With Consumer Spending Increasing Along with Inflation, Powell May Have to Rethink Gradual Rate Hikes

The major U.S. equity markets are trading lower on Thursday. We’re probably looking at profit-taking and end-of-the month position-squaring since there haven’t been any major shifts in the fundamentals. Investors could also be taking a breather after posting several record highs throughout the week. Volume is light as investors prepare for the long U.S. holiday weekend. Fundamentally, investors are concerned about trade negotiations with Canada.

Much of the rally this week has been driven by the announcement of a bilateral trade agreement between the United States and Mexico. Both countries are now waiting for Canada to join the deal.

Since trade worries kept a lid on stock market gains in recent months, especially in the Dow, there is still a little uncertainty in the markets today as investors wait for Canada to step up to the negotiation table.

The U.S. neighbor to the north has until Friday to join a trade deal made between the U.S. and Mexico, according to President Donald Trump. However, Trump said he was confident an agreement between the two nations was forthcoming. “I think Canada very much wants to make the deal,” Trump told reporters on Wednesday. “It probably won’t be good at all if they don’t.”

In other stock market related news, Amazon shares rose half a percent to break above $2000 a share for the first time.

U.S. Economic Data

Investors faced a slew of economic news earlier in the session, but not all were important to today’s trade.

The two most important reports were Core PCE Price Index and Personal Spending. According to the Commerce Department, U.S. consumer spending increased solidly in July, pointing to strong economic growth early in the third quarter, while a measure of underlying inflation hit the Federal Reserve’s 2-percent target for the third time this year.

The government said consumer spending, which accounts for more than two-thirds of U.S. economic activity, rose 0.4 percent last month after advancing by the same margin in June. Economists had forecast consumer spending rising 0.4 percent in July. When adjusted for inflation, consumer spending gained 0.2 percent in July after rising 0.3 percent in June.

The so-called PCE price index, the Fed’s preferred inflation measure, rose 0.2 percent after inching up 0.1 percent in June. That lifted the year-on-year increase in the so-called PCE price index to 2.0 percent from 1.9 percent in June.

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Fed Talk

With the PCE price index at the Fed’s target of 2.0 percent and its current upside momentum, the central bank is widely expected to raise rates for the third time this year in September. Earlier in the month the Fed warned in the minutes of its July 31-August 1 meeting “a prolonged period in which the economy operated beyond potential could give rise to inflationary pressures.”

If the upside momentum in inflation continues beyond August and September then the chances of a December rate hike are going to increase also. These trends are likely to continue until the Fed is satisfied that inflation is under control.

Last Friday, the market’s interpreted Fed Chair Jerome Powell’s comments on gradual rate hikes to suggest the central bank may be nearing neutrality, but given today’s inflation figures, this assessment may have been pre-mature.

Stocks rallied and Treasury yields fell after the comments, but economists at Goldman Sachs said the consensus view of a kinder, gentler Fed is mistaken and I tend to agree with this assessment.

“Unlike the bond market, we did not view Powell’s speech as dovish…our forecast remains another two quarter-point hikes this year and four hikes in 2019,” said Daan Struyven, senior economist at Goldman.

This assessment provides some support for my contention that Powell may have inadvertently put the stock market in a bubble.