Economic theory is playing out right in front of us. Economic growth remains above potential, so a solid pace of hiring has tightened up the labor market, raising wages and inflation. The bond market is responding by driving up interest rates. Stock investors are more uncertain, since rising interest rates hurt, but growing profits helps valuations. The Fed would like to keep this party going, but it will become more difficult, since inflation will soon exceed the target. We remain positive on the stock outlook, but negative on bonds.
GDP growth slowed to 2.3% in Q1 2018, but seasonal distortions account for some of the reported deceleration. Even so, growth remains too firm given the limited availability of labor. The unemployment rate is a mere 4.1% and initial claims of 209,000 hit another low last seen in 1969. Unemployed claimants are back to 1974 levels. If labor is scarce, economic theory projects rising labor costs, which is exactly what was reported this week in the quarterly Employment Cost Index. It rose by 0.8% for the quarter, the highest pace of increase in labor costs seen in this expansion. The one year measure hit 2.7%, also a high, and this compares to the 2% pace seen over multiple years. The CPI hit 2.4%. This is all textbook stuff.
The Fed meets May 1-2, but no change in monetary policy is expected, partly because no press conference is scheduled and partly because the Fed signaled it will raise rates only three times this year. But their views are shifting in response to the incoming data and their consensus is getting closer to projecting four hikes, which is what we are expecting. The next rate hike is likely coming at the June meeting.
The markets are appropriately anticipating some of these changes and interest rates are rising across the yield curve. The 10-year Treasury nudged over 3.00% this past week before retreating slightly. It had also hit this mark in 2016 before declining quite sharply. We expect rates to continue to rise. With inflation now above 2%, a 3% yield on a 10-year Treasury implies that investors earn a zero or slightly negative return after adjusting for taxes and inflation. So, monetary policy remains highly accommodative, despite the rise in bond yields.
The counterargument is that the economy will soon buckle under rising interest rates, so the increase will not be sustained. However, housing shortages in most U.S. markets keeps driving up prices, suggesting a need for more construction. Capital investment benefits from changes in taxes, which encourage corporate spending. Distorted seasonal factors imply that a “weak” first quarter will be followed by faster growth over the balance of the year, not that the first quarter was all that soft. The economy still enjoys plenty of momentum and no obvious imbalances. And the Fed remains reluctant, at least so far, to increase interest rates to slow down growth or brewing inflation pressures. Higher inflation is the key risk now looming for the economy. Until it causes a more severe decline in bond prices, we remain sanguine about the outlook.