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For the Week Ending October 13, 2017

The minutes of the Fed's policy-setting meeting on September 19-20, released with the usual three-week lag this week, generally confirmed the widespread perception that the central bank is poised to hike short-term interest rates in December. As expected, the meeting featured a vigorous discussion about the persistence of low inflation, which has remained stubbornly below the central bank's 2 percent target despite the ever-tightening labor market and above-trend growth in the overall economy. While some Fed officials would like to hold off on rate hikes until inflation perks up, the majority expressed confidence that underlying fundamentals in the economy, particularly the removal of slack in the labor market, would guide the inflation rate up to the 2 percent target over the medium term.

That said, even the hawks on the Fed expressed uncertainty about the future trajectory of inflation, noting that the steep and steady decline in the unemployment rate has yet to generate the wage and price pressures normally associated with a tightening labor market. Yes, the latest employment report suggested that wage pressures might be gaining traction, as the annual increase in average hourly earnings for all private-sector workers leaped to 2.9 percent in September, the strongest increase this year, and earnings for the previous two months were revised up. But Hurricanes Harvey and Irma may have injected an upward bias to these figures by boosting overtime pay for utility workers and temporarily altering the composition of the workforce.

Indeed, the earnings spike in September was hardly spread equitably throughout the workforce, Throw out the supervisory and management positions and an entirely different picture of wage growth emerges for blue-collar workers. Over the past twelve months, average hourly earnings for production and nonsupervisory workers increased by 2.5 percent, which is firmly ensconced in the 2.0-2.5 percent range seen since the end of 2015. Unlike the hefty increase for the broad private-sector group that includes managers and supervisors, earnings growth for these workers has actually retreated from the 2.7 percent peak reached last September. It is unclear if this divergence in earnings patterns is an aberration related to the hurricanes or a more systemic issue.

Another widely followed measure of worker earnings, the wage-tracker compiled by the Federal Reserve Bank of Atlanta, does not reveal a meaningful acceleration in wages. This gauge measures the percent change in earnings for the same individual over a twelve- month period, thus eliminating distortions caused by changes in the composition of the workforce. The latest figure, for the three-months through September, does track a higher growth rate in median earnings than the average revealed in the employment report, posting an increase of 3.6 percent. But that too is close to the 3.4 percent average increase seen since the end of 2015 and below the nearby peak growth rate of 3.9 percent set last October and November. Simply put, the jury is still out as to whether the tightening labor market is enhancing the bargaining power for a broad swath of workers.

Nor do the latest readings on consumer prices, released on Friday, provide more clarity on the inflation front. As expected, the hurricanes had an outsize impact on the consumer price index, boosting gasoline and lodging away from home prices, as strong demand from storm victims boosted hotel and motel prices. Overall, the CPI surged by 0.5 percent in September, the strongest since January, lifting the year-over-year rate to 2.2 percent. Hence, for the first time since April, the annual headline inflation rate exceeded the 2 percent threshold. But the Fed will look past that headline spike and focus on the core inflation rate, which excludes volatile food and energy prices. The core CPI actually rose more moderately in September than the previous month, increasing by a tepid 0.1 percent versus 0.2 in August. Over the past year, the core inflation rate remained at 1.7 percent, spot-on with the annual increase in each of the previous four months.

For the most part, the trend in consumer prices has a distinctly downward bias. Stripped of the hurricane related spike in lodging away from home, shelter prices posted modest gains. Rents of primary residences increased by only 0.2 percent compared to 0.4 percent in August, and owners' equivalent rent (the rent that owner-occupied homeowners would get if they rented out their homes) also advanced by 0.2 percent, down from 0.3 percent the previous month. Strikingly, a widening array of items moved into deflationary territory, including medical care, pulled down by drug prices, and apparel, new and used car prices. Core services prices, excluding energy, only increased by 0.2 percent in September, lowering the annual rate to 2.6 percent. At the start of the year, core services prices were rising at well over a 3.0 percent pace. And, of course, commodity prices continue to languish in deflationary territory, declining by 1.0 percent compared to a year ago.

Perhaps one glimmer of hope for inflation hawks is that the long and steep decline in prices of cell phone plans - one of the transitory forces cited by Fed officials - may be over. Wireless service prices actually rose 0.4 percent in September, although they are still down nearly 12 percent over the past year. The bad news for most consumers is that the hurricane-related spike in the overall CPI took a bite out of purchasing power, as real earnings fell by 0.1 percent in September following a 0.2 percent drop in August. The good news for senior citizens is that the headline jump in the CPI translates into a 2.0 percent cost-of-living adjustment in social security benefits starting January 2018. That's the largest upward bump since 2011, when the COLA resulted in a 3.6 percent increase in payments to beneficiaries.

While we don't think that the soft inflation data will derail the Fed's plan to hike rates in December, it does lower the odds somewhat. From our lens, the persistence of low inflation and the confusion about its cause will restrain future rate increases. We expect the Fed to pare back the number of rate hikes it currently plans for next year from three to two, based mostly on our view that inflation will once again come in below expectations. The financial markets appear to support that view. Bond yields, an inflation-sensitive metric, has slipped from recent highs, with the 10-year Treasury yield moving to 2.27 percent on Friday, down about 10 basis points during the week. Likewise, the dollar, which is also correlated with inflation expectations and Fed policy moves, eased to a two-week low on Friday.

To be sure, policy makers still have a lot of data to process before finalizing any decision. The problem is the hurricane effect will still be distorting much of the data, including inflation, for October. As we noted in last week's commentary, the distorting effects will be both positive and negative. The negative influence clearly showed up in the September employment report, as payrolls were slashed by 33 thousand workers during the month. Still, a closer look at the details of the report revealed underlying strength in the job market that should embolden the hawks on the Fed. If the reports for the next two months indicate that the job market remains robust and wage growth is accelerating, the decision to lift rates in December will be easier to make.

But other data will also be considered, including especially the strength of consumer demand. Like the jobs and inflation data, the weather-effects make it difficult to obtain a true reading of consumer spending. On the surface, the latest retail report, released on Friday, suggests that households flexed their spending muscles as the summer season drew to a close. In September, retail sales surged by 1.5 percent, the biggest one-month increase since March 2015. But again, the devil is in the details. Two components drove most of the increase: auto sales, which jumped by 2.5 percent, the largest in 2 ½ years, and an eye-opening 5.8 percent spike in gasoline sales. Both of these drivers, of course, were hurricane related. The increase in auto sales reflects the strong replacement demand for the more than half-million vehicles destroyed by the storms, which will likely spill over into October. And the strength in service station sales was clearly price-related as pump prices jumped 13.1 percent during the month.

Adjusted for these hurricane-related catalysts, sales look far less robust, although still decent. Total sales excluding autos and service stations, increased by a sturdy 0.5 percent and are up a respectable 3.8 percent for the year. Some of the strength, however, looks suspicious. For example, sales at food and drinking establishments rose a whopping 0.8 percent, the largest increase in eight months. You would think that the hurricanes prevented customers from going to bars and restaurants instead of stimulating sales at these establishments. Still, while the retail numbers look respectable we suspect that inflation accounted for most of the sales increase. We will see in the more comprehensive data on personal consumption released later this month, when an initial accounting for the third quarter's GDP will also be available. We are looking for real consumer spending to increase by 1.7 percent, underpinning a roundly 2.4 percent growth rate in real GDP for the period