INDICATOR: March Trade Deficit; 1^st Quarter Productivity and Weekly Jobless Claims

KEY DATA: Deficit: $49 billion (down $8.8 bil.); Exports: +2%; Imports: -1.8%/ Productivity: +0.7%; Over-Year: 1.3%; Labor Costs: +2.7%/ Claims: up 2,000

IN A NUTSHELL: “The good news is that we are exporting more, but with the labor markets incredibly tight, labor costs are accelerating as well.”

WHAT IT MEANS: The Fed is focused on the economy and inflation and it looks like both the economy and inflation are moving upward. The U.S. trade deficit narrowed sharply in March, let by a very strong rise in exports. The gains were in almost all areas except vehicles, which were off sharply. Aircraft, computer and pharmaceutical sales rose solidly. There was also a jump in soybean exports, but that is likely the result of moves to get in the shipments before the Chinese shut down the market, which they appear to be doing. Petroleum exports were also up, thought some of that may have been price related. As for imports, they declined across the board. With the economy growing solidly, the reduction in demand for foreign products is a surprise. You can say that the trade war fears are having an impact, but tariffs would affect only a small proportion of the imports. This was a broadly based drop, which I suspect will turnaround going forward. The greater than expected narrowing in the trade deficit could lead to an upward revision to first quarter growth.

Labor productivity grew a little faster in the first quarter than the last quarter of 2017, but the pace was still pathetic. At the same time, hourly compensation surged and that led to a sharp rise in unit labor costs. Still, the increase over the year in labor compensation is beginning to overwhelm the rise in productivity and that does not bode well for production costs and prices.

The labor market remains about as tight as you can get. While jobless claims edged up last week, they remain just about at record lows when adjusted for the size of the workforce. In addition, Challenger, Gray and Christmas reported that layoff notices fell sharply in April, though they chalk that up to one company. While layoff notices are up for the first four months of the year, the level remains pretty low.

MARKETS AND FED POLICY IMPLICATIONS: Today’s data are just another installment in the book of “no good economy goes unpunished”. The economy may be solid but there are few workers available and as a result, firms are slowly, but steadily being forced to bid up wages. The rise in labor costs will undoubtedly factor into the FOMC’s thinking when it meets again in June. Short-term rates are going to rise further and while longer-term rates have plateaued, they have done so at a rate that many thought they would not see until the end of this year. The markets have shown a capacity to digest the rise in rates and then move on and it will have to continue doing so because a 10-year Treasury note near 3% is not likely to be the end point of the current rising rate cycle. If the economy does rebound in the second half of the year, as most expect, inflation will accelerate as well, driving up rates further. I don’t rule out a 10-year rate threatening 3.5% before the end of the year. Whether that opens some investor eyes, though, is another question. Tomorrow we get the April jobs report and while job gains should rebound, the key number is likely to be hourly wages. Don’t be surprised if the increase over the year nears if not exceeds 3%, which would signal accelerating wage pressures.

May 1-2 2018 FOMC Meeting

In a Nutshell: “…both overall inflation and inflation for items other than food and energy have moved close to 2 percent.”

Decision: Fed funds rate target range kept at 1.50% to 1.75%.

To the surprise of absolutely nobody, the FOMC decided to keep the fed funds rate at its current level. Now that the non-news (as against fake news) is out of the way, there was some important information about the members’ perceptions of inflation in the Committee’s statement. Maybe most importantly, The Fed now says that their mission has been accomplished. Okay, they didn’t even come close to saying that, but they did indicate that inflation was basically at their target rate, no matter how you measure it. The FOMC members had been noting that inflation continued to run below their target. In addition, they indicated that “Inflation on a 12-month basis is expected to run near the Committee’s symmetric 2 percent objective over the medium term”. In previous statements they said inflation was expected to “move up”. Now all these comments may seem like nit-picking, but when it comes to the Fed, you have to pick the nits. Words matter and it is clear the members believe inflation will remain at or above the 2% target going forward.

This stance on inflation is critical in that it provides information about the future direction of rates. Since inflation is at the Fed’s target and “the labor market has continued to strengthen and that economic activity has been rising at a moderate rate”, we now have solid growth and moderate inflation. The Fed’s dual mandate is being met and it now must work to make sure that it stays that way. That is not accomplished by keeping rates excessively low and let’s be real, short-term rates below 2% are extremely low.

So, what should we take away from today’s statement? Barring something truly worrisome happening between now and the next meeting on June 12-13, a rate hike is in the cards. And unless there is a dramatic change in trend, rates should be increased every other meeting until it is clear the economy is slowing and/or inflation is decelerating. That is not likely to happen until the end of next year.

(The next FOMC meeting is June 12-13, 2018.)

Joel L. Naroff is the president and founder of Naroff Economic Advisors, a strategic economic consulting firm.