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KEY DATA: LEI: +0.4%/ Phila. Fed: -7.8 points/ Claims: down 11,000

IN A NUTSHELL: “Except for the manufacturing sector, the economy is in good shape, but that is a significant ‘but.’”

WHAT IT MEANS: With the rate hike behind us, it is time to start focusing on the economy and inflation. Inflation outside the energy sector is slowly accelerating, a reality the Fed has accepted, if not embraced. It gives them some breathing room to move gradually. But, as long as that acceleration continues, the rate hikes will follow. As for the economy, its strength will ultimately determine how fast labor shortages appear, wages rise and firms are forced to start raising prices. The Conference Board’s Leading Economic Index is pointing to very solid growth ahead. After jumping in October, it rose strongly in November. These back-to-back large gains are hinting that growth should accelerate going forward. I hope so, since my forecast has that. Current conditions are not that strong and that supports most economists’ views that fourth quarter growth will be good but not great.

The one sector that has been under pressure lately is manufacturing and that softness doesn’t look like it is going away. The Philadelphia Federal Reserve’s December Manufacturing Index plunged into negative territory after having crawled out of the red in November. Falling orders, shrinking backlogs and declining prices don’t indicate any strength in this sector. Interestingly, though, hiring and the workweek picked up. That seems to show that the slowdown may be viewed as temporary. The labor numbers need to be watched carefully as I believe that will be the source of cost pressures and ultimately price pressures. There were questions asked about 2016 cost projections and the respondents expect wages and benefits to rise by about 3.5%. Those that expect costs to rise faster next year and those that expect them to rise at the same pace they did this year were evenly split. Very few firms expect labor costs to rise slower in 2016.

Speaking of the labor markets, weekly unemployment claims dropped back to what is now the “usual” level last week. Of course usual is not normal as the level is consistent with further tightening in what is already a tight labor market.

MARKETS AND FED POLICY IMPLICATIONS: The Fed cleared easily the first hurdle in the process of moving back toward normal interest rates. The pathway, however, is hardly clear. The members, in their forecasts, point to moves every other meeting. The markets don’t quite agree and think there will be fewer increases. I don’t agree either, but I think there will be five, not four increases. The key, as I mentioned in my commentary yesterday, is inflation. Through most of 2015, the year-over-decline in oil prices had hovered between 40% and 50% down. Before the latest downdraft in prices, I had expected those drops to largely disappear in the first quarter of next year and the top line inflation number to move above 2%. If we stay below $40/barrel, that will take longer. I expect the core rate to hit 2% by the fall part and stay there. So, will the Fed worry about oil? Probably not. But what may concern them is the downward pressure created by declining import prices. If the dollar keeps strengthening, it will take even longer for the headline inflation number to get to 2%. That said, I would be surprised if it didn’t happen during the second half of 2016, which is why I have five moves next year.