Retail sales were much stronger than expected in June but were close to what most expected once adjusted for the downward revision for May. Sales rebounded 0.6% in June and were up 1.3% excluding autos. Core sales--headline sales excluding autos, gas, and building material, which are directly accounted for in GDP calculations--were up 1.3% in June after falling 0.6% the month earlier. Eating/drinking establishment sales rose a solid 2.3% following the prior month's increase of 3.7%, now back above the prepandemic high.

Chart 1

For the second quarter as a whole, core retail sales were up close to 14%, but when mapping into real consumer spending, or "volume" terms (these retail sales numbers are in nominal terms), the growth is only half as impressive given the relatively high CPI inflation during the quarter. Core retail sales combined with auto sales is a good proxy for goods consumption (which is about one-third of total consumption), so June's retail sales suggest that goods consumption growth likely peaked in the first quarter. Even as real goods consumption stalled in the second quarter, the strength in the spending rebound of services (illustrated by the restaurants and bars sales in the retail sales report) will likely still bring second quarter real consumer spending growth close to our forecast of 11.2% (quarter-over-quarter annualized).

Autos Holding Back Industrial Production

While weakness in vehicles and parts sales continued (declining another 2.0% in June after having declined 4.6% in May) in retail sales data, the auto-sector related drag also played out in industrial production. Industrial production increased only 0.4% in June, which was a tad below the consensus expectation. The monthly gain was driven by mining (1.4%) and utilities (2.7%), offset by a 0.1% decline in manufacturing, where supply chain problems continued to weigh on auto output.

Gains in manufacturing of aerospace and related transportation equipment as well as primary metals were more than offset by a 6.6% monthly drop in auto manufacturing. Motor vehicle production continued to seesaw--up one month, down another--throughout this year as the short supply of semiconductor (a much-needed input) continued to pose problems. On the bright side, the New York Fed's Empire Index rose to a record in July, an early indicator of factories working to fulfill orders to restock those depleted inventories. Business inventories rose 0.5% in May following a revised 0.1% in April, which helped the business inventories to sales ratio tick up to 1.26 in May from a nine-year low of 1.25 in April.

The pace of inventory accumulation has clearly been slower than we had anticipated in the second quarter. Combined with non-residential construction, which is tracking another quarter of decline, our GDP forecast for 11.6% annualized growth in the second quarter may be on the optimistic side when preliminary estimate comes out near end-July (see calendar of data release in table 2).

The Consumption Basket Costs More in June

The jump in June headline and core Consumer Price Index (CPI) inflation caught everyone's attention again, with headline and core prices rising 0.9% from a month earlier, translating to a rise of 5.4% and 4.5%, respectively, compared to June 2020 (see chart 2). In the second quarter, when the reopening of the economy was in full swing with steadily declining restrictions and increasing vaccinations, headline and core inflation averaged 4.8% and 3.7% respectively, close to our forecasts of 4.7% and 3.6%. (see "Economic Outlook U.S. Q3 2021: Sun, Sun, Sun, Here It Comes" June 24, 2021).

Chart 2

The price categories highly visible to households--energy and food--were up by 24.5% and 2.4%, respectively, over the past 12 months. Stripping out the generally volatile energy and food component, the uptick in core CPI (79% of the consumer basket) was mainly a result of higher vehicle prices, with the price index for used cars and trucks rising 10.5% in June from May and accounting for more than one-third of the overall price increase. Reopening-related goods and services, such as airline fares, event tickets, and apparel, also contributed to the rise in prices. Idiosyncratic supply constraints and price normalization due to the reopening has continued to contribute more to the recent spike in inflation compared to last year than anything else (see chart 3).

Chart 3

Auto-Related Supply Issues Pushed Prices Up

One outsize driver for the sharp consumer price hike can be found on the supply side. Higher costs of production are passed through to consumers, with automobiles and related goods and services contributing to a considerable portion of the price jump.

The Producer Price Index for final demand increased by 1% in June, increasing 7.3% on an unadjusted basis compared to the previous year. Almost 60% of the jump in producer prices came from a 0.8% increase in prices for final demand service, with the margins for automobiles and automobile parts retailing rising by 10.5%, exactly the same as the rise in the prices of used cars and trucks, signaling that bottlenecks in vehicle production (due to a shortage of semiconductors, which are essential to the production of integrated circuits or chips) have made substitutes of new vehicles more expensive. Against the backdrop of fewer vehicle sales in the second quarter, the hike in vehicle prices has mostly been a supply issue in the past three months.

