Fed's Hands Still Tied Despite Strong Data

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. We had three marquee economic reports this Friday morning. I'm here with Bob Johnson, he's our director of economic analysis, for his first take. Bob, thanks for joining me.

Bob Johnson: Great to be here today.

Glaser: So let's start with retail sales, up 0.6, another strong report here. The consumer is alive and well.

Johnson: Very much so. That's 70% of the U.S. economy, and so it's great to see the consumer doing well now. The goods part of it, is only a third of the consumption equation, we've got a lot of other things that go into that. But certainly the retail sales is a pretty darn good indicator of what's going on. So we were very pleased with the headline number, and even if you strip out the energy stuff and the strong building materials, we still grew 0.5 of a percent month-to-month. So a very nice number in retail sales, kind of a broad based increase in the numbers, with the only real disappointment being the autos, which you already knew about from the manufacturers data that we got at the beginning of the month. So retail sales were very strong, much stronger than anybody expected in their numbers. And on top of that there were some upward revisions to the prior months, which were already relatively high numbers, so clearly whatever happened to the consumer in the first quarter was temporary and indeed weather-related. And now we've seen that nice bounce back. Couldn't have come at a better time to indicate that things are really going ahead quite well.

Glaser: What does this mean for second quarter GDP?

Johnson: Well I think its very good news there. I think it means our 3% target, which looked unusually aggressive compared to everybody else a few weeks ago, that 3% target now kinda looks like in the bag to me, given the strong consumption and given that 70% of the data. So I'm real pleased with that number, and I think that consumption itself on a quarter-to-quarter basis maybe up as much as 4% in the report. When you take the 4% times 0.7% of the economy and already you're kinda starting out with a 2.8% GDP growth, if nothing else grows at all.

Glaser: Let's take a look at inflation, is this still an area that concerns you? Does the CPI number give you some pause?

Johnson: Well the headline numbers and even the core numbers were very kind of reassuring, if you will, if you just looked at the headlines. We got a 0.2 of a percent month-to-month increase, which annualizes to about 2.4% in both core and headline, and so that's not so bad. On the other hand, there were a lot of individual categories were kinda worrisome, and there was an odd mix of things that made the numbers come in in kind of on track, if you will. But there's a lot of things to worry about underneath. Shelter continued to boom, up 3.5% year over year and that's, a lot of everybody's paycheck goes to their homes every month. And that number is up 3.5%, so that was certainly not good news. And of course, that's a major component of services, and services were up about 3.2%, which I think is the highest it's been of this recovery, and getting near other periods where inflation's been a bit of a problem when you get services inflation that high.

So that remained worrisome, healthcare looked terrible, the drug side, the commodity side of healthcare, was particularly worrisome, up 1.1% in a single month, that's not a year-over-year number so certainly that was worrisome. Those were the two big worrywart things to have, but setting that off a little bit, was the fact that food inflation was down again, food at home was down 0.3 of a percent following 0.5 of a percent the previous month. That's given the Fed a little bit more breathing room, nobody really expected-it's hard to expect food to do anything, nobody knows. But the fact that it was down so much two months in a row, has kinda given the Fed just a little bit of breathing room in terms of worrying about that high inflation will ruin the consumer. So certainly that was good news, the other good thing... News in the report, again people don't see it very often, so not many will notice it, but auto prices were also down, both on a new and a used basis, which helped pull the numbers in a little bit as well. So overall, the number kinda you look at it and say, "Well it wasn't great, it didn't get a lot worse, it didn't get a lot better." But you tear behind a little bit and it's still very worrisome to me to see the services inflation as high as it is.

Glaser: Let's take a look at industrial production for a moment. That number shows that maybe manufacturing is turning the corner. I know we've said that a few times here.

Johnson: We've said that more than a few times, and we've said it stabilized, and in some ways it has. It always looks like its stabilizing but it's not really getting much better. This is the first month with a 0.6 of a percent increase, we haven't had time to rip the whole number apart but just on a headline basis, it's great to see a number that's that big, and that's the biggest number since all the way back to last July. And there were some revisions of previous numbers as well, so the trend in the year-over-year numbers will start to look a little better. So we were really glad to see that, manufacturing is certainly been one thing that's held us back this last year, and I think it looks like maybe it's turning the corner a little bit. And with consumers buying more things again, maybe there's some hope for manufacturing after all.

Glaser: So big picture after last week's jobs report, you said the market was in a nirvana, and we saw that certainly this week as we hit new records everyday, and we'll see what happens today. But you said that was because the economy has started to look like it was looking better but that the Fed, kind of their hands were tied in terms of raising rates due to international developments. Is that still the case or is data like this potentially force the Fed's hand even if there's weakness in the U.K. or Europe?

Johnson: I think that they are very, very focused on what's happening overseas and they can't let things get outta hand. The relationship between the different interest rates and the different currencies, so I think their hands probably remained tied. I think there's still talk of more easing yet to come in various economies, and more promises, "It will be next month... " and, out of the U.K. in particular, and so we've got this more easing coming. So, if they kinda stay the same at the Fed, it's still kinda creating a bigger gap than there was, and so it's going to make it tricky for them to raise rates.

On the other hand, the economic strength looks very high, to kinda have the consumer and industrial production doing well. There's a few more engines for potential inflation out there, and growth, and I think that certainly any issues that there were about U.S. growth have kind of gone by the way side now. And so, you put it all together, I think that normally I would have strong worries about the Fed acting quickly, to tap inflation and since growth was so strong; we had a great initial unemployment claims report, this week again, indicating the labor market is indeed still strong. And you roll that together and you say, "Well, yeah. They should be raising rates." But on the other hand we've got that international sector, and it makes it very difficult to raise rates, and that's why investors are so happy.

Glaser: Bob thanks for your take this morning.

Johnson: Thank you.

Glaser: From Morningstar, I'm Jeremy Glaser. Thanks for watching.