Friday 29 Mar 2024
By
main news image

ALTHOUGH some market participants are disappointed by the Fed’s further delay in raising interest rates, the key issue for markets is not when hikes begin, but how quickly they proceed once they begin. We still expect the first hike to occur in December.

Once hikes begin, monetary accommodation will be removed at a pace that is expected to be “gradual.” The Fed’s dot chart tells us that that FOMC members expect interest rates to eventually climb above 3%, perhaps as high as 3.5%, unless inflation overshoots, in which case they could do more, or declines unexpectedly, in which case they could do less.

The market’s expected path of the funds rate reveals an even more “gradual” pace than the FOMC’s projections. For example the 1-year swap rate, 5-years forward is 2.71%. Forced to choose between acceleration in inflation or a renewed slump, the market leans pessimistic.

Today’s Fed decision was a close call. The labor market did make “some further improvement” since July. But confidence that inflation will move steadily toward 2% in the coming quarters eroded, based on falling commodity prices and increased concerns about global growth. It is worth examining each of these things in order to understand why the Fed saw the balance of risks justifying a delay.

Good news in the labor market came in a variety of forms. The unemployment rate dropped to 5.1%, just above the Fed’s newly-revised 4.9% long-term expected level. Payrolls growth was steady. Nominal labor income accelerated modestly and has grown faster than 5% annualized so far this year. Initial claims remained historically low. And the JOLTS delivered the news that job vacancies have soared recently. If we take labor demand to be the sum of filled and unfilled positions (proxied by total payrolls plus total job vacancies), the growth of total labor demand has been very robust.

In contrast to the Fed’s characterization of household spending growth as “moderate”, consumption, 68% of US GDP, has been very strong. Following a soft patch in 2013, the past five quarters posted real q/q annualized consumption growth of 3.8%, 3.5%, 4.3%, 1.8%, and 3.1%. Our tracking estimate for Q3 is 3.4%. Oddly, many investors claim that US households have not “spent” the money they saved on gasoline. Strong consumption hardly fits that view.

In general, US households face rapidly improving conditions, and importantly, this is true across most of the income distribution. The recent increase in vehicle miles traveled and household formation data hint at this. But improving household credit growth, improved cash flow from falling energy prices, faster labor income growth, and improved confidence are driving these trends, which are set to continue if the labor market is not disrupted.

Services consumption, which is 45% of US GDP, has accelerated meaningfully in the past few years. History tells us that this is the steady “pulse” of GDP, and it can grow at the same rate for long stretches. Although there are clearly many headwinds to US growth now developing, steady 2.5%–3% real services consumption would be a powerful offset.

Now the bad news. A growth recession (a long stretch of below-trend growth) is underway in global industrial production and the global tradeable sector. Sluggish Chinese data have had major repercussions for parts of the world economy. The US is primarily hit through the energy sector, but also through volatility in asset prices, specifically the equity and credit markets. Commodity price weakness feeds through to inflation. The combination of dollar strength, commodity price weakness, and slack in the global manufacturing sector may put further downward pressure on goods prices around the world in the quarters ahead. And since concerns about commodities and global growth have intensified in recent months, it is reasonable to be less confident of rising inflation in the United States.

The actual inflation data have shown no signs of breaking higher. Nor have the actual wage data, broadly considered. The Fed relied on these facts to justify not hiking, and also signaled a heightened international sensitivity. Importantly, falling import prices, falling commodity prices, and especially falling gasoline prices, may reflect “good” deflation from a perspective of US households. Certainly we do not see signs of deteriorating nominal demand from US households. Where Americans are spending less, reserve managers around the world are accumulating fewer assets. Not such a problem onshore.

Many investors have told us in recent months that they hoped for a Fed hike so they can “stop focusing so much on the Fed.” More bad news: when Fed hikes start, or even if Fed hikes are prevented altogether by new developments, focus on the Fed will grow, not shrink.

What happens next to nominal GDP is critical and will determine how high rates go. In our view, using the Fed’s long term dots as a guide puts far too much emphasis on the Fed’s ability to forecast their own behavior and the economy’s. We break what happens next for nominal GDP into three simple scenarios, all of which can be logically supported.

Since the global financial crisis nominal GDP has growth steadily at around 3.8% p.a., well below the previous experience. And that weak growth has occurred mostly while rates were at zero, the unemployment rate was falling, and the dollar was cheap. It is thus logical that with rates rising, the dollar stronger, and the unemployment rate perhaps not falling at the same rate, nominal GDP will slow. Weak global conditions, of course, give further support to this view. If this occurs, and trend nominal GDP seems to be near 3%, the idea that the fed funds rate will not rise much will be well supported by the data.

However, above we described the very positive dynamics underpinning the US household sector. In our view, credit growth is more likely to accelerate than weaken as rates rise. Although global growth and the dollar are a concern, we think it is quite possible that nominal GDP growth actually accelerates. If this happens, markets will likely be surprised, and they will begin to price for a terminal rate closer to the Fed’s 3.5% level, or even higher.

A third scenario would be if nominal growth continues to grow at 3.8%. Perhaps weak international conditions, soft exports, and turbulent markets will offset signs of household sector strength. Ongoing 3.8% growth probably would put terminal rates somewhere below the Fed’s projections but above the market’s current trajectory.

We lean in the direction of faster nominal US growth even amid turbulent asset markets, sluggish global IP growth, and tightening US financial conditions. But our point is that the range of outcomes are wide, and that the market now must trade for which outcome is likely. Also, operational details of the Fed’s new policies are important: massive money flows will result from the use of the reverse repo facility, and from recalibration of bank balance sheets amid rising rates and changed capital and liquidity rules. We described these developments here.

Markets and policymakers are in uncharted territory. Operationally, economically, and in terms of short term market implications, hikes this time present unique or at least original challenges. Perhaps that is why the Fed’s behavior has been so cautious and skittish. Our key point is that nobody’s projection about future rates matters much at a time when the range of outcomes for nominal growth appears to be wide. What they say is much less important than what the economy does in the quarters ahead.

 

      Print
      Text Size
      Share