Introduction

The word "restrictive" is suddenly here, and it's probably no accident. The message from Wednesday's FOMC minutes is the possibility of more not fewer rate hikes to come which points to the chance that the Federal Reserve, in an effort to slow the economy and reduce the risk of rising inflation, could raise rates past neutral. The risk that the federal funds rate could move through 2 percent and not stop in the low 3 percent area but instead keep on going follows Donald Trump's extended criticism of monetary policy, criticism that has reached a new pitch with the president now calling the Fed "my biggest threat". And it may not be just how much rates go up but how quickly they go up, stated straight out on Thursday by former vice chairman Stanley Fischer who cited the possibility that the Fed could very well "raise rates faster" to defend its independence. Unlike Fed policy which has been less and less stimulative, the administration's economic policy has been aggressively stimulative which is certain to help third-quarter GDP as evidenced by much of the week's economic data. And a major consequence of this stimulative effort is where we'll begin: the deepening of the government's debt.

The economy

The Treasury posted a solid $119 billion surplus in September as seen at the far right of the accompanying graph which tracks the government's balance on a month-to-month accumulative basis through the fiscal year, beginning in October and ending in September. Yet September's surplus hardly made a dent in the government's fiscal-year 2018 deficit which totaled $779 billion. This is 17 percent deeper than the $666 billion deficit of fiscal-year 2017 which in turn was 14 percent deeper than the $586 billion deficit of fiscal-year 2016. Government outlays this past fiscal year totaled a numbing $4.108 trillion for a 3.2 percent increase from fiscal-year 2017. Increased government spending is a classic Keynesian tool, priming the economy to create jobs.

Another tool of fiscal poilcy is taxation where rates, both for individuals and corporations, have been cut sharply this year. The cuts began in January and were billed by their supporters as budget friendly, that more money in the hands of workers and businesses would stimulate economic activity and, in the end, actually make for more, not less, tax revenues for the government. Call this what you will, voo-doo economics or dynamic scoring. Whatever the name, is it working? The accompanying graph tracks the green area of individual tax receipts with the blue area of corporate tax receipts, again on a month-to-month basis from January through September this year (after the tax cuts) vs January through September last year (before the tax cuts). On the individual side, the tax cuts do indeed appear to have worked as receipts rose $63 billion or 5.1 percent to $1.297 trillion. Lower taxes here helped to stimulate consumer spending and in turn helped create jobs making for more workers paying taxes. But the corporate side is another story. Here receipts over this period fell $80 billion or 36 percent to $141 billion. And the net result: $17 billion less tax revenue for the government. Of course we can't jump to conclusions and we'll have to see how tax revenues play out over the next year or so, but still the early verdict on the 2018 tax cuts: voo-doo economics.

The government's big budget deficit has been building all year and really proved no surprise. The week's big surprise was the FOMC minutes from the September meeting when policy makers raised their federal funds target an incremental 25 basis points to 2.125 percent. The hazy verbiage of the minutes doesn't exactly say how many of the 17 members agreed with this or that, just rough descriptions are given. But based on these descriptions, the number of hawks on the committee appear to edging out the number of doves. According to the minutes, "a number" of the members warned that the Fed's policy rate would eventually have to be raised above the neutral rate and into the "restrictive" zone. And highlighting this perceived need to cool the economy, "several" members said inflation could exceed the Fed's 2 percent target. In contrast, however, only "a couple" of the members spoke against moving rates past neutral. Members in general stuck to their well telegraphed plans for further rate hikes on a gradual basis. And based on FOMC projections which were updated at the September meeting, this means one more 25-basis-point hike before year-end followed by three more hikes next year that would lift the funds target to the neutral area at just over 3 percent or so. After that, who knows? How much would another 100 basis points or more in the funds rate slow the economy is another unknown but one effect – rising mortgage rates – is likely to be an unwelcome one for the softest spot of the economy right now.

