Second Quarter June 14, 2015

blue bar Economic Forecast blue bar

Another soft start but another solid finish

As discussed in the March forecast, the U.S. economy got off to a sluggish start again this year. In fact, it now seems that the sluggishness was even more severe than estimated initially. According to the U.S Commerce Department's Bureau of Economic Analysis (BEA), first-quarter real gross domestic product (GDP) fell 0.7 percent at an annual rate from the preceding quarter versus the initial estimate of a 0.2 percent gain.1 In the March forecast, I expected real GDP growth to slow to 1.9 percent in the first quarter, but still grow 3.0 percent over the four quarters of this year.

  • Apparently, a series of one-off events, including the weather, the West Coast dockworkers' strike, the plunge in crude oil prices, and the stronger dollar, detracted far more from firstquarter real GDP than I was expecting in March. Although it is unlikely now that U.S. real output will grow 3.0 percent for all of 2015, it still should grow faster than the 2.2 percent average annual rate for the expansion so far.

  • One of the positive developments in the first quarter and a primary reason I expect the economy to rebound over the remainder of this year is that disposable personal income increased a very respectable 3.2 percent at an annual rate from the preceding quarter. In contrast, current-dollar consumer spending declined 0.2 percent, providing clear evidence that consumer spending failed miserably to keep pace with the gain in income.

  • As such, the personal saving rate increased to 5.5 percent in the first quarter from 4.6 percent in the fourth quarter of 2014. Indeed, the saving rate in the first quarter was the highest in over two years. That being said, it is more important to note the direction of the personal saving rate rather than its level because it tends to be revised dramatically over time, usually higher. As an aside on this matter, some of you may remember discussions about the negative personal saving rate on numerous occasions in the past. I suggested that it was overdone and that the government would eventually discover more income, which in turn would cause the personal saving rate to be revised higher. As shown in Chart 1, all evidence of a negative personal saving rate, which was once a major concern to some economists, has been removed from the historical data.

  • After adjusting for the 2.0 percent decline in consumer prices in the first quarter, both real disposable income (up 5.3 percent) and real consumer spending (up 1.8 percent) told the same story; that is, spending failed to keep pace with income. Not surprisingly, lower energy prices where the key factor behind the drop in consumer prices as measured by the personal consumption expenditures price index.

  • The conclusion is that household income had increased substantially in the first quarter even without the added purchasing-power effect of lower energy prices. In other words, there was more to the consumer income story than just lower prices.

  • As mentioned above, several one-off events may have contributed to the economy's soft start to the year. The first was the weather—again. Recall that unusually harsh winterweather was a substantial factor behind the first-quarter slump a year earlier. However, as shown in the data last year, weather effects are temporary and to 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 this year was not as widespread as a year ago, resulting is less of a drag on real GDP growth as well. Recall that real GDP declined a whopping 2.1 percent in the first quarter of 2014.

chart 1

  • However, there were other factors that may have come into play in the first quarter that are likely to be reversed over the remainder of the year or unlikely to be repeated. One such factor was the West Coast dockworkers' strike. It most likely had a negative effect on manufacturing, both in terms of the available of imported intermediate products as well as the export of final product. In addition, the stronger dollar made imports less expensive and U.S. exports more costly to overseas consumers. As a result, the international trade sector (real net exports) detracted a whopping 1.9 percentage points at an annual rate from firstquarter real GDP, the largest drag on growth from this sector since the second quarter of 1985.

  • There also may have been a transitory nature to the income gain that drove individuals to save rather than spend. In particular, the perceived temporary nature of the dollar's strength, low oil prices and the dockworkers' strike. Only if this income gain is perceived as permanent will consumers be more likely to spend it. However, developing such a perception takes a little time. Look for consumer spending to rebound over the remainder of the year, barring any major surprises. In fact, based on the surprisingly robust 1.2 percent gain in retail sales in May, this rebound may already be underway.

The economic data at the end of the first quarter and so far for the second quarter have been characterized by many financial analysts as mixed, raising some questions about where the economy is heading and adding some confusion to the timing, if not the actual decision, of the Federal Reserve removing some of the "excessive" accommodation now in place. Some suggest that the Fed should error on the side of caution because of the uncertain outlook for global economic growth rather than just the domestic economy.

  • The word "excessive" is my way of noting that it seems inappropriate for real short-term interest rates to be as negative as they are with the U.S. economy in the sixth year of an expansion and the unemployment rate at 5.5 percent (see Chart 2).

chart 2

  • This is not a plea for dramatically higher interest rates. Rather it is a recommendation that monetary policy shift to a more neutral stance before it is too late. The downside is that it is already too late. But too late for what?

  • Monetary policy cannot avoid recessions as evident by the frequency of such downturns in the post-World War II period.2 It can only delay the recession or at best damp its severity. Hence, I contend that if the Fed wants to avoid a recession as devastatingly severe as the last one, they should move to a more neutral interest rate policy sooner rather than later. It should be no surprise then that I totally disagree with the recommendations coming from the World Bank and the International Monetary Fund that the Fed delay any bump up in short-term interest rates until 2016.

