First Quarter
March 15, 2015

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"More is better" versus "diminishing marginal returns"

Apparently the Federal Reserve is not satisfied that the economy has recovered. The Fed wants more: more jobs, more wages, more inflation and more growth. The inference from recent comments from Fed officials is that the Fed wants evidence that the economy is at the brink of overheating before it shifts monetary policy away from its still extremely accommodative stance. If that is the case, then the Fed will have waited too long. After all, monetary policy cannot avoid business cycles but it may damp their oscillations. To do so, however, the Fed needs to make sure its policy stance anticipates and not reacts to the next turning point in the cycle.

  • The Federal Reserve Board Chair, Janet Yellen, noted in recent Congressional testimony that unemployment is still too high and inflation too low for the Fed to make any changes to its policy stance now or in the foreseeable future (at least a couple more policy meetings).  The major concerns about the labor market were the low participation rate and slow wage growth. The Fed Chair Yellen contended that both were signs of persistent cyclical weakness.

  • My view on the low participation rate has been chronicled in this report for the last five years. I do not believe it is a sign of cyclical weakness but rather a sign of an aging workforce. If you do not want us old folks to retire, then stop making it so easy to do so or start paying us more money. I personally would have preferred the latter over the former.

  • With regard to wage growth, it has been "sluggish" so far during the current expansion, but that most likely will change now that the unemployment rate has fallen below 6 percent. But even then, it is expected to unfold gradually over several months. By the end of this year, wage growth over the trailing twelve months is expected to accelerate to a pace closer to 3.5 percent from its current 2.0 percent pace. Although this still may not be perceived as much, it will most certainly be enough in an extremely low inflation environment to garner the attention of policymakers.

  • More importantly for business costs, unit labor costs are likely to climb as well, reflecting the combination of higher hourly wages and lower marginal labor productivity (the law of diminishing marginal returns states that the marginal product of an additional employee will at some point be less than the marginal product of the previous employee). In other words, as employers add more employees, unit labor costs will rise.

  • The implication is that the current low readings on inflation are likely to be very temporary. Not only are crude oil prices expected to rise over the remainder of this year and next but increases in core consumer prices most likely will accelerate over the same period. Businesses will be reluctant to absorb the higher labor costs expected, causing them to raise product prices if they can. The Laufenberg Quarterly (LQ) forecast assumes that businesses increasingly will raise their prices in 2015. This will lead to higher consumer price inflation, but it will also allow nominal corporate profits to continue to improve.

Real U.S. economic growth was about as expected for all of 2014, but far more uneven on a quarterly basis than anticipated a year ago.

  • Weather had a very adverse effect on the U.S. economy at the start of last year,
    pulling first-quarter real gross domestic product (GDP) down a shocking 2.1
    percent at an annual rate. Since then however, real GDP growth has rebounded
    dramatically, and has put real output roughly back on track with the Laufenberg
    Quarterly (LQ) forecast. Over the final three quarters of 2014, real GDP grew an
    average annual rate of 3.9 percent, raising the growth rate over the four quarters
    of last year to 2.4 percent.

  • A year ago, the LQ was forecasting real GDP growth of 3.1 percent in 2014, but at the time real GDP growth over the four quarters of 2013 was estimated at 2.5 percent. In the benchmark revisions in July 2014, real GDP growth over the four quarters of 2013 was revised upward to 3.1 percent, which essentially raised the bar for real GDP growth in 2014. As it turns out, the level of real GDP in the fourth quarter of 2014 was little different from the implied level in the LQ forecast of a year ago.

  • Fourth-quarter GDP growth slipped to 2.2 percent, which is less than half the pace in either of the two preceding quarters. But the gain was still fast enough to push the unemployment rate even lower. Indeed, despite the unevenness of real GDP growth over the four quarters of this year, the unemployment rate fell even more than the LQ below-consensus rate expected a year ago; in the fourth quarter of 2014, the civilian unemployment rate averaged 5.7 percent versus the LQ forecast of 5.9 percent.

  • Consumer spending improved markedly over the course of last year, ranging from a 1.2 percent increase in the first quarter to a 4.2 percent surge in the fourth quarter, bringing the gain over the four quarters of 2014 to 2.8 percent, which was not that different from the LQ forecast of a year ago. As long anticipated, spending on services accounted for a substantial share of the improvement in 2014, as well as the upward revision to consumer spending for all of 2013.