If not a surprise, existing home sales were the week's big disappointment. Sales of existing homes fell 3.4 percent in September to a 5.150 million annualized rate that missed, not only Econoday's consensus for the sixth straight month in a row, but the low end of Econoday's consensus range. September's result is the weakest in nearly three years, since November 2015. The breakdown between single-family and condo sales offers no solace, with both falling a monthly 3.4 percent. Hurricane Florence which hit the Carolinas at mid-month didn't help September any as sales in the South fell 5.4 percent. Yet sales in the Midwest were nearly as weak, down 3.6 percent with sales in the Northeast down 2.9 percent. The Midwest did the best in September – at no change.

And all this weakness came about despite price discounting by sellers. The median sales price for an existing home fell a monthly 2.8 percent in September to $258,100. A comparison of year-on-year rates, at plus 4.2 percent for prices, with the sales rate, at minus 4.1 percent, suggests that prices may have further down to go. The weakness in sales along with the weakness in prices, not to mention a lack of interest in new homes, are not encouraging sellers to put their homes on the market. The number of resales on the market fell 1.6 percent in the month to 1.880 million though relative to sales, given how low sales are, supply actually improved, to 4.4 months from 4.3 months in August. Rising mortgage rates, now over 5 percent for 30-year fixed loans, are not helping the housing market, though the enormous strength of both the labor market and the stock market along with very strong consumer confidence should all be positives for home sales. The lack of wage gains, however, is a negative for home buyers not even to mention a great mystery of the 2018 economy. And another great mystery of this year's economy is the lack of interest in home ownership.

However strong third-quarter GDP may prove, it won't be getting much lift from residential investment. Housing starts in September came in on the low side of expectations, down 5.3 percent to a 1.201 million annualized rate with completions very weak, down 4.1 percent to a 1.162 million rate that's the lowest since November last year. Hurricane Florence certainly didn't help the South where starts fell 13.7 percent but the Midwest, which was not affected by the hurricane, saw starts fall 14.0 percent. Permits, which should be less affected by weather, fell 0.6 percent in September to 1.241 million which was well below expectations and, like completions, the weakest since November. Permits were pulled down by a sharp 7.6 percent drop for multi-units with single-family permits up a solid 2.9 percent. But even here, the year-on-year rates show the weakness, up only 2.4 percent for single-family permits, down 7.8 percent for multi-units with total permits down 1.0 percent. Looking at quarter-to-quarter comparisons, starts averaged 1.218 million which is down from 1.261 million in the second quarter in what points to yet another quarter of trouble for residential investment. This is the weak link in the 2018 economy.

Now let's turn to the good news in the week. Constructive inventory growth looks to be a major plus for third-quarter GDP. Business inventories rose 0.5 percent in August to $1.961 trillion broken down, as seen in the graph, among wholesalers and retailers, both at $643 billion, and manufacturers at $676 billion. Inventories at the wholesale level jumped a very strong 1.0 percent in August following a sizable 0.6 percent build in July. Retail inventory growth will also be a strong positive for third-quarter GDP. Inventories in this sector jumped 0.7 percent and follow an upwardly revised build of 0.6 percent in July. Inventories at manufacturers did slip 0.1 percent in August but follow July's very sizable 0.9 percent build. Relative to sales, total inventories remain lean and very healthy, at a sales-to-inventory ratio of 1.34 which is unchanged from July. Total sales for these sectors rose 0.5 percent in August and, at a year-on-year plus 7.8 percent, remain well ahead of inventory growth which is at 4.2 percent.

Another positive for the third-quarter GDP is likely, once again, to be business investment which has been getting a boost all year from the corporate tax cut. September's industrial production report showed a second month of outstanding strength for business equipment, up 0.8 percent following a 1.0 percent jump in August and both are reminders of June's huge 2.2 percent surge. Year-on-year, production of business equipment is up 3.6 percent which looks like a moderate growth rate but industrial production data track volumes and when adding in the rate of inflation, growth is closer to 6 percent which is plenty strong. Production of consumer goods has been on a shallower rise, up 0.2 percent in September with this yearly rate at plus 2.5 percent. Yet consumer goods could get a lift if prohibitive tariffs on Chinese goods are put into effect and domestic producers step in to make up the difference. The graph tracks the index levels for these two market groupings. Note the downdraft for business equipment during 2016 in what was fallout from the sharp 2015 decline in oil prices and its negative effect on demand for energy equipment. The industrial economy's sensitivity to oil prices is something to keep in mind amid the negative headlines coming out Saudi Arabia as well as the cut-off Iran is facing.

