Sluggish pay gains holding economy back

INDICATOR: May Income and Spending/Weekly Jobless Claims

KEY DATA: Consumption: +0.3%; Disposable Income: +0.5%; Prices: +0.1%/Jobless Claims: 346,000 (down 9,000)

IN A NUTSHELL: "Wages and salary growth remains sluggish and that is what is holding the economy back."

WHAT IT MEANS: The economy limped along in the first quarter of the year and it looks like growth will not be much better in the spring quarter. Household spending rose moderately in May but we continue to see little gains in the key services component. As I have noted before, services are two-thirds of all spending and forty-five percent of the economy. While rising vehicle sales can help, we cannot get strong consumption or economic growth without spending on services picking up. Will that happen? Not unless we see better increases in wages and salaries. There was a nice rise in personal income and in labor compensation, but the level is still somewhat dismal. But the major reason there was a large rise in disposable income, the money we have left after the government gets it take, was a rebound in government social benefits, including Social Security, Medicare and Medicaid. That accounted for half the rise in personal income. Still, with income growing faster than spending, the savings rate did increase, though the 3.2% pace is nothing great. The one thing that is helping is minimal inflation. Over the year, consumer costs are rising at about a 1% pace, about half what the Fed would like to see.

The only way wages and salary growth will accelerate is if the labor market tightens and that is happening, but brutally slowly. Unemployment claims fell but the four-week average is still a lot closer to 350,000 than the 300,000 to 325,000 level that would signal a strong market. It is likely the unemployment rate will ease in June, probably back to 7.5%, but we need to get below 7% at a minimum before wage pressures start to build and that is a long way off.

MARKETS AND FED POLICY IMPLICATIONS: On the surface, the data look good but in reality they indicate more of the same. The robust income growth owed more to the government than the private sector while services spending remains weak. Consumption grew by 2.6% in the first quarter and it is not likely that pace will be matched in the second quarter. That does not bode well for GDP growth, especially if sequestration strangles government spending again. Whether traders recognize that the details are not great is a different story so it is hard to determine how the markets will react. But if anyone thinks this report supports the Fed's decision to start removing QE by year's end they are misreading this report. Indeed, with inflation well below the Fed's target, you would think the monetary authorities might want to encourage much faster growth.