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For the Week Ending September 14, 2018

A mixed bag of data highlighted the economic calendar this week, but the general theme of the economy's performance in the third quarter remains intact. Simply put, the economy still retains a good deal of momentum but growth in the July-September period is poised to slow modestly from the robust 4.2 percent pace registered in the second quarter. Mother Nature may once again influence the ultimate outcome, as Hurricane Florence, which hit the Carolinas on Friday, will no doubt have an impact on spending and production data over the final two weeks of the quarter. Meanwhile, the financial markets, which are marking the 10th anniversary of the Lehman Brothers collapse this weekend, continue to vanquish the scars and bitter memories of the financial crisis that followed, albeit recriminations and finger-pointing are still capturing headlines.

Happily, investors did not have to cope with unsettling political developments during the week. If anything, the news on this front was mildly positive, as the Trump administration held out an olive branch to China, hoping to resume trade negotiations before punitive tariffs on Chinese imports take effect. The prospect of an escalating trade war with China - not to mention the still-unsettled Nafta negotiations - continues to be a major wild-card in the economic outlook as well as a disruptive influence on the financial markets. So far, the negative ramifications have been mostly anecdotal, with myriad business leaders reporting supply chain disruptions, higher prices on foreign-bought inputs and delayed investment decisions due to trade uncertainty. While the ramifications have yet to infiltrate the hard data in a meaningful way, policymakers are becoming increasingly mindful of the potential effects, something that was clearly reflected in the latest Beige Book released this week.

That said, the Fed is virtually certain to pull the rate trigger again at its upcoming policy meeting on September 25-26. With officials confident that employment and inflation targets have been met, there is no reason to put on hold the planned strategy of gradually bringing interest rates up to normal levels. Interestingly, the current spread between the 10- and 2-year Treasury yield sits at a cycle low of 21 basis points, so the next 25 basis point Fed increase may well bring about the much-dreaded inversion, which historically correlates with a recession 12-18 months down the road. Whether "this time is different" as some Fed officials and many Wall Street analysts believe, a curve inversion has been an infallible precursor of economic downturns, so it is not a trivial moment to dismiss out of hand.

From our lens, the odds of a recession over the foreseeable future remain quite low, barring a surprise from external shocks or a policy mistake. The former, of course, is always unpredictable although an all-out trade war and escalating debt problems of emerging market nations are worrisome signals on the radar screen. However, the markets are understandably concerned about a policy mistake, as the Fed has a history of either overstaying a policy course or overreacting to events that sends the economy into a recession. No one is worried about the next move, which has been clearly telegraphed and widely recognized as justified by ongoing fundamentals. But as growth slows as expected later this year and into 2019 amid signs of higher inflation, we suspect that perceptions regarding how fast or slow the Fed should proceed will not be as harmonious as they have been to this point.

Indeed, recent crosscurrents in the data portend a widening divergence in opinion that is bound to unfold in coming quarters. Last week's jobs report, for example, bolstered sentiment for a quickened pace of rate hikes as the surprising jump in hourly earnings heightened concerns that wage inflation was gaining traction. Following the report, bond yields spiked, a time-honored response to higher inflation expectations and a more aggressive tightening of monetary policy. Indeed, a few Fed officials, highlighted by Fed
Governors Brainard and Evans, delivered speeches that sounded a decidedly more hawkish tone this week. Adding fuel to the fire, the escalation of wage growth comes on the heels of frisky price data, with the key measure the Fed monitors - the core personal consumption deflator - hitting the 2 percent target in July for the first time since April 2012.

But instead of confirming an upward trend, the latest consumer price report bent the inflation curve downward, defusing fears that an inflation outbreak was about to occur. The headline consumer price index increased by a mild 0.2 percent in August, weaker than the expected 0.3 percent increase. Importantly, the increase in the core CPI, which excludes volatile food and energy prices, was even tamer, coming in at 0.1 percent. As a result of the soft monthly advances, the steady increase in the annual trend took a detour. The overall CPI increased 2.7 percent from a year ago, down from a 2.9 percent annual pace in July. Likewise, the core CPI rose 2.2 percent over the last twelve months, slipping from the 2.4 percent year-over-year increase registered in July. It was the first time since last November that the annual rate of the core CPI fell from the previous month.

Nor was it just one or two items that skewed the results. Price increases for most categories of goods and services either slowed or declined last month. The major exception is shelter, as housing costs continue to exert an outsize influence on inflation, rising at a 3.4 percent year-over-year pace. Indeed, strip out housing costs, and the core inflation rate slows to 1.3 percent over the past year and a 1.2 percent annual rate over the past three months. But before heralding the resumption of disinflation, the weaker consumer price reading last month merely confirms our expectation that the pickup in inflation will be gradual instead of abrupt. Even the stripped-down core inflation measure that excludes shelter is increasing at more than twice the 0.6 percent pace that prevailed a year ago.

Unless there is an unexpected surge in productivity or a setback in wage growth, underlying inflation pressures should continue to build. The labor market is still running hot, spurring companies to compete more aggressively for a dwindling supply of available workers. That should keep upward pressure on wages, which will either be passed on to consumers in the form of higher prices or absorbed by companies willing to accept smaller profits. Some combination of the two will likely prevail, but businesses will strive to build as much of the higher labor costs as possible into the price structure. According to the latest survey of small businesses by the NFIB, a record share of firms plans to increase worker compensation in coming months while a smaller, but growing, share plans to increase prices.

Just as thoughts of an inflation outbreak were dashed by the latest CPI report, so too were visions of a consumer-spending spree quashed by this week's retail sales report. In August, revenues at retail establishments increased by a scant 0.1 percent, considerably weaker than an expected 0.4 percent advance. And like the CPI report, the soft reading was spread widely among key categories, including sales of autos, clothing, furniture, building materials and merchandise at department stores. If not for the 1.7 percent increase in gasoline sales at service stations, reflecting higher prices at the pump, overall sales would have actually declined by 0.1 percent for the first time since January.

But again, it would be a mistake to look at one month's figures and think that consumers are zipping up their wallets and purses. Like the underlying pressures that point to higher inflation, the fundamentals underpinning consumer spending remain robust. Indeed, the sting from the weaker than expected retail sales in August is diluted by an upward revision for July, which boosted the sales increase for that month from an already-formidable 0.6 percent to 0.7 percent. Even more impressive is the upward revision to the control group of sales - to 0.8 percent from 0.5 percent previously reported for July-- which feeds directly into the GDP calculations. In August, the increase in these core retail sales slowed to 0.1 percent, but the stronger momentum from the upward revision leaves consumer spending on a solid growth track for the third quarter. Compared to a year ago, overall retail sales are up a sturdy 6.7 percent, matching the strongest annual gain since October 2011.

By all accounts, the setback in retail sales last month will represent a brief respite, as consumer spending should bounce back in coming months. Households are exceptionally upbeat, drawing confidence from a robust job market, growing incomes, lower taxes and improved balance sheets, with personal savings at a healthy 6.7 percent. The latest University of Michigan Consumer Sentiment index, released on Friday, strikingly highlights this optimistic mind-set, increasing 4.6 points to 100.8 in September. That reading is only a tad below the cycle high set in March and well above every month, except one, during the expansion of the 1990s. But households do not always act as they feel, and sentiment has been running stronger than actual spending for some time. We suspect that optimism will cool later this year as job growth slows and income gains, particularly after adjusting for inflation, do not live up to expectations.