Global growth continues across regions, reasonably “synchronized” and broadening from consumption into investment. US growth remains decent, if “unexciting,” while Europe and Japan have shown upside and China has possibly peaked for now. Inflation remains weak despite declining unemployment; however, continued expansion should eventually reduce slack meaning policy makers should continue gradual monetary normalization to avoid an eventual overrun and risks to stability.
US economic growth is benefitting from the global upturn and improved financial conditions. A weaker dollar should help export growth while domestic demand should benefit from low long-term rates and “modest” fiscal stimulus early next year. GDP growth could accelerate from about 2% this year to maybe 2.5% next, though possibly followed by slowing in 2019. The pace of employment gains should slow in the coming years, but still be sufficient to gradually reduce the unemployment rate. Wage pressures, though missing so far, should warm up in the next several years. There are signs that the somewhat surprising deflationary pressure of early this year will begin to fade; core CPI, subdued near term, should begin trending higher next year and 2019 if all goes well. And assuming some tax cut or fiscal stimulus, Fed rate hikes can be expected next year.
The Federal Reserve announced the beginning of a balance sheet run-off or portfolio normalization at its recent meeting. While some might see it as a premature tightening move, it is instead likely to prove timely and, if anything, a bit tardy as we pursue a more normal, balanced monetary policy. This will be part of the Fed’s gradual normalization process where, globally, major central bank portfolios are still largely accommodative. Activity in the US is expected to be a bit volatile due to the recent hurricane activity while incoming data globally are likely to remain healthy.
The Fed’s announcement of balance sheet normalization was well telegraphed and caused little market reaction. Some on the FOMC continue to view much of the recent inflation softness as “transitory” and thus remain committed to policy rate normalization. The Fed remains data dependent though most FOMC members still view one more rate hike this year as appropriate.
Treasury yields and the dollar have moved higher because the market was unrealistically pessimistic about the US economy; the Fed and talk about fiscal policy “fixing” came just in time to correct that perception. Still, a large part of the bond correction may be done, for now, because it is unlikely we will get more clarity on either the tax plan or the Fed in the near term. The release of a tax plan is likely just the first step in a long march and it is reasonable to assume any significant breakthrough will take months. With the market now pricing a pretty good chance of December rate hike and Fed leadership next year still a mystery, it is difficult to see the market having a fundamental near-term change in expectations.
Many analysts who six-months ago predicted a 10yr Treasury yielding 3% have since lowered their forecast toward 2.5% with an eye on growth, inflation and a Fed that has revised down its estimate of the terminal funds rate in this well-telegraphed tightening cycle. Disappointing growth and inflation have pushed yields lower; however, prospects for the Fed’s balance-sheet tapering and a reemerging pro-growth fiscal policy and prospects for improved economic growth are placing a floor under yields. Still, a meaningful rise in rates doesn’t appear to be in the cards, at least in the near-term. Accommodative policy globally and in the US should keep a lid on rates for a while.
Chair Yellen clearly wants to raise rates in December, but she knows she must make it data dependent. The Fed will hike if it can. One note of caution is the prospect of a new Fed Chief. We should have an idea in the next several weeks or so. It is possible one of the choices does not believe the Fed should be involved in QE and is apparently inclined to shrink the Fed’s balance sheet faster than Chair Yellen. This could raise market rates faster than the expected normalization, at least initially. The message of the Treasury yield curve should be noted by Fed policymakers. Excessive flattening should argue for caution.
Manufacturing and Service ISM were both strong and broadly based. The hurricane effect is fading and underlying demand remains strong, consistent with solid GDP in the 2.5-3.0%+ range in coming quarters—and both surveys have had a decent relationship with the hard data over the last few years. Labor utilization is finally showing in monthly wage data, but importantly, trade and synchronization of this increasingly global economic growth is effectively keeping inflation down, at least for now. Reduced economic excesses and improved balance sheets, bank and individual, support the case for a lengthier expansion than many expect. Balance sheet health supports continued economic growth.
The Fed and markets should take the monthly employment report with a grain of salt as payrolls should rebound “markedly” over the next few months. However, the drop in UNR (unemployment rate) may well persist with consumer and small business surveys having suggested a UNR closer to 4% for a while. Stay tuned.