  • In 2014, international trade reversed its contribution to real GDP growth of a year earlier; that is, net exports detracted 0.2 percentage point in 2014 after contributing 0.2 percentage point in 2013. The LQ forecast of a year ago anticipated a smaller drag from international trade than reported so far. The bulk of the miss was in real exports, which grew only 2.8 percent over the four quarters of 2014, versus the 5.8 percent increase shown in the March 2014 LQ forecast. On the other hand, import growth was very much in line with the LQ's earlier expectations—actual of 5.3 percent versus expectations of 5.5 percent.

  • Another disappointment was residential investment, which was expected to increase at a double digit pace. Instead, such investment grew a mere 2.6 percent over the four quarters of 2014.

  • Consumer price inflation for all of 2014 was tracking the LQ forecast until the plunge in crude oil prices late in the year. Now inflation over the four quarters of 2014, which was expected to be a tad higher than in the preceding year, essentially came in equal to the year-ago advance. Core consumer inflation also came in a bit shy of earlier expectations, rising 1.4 percent over the four quarters of 2014 versus the earlier estimate of 1.8 percent.

Winter strikes again in the first quarter of 2015, just not as hard as it did a year ago for most. But don't try to tell that to Bostonians.

  • Despite very good job growth and a solid advance in real disposable personal income in the first quarter, consumer spending failed to keep pace. Once again, it looks as if winter weather had something to do with it.

  • The good news is that weather effects are temporary and in some degree reversible. The implication is that at least some of the economic activity lost in the first quarter will be recovered in the second and third quarters of the year, not that different from what happened in 2014. The difference is that the bad winter weather was not as widespread as it was last year, suggesting that the drag on real GDP growth will be less severe.

  • Our best guess at the moment is that the winter storms will detract about 1.0 percentage point at an annual rate from real GDP growth in the first quarter. The weather bounce will be worth at least 0.5 percentage point of real GDP in the second quarter and 0.2 percentage point in the third quarter.

  • Interestingly, the late-2014 plunge in crude oil prices most likely will help soften the weather-related hit to growth in the first quarter, as well as accelerate the rebound in the subsequent quarters.

Although real GDP growth in the first quarter most likely will disappoint somewhat, the LQ outlook over the four quarters of 2015 is little changed from last time, including a slight acceleration in real GDP growth, moderately higher inflation, more jobs, lower unemployment, and higher interest rates. Many aspects of the LQ forecast for 2015 are consensus or increasingly becoming the consensus.

  • The LQ outlook for stronger real GDP growth, more jobs and lower unemployment were consistent with the consensus forecast near the end of last year, albeit a tad more optimistic on most counts. In contrast, the LQ forecast of moderately higher inflation and higher interest rates differed from the consensus view of low inflation and low interest rates through the end of this year.

  • More recently, the consensus seems to have moved closer to the LQ view on most features of the forecast but not all the way. Given the very good February employment report, the consensus has revised the timing of the Fed's welladvertised rate hike from next year to this year. Recall that many market participants believed that the plunge in crude oil prices, the stronger dollar and extremely low interest rates elsewhere in the world, would force the Fed to postpone the rate hike at least until 2016. That still could happen but it seems far less likely now than it did a few months ago.

  • While the consensus has shifted its view on the timing of the Fed's rate hike, it still expects very low inflation and an extremely gradual increase in interest rates over the remainder of 2015. Many economists are still convinced that low crude oil prices will be sustained at least through the end of this year and that the spillover into core prices from low energy costs will be substantial. The LQ forecast disagrees on both scores. That is, crude oil prices are expected to rebound over the course of 2015, causing overall inflation to bounce higher. This alone would not be enough to concern the Fed but with labor markets continuing to tighten and capacity utilization continuing to rise, I expect that there will be upward pressure on core pricing as well. Undoubtedly, the stronger foreign-exchange value of the U.S. dollar will constrain pricing power somewhat, but it will only moderate the increases in core prices and not prevent them.

  • The bulk of the acceleration in real GDP growth this year is expected to reflect further gains in real consumer spending and a mild improvement in housing. The fundamentals for consumer spending are the best they have been for quite some time, which should help support consumer spending growth in the months ahead. Indeed, as the year unfolds, more jobs and wage gains, along with still relatively benign inflation, should continue to provide consumers with the wherewithal to spend (see Chart 1). Also, a sharp improvement in household balance sheets in recent years should help encourage consumers to spend more of the income they earn (the proverbial wealth effect).

chart 1

  • In addition, household formation increased dramatically late last year, which should not be a surprise given the improving jobs market. More households mean more demand for housing units, both owner occupied and rental. This should bode well for housing starts ahead.

