The Business News Week In Review

It was a week you can't forget. The Fed raised rates and upped the ante for more, the European Central Bank shifted to tapering as it shuts down its bond-buying program, and the U.S. and China launched 25 percent tariff hikes on $100 billion of combined trade. And behind the headlines is a visible shift higher in underlying inflation, reflecting oil prices but also including emerging tariff pressures. Before turning to prices and the risk to the outlook, we'll update the biggest factor of all for the U.S. economy -- and that's a surprise upgrade for the consumer.

The economy

Wednesday's FOMC statement opened with the line that "recent data suggest that growth of household spending has picked up." This of course is very good news but it isn't at all what the Beige Book said, a report assembled by the Fed in preparation for the meeting. This report said consumer spending "was soft" in late April and early May. What are the "recent data" the Fed was referring to that has changed the outlook? Consumer spending in the personal income and outlays report, which was posted in late May, did rise strongly but this was lagging data for the month of April as a whole. The next set of spending data -- a very strong retail sales report for May -- was posted immediately after the FOMC meeting, on Thursday. Could it be that FOMC policy makers, as part of their deliberations, took a peak at the retail sales numbers a day early? In any case, the movement in just two weeks from a "soft" assessment to a "picked up" verdict highlights how immediate the focus is on economic data and how powerful the resulting conclusions for policy can be. The boilerplate Fed phrase "informed by incoming data" finds new justification. As seen in the graph, advance data on retail sales rose strongly in May, posting a 0.8 percent monthly gain to easily surpass Econoday's consensus range for the best showing since September which was skewed higher by post-hurricane vehicle demand. Retail sales, specifically durable and non-durable goods, make up about 1/3 of total consumer spending with spending on services, where advance data in contrast are very scarce, making up the other 2/3.

But the retail numbers do include some services, those directly related to merchandise sales. And they also include food services which are tracked in a separate component, labeled here as restaurant sales in the green line of the graph. The blue line tracks auto sales and together they make up nearly 1/3 of total retail sales, a chunk that offers a convincing view of discretionary demand. And "picking up" is definitely a good description with the 3-month averages moving together and pointing higher, currently just under 4.5 percent year-on-year growth for both. There are no flukes to the May retail sales report with strength appearing nearly throughout including strong bounce backs for both clothing stores and department stores. With 1.453 million jobs having been created so far this year, building strength for consumer spending should be no suprise.

The green columns of the graph are monthly percent change in total consumer spending, set next to the blue columns of the advance retail sales report. The two columns don't always move together but they often do and the strong indication from May retail sales may not only have lifted the FOMC's consumer assessment but it is also heating up expectations for second-quarter GDP.  The Atlanta Fed's forecast rose following the results and is approaching 5 percent at 4.8 percent. The last 5 percent result for GDP, and they are rare, was third-quarter 2014 which was just before that year's oil slump began to pull down the energy sector.

Looking back at that oil slump, when prices fell in half to $50, the argument could be made that it not only pulled down energy and related manufacturing but it also led to several years of overall disinflation from which the economy is only now beginning to emerge. Energy prices at the producer level jumped to a 4.6 percent annual rate in May and helped drive up overall producer prices (dark line in graph) to 3.1 percent, the highest rate in more than 6 years. West Texas Intermediate has backed off the $70 level over the past month but high oil prices, as underscored directly by Jerome Powell at his FOMC press conference, point to rising inflation rates through the summer, something which the Fed chair suspects will only be temporary. An outlook for steady $60 oil may be confirmed at OPEC's upcoming meeting on June 22 when production quotas, in a sign of stability and cooperation, are expected to be increased. Yet there's more going on than just oil. The core rate (light line in graph) is also at a 6-year high, at 2.5 percent and reflecting pressure from a new risk -- tariff wars. Prices for steel mill products surged a monthly 4.3 percent in May following a 3.2 percent gain in April. Prices for aluminum mill shapes came in at an even hotter 5.0 percent monthly gain that follows April's 1.8 percent climb. Gains in metals are at the intermediate level but may already be affecting the finished level where goods prices rose a sharp 1.0 percent in the month.

Oil is also the major factor on the import side of inflation, jumping 6.7 percent in May and driving import prices suddenly past 4 percent for yearly growth of 4.3 percent. Export prices, where oil also has an effect, are at 4.9 percent with these readings, like producer prices, at more than 6- year highs. Tariff effects are also evident here with prices of imported iron and steel up 1.5 percent in May following 3.7 and 2.6 percent gains in April and March. Aluminum import prices, also the subject of tariffs, jumped 5.1 percent in May.

