Reluctant retail reversal

Retail sales fell sharply in January, but most economists blamed wildfires and unusually bad weather. Hence the consensus was looking for reversal of most of the drop. Today’s data showed a weaker than expected reversal. For sales overall, the drop in January was revised down from -0.9% to -1.2%, and the rebound in February was just 0.2%. The “control” measure that is used to calculate GDP was better, rising 1.0% on the month following a 1.0% decline in January. The consumer may have stalled to start the year.

Blame game

A key question for economists and investors is how much of the weakness was due to policy uncertainty shocks and how much was already in train before those shocks appeared. If the weakness was already in train, then the economy could remain weak even if the policy uncertainty abates. By contrast, if policy uncertainty is the story, then the Trump Administration could stop the weakening going forward by reducing uncertainty.

My guess is that there is a little of both here. Clearly the drop in retail sales in January was too early to blame on uncertainty and confidence shocks. Wildfires and unusually bad winter weather are an obvious culprit. The lack of a strong reversal could be blamed on confidence and uncertainty shocks that built over the month, but in my view, those effects should have been small for the month overall. I still think hard data for February should look solid, as we already saw with the jobs report.

Looking ahead, I still see a “calm before the storm” as it takes time for the policy shocks to impact hard data. Policy uncertainty has been steadily building for three months now, impacting growth with a lag. I expect much weaker data this month and in the Spring.

The Fed: like a deer in the headlights?

This adds to the dilemma for the Fed. While most press coverage suggests the main risk to the economy is weaker growth, in fact there are major concerns on both sides of their mandate.

On the inflation side, despite the optimistic spin in the press, the February CPI report was not encouraging. Modern measures of core inflation—that strip out the most volatile components—remain sticky high (chart). Every month of above-target inflation increases the risk of inflation expectations unanchoring higher. The Fed should be worried that tariff-driven price increases could be the final straw.

Inflation expectations have moved up since the COVID shock and that increase could be accelerating. The good news: data from the NY Fed shows household expectations are relatively stable at about 3%. This is true for one-year, -three-year and five-year expectations. The mixed news: the bond market is now pricing in higher inflation for the next five years, but after that expects it to be softer. The bad news: both the Conference Board and Michigan metrics have surged. Most important, my favorite gauge of inflation expectations—five-to-ten-year expectations from the Michigan survey—has jumped to 3.9% (Chart).

At the same time, the Fed must be increasingly worried about growth. The economy may have already been slowing before the uncertainty/confidence shocks hit. More important, the evidence of major shocks is building. The latest evidence is the very sharp drop in the Michigan sentiment index and the continued rise in the economic policy uncertainty index. This index is based on a search of major newspapers and is now at its highest level in its roughly 40 year history. (Chart)

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All of this puts a wide-eyed Fed in the headlights. FOMC members say they are in a good position to react to the risks on both sides, but it is not at all clear which way they should “jump.” ?Adding to their balancing act, they also want to avoid sounding political or taking sides in the policy debate. That is very hard to do when most of the risks come from policy. Hence, I don’t expect a lot from this week’s meeting as they underscore uncertainty, patience, and two-sided risks.