Outlook and Market Review - First Quarter 2018

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The U. S. economy grew at a 2.2% rate in the first quarter of 2018, according to the first revision from the Bureau of Economic Analysis. Fourth quarter 2017 growth was 2.89%. Slower first quarter growth is partly due to seasonal adjustments and slower consumer spending. The tax reform act stimulated business investment to overcome part of the slack in consumer spending. Most analysts project an accelerated GDP growth rate above the long run trend for the second and third quarters as tax cuts and government spending under the new budget take hold.

Many analysts believe the economy is now testing the non-inflationary rate of unemployment. The unemployment rate fell to 3.8% in May from 3.9% in April and 4.1% in March. The unemployment rate declined in part due to a lower labor-force participation rate of 62.7%. Nevertheless, payroll expansion remains strong with an increase of 223,000 jobs in May following a long trend of payroll expansion above 150,000 per month. Worker compensation continues to lag behind the strong labor market but the trend for better compensation is picking up. On a year-over-year basis in April, wages and salaries increased 2.7% while benefits increased at a 2.6% rate. Both of these measures exceeded the inflation rate, reflecting an improved position for workers. Labor productivity, an important ingredient for growing wages, remains below trend with only a 1.3% year-over-year growth rate in May.

Industrial capacity utilization reached 78% in April. Capacity utilization at full employment normally reaches a bit over 80%, suggesting that there may be added room for growth without typical bottlenecks. A positive aspect of growth in 2018 is that relatively more spending is going into core capital assets that expand capacity. Even so, inflation pressures are likely to build for the remainder of 2018. Currently, the economy is on the threshold of exceeding the Fed’s 2% target for the PCE index and should overshoot the target in 2018. The all-items PCE measure increased 2% on a year-over-year basis in April while the core PCE index increased 1.8%. The consumer price index (CPI) increased 2.5% in April with the core CPI rising 2.1%. The producer price index (PPI) increased 2.6% in April with a core PPI increase of 2.5%. Inflation in the remainder of 2018 should pick up as both consumer and government spending rebound.

When taken as a whole, the U. S. economy continues to expand with prospects for improved growth beyond 3%, healthy job creation, higher worker compensation, and higher inflation. The long-term downside is a continuation of low productivity and the decade long pattern of government deficits and growth in the federal debt. Other threats to growth include uncertain Euro Zone expansion, trade war bluster, and geopolitical risk. The Fed recently raised the target for the fed fund rate to the 1.75% – 2% range. Most analysts expect two to three more rate increases in 2018 on the way to an expected neutral rate of about 3% by 2020. Long-term yields on Treasury bonds are hovering just below 3%, but the yield curve should become steeper as inflation expectations gain momentum.