December 21, 2015
Daniel Laufenberg, Ph.D.
On our way!
The Federal Open Market Committee (FOMC) finally took the first step toward the normalization of interest rates by raising their "target range for the federal funds rate to 0.25 to 0.5 percent" from 0.0 to 0.25 percent. This was the first federal funds rate hike in over nine years (June 2006) and was widely anticipated by market participants. To be honest, I have been anticipating it for a long time—for the last three years to be precise.
Although the FOMC removed the uncertainty about the first federal funds rate hike, it was quickly replaced by few others. In particular, where do we go from here, how do we get there, and what will it mean? This sentiment was echoed by the Fed in its usual guarded way in the press release following its December policy meeting:
In determining the timing and size of future adjustments to the target range for the federal funds rate, the [Federal Open Market] Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.1
An appropriate summary of the FOMC's comments may be contained in the slightly modified lyrics of the theme song from the movie Paint Your Wagon: Where are we goin'?, I don't know; When will we be there?, I ain't certain; All that I know is we are on our way.
So why did the FOMC act now? What happened over the last couple of months to change their mind about hiking the funds rate? According to the FOMC, the reason for its latest move was that in its judgement the underutilization of labor markets had "diminished appreciably" rather than simply "diminished" and that the risks to the outlook were "balanced" rather than "nearly balanced".2 Also, the FOMC recognized the "time it takes for policy actions to affect future economic outcomes," suggesting that it may have been revised expectations more so than realizations that triggered the move.
Although the actual trajectory of the federal funds rate in the future is unclear, I remain convinced that for an economy in the seventh year of an expansion it is probably above zero. I suspect that the new target range is still too low, which means that there will be more hikes to follow. My best guess is that the FOMC will need to do more than most market participants now expect. But a note of caution is warranted on this score given the accuracy of my federal funds rate forecast over the last few years.
What does this mean for the economy? According to the FOMC, growth should remain moderate, inflation should pick up a bit, and employment should continue to improve. Any setback owing to a stronger dollar and lower commodity prices is expected to be temporary, which in turn will allow the FOMC to raise short-term interest rates further, albeit very gradually.
Economic outlook: Ours versus theirs
The Laufenberg Quarterly (LQ) forecast, which will be the Stonebridge Capital Advisors (SCA) forecast going forward, differs a bit from the median projections of the members of the FOMC. First, real gross domestic product (GDP) growth in the LQ/Stonebridge forecast is a tad less in 2016 than the FOMC expects, even after postponing the start of the next recession from the end of 2016 to sometime in 2017 (see Table 1). In large part, the unusually mild weather accounts for the difference. Recall that a pickup in service spending was expected to drive an acceleration in real personal consumption expenditures (PCE) growth this quarter and into early 2016. However, warmer than normal weather this winter will be a drag on consumer demand for home heating services, causing real consumer spending on services (seasonally adjusted) to be lower than it would be otherwise. Just how much lower depends on how long the unusually warm weather will last. At the moment, it looks like it may last longer than expected earlier. Of course, because it is the weather, it could change.
Another factor having a damping effect on growth in 2016 will be the stronger foreign exchange value of the U.S. dollar, which makes U.S. products more expensive versus foreign products. Although it provides consumers with some added purchasing power in the form of lower import prices, it also may reduce U.S. job growth in some multinational companies. In the past, a stronger dollar may have been a relatively large net positive for the overall U.S. economy (usually in the form of lower crude oil prices), but with the increase in domestic oil production in the last decade, the net positive effect may be somewhat muted.
On the other hand, the current weakness in the industrial sector, as well as the international trade sector, may prove to be temporary given the expectation that the price of crude oil and the foreign exchange value of the dollar will stabilize soon. By the end of next year, I expect the trade-weighted dollar to give back some of its gain over the last four years, and the price of crude oil to recover a bit. Although this should help revive the industrial and energy sectors, it could take some of the steam out of consumer spending growth.