  • And the data may not be as mixed as many seem to claim. More recent data releases have been more upbeat than many expected, which is consistent with the one-off nature of the economic weakness displayed in the first quarter.

  • On the positive side, the solid gain in the May jobs report suggest that personal income will continue to improve in the second quarter. In fact, the level of personal income in April was already 2.2 percent at an annual rate above the first-quarter level, suggesting that even after adjusting for higher consumer prices in the second quarter, real personal income should show a solid gain. And eventually, more income should lead to more consumer spending. In addition, household balance sheets are in very good shape (asset prices higher and debt levels lower), suggesting that they have the potential to boost spending in a major way in the months ahead. The LQ forecast assumes that they will.

  • Of course, consumers have already increased spending on goods at a pace roughly in line with the historical standards of modern day expansions but not their spending on services (see Chart 3). Real consumer spending on goods, which account for roughly one-third of all consumer expenditures, have increased about in line with past recoveries, albeit maybe a bit less robust on average. On the other hand, consumer spending on services, which are about twice as high as spending on goods, has grown at a considerably slower pace so far during the current expansion than during prior expansions. Nevertheless, the growth rate for real spending on services is moving upward as expected for an improving economy. Income and balance sheet data suggest that this upward direction in service spending is likely to continue.

chart 3

  • Another plus for the U.S. economy's outlook was the surprising uptick in housing starts in May to 1.135 million units after a couple of disappointing data points. This bodes well for further improvement in the housing sector, possibly in the second quarter but more likely in the second half of the year.

  • Finally, the foreign exchange value of the U.S. dollar has "stabilized"; well, to the extent that the value of the dollar does stabilize (see Chart 4). A trend line has been added to the chart to provide a benchmark for the direction of the dollar over the last 40 years or so. This is not to suggest that the dollar cannot go higher but only that it is already well above its longer-term trend.

chart 4

  • The implication for the economy is that the trade sector, which was a significant drag on the U.S. economy in the first quarter and may be again in the second quarter, most likely will not be as constraining in the second half of 2015. This will be especially the case if consumer spending shifts to services as expected, which are less likely to be imported than are goods.

  • On the negative side of the data, industrial production has been hampered somewhat by the stronger dollar, as well as the bad weather and plunging oil prices. But again, I view the adverse effects of the latter two factors to be temporary and the former factor showing some sign of turning. As such, I suspect that industrial output will improve over the remainder of this year, but probably not at as robustly as it did earlier in the current expansion. This is another reason why consumer spending on services will become increasingly important to the pace of the expansion over the remainder of 2015.

The investment implications for 2015 are unchanged from March. The stock market may still have room to move higher but it will be very uneven owing to uncertainty about the future course of monetary policy. Bonds likely will be volatile as well but with a downward price trend over the next year. Nothing has happened in the last few months to change my view on this score.

  • The U.S. economy is expected to put in a solid performance in 2015, including solid 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 surprising pace. Recall that not much inflation is needed in the current price environment for it to be surprising.

  • 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.

  • Dollar strength is not a new longer-term trend. For that reason, any drag on the industrial sector from the stronger dollar may prove temporary. Moreover, when the Fed does decide to hike short-term interest rates, most of the dollar's response, if not financial asset price response, may already be in the market.

  • Finally, I think it is important to reiterate the outlook for corporate profits. Companies are very likely to experience some downward pressure on profit margins this year owing to an even tighter labor market and the upward pressure on wages that will ensue. Obviously, corporations with the power to raise prices on their products will be able to counter some if not all of the impact of higher labor costs. Although the LQ forecast expects an increasing number of corporations will have such power in 2015, it will not be enough to avoid a meaningful slowdown in the growth of operating profits this year.

Daniel E. Laufenberg, Ph.D.

LQ Economic Forecast Second 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. f—forecast


1 According to more recent data on international trade, retail sales and housing, it now looks as if first-quarter real GDP will be revised slightly higher to show little or no gain in the final estimate to be released later this month.

2 According to the National Bureau of Economic Research, the U.S. economy has had ten recessions of varying degrees of severity since the end of the Federal Reserve's wartime "pegging policy" in March 1951 (an average of about one recession every six years). Although the Federal Reserve was created in 1913, it was dramatically redesigned in the midst of the depression. The result was a policy of very low interest rates—not that different from the policy now being pursued. With the attack on Pearl Harbor in 1941, the Federal Reserve worked to maintain depression level interest rates (pegged rates) throughout the wartime period to minimize the borrowing costs of financing the war. Of course, prices were controlled and commodities rationed as well, but they were lifted for the most part by the end of 1946. On the other hand, it was not until a fresh outbreak of inflation occurred in 1951 as a side effect of the Korean War that the Federal Reserve finally abandoned its pegging policy. For a more complete discussion of the pegging episode, see Dudley G. Luckett, Money and Banking (McGraw-Hill, 1984), pp. 561-63.


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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