  • Furthermore, consumer spending growth will support more business fixed investment, which after increasing 6.2 percent over the four quarters of 2014 is expected to climb 5.5 percent over the four quarters of 2015. The deceleration in 2015 is likely due to weak demand for equipment and structures in the oil industry, as well as less need for new investment by exporters in a strong-dollar environment.

  • Corporate profits are expected to increase again this year but at a much slower pace owing to lower profits in the oil industry, more bad weather, the dock workers strike, a flatter yield curve, and the potentially adverse effect of a stronger dollar.

In sharp contrast, the LQ outlook for 2016 at the moment is very much out-ofconsensus in that it has real GDP growth slowing down dramatically over the four quarters of the year. In fact, the forecast shows real GDP declining in the final quarter of next year. My initial impression is that this is the first quarter of the next recession. It could also be interpreted as the pause that refreshes but I doubt that will be the case.

  • As I have mentioned before, expansions do not die of old age, they are shocked to death. So what will be the shock that ends the current expansion? I believe that it will be consumer price inflation.

  • In order for inflation to be shocking, it does not need to be very high following an extended period of very low inflation. After all, the expectation is that the Federal Reserve knows how to fight inflation and as such will not let it get out of control. I agree that the Fed knows how to fight inflation but the battle against inflation can still be very disruptive to the economy.

  • In particular, consumer spending is expected to lead the way downward, as consumer prices rise faster than incomes, causing consumers to lose purchasing power. In the process, interest rates will rise, stock prices will fall, house prices will stagnate (if not fall somewhat), and real corporate profits will lag. The implication is that household wealth will take another hit, which will swing the wealth effect from a positive to a negative for consumer spending. In addition, fixed investment slows, employment suffers, bank loan losses pickup, credit-risk spread widens, and confidence wanes.

  • I doubt that the anticipated inflation shock will be as disruptive to the economy or to financial markets as the housing and mortgage debacle of the previous recession, but it is expected to be shocking enough to cause real output to falter for a few quarters. By historical standards, the next recession likely will be on the mild side with regard to real output lost, but the declines in employment and the stock market may be closer to average.

The investment implications for 2015 are mixed. The stock market may still have room to move higher but it will be very uneven owing to uncertainty about monetary policy. Bonds likely will be volatile as well but with a downward price trend over the next year.

  • The U.S. economy is expected to put in a solid performance in 2015, including strong real output growth, more jobs, and lower unemployment, despite a few one-off headwinds for the economy early. However, with the unemployment rate already down to 5.5 percent and manufacturing capacity utilization near 80 percent, there may be more of an opportunity for higher prices in 2015 than any time in recent years.

  • Such pricing power is expected to spill over into 2016 at a shocking rate. Recall that not much inflation is needed in the current price environment for it to be shocking.

  • Although most economists agree that the Federal Reserve will raise rates, there still is some disagreement about the timing of this policy shift. The LQ forecast continues to expect it will be sooner rather than later. But more importantly, the LQ forecast expects the Fed to be far more aggressive about hiking rates than most.

  • Monetary policy cannot avoid recessions, but it can soften their impact by minimizing the excesses of debt. By waiting too long to normalize interest rates, the Fed may extend the expansion in the near term but not without substantial costs later.

  • In addition, it is very likely that higher wages this year will put some pressure on profit margins, causing corporate profit growth to slow. Obviously, corporations with the power to raise prices on their products can counter the impact of higher costs. The LQ forecast assumes that an increasing number of corporations will have such power in 2015. What is even more interesting, such behavior apparently is more acceptable to policymakers—within reason of course—than it was in the more distant past. After all, at the moment, a little more inflation is viewed as a good thing. The last time a "little" inflation was considered a good thing was in the 1960s. Although it is not the 1960s, it is still important to be careful about what you wish for.

Daniel E. Laufenberg, Ph.D.

LQ Economic Forecast
First Quarter 2015

blue bar spacerAppendix: Laufenberg Quarterly forecast at a glance blue bar chzrt 1 - 4

bluebarspacerAppendix: Laufenberg Quarterly forecast details blue bar

Forecast Details

Statistics highlighted in bold have changed substantially from the previous forecast.

The views expressed here reflect the views of Daniel Laufenberg as of the date referenced. These views may change as economic fundamentals and market conditions change. This commentary is provided as a general source of information only and is not intended to provide investment advice for individual investor circumstances. Past performance does not guarantee future results.

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