Second, the LQ/Stonebridge forecast for core inflation over the four quarters of 2016 at 2.5 percent is more aggressive than the FOMC's median projection of 1.6 percent over the same period. Of course, some difference is expected given that the two measures are calculated differently—the FOMC forecast is for the PCE price index, while the LQ/Stonebridge forecast is for the consumer price index (CPI). As shown in Chart 1, the CPI core measure of inflation is frequently higher than the PCE core measure. The only exception in the last decade was during the depth of the last recession.
The primary difference between the two inflation measures is the degree of product substitution. That is, if the price of a consumer item goes up, the weight assigned to that item in the calculation of the PCE index is adjusted to reflect any move by consumers to a cheaper alternative, whereas the weight assigned to that item in the CPI index is largely fixed. Over the last two year, the gap between the two inflation measures seems to have widened, suggesting that consumers have increasingly substituted to less expensive items. Through the third quarter, the core CPI was up 1.8 percent from a year earlier, while the core PCE index was up only 1.3 percent over the same period.
In addition, the core CPI in November (the most recent available) was up 2.0 percent from a year earlier and is on track to increase at a 2.2 percent annual rate in the current quarter. Although the stronger dollar may provide an opportunity for lower import prices, I suspect that companies will want to improve profit margins instead and that the strength in consumer demand will allow them to do so. That being said, core inflation for 2016, which was 3.1 percent in the previous LQ/Stonebridge forecast, has been revised lower owing to a slower reversal of the foreign exchange value of the dollar than anticipated earlier.
With regard to the outlook for employment, the LQ/Stonebridge forecast is roughly in line with the FOMC projection. That is, the FOMC expects the unemployment rate to fall to 4.7 percent by the fourth quarter of next year, while the LQ/Stonebridge forecast is for the rate to fall to 4.6 percent. The slight difference may be due to expectations about the labor force participation rate next year more so than job growth.
Based on the FOMC's projections, as well as its decision to hike its federal funds rate target, policy makers have come to realize that the aging of populations in many economies, including the U.S., may impose supply limits on economic growth, especially in the absence of substantial gains in labor productivity. This implies that economic growth may be slower than history would suggest but still fast enough to push the unemployment rate down further and to generate some inflationary pressures, especially in labor intensive industries.
The evidence of this new trend, in my view, is overwhelming. After all, real gross domestic product (GDP) has averaged only 2.2 percent a year so far during the current expansion, yet the unemployment rate has dropped to 5.0 percent last month from its high of 10.0 percent in September 2009. Although a 2.2 percent average growth rate for the early phase of an economic expansion may be disappointing by historical standards, apparently it still is fast enough under the new supply limit to lower the unemployment rate and to generate at least moderate wage gains.
Industrial sector takes a licking (but keeps on ticking)
Total industrial output was down 1.2 percent from a year ago in November according the latest report from the Federal Reserve Board, causing some to use the "R" word and question the FOMC's recent decision to raise its federal funds rate target. Without a doubt, the bad news is that a litany of factors, including slower global economy, a stronger dollar, milder than normal weather and sharply lower crude oil prices, have contributed to the weakness in the U.S. industrial sector. The good news may be that all of these factors are likely to be temporary and insufficient, even in total, to derail the current economic expansion in the near term.
Another unusual aspect of the recent slump in the industrial sector is that most of it was due to sharp declines in the utility and mining output. As shown in Chart 2, manufacturing output growth has slowed considerably so far this year but unlike total industrial output, it is still up from a year earlier. More importantly, if the weather reverts closer to normal, the price of crude oil stabilizes, emerging economies stop decelerating, and the U.S. dollar slowly reverses course, then industrial output most likely will turn positive. These assumptions underlie the LQ/Stonebridge forecast and are key to the anticipated rebound in industrial output in 2016.
