The Economy: May's Signs of Strength

A stronger-than-expected surge in retail sales and a spike in import prices will keep things tricky for the Fed

Economic reports released June 13 should turn up the heat for the remarkably bearish bond market—and for the Federal Reserve. The day's economic releases included reports showing surprising headline strength in U.S. May retail sales, alongside a troublesome rise in import prices. Adding insult to injury, the MBA purchase index posted a robust 7.2% surge for the first full week of June.

Despite an eye-popping May headline gain for retail sales, the strength will be readily absorbed in our forecasts of 2.0% real consumption growth in the second quarter, and our expectation of a 3.5% gross domestic product gain. And while import prices spiked, export prices finally broke a five-month string of oversized gains, providing a small silver lining for the Fed's inflation cloud. The MBA purchase index surge was impressive, but its likely to be reversed over the coming weeks as the mortgage market reacts to outsized rate increases.

Here is Action Economics' rundown of the June 13 reports:

Retail Sales: Retail sales rebounded a solid 1.4% in May. This followed an upwardly revised 0.1% decrease in April from a 0.2% fall initially. The ex-auto component rose 1.3% following a revised 0.1% increase in April (flat previously). Strength was broad-based, but rising gas prices continued to provide a boost, with gas station sales up 3.8%. A 2.7% rebound in clothing sales also boosted spending. Building materials climbed 2.1%, and food and beverage sales were up 0.3%.

The May sales data were certainly strong, though the auto and building material gains won't translate to the consumption figures in the GDP accounts. And the 2% second-quarter real (i.e., adjusted for inflation) consumption gain we project is still quite respectable, given the outsized consumption increases over the prior two quarters of 4.4% in the first quarter and 4.2% in the 2006 fourth quarter. Those prior gains left the strongest two-quarter combo since the middle two quarters of 2003.

The moderation in real spending growth in the second quarter must be seen as a temporary hit from the gasoline price surge, with continued strength in nominal spending. This strength in sales over the last half-year is the primary driver for the end to the inventory downdraft at the start of the second quarter, which explains the likely stronger growth path for GDP in the second quarter and beyond. We will continue to assume an upward adjustment in the first-quarter GDP gain to 0.9% from 0.6%, with the boost from net exports and inventories, alongside a downward construction revision.

Trade Prices: Import prices were up another 0.9% in May following a 1.4% surge in April (revised up from 1.3%). Petroleum import prices rose 2.7%. Excluding petroleum, import prices were up 0.5%. Food and beverage import prices were up a hearty 0.9%, though consumer goods import prices were flat. Export prices rose 0.1% after a 0.3% increase in April. Food and beverage prices fell 0.2%, and the agricultural-price component was flat, though ex-agriculture prices rose 0.2%.

The pause in big export price gains made the report somewhat less troublesome than the big headline import price gain might suggest.

May import price strength will still be of concern to the Fed, as it reflected both the big 0.5% ex-petroleum increase and a 2.7% petroleum price surge that reflected bigger price gains in global oil prices than what the smaller increase in the U.S. benchmark grade of crude oil would suggest. Refinery shutdowns in the U.S. widened these spreads, leaving a stronger growth path for oil prices through the month than suggested by the U.S. benchmark.

The May export price data were restrained by the flat ag-price figure, but we still saw a 0.2% ex-agriculture price gain that fell only modestly short of our 0.3% estimate. Nevertheless, this gain fell well short of the remarkably large 0.5%-0.6% gains seen in each of the prior five months, and is of some relief even though the Fed will presumably want this growth trend to cool further.

We will assume 0.2% core (excluding food and energy) gains for the producer price, consumer price, and core PCE chain price indexes in May, but with larger headline gains of 1.0% for PPI, 0.6% for CPI, and 0.5% for PCE chain prices. The firm import price data and still troublesome export price gains despite some May relief will remain a thorn in the side of the Fed, especially now as downside economic risks appear to be diminishing rapidly.

MBA mortgage index: The index bounced 6.6% for the first full week of June, along with a 7.2% jump in the purchase index and a 5.6% surge in refinancing activity.

The sharp across-board gains—at the same time that fixed mortgage rates surged over a quarter percent—suggests that some home buyers were panicked into locking-in mortgages before rates ran even higher. The average 30-year fixed rate jumped 26 basis points to 6.61%, the highest level in nearly a year and above the 6.5% psych threshold. The 15-year fixed rate surged 15 basis points to 6.28%, and the 1-year ARM inexplicably fell 26 basis points to 5.48% (perhaps lack of demand).

Thus for the near-term it appears that the jump in mortgage rates might be a stimulant for home buyers sitting on the fence, though a sustained drive higher would certainly slow the housing market recovery.

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