What are showing fewer effects, however, are prices at the very end of the pipeline including finished goods in the import and export data where annual rates of growth are no better than 1 percent. Also showing limited pressure, but still tangible pressure, are consumer prices where the core rate for May rose 1 tenth to 2.2 percent to extend a shallow but clear trend higher as tracked by the graph's blue line. This index, because of methodological differences, runs several tenths above the FOMC's target PCE rate but the direction for the CPI points definitively to a similar climb for the core PCE, which in data for April was last at 1.8 percent. It's the immediate prospect that the core PCE will hit 2 percent that has put the FOMC on guard, as policy makers increasingly stress the symmetry of their inflation goal; implying that they will defend against a breakout over 2 percent with higher interest rates.

Are we approaching a flashpoint for inflation? Inflation expectations, a key reading for the psychology of inflation, are warming up but not dramatically. Yet year-ahead expectations at the consumer level, data that are part of the consumer sentiment report, are at a 3-year high of 2.9 percent and climbing. Expectations at the business level, as tracked by the Atlanta Fed, have been mixed but did hit a 7-year high of 2.3 percent when tariffs first hit in March. Both readings are trending at a parallel upward slope. Inflation expectations are cited directly in the first paragraph of each FOMC statement and a pivot higher would be the flashing red light that few in the stock market would want to see.

Boiling it down, monetary policy will turn on the play between the strength of demand, which has been good, and the available capacity in the labor market, which has been uncertain. Tax cuts and fiscal stimulus are positive wildcards for demand though an apparently increasing wildcard may be a negative, and that is a tariff war. Yet the short-term effects from tariffs are uncertain and could work to increase domestic production at the expense of imports. But maybe not. Prices for steel and aluminum are definitely up but not domestic production which, in details of the industrial production report, have fallen sharply the last two months. Manufacturing volumes, the blue line in the graph, came down in May, skewed lower by a fire at an auto supplier but showing a decline nevertheless when excluding autos. The green columns of the graph track goods exports in dollar terms which are just over $140 billion per month. Should tariff retaliation take hold and should exports begin to come down, the outlook for domestic manufacturing may not benefit.

Markets: The harrowing march of the 2-year yield

Of all the numbers in the economy and the markets, there's one of no greater significance for FOMC members than the spread between the 2-year and 10-year Treasury yields. When these two meet, that is when short rates are the same as long rates, recession is a predictable outcome. And the two yields are getting increasingly closer especially in the latest week which saw the spread narrow by 11 basis points to 35 points, at 2.57 percent for the 2-year and a gain of 9 basis points in the week, and to 2.92 percent for the 10-year and a decline of 2 basis points. The gain in the 2-year note tracks in apparent lockstep the gain in the FOMC's overnight policy rate and with the outlook for rate hikes having been increased at the week's FOMC meeting, from one left this year to two still to go, the outlook for the 2-year yield is pointing in only one direction, and that's up. For the 10-year, which is less affected by changes in the funds rate, the outlook is less certain. Rising government debt and the resulting need to increase Treasury issuance points to a dilution in demand and a higher 10-year yield though global uncertainties, especially the risk of a trade war, point to more demand and a lower yield. If these two yields meet in the weeks ahead, Jerome Powell, who has played it carefully on issues like tariffs and fiscal stimulus, could suddenly find himself in a white-hot battle test on the national stage.

Markets at a Glance	Year-End	Week Ended	Week Ended	Year-To-Date	Weekly
	2017	8-Jun-18	15-Jun-18	Change	Change
DJIA	24,719.22	25,316.53	25,000.48	1.1%	-1.2%
S&P 500	2,673.61	2,779.03	2,779.42	4.0%	0.0%
Nasdaq Composite	6,903.39	7,645.51	7,746.38	12.2%	1.3%
Crude Oil, WTI ($/barrel)	$60.15	$66.63	$64.66	7.5%	-3.0%
Gold (COMEX) ($/ounce)	$1,305.50	$1,302.70	$1,282.70	-1.7%	-1.5%
Fed Funds Target	1.25 to 1.50%	1.50 to 1.75%	1.75 to 2.00%	50 bp	25 bp
2-Year Treasury Yield	1.89%	2.48%	2.57%	68 bp	9 bp
10-Year Treasury Yield	2.41%	2.94%	2.92%	51 bp	−2 bp
Dollar Index	92.29	93.78	94.79	2.7%	1.1%

The bottom line

Price data below the consumer level are showing acceleration while indications at the consumer level are marching incrementally higher, both underscoring the FOMC's rate hike and increased forecast for rate hikes to come. This inflationary point is appearing at a time of rising uncertainty especially for trade and perhaps for the bond market as well. All this at a time when the two largest central banks in the world -- the Federal Reserve and the European Central Bank -- are looking less and less friendly.