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Posted on JUN 19, 2017

Johnson Bank Wealth Weekly Investment Commentary | Monday, June 19

This is part of an ongoing series of Weekly Commentary articles published by Johnson Financial Group.
This week's issue is written by Brian Andrew, SVP, Chief Investment Officer.

Window Washing and the Fed

It seems unlikely that a visit from a local high school senior could have anything to do with the Fed's decision last week to raise the Federal Funds rate by a quarter of a percent. However, the two are inextricably linked as they wrestle with the same forces in their decision making. The factors the senior considered before starting his window washing business are the same as those considered by the Fed. Let me explain.

Labor Cost

Last weekend I was paid a visit from a neighbor's son, who was passing out fliers for his window washing business. He explained that he had started this business in order to “develop real‐world business experience.” The cost was $12 per window. I remembered that he had been around the previous summer and the cost was $10. He explained that he would have liked to keep the price the same but in order to entice his classmates to come work for him, he needed to pay them a wage that was competitive with their other opportunities. He said there were more jobs available this summer than last.

That story sounded familiar. Last week when the Fed issued its statement along with the bump up in interest rates, it indicated that one of the reasons it wanted to stay the course with increases was its concern about wage inflation as the labor market tightens. The current unemployment rate of 4.3% not only tightens the labor market for high school seniors but for many other industries as well. The chart below shows the acceleration in wage growth that has occurred in the last several years. The chart provides the year‐over‐year change in the average hourly earnings for all employees in the private sector. While the last two months have shown a decline from 2.8% to 2.5% growth, the positive trend appears intact.

Graph showing the average hourly earnings of all employees percent increase from year to year.

We've written about the Fed's desire to “normalize” interest rates. It believes inflation and employment are at such levels that it no longer needs to maintain its abnormally low interest rate policy. The chart above highlights why the Fed's policy is more about normalization than about raising rates. Normally, wage growth would be closer to 4% at this point in a business cycle recovery, and the most recent number was 2.5%. Apparently, the rest of the economy isn't growing wages at the same pace as the local window washing service.

In fact, on the day the Fed announced the higher target for the Fed Funds rate, a measure of inflation, the Consumer Price Index (CPI) was released. The annual rate for CPI was 1.9% and the less volatile core rate was up 1.7%. Both numbers were below the Fed's target rate of 2%.

So if unemployment is at 4.3% and the labor market is tightening, why aren't wages, along with other forms of inflation, going up faster?

Low Inflation

One of the main reasons for the lack of inflation has to do with another announcement last week: The acquisition of Whole Foods by Amazon. The juggernaut that is Amazon has made consumers smarter about prices. Price shopping has become significantly easier because of Amazon and other internet‐based disruptors. You no longer have to travel from store to store looking for the best price — you can log into your Amazon Prime account, compare prices from a number of providers and place your order.

As was written in many of the stories over the weekend regarding the Amazon/Whole Foods acquisition, Amazon will likely be able to provide more competitive pricing for the organic foods that Whole Foods offers, i.e., reduce the inflation rate of the food we buy.

Another reason for low inflation and wage growth has to do with the skills gap. Many of the commercial customers I've met with over the last several months have told the same story. They have jobs available but they cannot find the right people with the skills needed. Moreover, they say there aren't any people with the skills needed and they know they have to be careful about bidding up the cost of jobs too much, so they do less poaching of employees from competitors. Some indicate that labor is global now, so they can find overseas methods of fulfilling the skills gap at a lower cost. Of course, in the case of the entrepreneurial senior, that isn't an option. He must raise wages to attract talent to his business.

Bond Market

While the rate of economic growth and inflation remain low, the Fed will continue down the same path of normalizing short‐term interest rates and its policies. However, bond investors will continue to focus on the economy's performance and the real rate of inflation to price bonds. This was evident last week. As the Fed was announcing higher rates, the 10‐year Treasury price rallied, sending its yield lower. In fact, the rate got as low as 2.1%, half a percent below where we were at the beginning of the year. Bond investors were reacting more to the low rate of inflation announced last week as well as economic data that was weaker than expected. This conundrum will continue to play out between the Fed and bond investors, and our current view is that the investors are likely right about slower inflation and growth ahead.

Brian Andrew
As Chief Investment Officer, Brian Andrew leads Johnson Financial Group's investment strategy
to provide consistent, actionable investment solutions for our clients.

This information is for educational and illustrative purposes only and should not be used or construed as financial advice, an offer to sell, a solicitation, an offer to buy or a recommendation for any security. Opinions expressed herein are as of the date of this report and do not necessarily represent the views of Johnson Financial Group and/or its affiliates. Johnson Financial Group and/or its affiliates may issue reports or have opinions that are inconsistent with this report. Johnson Financial Group and/or its affiliates do not warrant the accuracy or completeness of information contained herein. Such information is subject to change without notice and is not intended to influence your investment decisions. Johnson Financial Group and/or its affiliates do not provide legal or tax advice to clients. You should review your particular circumstances with your independent legal and tax advisors. Whether any planned tax result is realized by you depends on the specific facts of your own situation at the time your taxes are prepared. Past performance is no guarantee of future results. All performance data, while deemed obtained from reliable sources, are not guaranteed for accuracy. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Asset allocation and diversification do not assure or guarantee better performance and cannot eliminate the risk of investment losses. Certain investments, like real estate, equity investments and fixed income securities, carry a certain degree of risk and may not be suitable for all investors. An investor could lose all or a substantial amount of his or her investment. Johnson Financial Group is the parent company of Johnson Bank, Cleary Gull Advisors Inc. and Johnson Insurance Services LLC. NOT FDIC INSURED * NO BANK GUARANTEE * MAY LOSE VALUE


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