A Thumbnail Sketch of US Economy: No QE3

The US reports April PPI Friday and after the unexpectedly large decline in April import prices (-0.5%), there is downside risk to the Bloomberg consensus estimate of no change on the month. Import prices are up 0.5% year-over-year, the smallest increase since late 2009.

The trend lower in commodity prices is likely to be picked up in the PPI figures. Headline PPI has been trending lower since last September. The more worrisome impulses for core inflation is emanating from rising unit labor costs. Headline inflation converges with core and core itself appears to track unit labor costs fairly closely.

Also, what is pushing up measure of core inflation is the decline in vacancy rate in both rental and owner occupied properties. While this is encouraging for the depressed housing sector (where some signs of life have been detected, especially among multifamily units), it warns of limited downside to core inflation.  

Separately, the Atlanta Fed has something interesting to say about the decline in the labor force participation rate. Its study suggest 40% of the decline to 63.6% (lowest since 1981) is due to demographics--baby boom generation--which corresponds to our analysis that a good part of the decline in the participation rate can be attributed to people who say they do not want a job.

The Atlanta Fed found that if the unemployment rate fell to 7.5%, as the mid-point of the Fed's forecast has it, by the end of next year, and the participation rate remained at 63.6%, it would require an average monthly non-farm payroll gain of 144k.

This job creation pace seems to be modest and do-able.  That means that core inflation is unlikely to show any sign, not even one iota of deflation risks and job growth is likely to be in line with the Fed's forecasts.  In turn, this is why, contrary to what some have suggested, QE3 is unlikely to be announced in June and that Operation Twist will simply be completed.  

The moderation of the US economy in Q1 and likely in the current quarter seems partly a function of seasonal adjustment issues (weather as well as Lehman-related) and bringing production back into line with demand. However, there are several reasons to expect the US economy to re-accelerate in the coming months.

The decline in the price of gasoline should help lift disposable income. The survey of senior loan officers reported the strongest demand for both household and business credit. Demand had seemed to be the missing element. Consumer credit has increased and it cannot all be written off to trying to beat the doubling of the interest rate on student loans. The falling vacancy rate discussed above is also is a supportive factor for confidence and perhaps even the wealth effect if it leads to firmer prices.