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The U.S. economy at midyear: Little evidence of climbing inflation

First-quarter gross domestic product growth stumbled from a reasonable 2.1 percent gain in the fourth quarter of 2016 to a mediocre gain of 1.4 percent. While less than impressive, that gain was revised upward twice from its earliest abysmal reading of 0.7 percent. Both consumers and businesses grew more cautious in the first quarter and recorded only small spending gains. Inflation seemed to be returning in the first quarter, as the Personal Consumption Expenditure Index rose 2.4 percent from fourth-quarter levels, and the core PCE, which excludes food and energy, rose 2 percent from the last quarter of 2016. Sensing rising inflation and seeing the unemployment rate dropping steadily, the Federal Open Market Committee raised the federal funds rate by 0.25 percent in both December and March.

The second quarter showed some improvement, while still dealing with some issues.

Consumer spending rebounded from a terrible January, which saw a decline of 0.3 percent, and a flat February. Personal consumption expenditures rose modestly in April and May. Total retail sales from the January to May period were up a healthy 3.9 percent over the same 2016 period, with some recent weakness in auto sales being offset by strong growth in building materials and non-store retailers.

Existing home sales have been hampered for some time by lack of inventory, but these low levels have pushed up the median sales price by 5.8 percent in the past year, while holding one year sales growth to 2.7 percent. New home sales have been road-blocked by lack of land, lack of materials and tougher credit standards. Yet sales in May of new homes were 8.9 percent higher than one year ago, and the median price was up a whopping 16.8 percent. First-time buyers are returning to the market, and builders have taken note, with single family permits up 6 percent year-over-year and single family starts up 8.5 percent. These data suggest some growing strength from consumers later in the year.

Business data for the second quarter was somewhat lackluster. Durable goods orders fell in April, down 0.9 percent, and in May, down 1.1 percent, as most categories struggled to hold earlier gains. Weakness in autos and aircraft held gains in the first five months of 2017 to just 2.8 percent above year earlier levels.

There was some strength recorded in energy related categories as U.S. oil exploration and development continued to ramp up. Industrial production levels also showed strength in mining, which carried overall industrial production up 2.2 percent year-over-year in May, even as manufacturing continued to weaken. However, the recent weakness in crude oil prices, with its possible damage to mining, may be offset by a slow rebuilding taking place in both wholesale and retail inventories. With all this in mind, it seems that the net contribution to GDP from business in the second quarter will be minor.

Inflation tossed a curve ball in the second quarter: the PCE Index dropped from 2.1 percent in February to 1.4 percent in May as energy prices continued to fall due to oversupply and weak demand.

Yet the FOMC raised the federal funds rate for the third time in seven months in June, still anticipating that strong employment would beget inflationary pressures. I expect second-quarter GDP growth at about 3 percent, with the first half of 2017 in the 2.1 to 2.2 percent range.

The second half of 2017 is full of challenges. At the heart of all discussion is the state of the current economic expansion, now entering its ninth year as the second-longest expansion since record keeping began. This expansion has reduced unemployment to prerecession levels, but has yet to produce sustained inflation above the 2 percent level considered normal.

While the FOMC continues to believe that lower prices are “transitory” and will rise over the “medium term,” market-based surveys of inflation show little evidence of growing inflation. Thus market participants and the economic press are questioning the need for more interest rate hikes with the thought that future hikes might stall the expansion and growth in the financial markets.

Gregory McKay is economic consultant to Canandaigua National Bank.

(c) 2017 Rochester Business Journal. To obtain permission to reprint this article, call 585-363-7269 or email madams@bridgetowermedia.com.

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