It’s been a 'mixed' few weeks for the US economy and the outlook for US monetary policy has become a tad murkier as market expectations of the number of Fed rate hikes this year have waxed and waned. At the time of writing, markets are pricing in about one-and a half rate increases by year-end, 10-year Treasuries are at the bottom of their recent range, and the US dollar index (DXY) is at its weakest since before the election in November last year.
There has been a lot for markets to digest, not the least of which has been the turmoil surrounding the Trump administration. Given the low probability of impeachment, at least until next year’s mid-term elections, we think of this as mostly noise. The turmoil hasn’t stopped speculation about what this means for the administration’s pro-growth policy agenda: depending on which political analyst you believe it will either slow it down or speed it up.That’s helpful…
What ultimately matters is the data, and that has been mixed. First-quarter GDP was just revised up to a seasonally adjusted annual rate (saar) of 1.2%. Residual seasonality usually sees March quarter GDP print weak, only for activity to recover over the subsequent quarter or two.
This year the weakness was centred on consumer spending and inventories. The drag from inventories is unlikely to persist and we think consumer spending will recover too. Indeed, June quarter data, while not universally strong, points to growth of around 3% (saar). Last night’s consumer spending data (0.4% mom in April) gave that view a shot in the arm. The upshot is that over the first six months of the year the economy will have grown at around a 2.0% annual rate, in line with recent trends and slightly ahead of potential.
But it’s harder to look through the recent weakness in in core inflation. After peaking at 2.3% in the year to January, the annual rate of core inflation has now dipped to 1.9% (year to April), and could head lower still.
This is where it’s important to remember how the Federal Open Market Committee (FOMC) thinks about inflation. In short, lower unemployment will result in higher inflation (ie the good old Phillips curve from Econ 101). To that end, the FOMC will only start to worry about PERSISTENT weakness in core inflation if the labour market starts to weaken.
And right now, the labour market is looking pretty good. Indeed we are seeing a number of characteristics in the data that are consistent with a tightening labour market. First and foremost, the unemployment rate is at 4.4% and we are still seeing healthy gains in the monthly payrolls data. Payrolls are currently running at a three month average of 174,000, and at 4.4% the unemployment rate is below most (including the FOMC’s) estimate of full employment (or NAIRU).
With strong employment growth and a declining unemployment rate, wages have been trending higher.
And as wages have moved higher, that has drawn people back into the labour market with the participation rate now displaying a modest upward trend...
Indicating that some 'disenfranchised' people are moving back into the labour market. That is leading to a decline in the broader U6 measure of unemployment…
…and a closing of the 'under-employment' gap. The difference between the U6 unemployment rate and the official U3 measure is now below its long-term average.
At the same time, the forward indicators are looking good. In particular, job openings remain at their highs for this cycle, and the quit rate is trending higher.
But the most important indicator of all shows that right now, despite the recent softness in core inflation, trend unit labour costs remain consistent with 2% inflation.
So what does that all mean? It means that unless the FOMC has changed its framework of thinking about inflation, they will still be confident of meeting their 2% mandate over time, and that the current weakness in core inflation will ultimately prove transitory. Labour market data will be the key data to watch in the period ahead with the next print due at the end of this week. Focus on the unemployment rate and wages.
In line with FOMC guidance, we expect two further 25 basis points hikes this year, one in June and one in September. The Committee also appears keen to push on with plans to reduce its balance sheet. A formal announcement on that appears likely in December.
The critical meeting this year will be in September. If labour market data has softened and/or core inflation still looks soft the committee may back off a third hike in favour of announcing its intentions with respect to its balance sheet, even if it doesn’t start to enact it until later. We think the Committee will be keen to begin the third and final phase of monetary policy normalisation while the window of opportunity remains open.
Of course I haven’t even started to address the biggest monetary policy question of them all: Where’s the neutral monetary policy rate? That’s because I don’t know the answer. But it’s the eventual answer to that question that will determine the overall rate hiking cycle and how much further rates need to rise beyond this year as signalled by the Committee’s dots.
While bond yields have trended lower in recent weeks, we retain our underweight to the fixed income sectors in our asset allocation. We believe this soft period of core inflation will prove transitory and that there is more US tightening to come, and more than the market is currently pricing in.
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