Strong Jobs Report Puts Fed in a Quandary

The US economy added a much stronger than expected 242,000 jobs in February and the two previous months were revised higher by 30,000, pushing up year-over-year job creation to a solid 2.67 million. The unemployment rate remained at 4.9 percent, the lowest level since February 2008. The report puts the Federal Reserve in a quandary for its upcoming policy meeting. With job creation averaging 228,000 over the past three months and the labor force increasing by 555,000 in February and by 1.5 million in the last three months, the participation rate rose to a 15-month high of 62.9 percent. According to Capital Economics, the report shows that “remaining labor market slack is getting eaten up very quickly.”

If the central bankers are in fact “data dependent,” then the strong jobs report, along with rising core inflation (the Fed’s favorite inflation measure, the core PCE price index, was up 1.7 percent in January from the prior year), would add to the rationale for increasing the fed funds rate by another quarter of a percent in March.

But by now we know that the Fed likes to err on the side of caution. Officials are likely to cite some negatives from the February jobs report as a rationale for doing nothing in March. Chief among the concerns would be the drop in average earnings in February, which translated into a 2.2 percent annualized increase—that’s down from 2.5 percent in the previous month — and average weekly hours worked, which fell sharply to 34.4, from 34.6.

Part of the issue on wages may be the quality of jobs created in February. Big gains in retail and food and drinking establishments contributed to the weakness. Additionally, although the broader unemployment rate (U-6), fell to 9.7 percent, that is still about 1.5 percent ABOVE the precession level.

Bond investors put the likelihood of a March rate hike at essentially zero, believing that the slowdown in global growth will prompt the central bank to do nothing in a week and a half. But if there is continued improvement in the labor market and inflation marches towards the Fed’s desired 2 percent pace, the central bank may by eyeing April or June for the next increase.

MARKETS: HAPPY ANNIVERSARY! I hate to bring you back to a scary time, but seven years ago this week; US stock markets plunged to their worst levels of the entire bear market of 2008-2009. Although the entire financial system almost went over the cliff in September and October of 2008, it wasn’t until March 9, 2009 that stocks hit rock bottom. On that day, the Dow closed at 6547; the S&P 500 fell to 676; and the NASDAQ was at 1268. Time may not heal all wounds, but it certainly has helped investors...

• DJIA: 17,006 up 2.2% on week, down 2.4% YTD
• S&P 500: 2000 up 2.7% on week, down 2.2% YTD
• NASDAQ: 4717 up 2.8% on week, down 5.8 % YTD
• Russell 2000: 1081, up 4.3% on week, down 4.8% YTD
• 10-Year Treasury yield: 1.88% (from 1.77% a week ago)
• Apr Crude: $35.92, up 9.6% on week, up 37% from the 13-year low in Feb
• Apr Gold: $1,270.70, one-year high
• AAA Nat'l avg. for gallon of reg. gas: $1.81 (from $1.74 wk ago, $2.46 a year ago)

THE WEEK AHEAD: A few key speeches by Fed officials could provide the last clues before the central bank’s March policy meeting. All eyes will be on the ECB—it is expected that Draghi & Co will provide more stimulus to the ailing European economy.

Mon 3/7:

3:00 Consumer Credit

Fed Governor Lael Brainard and Fed Vice Chair Stanley Fischer speak

Tues 3/8:

6:00 NFIB Small Business Optimism

Weds 3/9:

10:30 EIA Petroleum Status Report

Thursday 3/10:

ECB Policy Meeting

Friday 3/11:

8:30 Import and Export Prices

Inflation Agitation

If the past week’s news cycle did not rattle investors, what will? Oh sure, on Thursday when it seemed like the world was spinning out of control, the CBOE Volatility Index (VIX), which helps gauge investor fear, surged 32 percent, its biggest jump in more than a year. Then on Friday, it fell 17 percent to 12.06, far below historical norms of around 20. Evidently, geopolitical events are not sufficient to cause more than a one day stock sell-off and flight to quality, most of which was reversed on Friday. So what would it take? Maybe run of the mill inflation, which has been almost absent for the past six years, would spook investors.