Keeping our focus on the factory sector, October reports from both the Philly Fed and Empire State showed a new twist: the working down of unfilled orders as well as improvement in delivery times and easing in cost pressures. Capacity stress has been a risk for these two samples who, on the demand side, are enjoying one of the great runs on record. Unfilled orders had been backing up but now both reports posted outright contractions in their October reports, at minus 2.3 for Philly and minus 8.4 for Empire State. This at the same time that new orders keep pouring in, at 19.3 and 22.5 respectively. Both of these samples appear to have built out new capacity limiting the risk that suppy-side shortages and contraints will slow future production and shipments. These report offer the best of both worlds and hint at a strong and well balanced year-end finish for the nation's manufacturing sector.

Long settled into a sweet spot are jobless claims with the latest data pointing squarely at solid strength for the October employment report. Initial claims fell 5,000 to a lower-than-expected 210,000 in the October 13 week with the 4-week average edging 2,000 higher to 211,750. The first reading on the effects of Hurricane Michael which hit Florida in the latest reporting week showed no impact as initial claims in the state actually fell, down more than 600 to just over 6,400. The effects of Hurricane Florence which hit the Carolinas last month appear to have faded altogether with claims in both states down sharply in the latest week. The October 13 week was also the sample week for the monthly employment report and a comparison with the sample week of the September employment shows only a slight increase, up 8,000 at the headline level and up 5,750 for the 4-week average. Though these comparisons do not point to accelerating strength for the October employment report, they nevertheless do point to healthy and steady month-to-month conditions in the labor market.

Continuing claims in lagging data for the October 6 week continue to make historic lows, down 13,000 overall to 1.640 million with the 4-week average down 1,250 to 1.653 million. Both of these readings are 45-year lows. The unemployment rate for insured workers remains unchanged at only 1.2 percent. Labor is hard to find and employers are holding on like never before to the employees they have which are central reasons why the Federal Reserve, seeking to avoid overheating in the jobs market, is raising interest rates.

Another reason employers are holding onto employees is that they have more and more jobs that are going unfilled. Job openings swelled to a record 7.136 million in August which easily exceeded Econoday's consensus range. Underscoring the surge is the comparison with last August which was at 6.044 million for an 18.1 percent gain. But the comparison that's most critical here is the number of unemployed actively looking for work, a number that is also compiled by the Labor Department and which stood at 6.234 million in August before moving sharply lower in the September employment report to 5.964 million. This gap between job openings and job seekers, which first opened up earlier this year, is hard evidence that labor is scarce. Other readings in the JOLTS report include a modest gain in the number of hires, to 5.784 million vs July's 5.713 which also is far below the number of openings. The number of quits are closely tracked in this report as an early indication of wage inflation. But there's no indication that workers are being pulled to higher paying jobs as quits slipped in the month to 3.577 million from July's 3.608 million. Jerome Powell concedes that it's a mystery why wages haven't been going up very much as demand for labor grows and the supply of labor declines. Yet sooner or later, the law of supply and demand is bound to assert itself, at least this is the risk that the Fed is guarding against in its rate-hike regime.

Markets: Cross-border cross fire

The threat of a tariff war with China has put cross-border trade in focus as well as cross-border investment. Treasury holdings by Chinese accounts are closely watched and so far there is no indication of concerted retaliation. Nevertheless, Chinese accounts did decrease their holdings in August but only slightly, by $6.0 billion to $1.165 trillion. Yet looking back at August 2017, Chinese holdings are down a noticeable $36.6 billion over the last year. A real surprise in the cross-border investment data is heavy outright selling of U.S. equities by foreign accounts, at a net $16.9 billion in August for the fourth decline in a row and the sixth decline of the last seven months. This is a heavy burst of selling that belies the record territority U.S. stocks are at and suggests that bullishness may be narrowly based among domestic accounts. And market turbulence is probably not a positive for any improvement in foreign investment during October.

