How the US economy is shaping up in 2016 and how the Fed will react
The US economy – while still far from recession – is still downshifting. At the same time, the Federal Reserve – while less hawkish than in December – is still in tightening mode. This combination still makes recession a reasonable worst case scenario, though not a base case. Below I want to review how the recent data stack up still in the 2%ish real range and why that will compel the Fed to raise interest rates multiple times until that growth rate declines into the 1%ish real range.
Right now, the US is running at about a 3% nominal, 2% real GDP growth rate. That’s a stall speed level, down about a percentage point from the pre-oil and gas capex crisis level in mid-2014.
One way to look at the oil and gas capex decline is as a recurring downshift in GDP growth similar to the collapse in housing from the previous economic cycle. We should assume that the oil and gas capex levels from early in this cycle were unsustainable, bubble levels that will not recur. And, thus, going forward there is a long-term 1% loss to GDP growth, permanently moving real GDP growth down to the 2%ish level from the 3%ish level of 2014 and early 2015.
A more optimistic take here is that, as this business cycle advances, the ‘lost growth’ from oil and gas will be made up by growth elsewhere, in housing, in retail and in other industries, as the economy adjusts to a shift in investment portfolio preferences. This is the thinking behind calling the downshift right now a mid-cycle pause rather than an end of cycle harbinger. While I lean in the direction of the first interpretation, given the right policy responses, the mid-cycle pause story is achievable with GDPNow for Q1 running above 2.0%.
And that brings us to the Fed. Fiscal policy has been relatively tight, in that the deficit has fallen to 2.5% of GDP in fiscal year 2015 from 12.1% in 2009. While the fall in deficits is not a priori evidence on the tightness of fiscal policy, much of this fall has been due to a conscious desire to slow the rate of growth of spending off to a level below its longer-term path. That has left monetary policy as the driving force regarding policy accommodation in the US. I expect this to continue to be the case. And the Federal Reserve has been in tightening mode for almost three years now – from the time it began forward guidance to dial back quantitative easing. And now the Fed is on a rate hike train that in December foresaw 300 basis points of hikes over a three-year period.
When I last wrote about the Fed, I wrote about how the Fed could cause recession in 2016 by continuing on this path. However, since that time, the Fed has made clear that it is not on this path. In fact, San Francisco Fed President Williams has indicated we should expect the Fed’s dot plot to shift down from the 300 basis point level we saw in December. That said, I believe multiple rate hikes for 2016 are still on the table. And therefore, I do not believe the downshift is meaningfully close to a level which will ease monetary conditions significantly.
The Fed seems to be operating using a Phillips Curve type of ideology, which sees a trade-off between inflation and employment, its two governing mandates. The data duiring this cycle belies this policy framework, with inflation remaining below target despite the decrease in the unemployment rate. Janet Yellen has speculated that this conundrum owes to the downshift in the labor participation rate, due both to demographic factors – and other non-demographic factors. For example, if one looks at the 25-54 age cohort’s labor participation rate, it has steadily declined for almost two decades, with the decline rate increasing noticeably after 2007.
At the same time, if one looks at the job picture froma stock/flow perspective, it’s clear that while the stock levels for U-3 at 4.9% and U-6 at 9.7% are at cycle lows, the flow numbers have slackened, with the rolling year-on-year change in non-farm payrolls decelerating from approximately the same point in the cycle that nominal and real GDP growth slowed, with a lag of about 3-6 months.
The obvious conclusion here has to be that the factors which have slowed nominal GDP have also slowed employment growth. Moreover, the evidence that this slowing is also in the non-manufacturing sector has increased in recent months.
My overall take here is that the capex shortfall and the strong dollar have ‘infected’ the employment data as well as the non-manufacturing sector in a demonstrable way. And the question now is what monetary policy stance is consistent with preventing that contagion from becoming more pronounced. I believe the Fed’s Phillips Curve framework and its bias toward normalizing policy will prevent the Fed from fully adjusting to the new, less robust reality in the US economy, creating downside risk on growth as we head further into 2016. Even March is on the table for a hike, after the strong 242,000 non-farm payrolls number today and the upward revisions to prior numbers.
Unless the data weaken materially from here, the unemployment data and the need to normalize policy will compel the Fed to raise interest rates multiple times in 2016. With corporate earnings already declining, even as mean-reverting P/E ratios, PEG ratios, and profit margins are cyclically high, US business will be forced to take their first lines of defense to forestall even more profit erosion: delaying loss recognition, reducing capital expenditure, and reducing employment growth. I anticipate corporates will do this until real GDP growth declines into the 1%ish range before the Fed materially changes policy further. This economic environment, therefore, continues to be more favourable for government bonds and less favourable for risk assets like high yield and equities.