The U.S. economy showed remarkable resilience at the start of the year, highlighting robust demand that’s keeping inflation elevated and heaping pressure on the Federal Reserve to stomp the brakes even harder.
Retail sales rose last month by the most in nearly two years, and separate measures of manufacturing also came in better than expected, according to data out Wednesday. And home builders are feeling more confident as mortgage rates settle back from their highs late last year.
Combined with Tuesday’s inflation report, which showed annual consumer price increases were higher than forecast, the figures illustrate an economy seemingly spurning the Fed’s efforts to slow it down. Demand for goods and services is holding up, bolstered by a sturdy job market, while inflation remains persistent and elevated.
Bottom line: The Fed’s most aggressive interest-rate hikes in a generation haven’t yet had their intended effect, and policymakers are facing the prospects of having to do much more to corral inflation for good.
“The economy is generally performing better than expected so far in 2023, and inflation’s decline slowed at the turn of the year too,” Bill Adams, chief economist for Comerica Bank, said in a note. “These data collectively make the Fed more likely to surprise to the upside on interest rates again in 2023.”
Several Fed officials on Tuesday stressed the need for further interest-rate increases, but expressed differing views about how close they are to stopping.
Traders continued to see about a 50-50 chance of a quarter-point rate hike in June following increases of that magnitude in March and May, and they expect interest rates to peak around 5.3% in July.
The value of overall retail purchases increased 3% in January, the most since March 2021, according to Commerce Department data. The figures aren’t adjusted for inflation. All 13 retail categories rose last month, led by motor vehicle dealers, furniture stores and restaurants.
It’s not clear how much warmer weather may have helped underpin demand during the month and the sales figures mainly capture spending on merchandise. But receipts at restaurants and bars—the only service-sector category in the report—increased 7.2% in January. That was also the most since March 2021, when vaccines were rolling out and Americans took advantage of a fresh wave of stimulus payments.
Much of this demand is still traced to a strong job market, which stands at the heart of the Fed’s inflation fight. Hiring last month unexpectedly surged and unemployment fell to a 53-year low, while average hourly earnings grew at steady clip.
Areas of the economy that had been suffering like manufacturing and housing also appear to be stabilizing. Factory output rose in January by the most in nearly a year, according to Fed data, while a separate report showed New York state manufacturing activity shrank in February by less than forecast.
The New York survey showed increases in the measures of prices paid and received by the state’s manufacturers, indicating that while inflationary pressures are cooling, they remain stubborn. The index of prices received reached a six-month high.
In the housing sector, home builder sentiment increased in February by more than forecast, fueled by more optimism about sales, the outlook and a pickup in prospective-buyer traffic. Despite a tough 2022 for real estate, consecutive monthly gains in confidence suggest cautious optimism about demand during the critical spring selling season.
Both sectors are treading lightly as the heightened prospect of tighter Fed policy dashes hopes of a sustained recovery in the near term. While mortgage rates have retreated from last year’s highs, they still rose last week by the most in four months. And higher borrowing costs risk a pullback in capital investment.
Economists are reluctant to draw conclusions about one month’s worth of data, and some series can be especially volatile. Some also said a boost to incomes from a cost-of-living-adjustment to Social Security recipients in January helps explain some of the spike in spending.
Just as several questioned whether seasonal adjustments affected the employment data, some economists also wondered if unusually warm weather at the start of the year bolstered Wednesday’s data. In the industrial production report, the Fed said that milder temperatures depressed demand for heating in January, resulting in a record drop in utility output.
“Was manufacturing, consumer and home builder sentiment a weather story?” asked Neil Dutta, head of U.S. economic research at Renaissance Macro Research. “Some of these takes really strain credulity.”
Still, implications for near-term growth are strong. Several economists raised their estimates for first-quarter gross domestic product after the retail sales report, and a pickup in manufacturing and housing activity would be positive as well.
The Atlanta Fed’s GDPNow forecast for the first quarter was boosted to 2.4% from 2.2% after the Wednesday reports.
“The message is the economy doesn’t appear to be on the verge of slowing down rapidly in the first quarter,” said Michael Gapen, head of U.S. economics at Bank of America, who was one of two forecasters to correctly predict the 3% rise in retail sales.
Whether that momentum can be sustained is a different story. The higher the Fed goes, the greater the risk of recession. Oxford Economics anticipates that’ll happen as consumers burn through savings and spend less.
“While it may take time for spending to soften, we anticipate that cooling job and wage growth alongside stubborn inflation will drag down consumers’ willingness to spend,” economists Oren Klachkin and Ryan Sweet said in a note. “We continue to expect a recession later this year.”
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