While momentum has probably peaked, the global recovery remains intact. Investment activity actually seems to be strengthening in the developed economies which together with global trade is a plus for global economic sustainability coming as it does on top of existing consumption-reliant advanced economies. It is noteworthy that in the past month, markets have re-priced central bank rate hike expectations, raising them for some but lowering them for the Fed. Still, accommodative policies and financial conditions remain overall positive.
Soft April and May economic data raised concern the economy may be losing momentum, yet markets continued steady improvement with employment growth close to a recovery average, supported by trade, inventories and personal spending. The unemployment rate (UNR) reached its lowest point in over a decade, accompanied by continued modest wage growth. The current expansion began in 2009 and would become the longest on record by early 2019. The post-election surge in expectations last November had everything to do with the prospect of stimulation in the form of deregulation, tax cuts and infrastructure investment. While those hopes have diminished, action on those fronts could still take the expansion another several years. Policy is still the primary potential source of upside and downside risk.
CPI inflation has softened reflecting fading oil prices and marginal aggregate wage growth, while the Fed indicates further policy normalization, seemingly confident that the economic recovery would push inflation toward its target. This would seem to be the more dangerous approach inasmuch as the Fed’s policy tools to support a lagging economy are not nearly as effective as restraint if and when it becomes necessary to slow a more rapidly growing economy.
So far, the Fed is looking through softening inflation prints and seemingly adhering to Phillips Curve logic that declining unemployment will ultimately deliver upward wage pressures and inflation. Yet, while global growth forecasts are up from three months ago, those for inflation are if anything trending weaker. It may be that globalization and technology are changing the relationship between growth, labor and inflation, perhaps changing existing monetary policy frameworks. Maybe the Phillips Curve models are non-functional in today’s economic environment. The answer should be more apparent in the next year or so. If inflation remains below 2% despite satisfactory growth and arguably tight aggregate labor, economic guidelines will be questioned. Meantime, the Fed should go slowly on policy normalization. Ideally, a timely reduction of the Fed’s QE portfolio, best achieved by allowing gradual runoff of maturing issues, should begin as expected in Q4. Such a procedure should be blended with gradual Fed rate moves. The yield curve is flat and an inverted curve historically conveys a negative economic message. However, this time, it is possible that the Fed’s QE bond-buying program confused the curve’s message, something that could be clarified by the Fed’s upcoming QE unwind, effectively a timely curve move enroute to policy normalization. In this economic environment, premature policy tightening could be difficult to reverse.
It would seem productivity is better and inflation lower than currently believed, at least by policymakers, suggesting continued growth until pressure points and price pressures are reached. This could be a while. Meanwhile, policymakers are beginning to believe that the “natural rate” of interest is falling and has been falling for maybe 40 years. This could be a central bank issue inasmuch as premature interest rate increases may have caused the natural rate of interest to trend lower. The Fed should err on the side of wage growth and full employment for now, particularly as it enables fiscal policy to work more effectively. Meantime, volatility is low, and foreign growth looks good.
Auto production isn’t quite the “driver” of US growth it used to be, but it still matters. The number of unsold vehicles continues to rise absolutely and relative to sales, spelling likely further production cuts. Yet, while the Fed’s strong policy ease actually helped pull auto sales forward, setting up the weaker phase for now, it didn’t help housing, suggesting stronger home buying could become an economic positive—and a timely one. Stronger home buying could be more likely now given that 25-34 year olds are plentiful and may be employed long enough now to boost their means, and confidence. Stay tuned.
Demographic changes in the work force could have an important bearing on the economics of the labor market, creating a factor that could change the Fed’s perspective. Generational shifts are translating into decent individual wage growth, yet stable aggregate wages. Individual wage growth outstripping aggregate wage growth results from demographic change, with probably a long-time to run.
Meanwhile, trade and inventory data boosted the Barclay’s Q2 GDP estimate to 2.5%. Exports reduced the trade drag while capital goods imports suggested stronger equipment spending. Importantly, history would suggest upgrades to income growth are likely. The domestic economy should remain in a shallow path over H2 and maybe all 2018, say 2.25% to maybe 2.5% next year and this assumes modest tax and infrastructure help next year. However, risks are probably to the downside, a big reversal from the post-election surge in expectations. Congressional focus on healthcare reform and a disorganized GOP could delay business spending decisions into next year. Inflation, or the decline thereof, is beginning to concern the Fed, based on the minutes of their June meeting. Still, the view that “idiosyncratic” factors have weighed on core inflations (the leader of inflation trends) should pressure moderate Fed policy normalization plans at least through year-end.
A recent WSJ headline says that “If you think stocks are dull, look at the economy.” So far, not a bad thing. Stay tuned.