US: Three rising pressure points for investors – Wells Fargo

John E. Silvia, Chief Economist at Wells Fargo Securities, explains that they have witnessed in recent months a continued movement in the following three economic fundamentals that signal rising pressures on the sustainability of the economic expansion at recent rates of growth.

Key Quotes

“Fed’s Inflation Target Met

• The gains in the PCE deflator have largely met the Fed’s inflation target. Both the overall PCE and the core PCE have risen over the past six months. Our outlook has been that the PCE deflator would hit two percent in the first quarter of 2017, with the core deflator reaching the two percent mark later this year. 
• One factor supporting the rise in the PCE deflator has been the steady rise in labor costs. Wages have been accelerating over the past year, as illustrated by the rise in average hourly earnings and the Atlanta Fed wage index, which now registers 3.2 percent year-over-year growth and has been steadily rising over the past year as well.
• What we have witnessed, therefore, is that the pattern of wage/price movements has reached the point that the “low-wage growth, low-inflation” framework of decision making of recent years has now faded away. We are challenged to look forward and drop the price assumptions of the past five years.”

“Room to Move 

• Now that the inflation data have shown firm signs of moving toward the two percent policy threshold, we note that the FOMC instrument, the nominal fed funds rate, remains far below the current pace of inflation. As a result, there is plenty of room for the FOMC to move to achieve a target zero percent real funds rate. 
• There is an active debate about what should be the target real federal funds rate to return policy to normal. This debate typically focuses on the options of either a zero real funds rate or some number above that. Therefore, the bias is that the FOMC has plenty of room to move.
• Yet, a move to zero would indicate a funds rate increase of about 100 basis points that would likely boost short-term borrowing costs for housing and business lending. Current market pricing may not account for this, and this magnitude of movement in short-term borrowing costs could generate a moderation in the pace of economic growth. Moreover, a movement of FOMC policy that marches toward a zero real funds rate would be consistent with the rise in the funds rate indicated in the dot plot.”

“Shrinking Margin for Error

For both investors and private businesses, the peak in profit margins indicates that the combination of rising short-term interest rates and shrinking profit margins provides a smaller margin of error for decision makers. Looking forward, the rise in unit labor costs, in the face of another year of two percent real growth, likely means the pressure on profit margins continues.”