Headline inflation (CPI), which includes everything you care about, is up about two percent year over year. I know what you’re thinking: Why would the central bank exclude the stuff that impacts my daily life? Surely when I am spending more on food and gas, I have less money to spend elsewhere in the economy. (A recent Gallup poll found that 1/3 of Americans said higher prices are impinging on their ability to spend on travel, dining out and leisure activities.) But the Fed is not tasked with addressing short-term price increases, like those at the pumps, or even for agricultural items like beef, pork or chocolate -- the central bank can’t be at the mercy of the weather or events in the Middle East.

That’s why during the recovery, when prices have increased sporadically, the Fed downplayed the idea of broad-based inflation, calling the higher readings transitory (like when gas spiked due to the Arab Spring). More recently after the Fed’s June policy meeting, Chair Janet Yellen said that while “Recent readings on, for example, the CPI index have been a bit on the high side,” the data are “noisy.” Translation: Stop worrying about inflation—we have it under control.

The Fed is looking for a gradual increase of core inflation, which excludes food and energy, to a pace of two percent annually. Over the past six years, core inflation as measured by the CPI or by the Fed’s preferred metric, the Commerce Department’s personal consumption expenditures price index (PCE), has remained below that level. But over the past three months, core prices have started to accelerate across a variety of categories, including shelter, airfares, clothing and medical care.

It’s not so far-fetched to see how as the economic recovery accelerates, a chain of events is likely to spur price increases. Here’s what could happen: as the labor market improves, there is likely to be an increase in wages. As people earn more money, they may be willing to spend more. An uptick in spending could be the opening that retailers have been waiting for since the recession and allow them to finally increase prices for all sorts of stuff.

While it is unlikely that any of this would create runaway inflation, despite what some inflation hawks (including the usually wrong CNBC editor Rick Santelli) have been arguing for years. Remember we’re talking about what could spook investors, who are hyper-focused on when the Fed will begin to raise interest rates. It is widely believed that the central bank will begin to nudge up rates at the beginning to the middle of next year. But if prices rise faster than expected, it may prompt the Fed to hike rates sooner and more aggressively than widely expected. If that were to occur, stock investors might take a time out from the bull market and wait to see how things shake out.

MARKETS:

• DJIA: 17,100, up 0.9% on week, up 3.1% YTD
• S&P 500: 1978, up 0.5% on week, up 7% YTD
• NASDAQ: 4,432, up 0.4% on week, up 6.1% YTD
• 10-Year Treasury yield: 2.48% (from 2.52% a week ago)
• August Crude Oil: $103.13, up 2.3% on week
• August Gold: $1309.40, down 2% on week
• AAA Nat'l average price for gallon of regular Gas: $3.58 (from $3.67 a year ago)

THE WEEK AHEAD: The SEC is poised to impose new requirements on the $2.6 trillion dollar money-market mutual fund industry, when it votes on whether the riskiest money-market funds will have to let their share prices fluctuate; and charge investors withdrawal fees during times of stress. The government was forced to provide a backstop to money market funds during the 2008 financial crisis.

Mon 7/21:

Haliburton, Hasbro, Texas Instruments, Netflix

8:30 Chicago FedNational Activity Index

Tues 7/22:

Altria, Dupont, Kimberly Clark, McDonald’s, Apple, Microsoft, Coca-Cola, Verizon

8:30 Consumer Price Index

10:00 Existing Home Sales

Weds 7/23:

AT&T, Boeing, Facebook, Pepsi

SEC vote on Money Market funds

Thurs 7/24:

Ford, GM, Hershey, Starbux, Visa, 3M, Amazon, Caterpillar

8:30 Weekly Jobless Claims

10:00 New Home Sales

Fri 7/25:

Xerox

8:30 Durable Goods