Expect Fed optimism to fail again

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From Westpac’s Elliot Clarke:

Leading into the June meeting, we noted that changes to the inflation and unemployment view would be minimal and that the growth outlook would be the focus. We suspected that the 2014 growth forecast would likely be revised down to as low as 2.4%, with the 2015 and 2016 forecasts to be unchanged. That lower-bound for growth was predicated on the new forecast needing to emphasise that the FOMC remained optimistic on the outlook – necessary to justify a continued reduction in marginal liquidity in the economy post the –1.0% annualised Q1 GDP outcome.

In the event, our expectations were broadly met by the Committee. The unemployment rate forecast for end-2014 effectively settled at the bottom of the previous range, now 6.0–6.1% compared to 6.1–6.3% in March. And the Committee continue to expect ‘full employment’ to be reached by end-2016 – as measured by the unemployment rate. On inflation, the headline PCE inflation forecast for 2014 was effectively unchanged. That the 2015–16 PCE annual inflation forecasts continue to be bounded by 2.0%yr indicate an absence of concern over the potential build-up of inflationary pressures.

On growth, the revision to the 2014 forecast was actually a little larger than we had anticipated, with the forecast range revised down to 2.1–2.3%, well below March’s decidedly above-potential 2.8–3.0%. The mid-point of the new forecast range (2.2%yr) is well below the growth pace seen in 2013 (2.6%yr), consistent with our long-held view that growth in 2013 was biased up by abnormal contributions from inventories and net exports which were set to reverse.

Even if we abstract from the impact of inventories and net exports by focusing on domestic demand, it is clear that underlying growth has fallen well short of the FOMC’s a priori expectations. Annualised growth in Q1 domestic final demand is currently estimated at 1.6%, unchanged from the average of 2013. And, as we highlighted last week, this estimate will be subject to substantial downward revision come the third estimate, due 25 June.

So as to combat this unfortunate reality, the FOMC again deferred to their forward guidance on the economy. Based on recent partial data, growth is expected to rebound in Q2 and accelerate in the second half of 2014. In quantitative terms, the 2.2% growth mid-point requires average annualised growth of 3.3% through the remainder of 2014 –twice the pace of average domestic demand growth over the past 18 months. If we do see a material downward revision to the current Q1 estimate on 25 June, then growth over the next three quarters must average 3.6% annualised, last seen a decade ago.

This optimism (and that of the market) is based on ‘signs of improvement’ in Q2, namely the recent nonfarm payroll outcomes; growth in industrial production; a rebound in home builder sentiment; and robust ISM readings. Our regular readers will know that we instead prefer to build our US view on key components of GDP (namely household and business demand) as well as available labour market detail.

On these metrics, there is little supportive evidence for the growth outcomes expected by the FOMC – see last week’s Northern Exposure for more detail. Rather, they are more in keeping with the qualitative guidance provided in the FOMC’s statement: that “Household spending appears to be rising moderately… business fixed investment [has] resumed its advance, while the recovery in the housing sector [has] remained slow”. To us, such a characterisation (i.e. modest growth in household demand and business investment) is more in line with annualised growth near potential (2.2%), which is broadly what we have forecast for the rest of 2014.

While likely to support headline payrolls jobs growth similar to that seen over the past year (circa 198k per month), it is not enough to drive a further acceleration. Hence, we are unlikely to see a notable change in the historically low participation of prime-aged workers anytime soon, nor a marked acceleration in wages. To that end, the structural decay in US labour productivity and real household purchasing power, both associated with the ‘significant’ underutilisation of workers apparent to the FOMC, is set to persist.

This imbalance between expectations and reality, and cyclical and structural concerns, then frames the looming policy debate. Bar an abrupt, material, unforseen deterioration in payroll job growth, a H2 2014 completion of the tapering process is a given. But, on the pace and inevitable scale of any Fed Funds rate normalisation, there is much-less certainty. This is a point which finds support in the FOMC participants’ June decision to nudge down their ‘longer-run’ median Fed Funds rate expectation, from 4.0% to 3.75%.

As evinced by the experience of the housing market through 2013 and into 2014, the US economy remains highly susceptible to changes in term interest rates. And continued low (or no) growth in real household incomes will exaggerate this issue. How term interest rates respond to the initial steps towards normalisation (we believe from late 2015) will dictate how far the Fed Funds rate can eventually be raised. Our own expectation is that above-trend growth through 2015–16 will permit it to be raised from 0.50% at end-2015 to around 2.50% by mid-2017; however, this is likely to be the limit of said action, not the FOMC’s 3.75%.

Expectations have allowed for a disappointing reality to be overlooked in favour of a brighter tomorrow. The consequence has been greater pressure on households and less reason for firms to invest in the domestic economy. There are definite limits to this approach which, sooner or later, will be found.

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