US: All eyes shift to the Fed
House View: Q2 2017
- Activity picked up in H22016 and looks set to remain robust
- Limited spare capacity set to increase wage and price inflation
- Much focus will be on delivery of fiscal stimulus, but Fed reaction will be increasingly important
The US economy is approaching the point at which the debilitating effects of the 2008 financial crisis have largely passed and a degree of normality has returned to the economic landscape. Progress has been steady rather than spectacular, as ongoing headwinds from the crisis, alongside global factors have weighed on the pace of recovery. However, by the end of 2016 a vast array of macroeconomic data showed how much the economy had strengthened.
That is not to say that the US economy. Business investment (as a share of GDP) peaked two years ago, well below the pre-crisis level, and has shown only limited signs of improving since the energy sector stabilized. Corporate profits grew only modestly in 2016 and the fiscal position remained challenged. Participation in the labour market by prime-age workers, particularly men, is also well below the level implied by the pre-crisis trend. Inequality, as measured by household income distribution, worsened almost every year since 2000. It showed a small improvement in the latest available data, but inequality remains high in both a historical context and when compared to other countries.
So while the economic picture was as positive as at any time in the past decade, it was not without its challenges. It was against this backdrop that President Trump took office in late January. Survey indicators for Q1 suggest that the economy has continued to grow robustly since the start of the year, although the hard data has been less effusive. Our estimate for growth in Q1, which is based on a range of survey indicators, suggests a figure of close to 4% (Figure 1). However, approaches that put more weight on hard data suggest a more modest pace of increase.
We expect that the direct boost to growth from new fiscal measures from the Trump administration will be small this year, as they are unlikely to be implemented until Q4. However, we do think that the increase in household and business optimism will deliver somewhat faster growth this year than would otherwise have been the case (Figure 2). We expect growth to pick up further in 2018 as the proposed tax cuts boost consumption and investment spending. That should put further modest upward pressure on inflation. Against this backdrop, policy rates remain close to their all-time lows, with the Fed having raised rates only once in 2016 and again in March. We expect that they will raise at least two more times this year, with the risks skewed to one more, rather than one fewer hikes. We expect another three rate increases in 2018. While that would mark a stark increase in the pace of rate hikes, it would still only be enough to bring short-term real rates back up to around zero.
US growth accelerated beyond 2.5% in H2 2016, its fastest pace in two years, rising above the average rate of increase since the financial crisis and above potential supply growth of around 2%. The pick up in growth reflected a faster pace of household consumption growth, alongside a turnaround in investment spending and inventory accumulation. The improvement in investment spending partly reflects the smaller drag from mining investment, as well as a modest rise in non-mining business investment. Looking ahead, a pick up in business investment will likely be necessary to sustain the above-trend rate of growth, with the additional benefit of increasing potential supply at the same time. Survey evidence is supportive of a revival in investment spending. Business sentiment has increased substantially in the past year, across a range of large and small business surveys. In some instances sentiment is a strong now as at any point since 2005 (Figure 3).
The catalyst for the improvement in sentiment was the US election. In the Q1 House View, we described Trump’s fiscal policy platform as likely to give US reflation – that is growth and inflation – a turbo-charge. That reflected our central view that the Congress would deliver a meaningful fiscal stimulus in the second half of 2017, worth around 0.5% of GDP, and Trump would not unilaterally raise tariffs in a way that would likely lead to retaliatory action. It seems that US businesses continue to expect a similar outcome, with reductions in regulatory burden adding to the optimism. That may be the catalyst for driving the “animal spirits” needed to boost investment spending, and is something we are monitoring particularly closely. Consumer sentiment has also responded positively, rising above the pre-crisis peak.
We continue to expect individual and corporate tax cuts to be delivered; however, we do not have as much clarity as we had hoped by this time. They may well be delayed into Q4 of this year or even 2018. Any additional spending on infrastructure seems even further down the road. However, on the other side of the ledger, President Trump has not taken any policy actions on trade protection, and has seemingly had a more positive initial dialogue with China than many had feared. That said, risks remain that a more protectionist set of policies could be pursued, which would be detrimental not only for the trading partners, but for the US as well.
The strength of the economy continues to show through in the labour market. The rise in monthly payrolls continues to be well above the “breakeven” rate needed to just keep the unemployment rate steady. The fact that it hasn’t fallen more sharply reflects the recent rise in participation (Figure 4). We do not expect that rate of increase in participation can be sustained, and as such expect the unemployment rate to fall further, to around 4.5%, over the course of 2017. However, the scope for the unemployment rate to fall much beyond that is limited, given the natural frictions in the labour market. Indeed, the number of unemployed per job vacancy is already below the pre-crisis trough, indicating the tightness of the labor market.
Focus shifts to the Fed
Hourly wage growth picked up modestly over 2016, but reached the fastest pace of increase since 2009. With the labor market already close to full employment, minimal spare capacity within businesses and an expectation of continued robust economic growth, we think that wage growth will rise further over the coming year. That is expected to put further upward pressure on core inflation, pushing core PCE towards 2%. Other approaches to measuring core inflation already show inflation above 2.5% (Figure 5). While core inflation is expected to rise over 2017, headline inflation will initially fall back somewhat as the positive boost from energy prices subsides over the next few months.
With the economy close to full employment and inflation nearing 2%, the Federal Reserve raised rates in March for just the third time in this cycle. Despite raising the policy rate twice in the past three months, broader measures of financial conditions have actually softened over the period. That reflects a moderation in the strength of the dollar, rising equity prices, tighter credit spreads and little change in longer-term rates. If that were to persist, it would likely require the Fed to increase raise rates more quickly. We expect two more rate rises this year – which is broadly priced into the short-term rates market (Figure 6) – with a risk of three. We expect three more rate rises in 2018. That said, with Chair Yellen expected to retire in January 2018, there will be more uncertainty than usual about the future reaction function of the Fed.
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