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Fed faces difficult call on level of rates

Federal Open Market Committee Chair Janet Yellen made a West Coast swing recently to discuss the progress being made in the economy. She suggested that the economy is “close” to maximum employment and price stability, citing the long-held goals of roughly 4.75 percent unemployment and 2 percent inflation. She sees slow productivity and labor force growth, weak growth abroad, and the lingering headwinds from the recession as primary factors in holding down both GDP growth and interest rates over the medium term.

Yellen sees little inflation threat and believes the federal funds rate could be around 3 percent by the end of 2019. That doesn’t mean the expansion is ending, just that determining the appropriate level of interest rates going forward is “highly uncertain” given domestic productivity questions, global growth uncertainty and possible fiscal policy changes. It appears that moderate economic growth of 2 percent to 2.5 percent annually for the next several years remains the general consensus of the FOMC.

The consumer price index for December increased 0.3 percent, and was up 2.1 percent for the past 12 months. “Core” CPI rose 0.2 percent and was up 2.2 percent over the last year. Energy costs escalated in December as gasoline rose 3 percent and fuel oil jumped 6 percent. For the year, all energy rose 5.4 percent, as gasoline rose 9.1 percent, fuel oil was up 12.7 percent, and natural gas prices increased 7.8 percent. Offsetting the energy increases were food prices, which fell 0.2 percent for the year. Service items continued to have price increases for the total year as medical commodities jumped 4.7 percent, medical services rose 3.9 percent, transportation increased 2.8 percent, and shelter rose 3.6 percent.

Home sales chilled in December. Existing home sales fell to an annualized level of 5.49 million units, down 2.8 percent from November 2016 levels, and were only 0.7 percent above December 2015 sales. Prices were also subdued, with the median price of $232,200 being 0.9 percent below November prices, but 4 percent above December 2015 prices. It appeared that some purchases were pushed back into November to avoid interest rate increases.

New home sales had the same weak December, down 10.4 percent to an annualized rate of 536,000 units, which was also 0.4 percent below December 2015 levels. The median price of a new home in December was $322,500, up 4.3 percent from November 2016 and 7.8 percent above December 2015 prices. The trend looks better, as full-year sales for existing homes were up 3.8 percent over 2015, new home sales were 12.2 percent higher, and housing starts in December were 5.7 percent above year ago levels.

Business data remained mixed. Industrial production in December rose a healthy 0.8 percent, mostly due to a jump in utility usage. For the total year, utility usage rose 6.2 percent, manufacturing advanced a small 0.2 percent gain, but mining remained poor, losing 2.8 percent of its production levels. Capacity usage of utilities showed a good increase for the year, a small increase in mining and lagging manufacturing usage.

The durable goods report for December showed improvement over November but remained lackluster. New orders for all durable goods fell 0.4 percent in December. However, excluding transportation gave a 0.5 percent increase, and excluding defense purchases gave a healthy 1.7 percent increase. While autos and non-defense aircraft had modest gains, defense spending on aircraft and other capital goods plummeted.

The Fed’s Beige Book of economic conditions suggested the modest pace of growth continued toward year end, as manufacturing was stronger while energy industries were mixed. The respondents saw the labor market tightening, and some wage pressures were beginning to show. Inflation in prices, both retail and wholesale, appeared to be developing.

But the “clunker” of the week was the first report of fourth quarter GDP growth. Analyst expectations ranged from 2.2 percent to 2.8 percent growth. This first of three reports indicated economic growth of only 1.9 percent in the quarter, which would bring full-year growth below 2 percent and would certainly concern FOMC members. With the economy near full employment and inflation approaching 2 percent, this weak GDP report was exactly what Yellen was referring to when she suggested that the level of interest rates is highly uncertain. The report indicated slower service consumption by consumers, negative federal government spending and a huge drop in exports while imports climbed rapidly. On the positive side, fixed investment and inventories rose. Overall it was a mediocre—at best—report highlighting the problems of a strong dollar and vacillating consumers. I can only hope that the two revisions will show more strength.

Gregory MacKay is economic consultant to Canandaigua National Bank.

2/3/2017 (c) 2017 Rochester Business Journal. To obtain permission to reprint this article, call 585-546-8303 or email rbj@rbj.net.


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