The bottom line

From the Fed's perspective, the real risk of having their independence challenged is tied to psychology, inflation psychology that is from the point of view of the nation's consumers and businesses. Lack of certainty in the Fed's determination to hold down inflation, even the distant possibility of inflation, risks unanchoring inflation expectations. It's the long stability of these expectations and the confidence that the Fed is securely at the helm which Jerome Powell believes is behind three decades of price stability. The open conflict between monetary policy and fiscal policy, one in the making for the last two years, is a unique story of 2018.

Week of October 22 to October 26

The first look at third-quarter GDP caps off the week on Friday which will open on Monday with the national activity index. This index is expected to post a third straight solid reading in September in what could very well offer a preview of what to expect for Friday's GDP report. Housing is back in the news including FHFA house price data and new home sales, both out on Wednesday, and pending sales on Thursday which will update the biggest disappointment of 2018 – the existing home sales market. The Fed also gets back in the news with the Beige Book on Wednesday in a report where clues on wages and whether they're finally showing any life will be a main focus. Durable goods orders are out on Thursday with an aircraft-distorted downswing the expectation as will be international trade in goods which will offer a last look at what to expect for net exports in Friday's GDP report. The consensus for third-quarter GDP is a solid 3.3 percent growth rate with consumer spending, the economy's main driver, also seen at 3.3 percent.

Monday

National Activity Index for September

Consensus Forecast: 0.18

Consensus Range: 0.11 to 0.22

The national activity index has been posting solid gains though contributions from the report's four indexes have been shifting as production moved slightly higher in August and employment slightly lower. For September, forecasters see the national activity index, likely boosted by employment but held down by building permits, coming in at a consensus 0.18 in what would be unchanged from both August and July.

Tuesday

Richmond Fed Manufacturing Index for October

Consensus Forecast: 24

Consensus Range: 16 to 28

Acceleration for new orders in September points to overall strength for the Richmond Fed's manufacturing index in October which forecasters see coming in at a very strong 24 though down from September's 29. Unlike other regional reports where constraints appear to be easing, indications of capacity stress in this report, including rising costs and selling prices, have been on the climb.

Wednesday

FHFA House Price Index for August

Consensus Forecast, Month-to-Month Change: 0.3%

Consensus Range: 0.2% to 0.3%

Continued softness is what forecasters see for the FHFA house price index in August, at a consensus gain of 0.3 percent vs July's 0.2 percent rise which was the weakest since March this year. The year-on-year rate in July, at 6.4 percent, was the lowest since January last year.

PMI Composite for October Flash

Consensus Forecast: 54.1

Consensus Range: 53.7 to 54.7

PMI Manufacturing

Consensus Forecast: 55.5

Consensus Range: 53.3 to 55.6

PMI Services

Consensus Forecast: 54.0

Consensus Range: 52.6 to 54.5

A step back for services, tied to a drop in the year-ahead outlook amid rising costs, pulled down September's PMI composite to a final 53.9 vs September's mid-month flash of 53.4. In contrast the manufacturing PMI moved higher, rising to 55.6 on strength in domestic orders. For October's flashes, forecasters see little change with the consensus for the PMI composite at 54.1 with reacceleration for services to 54.0 and steady strength in manufacturing at 55.5.

New Home Sales for September

Consensus Forecast, Annualized Rate: 625,000

Consensus Range:  610,000 to 640,000

New home sales are expected to hold steady and relatively solid, at a 625,000 annualized rate in September vs August's 629,000 rate. Supply has been improving but price discounting has been apparent.