Considering supply chains, we could see that the major contributors to the price increase in June are also auto-related. Nearly one-fifth of the rise in the price index of processed goods for intermediate demand can be traced to a 6.2% jump in prices for steel mill products, and 30% of the rise in the index of services for intermediate demand came from a monthly increase of 13.9% in the prices for metals, minerals, and ores wholesaling.

In fact, auto-related supply chain issues emerged as the major driver of price increases in the second quarter. From April to June, the contribution to headline CPI inflation from auto-related goods and services averaged 20%, much higher than the average of 3.7% in the first quarter. At this point, it is hard to say when this supply issue might get resolved--it could take much of this year and perhaps some time through next year for the resulting chips to work their way through the supply chain products.

Near-Term Inflation Expectation Picked Up, But Long-Term Expectation Stabilized

As gasoline and food prices resurged since February, consumer short-term inflation expectations jumped around in the range of 4.2%-4.8%: rising to 4.6% in May, dipping to 4.2% in June, and hitting 4.8% in early July (compared with 2.5% precrisis), due to the high visibility of these prices in daily life. However, long-term inflation expectations from the financial markets' point of view seem to have stabilized, with the five-year forward looking inflation rate expected five years from now, a reflection of financial market participants' long-term inflation expectations (five to 10 year time horizon), increasing at a slower pace since February and retreating from its peak in May. Long-term market expectations stood at 2.3% as of June, while medium-term (five-year horizon) average inflation expectations were a bit higher at 2.5%. Clearly, the markets don't believe in the staying power of current inflation handles.

Chart 4

While the pick-up in inflation and short-term inflation expectations is mostly due to surging reopening demand and supply bottleneck issues, the stabilization of long-term inflation expectations may reflect improvements in monetary policy credibility. The Federal Reserve describes the current hike in prices as "transitory", and signaled in its July Monetary Policy Report that its policy stance is not likely to change unless long-term inflation expectations exceed the level "consistent with the Federal Open Market Committee's (FOMC) longer-run inflation goal".

How Have U.S. Small Businesses Recovered?

As the economy reopens from the once in a lifetime pandemic, small businesses in the U.S. are slowly getting back to normal. Small businesses, which constitute nearly 97% of total U.S. businesses (firms with less than 100 employees), were the most impacted by social distancing restrictions. As half of the U.S. population has already received at least one dosage of the vaccine, while new COVID-19 variants are starting to challenge the health systems in many developed and emerging market countries, the new $1.9 trillion American Rescue Plan (ARP) is providing emergency support to localities, people, and hard-hit small businesses.

For the Federal, state, and local governments, supporting small businesses during the pandemic remains a priority to broaden the economic recovery. Around $1 trillion has already been deployed as relief for small businesses since the pandemic struck the country last summer. However, it is unclear whether the historic mobilization of resources has been adequate or whether the funds have reached the targeted businesses. According to the Census Bureau's weekly Small Business Pulse Survey (for the week ended July 11, 2021), 44.3% of the businesses surveyed stated they haven't received financial assistance from any source since Dec. 27, 2020. Meanwhile, 41.7% of businesses surveyed stated they have received financial assistance under they Paycheck Protection Program, up from 30.3% since the week ended Feb. 21, 2021.

Chart 5

Chart 6

On the other hand, the survey also pointed out that the effect of COVID-19 on small businesses started to recede as the pace of vaccinations accelerated and new cases dropped, which allowed the authorities to lift the restrictions on businesses, particularly high-contact services. Nearly 24.4% of businesses surveyed stated they experienced a "large negative impact" from the pandemic (as of survey week ended July 11), which was as high as 51% in April 2020 and 30.7% in January 2021. This shows how effective the unprecedented fiscal and monetary measures were at helping the businesses overcome the challenges quickly. Nonetheless, the survey also pointed out the impact on high-contact services is still significantly higher than the national average by sector. For instance, 51.3% of businesses surveyed in accommodation and food services still see a large negative impact from the pandemic, followed by 43.1% in entertainment, and 29% in transportation, compared to a national sector average of 24.4%. However, we continue to see steady improvements in the sentiments of these touch-sensitive sectors as the economy reopens. Employment in these high-contact services also increased substantially in the past couple of months.

Table 1

Table 2