Today's Headlines: Can the Fed Balance Inflation and Unemployment as the Mideast Erupts?

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Today's Headlines: Can the Fed Balance Inflation and Unemployment as the Mideast Erupts?
June 24, 2017
Iraq in Turmoil as Fed Adjusts GDP Downward

The reputed Chinese curse, “May you live in interesting times,” is a good descriptor of the current headlines. On the geopolitical front, the long civil war in Syria has now engulfed Iraq, as Sunni forces (the self-proclaimed ISIS) are threatening the Shiite dominated Maliki government – which for the moment is supported by both the US and Iran. (Interesting bedfellows, indeed.) ISIS now controls oil-rich northern Iraq, has secured the border with Syria, and has occupied the nation’s second largest city, Mosul.

Meanwhile, back at the Fed, the big headline last week was their downward revision of the 2014 GDP forecast. The 2014 estimate was revised down to 2.1-2.3% from March's projection of 2.8-3.0%. This is in line with International Money Fund actions – the IMF dropped their estimate on U.S. GDP growth from 2.8% to 2%. Both the IMF and the Fed continue to predict stronger growth of near 3% in 2015, and similar growth beyond that. Both forecast inflation to remain below 2% through 2017 (the current Fed Forecast is 1.5-1.7% inflation for 2014).

With the Mideast in turmoil and US housing facing stronger than expected headwinds, is that optimistic or realistic? Let’s dig deeper to find out….

The Unemployment and Inflation Tightrope

While the Fed’s GDP projection is now gloomier for the year, its employment projection improved somewhat. Their 2014 unemployment forecast was reduced from 6.1 - 6.3% to 6.0 - 6.1%, with an expectation of leveling into the mid-5% range around 2015 and 2016. As new jobless claims have trended downward for the past two months, that projection is plausible. However, the unanswered question is whether there is more slack in the employment market than those numbers would suggest -- due to the long-term unemployed and underemployed.

The US mission chief for the IMF, Nigel Clark, said the IMF foresees continued "relatively high unemployment and a lot of slack in the labor market". The Fed seems less pessimistic but echoes those potential concerns.

The Fed's mission, of course, is to simultaneously maximize employment and price stability, sparking growth to initiate job creation while balancing any resulting inflation. Those properties do not always behave in lockstep.

The inflation projection already seems shakier than unemployment. The Consumer Price Index (CPI) rose 0.4% in May after a 0.3% rise in April, putting the inflation number for the last 12 months at 2.1%. Inflation is already above the estimate and trending upward, with price increases in all sectors across the board – without factoring in the current instability in Iraq.

As to oil prices, that instability is having an immediate impact. The ISIS threat in Iraq pushed the price of Brent crude oil to $115 per barrel last week, and WTI crude hit $106 per barrel. As a frame of reference, Brad McMillan, the CIO of Commonwealth Financial Network, said, "Estimates vary, but each $10 increase per barrel can knock off about 0.2% from economic growth." Clearly, sustained turmoil in in the Mideast can be catastrophic to western economies, just as it devastates local populations.

So at this point, we have rising prices compared with inflation-adjusted earnings decreases of 0.1%, which adds up to lower consumer spending and still slower growth. We have slowly improving employment, which may pick up some of the growth slack – depending on how representative the numbers are. The housing market doesn’t seem capable of picking up that slack at this point in time. According to Freddie Mac’s June 2014 Economic & Housing Market Outlook, housing growth is “lackluster.” Freddie’s chief economists, Frank E. Nothhaft and Leonard Kiefer said in the report that the year had started out “far more sluggish than anticipated. Existing home sales have slipped 7% compared to the same period in 2013 and new home sales are off 3%.”

How high oil prices climb is unknown, but higher costs are likely to depress growth for some time given the Mideast instability. Consequently, we have the potential of inflation increasing disproportionately to growth, and therefore to job creation.

The Takeaway

The CPI rise has been dismissed so far as noise, but a couple more months of rising prices and/or continued disruption in the oil supply is likely to cause a change of tune. How the Fed will dance to that tune remains uncertain.

They have continually suggested interest rates will be kept low for some time after the bond-buying program ceases, but always include caveats based on the inflation rate. The Fed may have to accept higher inflation (for a hopefully short time) to improve the employment picture.

Perhaps the Fed can tweak the economy and meet their dual goal, attempting to steer an aircraft carrier with the precision of a speedboat. It seems increasingly difficult for them to do so – as the sources of inflation today are not entirely within their control.

From an investing standpoint, after turning in a strong performance last week, the stock market appears to lack direction due to growing Mideast turmoil. However, our old friend-in-a-crisis -- gold -- is rebounding smartly. After losing 30% of its value in 2013, bullion saw its biggest one-day rise over the past nine months on Friday, surging 3.4%. It continues climbing as of this writing on June 23, 2014.

So what lies ahead for you and your money? The signals are mixed, so it’s anyone’s guess. The only sure bet is that the next few months will remain interesting.

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