The Fed’s Delicate Balancing Act as U.S. Economy Gains Steam
As the U.S. economy approaches its ninth year of expansion, unemployment has reached a 17-year-low. This has some market participants worried that the Fed may see a need to act more quickly this year than in the past in order to stay comfortably ahead of inflation.
GDP looks impressive, having posted back-to-back growth rates of 3% plus year over year (yoy). U.S. retail sales for the three weeks preceding Christmas, closely watched by economists as an indicator of monthly same-store sales strength, had their strongest showing (53.4) since 2014 (49.6), according to the Evercore ISI Sales Survey. This is a stark improvement after years of GDP limping along below 2%. Moreover, tighter inventories and solid demand have enabled retailers to offer fewer price discounts than in recent years.
Based on Evercore’s company survey data, we have seen strength in various international manufacturing sectors from the chemical industry to technology sectors. Improved sales from tech and chemical companies also boosted European sales metrics during the second half of 2017 and into January to the highest levels seen since mid-2014.
The housing market is proving formidable, demonstrating positive growth in both existing and new home sales. Lower inventory levels have served to push housing prices steadily higher. After running at a pace of 685,000 units in October, new home sales surged to 733,000 in November, compared with 548,000 at the start of 2017. A significant undersupply in new homes should keep the construction market rocking at least until mortgage rates rise to a level that would temper demand. Since mortgage rates are tied to the longer end of the Treasury yield curve, as those rates rise, we may see demand impacted from higher mortgage rates.
Non-farm payrolls, a key factor reflecting the state of the economy, ended the year on a stable note by adding 148,000 jobs in December. That fell short of an expected increase of 190,000, but was offset somewhat by an upward adjustment to November payrolls. Nevertheless, the two-month net revision was lower by 9,000 jobs. This adjustment was due to a decline in retail positions, reflecting what CNBC recently labeled the “Amazon effect,” as brick and mortar retailers continue to surrender market share to internet-based retailers. In essence, retail losses offset gains in manufacturing jobs.
Headline unemployment has been at 4.1% for three straight months, but the participation rate remains distorted, trending at 62.7% for all of 2017 due to people who have left the workforce. This compares to participation rates of 68% before the financial crisis. Only those actively looking for a job are counted as unemployed. The unemployment rate has dipped below 4.0% for a total of only five months since 1969.
Employment statistics by demographics have also shown substantial improvement lately. The jobless rate for African-Americans hit 6.8% in December, the first reading under 7.0% in the 47 years that it has been measured. These figures could indicate that the U.S. economy is approaching or has already reached full employment.
One key statistic to watch in 2018 will be the change in monthly average hourly wage growth. That will tell us the extent to which tax cuts and other progrowth measures are filtering through to the labor market and will surely be a high priority on the Fed’s radar in 2018. If productivity picks up slightly, with support from business investment associated with tax cuts, Evercore ISI believes that should slow the decline in unemployment relative to the growth rate.
After raising its benchmark interest rate in December to the range between 1.25% and 1.5%, Fed officials are targeting three more rate increases for 2018. It is hard to overstate the delicacy of the balancing act now demanded of the central bank as it tries to ensure the economy does not overheat from stimulative policies without putting the kibosh on factors driving growth.
First, there is the uncertainty around how the pace of GDP growth will respond to tax and federal spending policies. A second question to wrestle with is to what extent these policies will cause the national debt to balloon. Driving the deficit higher reduces the productivity of every new dollar of debt, which could put a constraint on economic growth.
Further impacting how quickly the Fed may choose to act this year is the lack of inflation growth. Most economists find the “lack of inflation growth” perplexing in view of the tight labor market and a pickup in GDP growth. Although core producer prices, excluding food and energy, are growing at 2.1% year over year, the Fed’s preferred inflation measure is personal consumption expenditures (PCE), which are growing at just 1.8%. Presumably, the Fed would like to see that number closer to 2%, which is considered the sweet spot. It remains to be seen how aggressive the Fed gets in raising rates given that inflation has yet to infiltrate the economy.
Among recent signs of economic progress is a 2.2% increase in personal consumption, a very strong 7.3% jump in private investment, and an increase in government spending that was revised up to 0.7%.
Together, these factors illustrate a U.S. economy firing on all cylinders. If GDP growth for the fourth quarter comes in above 3% (the Atlanta Federal Reserve Bank is currently projecting 3.3%), it would be first time that GDP has logged three consecutive quarters of growth above 3% since 2004. The cumulative impact of tax and fiscal policies might imply a GDP growth rate quarter to quarter of 3.5% to 4% in some instances for 2018.
In the U.S., attention will be focused on how stimulative the tax cuts turn out to be for the economy. Although the impact on GDP growth has been projected as high as 1%, the consensus is that the tax cuts will likely add 0.5% to annual GDP growth in 2018. The BBVA Compass Research Department is predicting a smaller impact around 0.2% this year (see Q&A section).
If President Trump’s promise of infrastructure spending to fix and replace bridges, roads, airports and other aging public facilities across the country comes to fruition, it would also be expected to add to GDP growth. As the Fed raises rates to stave off inflation, it will be necessary to keep an eye on how well fairly new companies that were launched in an abnormally low interest rate environment continue to perform. It’s not clear how quickly certain businesses will be able to change their business models if they have to in order to adjust to higher borrowing costs. Businesses with less free cash on their balance sheets and higher debt levels would be expected to be more sensitive to absolute rates and/or interest rate changes than others.
Not only are equity valuations stretched, but also a lot of the upside expected from the tax cuts has already been priced into markets. Liquidity could become tighter based on the Federal Reserve raising rates and decreasing its balance sheet. Among the unintended consequences of the tax cuts could be that the Fed ends up raising interest rates more quickly due to elevated worries about inflation.
A higher value of the U.S. dollar and real rates could lead to tighter conditions and less support for equities. There could also be increased complacency regarding the balance sheet decrease.
Growth has not only been funded through debt, but by U.S. household savings. The National savings rate fell to 2.9%, the lowest since November 2007. Australia’s savings ratio fell 3.2%, down from 7% just three years ago, highlighting the liability side of the growth. Stephen Roach, writing on Project Syndicate, said that China’s domestic savings rate has fallen from a peak of 52% in 2010 to 46% in 2016, and forecast it to fall to 42% or lower over the next five years. A soaring dependency ratio will further reduce the savings ratio in China.
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