Low wage growth is still seen as challenging Fed policy normalization, much like a year ago. We have enjoyed steady job gains, yet an absence of larger pay increases still argues for a moderate policy path. The economy is growing but not “taking off” with Q2 growth at 3% though the Fed and many economists still expect 2% growth for the year. While July construction spending declined for the third time in four months, ISM reports factory activity hit its highest level in six months, coinciding with July’s increased manufacturing and construction hiring, this year’s accelerating business investment and the best improvement in consumer sentiment in a decade or more. Service sector hiring—which had been carrying the ball—slowed in August although service ISM is close to its six-month moving average with healthy new orders.
The Fed is still likely to proceed this Fall on normalization of its QE (quantitative ease) portfolio, originally acquired to stem the Great Recession. As QE was aimed at achieving economic stimulation through significant monetary growth, steps toward policy normalization by letting Treasury holdings run off, effectively contracting money supply, should be done as gently as possible. Like QE was intended to be a powerful monetary ease, the Fed’s portfolio contraction is de facto the opposite in this economic environment, thus a slow or gentle process is necessary. It is a form of monetary tightening, and so will likely take the place of Fed interest rate increases, at least until economic performance and the impact of portfolio normalization can together be monitored.
The Fed is increasingly mixed in its reaction to softer than expected wage growth and inflation pressures. Recent inflation pressures have actually moved farther away from, and short of, the Fed’s 2% inflation target. Soft wage growth, the key measure, actually suggests excess capacity must be more fully utilized before inflation is likely to normalize and become a valid concern. Plus, the employment rate is still arguably low, suggesting the natural growth phase is not over. The soft August employment report didn’t show a further decline in slack. If incoming economic data don’t change the existing economic picture, the Fed is likely to feel greater comfort near current policy levels.
Performance of the yield curve and risk assets will be closely watched by policy makers and markets. Chair Yellen has expressed concern about potential excesses in financial assets and whether they reflect potentially excessive monetary policy ease, remembering that the Great Recession arguably resulted from financial market excesses. However, risk/reward would seem on the side of policy caution, at least for now. It would be easier for the Fed to hit the brakes if the economy surged with policy rates at these levels; premature tightening would be more difficult for monetary policy makers to reverse from these levels. On the other hand, gradual normalization of the Fed’s portfolio should be the right track for now. Further policy moves can wait—for now. If the economy begins to get needed investment or appropriate fiscal policy help toward the end of this year, the Fed can react in a little more balanced fashion.
Despite the occasional volatility, markets have enjoyed a fairly calm summer. However, looking forward, muted inflation, significant currency moves and currency valuations can complicate central bank decisions. Incoming data suggest some moderation in Q3 activity. Softer spending and income data suggest some deceleration. A slowing in bank lending is but the latest economic riddle to confront investors. At least it would appear that the economy took a “breather” that should keep inflation low for now, restraining the Fed a bit. Meanwhile, market strength and solid corporate earnings continue.
Fiscal policy should get on-track sometime this year or early next year—before next year’s elections take over. Business and infrastructure investment are timely and would likely become seen as self-fulfilling positives from an economic standpoint. Meanwhile, Harvey and Irma should underscore prompt Q4 infrastructure spending. Rebuilding should spur bottom-line productive growth. Productivity is key to long-term investment return, compensation and growth.