Today’s Beige Book indicated that economic activity across all twelve Federal Reserve Districts expanded at a modest to moderate pace in January and February. Led by strong consumption fundamentals, sentiment remains positive and has further upside potential, owing to tax cuts.
Consumption was reported to be mixed, with non-auto retail sales posting solid activity, in contrast to auto purchases which floundered across districts. This confirms that previous strength related to hurricane vehicle replacement has likely dried up, with an increase in borrowing costs likely to weigh on auto purchases over the remainder of the year. On the other hand, retailers are confident that non-auto purchases will continue to be supported by consumer confidence and tightening labor markets.
Prices increased at a moderate pace, with inputs to construction, including lumber and steel, increasing notably. Transportation costs also ticked up on higher fuel costs that increased freight rates. Some steel producers reported raising selling prices on account of the resolution of pending trade cases and these cost increases were absorbed by manufacturers further down the supply chain. However, their ability to pass these increases on to final consumers was largely unchanged from the previous report. At the same time, retailers cited competition as a reason for holding selling prices steady or decreasing them in some cases.
Extending last year’s trend, residential real estate inventories remained thin, leading to steady growth in home prices. Continued labor scarcity and a lack of land proved to limit construction of homes. In turn, this restrained home purchases, due to the lack of options on the market. At the same time, a scarcity of labor also limited construction activity, with contacts reporting little relief in the near future. This is in contrast to the commercial real estate segment, with reports of robust activity in three Districts representing an improvement from the prior report. Favorable business conditions have supported this trend recently and will likely continue to as the effects of the Tax Cuts and Jobs Act (TCJA) continue materializing over the remainder of the year.
Employment grew moderately, with Districts universally reporting labor market tightness and heightened demand for qualified workers. Increasingly, employers are outsourcing hiring to staffing placement services as the search for workers becomes cumbersome. Again, manufacturing and construction workers were in short supply, with information technology workers being added to the list. This led employers to increase wages and expand benefit packages, with a select few Districts reporting compensation increases owing to the TCJA.
Key Implications
This Beige Book confirms that the economy continued to expand at a solid clip at the start of 2018. Employer sentiment remained elevated amid strong household spending, while inflation pressures continued to build, with steady increases in labor and non-labor input costs suggesting that selling prices will rise over the year. Several employers reported increasing compensation as a result of the TCJA, with others raising wages in order to remain competitive and retain workers. Building material prices and transportation costs continued to exhibit some of the most pronounced price pressures amid heightened demand. This could be amplified in the near future with the implementation of tariffs that producers would pass on to consumers. Speculation surrounding the implementation of tariffs adds to pre-existing uncertainty in the manufacturing industry regarding NAFTA negotiations. Moreover, the increase in input costs could further strain housing construction that is already being limited by quickly rising land and building material costs.
Despite supply-side uncertainty, household spending continues to be upheld by labor market tightness, and that has propped up demand in housing markets amid quickly escalating prices. However, some metro housing markets are becoming increasingly unaffordable as housing inventories dwindle. Tax code changes will amplify this in high-priced and high-tax markets, with robust wage gains only partially mitigating these effects. Specifically, the lower cap on the mortgage interest deduction (down from $1M to $750k), combined with the implementation of the $10,000 cap on state and local tax deductions (which includes property taxes), will raise the cost of homeownership notably in high-priced and high-tax markets including those in New York and the District of Columbia, which will slow home price growth. Additionally, these unfavorable tax measures may hinder the ability of these regions to attract workers in the future, exacerbating labor shortage issues.
This report suggested that businesses remain optimistic and are increasingly passing on increases in input prices. As such, these should show up in headline inflation figures in the near future. That will enable the Fed to proceed with three hikes this year, with the first of these likely to take place later this month. Further upside potential comes from the budget deal that should foster additional growth and inflationary pressures.
