in energy prices. Moreover, producers are complaining that they have been unable to pass any increases in energy or food prices along to consumers. Food producer margins are getting squeezed. The result is an inflation rate that falls short of a healthy buffer zone for the overall economy. The Fed will not only continue to expand its balance sheet at the current $85 billion per month pace next week; its statement after the meeting will make clear that current policy will continue until both inflation and labor markets show more reassuring signs of firming.

Separately, import and export prices both dropped. Declines were fairly broad-based from finished goods to agricultural prices. That suggests that inflation remains more than well-contained, something that may become a concern for the Fed if labor markets don’t show more substantive gains over the next several months. (Deflation, or falling prices, could cause businesses and consumers to delay purchasing decisions and slow the economy.)

Jobless claims continued to trend lower, which suggests that job cuts are still abating. We are still waiting for hiring to pick up. A slowdown in firing, however, has clearly given some people more confidence in the workplace; the number of people willing to voluntarily leave their jobs actually picked up last month.

Bottom Line: The consumer remains a bright spot in the economy, largely reflecting moderate job gains since the start of the year and the ongoing rise in home prices. Refinancing and new mortgage applications picked up last week; both are critical to getting us through the summer headwinds of sequestration (automatic, across-the-board budget cuts). The Federal Reserve will remain fully engaged in easing next week. Financial markets have gotten way ahead of the Fed in terms of an exit strategy for its large scale asset purchases.

Gains in employment were concentrated in low-wage professions in the retail, restaurant, bars, food preparation industries and amusement and gambling. Much of the increase we saw, however, followed downward revisions to the previous month. The upward trend in healthcare continued, mostly in the ambulatory area. Hospitals are not hiring, which again could reflect a squeeze from sequestration as many hospital CEOs are worried about the 2% cuts in Medicare reimbursements they will feel later in the year. (It takes up to six months for reimbursement to be paid by the government; sequestration started on March 1.) Finally, temporary employment continued its upward march. Employers have yet to pull the trigger on converting that contingent labor force into full-time hires.

Construction employment increased by only 7,000 jobs but also got an upward boost from the revisions for March and April. The bulk of the gains was outside of the residential sector and remains tepid, given the role the rebound in the housing market should be playing in the economy today.

The average workweek was essentially unchanged, along with average weekly earnings. Weekly earnings are up a tepid 2% from a year ago.

Separately, the unemployment rate ticked up slightly to 7.6%, but this month the increase was for the right reason. The labor force jumped by more than 400,000, as more people decided to throw their hats in the ring and look for work; also, the number of people willing to leave their jobs picked up, which indicates some confidence in the labor market. The data is seasonally adjusted, so it does reflect a move by new job entrants. The seasonally-adjusted teenage participation rate for the month jumped from 33.8% to 35%, which means teens are more hopeful about getting jobs, but not necessarily finding them. The unemployment rate for teens moved up from 24.1% to 24.5%.

Bottom Line: Employment growth has moderated since the turn of the year and is likely to moderate further as we move into the summer months. Moreover, the weakness looks broader-based than the sequester alone would account for, especially when it comes to the composition of job gains. Concerns about the Federal Reserve tapering its asset purchases are overblown because the economy has hit yet another speed bump.

Construction employment was up slightly, but nowhere near the pace seen earlier in the year. Indeed, the moderation was fairly broad-based and follows other trends in manufacturing, consumer spending and construction activity.

We have also seen a slowdown recently in small business hiring relative to large business hiring. This could be worrisome if it reflects a slowdown in new business formation, which the government’s “official” report on payroll employment has a hard time capturing in the initial cut of the data. (New businesses are more prone to use payroll services than older, family-run small businesses.)

Bottom Line: Our forecast holds for 140,000 total payroll employment gains and 150,000 private payrolls in the Friday release of May’s employment report. This marks a sharp moderation from the 200,000+ job formation we saw in late 2012 and the first quarter of 2013 and suggests that we are still a long way from the Federal Reserve tapering.

Residential investment moderated on a slowdown in remodeling activity. Single- and multi-family home construction remained on an upswing. Moreover, a jump in building permits in April suggests that housing will remain a much needed bright spot for construction.

Separately, the Institute for Supply Managers (ISM) manufacturing index dropped to 49.0 in May from 50.7 in April. Anything below 50 marks a contraction in manufacturing activity; this was the weakest we have seen the index since Superstorm Sandy disrupted manufacturing activity last fall. Both production and orders dropped, which suggests additional weakness in June. Industries related to housing held up in April, while those tied to the aircraft and computer industries posted declines.  Everything, from weakness in Europe and China to a drop in government contracts, was blamed for the weakness.

Bottom Line: Growth has moderated since the start of the year. The weakness is mainly concentrated in the public sector, which is influenced by sequestration (mandatory, across-the-board spending cuts), but losses are more broad-based than the sequester alone would account for. This will keep the Federal Reserve firmly committed to easing in June. We are still expecting the Fed to taper in October. It is worth noting that this third round of quantitative easing, QE3,  has just surpassed QE2 in size and could easily exceed QE1, when the Fed committed to $1.2 trillion in mortgage-backed securities (MBS) and Treasury purchases to jump-start the stalled mortgage market in 2009.

We also saw spending on utilities abate as the weather returned to more “normal” conditions in April. Spending on services declined. The bright spot in the spending report was big ticket durable goods, which jumped 0.7% after adjusting for inflation. That reflects pent-up demand for vehicle sales and healing in the housing market.

Disposable personal incomes declined 0.2% in April, but rose 0.1% after adjusting for the decline in price levels. The nominal declines were concentrated in a drop in farm income and transfer payments, most of which were social security payments. Wages and service-sector payrolls expanded, but at a slower pace than in March.

This month’s report included benchmark revisions from October through March, which revealed more spending and income than was previously reported. Both spending and income were revised up for the previous six months. Much of that increase in income was due to hedging by wealthy households ahead of tax hikes in 2013; bonuses and dividend income were particularly strong in the fourth quarter of 2012.

Bottom Line: The data on spending and income were not as bad as some expected, when taking into account revisions and inflation shifts. We will need that resilience this summer when the full effects of sequestration (mandatory, across-the-board cuts in government spending) emerge. Most government agencies didn’t prepare for the cuts and delayed acting. The irony is that those delays have fed complacency in Congress.

Across-the-board cuts from sequestration reduce the near-term deficit but do not deal with the future pressures on the deficit from demographics. The falling deficit currently reduces any pressure for an budget deal in Congress: a lost opportunity.

Consumer spending was revised up in the first quarter, showing positive effects of home prices and mortgage refinancing. Investment was still disturbingly weak; this is a long-term worry about the foundation for future growth.

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