Beige Book

Prepared for the FOMC Meeting on November 7 & 8

The Beige Book's assessment of economic conditions has been noticeably softer this year than the FOMC's assessment. Though the last Beige Book in September did upgrade economic growth to "moderate" from "modest-to-moderate", household spending was described as only "modest". In contrast, "strong" was the FOMC's assessment for both. Yet the Beige Book's and the FOMC's assessment of the jobs market were the same, "strong". Given strong demand for labor and scarcity of quality labor, comments on wage inflation will be closely watched.

Thursday

Durable Goods Orders for September

Consensus Forecast, Month-to-Month Change: -1.4%

Consensus Range: -3.0% to 1.8%

Durable Goods Orders, Ex-Transportation

Consensus Forecast: 0.4%

Consensus Range: -0.5% to 1.0%

Durable Goods Orders, Core Capital Goods (Nondefense Ex-Aircraft)

Consensus Forecast: 0.5%

Consensus Range: 0.1% to 1.5%

Up one month and down the next is the usual story for durable goods orders due to large batches of aircraft orders that hit all at once and then ebb back. After August's 4.4 percent surge (revised from an initial 4.5 percent), forecasters see September durable goods orders falling 1.4 percent. Orders for core capital goods (nondefense ex-aircraft) were soft in August but were stronger in earlier months and a solid 0.5 percent gain for this reading is September's consensus. Ex-transportation orders are expected to rise 0.4 percent.

International Trade In Goods for September

Consensus Forecast, Month-to-Month Change: -$74.4 billion

Consensus Range: -$79.4 to -$72.6 billion

The September goods deficit is expected to narrow to a consensus $74.4 billion vs $75.5 billion in August (revised from an initial $75.8 billion). The results will update progress on third-quarter net exports which have been very unfavorable following what was solid improvement in the second quarter.

Advance Wholesale Inventories for September

Consensus Forecast, Month-to-Month Change: 0.4%

Consensus Range: 0.0% to 0.5%

Wholesale inventories are expected to rise 0.4 percent in September following a very sharp 1.0 percent build in August (revised from 0.8 percent in the advance reading). Despite the strong build underway, inventories relative to sales at the wholesale level have been lean.

Initial Jobless Claims for October 20 week

Consensus Forecast: 212,000

Consensus Range: 208,000 to 220,000

Hurricane Michael had no initial impact on jobless claims and very little impact is expected in the October 20 week. Initial jobless claims are expected to come in at 212,000 vs 210,000 in the October 13 week. Jobless claims are at historic lows to indicate unusually strong demand for labor.

Pending Home Sales Index for September

Consensus Forecast, Month-to-Month Change: 0.0%

Consensus Range: -0.5% to 0.5%

Pending home sales are expected to come in unchanged in September after falling a steep 1.8 percent in August that followed a 0.8 percent decline in July. Sales of existing homes have been very soft and may be the biggest disappointment of the 2018 economy.

Friday

Real GDP: 3rd Quarter, 1st Estimate, Annualized Rate

Consensus Forecast: 3.3%

Consensus Range: 2.6% to 3.8%

Real Consumer Spending, Annualized Rate

Consensus Forecast: 3.3%

Consensus Range: 3.1% to 3.5%

GDP Price Index

Consensus Forecast: 2.0%

Consensus Range: 1.4% to 3.2%

The first estimate for third-quarter GDP is expected to come in at a 3.3 percent annualized rate vs 4.2 percent in the second quarter. Consumer spending is expected to also come in at a 3.3 percent rate vs the prior quarter's very strong 3.8 percent. Inventories also look to be a central positive in the quarter along with business investment. Residential investment, however, looks weak. The GDP price index is seen at 2.0 percent vs 3.0 percent.

Consumer Sentiment Index, Final October

Consensus Forecast: 99.0

Consensus Range: 98.0 to 100.2

Expected to hold at the preliminary score of 99.0, Econoday's consensus for the final consumer sentiment index for October is expected to come in at 99.0. Despite strong confidence in the government's economic policies, October's preliminary report eased from September.