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For the Week Ending August 11, 2017

President Trump's bellicose comments regarding North Korea sent shivers through the financial markets this week, driving stock prices down and volatility up. The CBOE's volatility index, aptly referred to as the "fear index" soared to the highest level in nearly ten months on Thursday following Trump's statement that it would respond with "fire and fury" to North Korea provocations. The tremors barely receded on Friday, although stock prices did stage a modest rebound. With geopolitical tensions ramped up, another element of uncertainty overhangs the economic landscape. So far, households and businesses have taken the ever-evolving political chaos in stride. It remains to be seen if the existential threat posed by the prospect of nuclear warfare changes that dynamic.

 

As it is, Washington legislators face an array of policy challenges whose outcomes are looking increasingly tenuous. When they return from their August recess, lawmakers will have only twelve sessions on the September calendar to agree on a budget resolution and, most importantly, to lift the debt ceiling before the end of the month. Failure to meet the deadline could result in a government shutdown and possibly a debt default that would wreak havoc in the financial markets - a confidence-shattering event that would surely bleed into the real economy. Our base case scenario is that Congress will get its act together and allow the government to keep paying its bills and honor its debt obligations. But if recent history is any guide, negotiations will go down to the wire, once again pushing the nation perilously close to a fiscal cliff. If so, we suspect that the volatility seen in recent days will be a common feature in the financial markets over the course of the next month. Fasten your seat belts.

Happily, events on the economic front are considerably more tranquil. There were few, if any, surprises in the latest batch of economic data. As noted, businesses are still taking things in stride, as small firms remain highly upbeat regarding economic prospects. More broadly, the Labor Department provided additional detail on the job market, confirming the strength revealed in last week's monthly employment report. Inflation remains dormant, as reflected in the latest consumer and producer price releases, which will likely keep the Fed's finger off the interest rate trigger for the rest of the year. Finally, despite the strength in the job market, consumers are showing no signs of flexing their spending muscles; indeed, they appear to be turning more cautious about taking on new debt to finance purchases.

As has been the case for several years, the job market remains the bright spot for the economy. As noted last week, companies are expanding payrolls at a faster pace than expected. This week, the Labor Department provided more evidence that job growth would probably be even stronger if more qualified workers were available. In its latest Jobs Opening and Labor Turnover Survey, the BLS noted that companies posted a record number of job openings in June, as the total surged by an eye-opening 461 thousand to a record high of 6.163 million. That's 807 thousand more than the number of workers hired during the month, resulting in a huge number of unfilled openings. As the chart shows, the worker shortage - as measured by the excess of openings over new hires - first appeared in 2015, but the shortfall has been particularly acute in recent months, reaching nearly 1 million in April and only slightly less in June.

Needless to say, companies are striving to hold on to their workers as long as possible. This is reflected in the record low fraction of the workforce collecting unemployment benefits as well as the deep reluctance of companies to lay off workers. The layoff rate is only a tad higher than the record low set last fall, and the increase is likely concentrated in a few sectors, including retail where stores are closing in droves. The strong desire to retain personnel, in turn, is giving jobholders a strong sense of job security. Thus emboldened, workers are more inclined to quit their jobs to pursue better opportunities elsewhere. Over the past year, more than 60 percent of job separations have consisted of voluntary quits, a threshold that had never been achieved prior to 2016 since the series began more than seventeen years ago. Indeed, from October 2008 through the end of 2012, layoffs and discharges accounted for more than half of job separations.

Nowhere is the search for workers more intense than among small businesses. According to the National Federation of Independent Business, a record 35 percent of mom-and-pop establishments have at least one job opening that can't be filled. Yet they remain stubbornly optimistic, as the fraction expecting to increase hiring in coming months has increased to a record-tying pace in July. That wouldn't be the case, of course, if business sentiment regarding future prospects were declining. But just the opposite is the case. The latest NFIB survey revealed an uptick in optimism amoung business respondents, lifting the optimism index close to the cyclical high reached in the immediate aftermath of last year's election. Clearly, the dysfunction in Washington since then has not dimmed the enthusiasm of this segment of the business community - at least not yet.

The good news for workers is that an increasing fraction of small businesses are offering increased compensation, albeit the survey doesn't specify how much pay packages are being increased. As we know from the broader monthly report from the Labor Department, the growth rate of average hourly earnings for all private-sector workers remains stuck in the upper end of the 2.0-2.5 percent range, hardly a breakout for budget-constrained households. The only consolation is that inflation is not eroding the purchasing power of paychecks. Like the growth in earnings, price increases are being held in check - much to the dismay of the Federal Reserve. In July, the consumer price index inched up by 0.1 percent, bringing the annual increase to 1.7 percent. That's a tad higher than the 1.6 percent pace recorded in June, but still too low for the Fed's comfort. The so-called core CPI, which excludes volatile food and energy items, has not fared any better. This measure also increased by 0.1 percent for the fourth consecutive month, and the annual growth rate remains mired at 1.7 percent for three months in a row. You would have to go back to January 2015 to find a lower core inflation rate.

To be sure, the Fed remains confident that inflation will move up to its 2 percent target over the medium term, underpinning its plan to continue normalizing monetary policy through next year. Its confidence, in turn, reflects the view that transitory forces have held back inflation, most notably the plunging cost of cell phone plans and an aberrational slowdown in prescription drug prices. As these forces recede or are reversed, the drag on inflation will dissipate, allowing inflation to move up to the central bank's target. It may be a long wait for cell phone prices to reverse, as they continued to tumble by another 0.3 percent in July, bringing the annual decline to 13.3 percent. That alone has sliced a quarter of a percent off the core inflation rate over the past year.

But the Fed may be hitting the mark with its prediction of prescription drugs. From last September through May, the annual increase in prescription drug prices fell by more than half - from 7.0 percent to 3.1 percent. However, over the past two months, these prices have rebounded sharply, increasing by 1.0 percent in June and 1.3 percent in July. The annual rate of increase through July is now up to 4.2 percent, which is actually above the 3.8 percent average annual increase for these pharmaceutical products since the end of the recession. The main disinflationary thrust has now shifted to motor vehicles, where sales have tapered off, leaving dealers with an outsize inventory on their lots. This is not a recipe for higher prices going forward and, given the sensitivity of auto sales to interest rates, is something that may be more concerning to the Federal Reserve.

Keep in mind that booming auto sales has been a key driving force behind the recovery through the end of last year, when sales of cars and SUVs hit a record high. The sales revival, in turn, was made possible by a credit spigot that remained wide open until recently. Lenders were attracted to the lucrative returns on auto loans relative to other assets, and investors eagerly snapped up bundles of these loans that were securitized and sold into the secondary market. However, in an unsettling echo of subprime mortgages, a large fraction of these loans were extended to customers with lower credit scores, resulting in a predictable increase in delinquencies and defaults. In response, lenders are now narrowing the credit spigot, which is contributing to the slowing pace of auto sales.

The slowdown is reflected in the consumer credit data. In June, total household borrowing, excluding mortgages, stood 5.7 percent higher than the year-earlier level, the slimmest annual increase since September 2012. As recently as December, credit was growing at a 6.5 percent annual rate. What's more, the slowdown in gaining traction, as the monthly increases have decelerated to a 4.3 percent annual rate over the last three months. The biggest drag is coming from nonrevolving credit, which includes auto loans as well as student loans. Both categories have been slowing noticeably. Significantly, consumers are also pulling back on their use of credit cards, as revolving credit is increasing at a 5.5 percent annual rate, a full percentage point slower than at the end of last year.