For example, recall that at the start of this year, unusually cold and snowy winter weather was a problem for U.S. factory output. In the absence of another cold spell early next year, the seasonally adjusted output for manufacturing in the first quarter of 2016 will show a solid gain from a year earlier. Indeed, in the first quarter of next year, if the average manufacturing index equals its November reading of 107, then manufacturing output would register a gain of 1.4 percent from a year earlier. Obviously, if the foreignexchange value of the dollar would stabilize, let alone decline, it would mean an even better improvement in factory output next year.
Moreover, if weather returned to normal, then utilities production, which was down 7 percent over the two months ending in November owing to the unusually mild weather (and likely to drop further in December), most likely will rebound sharply. Mining output, which is down as well in recent months, is unlikely to register a gain until well after the dollar has stabilized and crude oil prices have stopped falling.
Consumers expected to carry the day—once again
This is a familiar refrain. Job growth, wage gains, lower gasoline prices and a still positive wealth effect have helped drive real personal consumption expenditures (PCE) higher over the last year and are expected to continue to do so over the next year. With real PCE representing 68 percent of GDP, this is key if the expansion is expected to continue. For example, in the third quarter, consumer spending grew a solid 3.0 percent at an annual rate and contributed two percentage points to real GDP. Recall that real GDP grew only 2.1 percent in the third quarter.
Moreover, consumer spending on goods and services contributed equally to overall growth in the third quarter, even though the level of spending on services is nearly twice that of the level of spending on goods. This is because real spending on goods increased at a 4.8 percent annual rate, twice as fast as the increase in real spending on services. And based on the limited data available for the current quarter, it looks like more of the same going forward—but with a few caveats. First, with the stronger dollar, there is a chance that an increasing share of consumer spending will be imported, which means that such spending will not add as much to overall real GDP growth as it may look at first blush since more of PCE will be foreign made. However, given how broadly consumer goods are already foreign made, there doesn't seem to be much room for more. Second, growth in spending on consumer services may be held in check a bit in the current quarter owing to the unusually mild winter weather, which in turn has reduced the demand for electricity and natural gas production. On the other hand, lower prices on consumer imports and less spent on utilities frees up household income for other uses. As I have noted on several occasions in the past, if U.S. consumers have income, they tend to spend it. Therefore, be careful not to overstate any negative impact from the dollar or the weather on consumer spending because spending less on some items may allow consumers to buy other stuff.
As shown in Chart 3, real PCE has been a key driver of real GDP growth over the last year and is expected to remain a key in the near term. In particular, the growth rate for real PCE seems to be off to a decent start but it is still early. Based on only the October data, real PCE is already up 1.0 at an annual rate over its third-quarter average. In other words, consumers seem positioned to deliver a solid Holiday shopping season, but maybe not as much as anticipated in the September forecast. Nevertheless, consumers should come close. The LQ/Stonebridge forecast now shows real PCE increasing at a 2.5 percent pace in the fourth quarter, down from the 3.0 percent gain expected earlier as well as the 3.0 percent gain in the third quarter.
Next year, a return to more normal weather will provide a tailwind for consumer spending growth, while somewhat higher crude oil prices and a slightly softer dollar may represent minor headwinds. Minor because the negative price effects may be offset in part by more positive income effects. After all, higher crude oil prices and a weaker U.S. dollar may bode well for jobs in the U.S. energy and manufacturing sectors.
Taking a measured risk is still a good bet
Many of the factors that have hampered the U.S. industrial sector have also had an adverse effect on U.S. corporate profit growth this year. These factors, along with the FOMC's decision to raise its funds rate target, most likely explain the nervousness in stock and high-yield bond markets. However, once the temporary factors subside and the expansion survives a higher federal funds rate, risk most likely will be in favor again. I thought third-quarter corporate profits, as reported in the National Income and Product Accounts, told the story. Overall corporate profits in the third quarter were down $22.7 billion from the preceding period, owing entirely to the profit loss from the rest of the world (stronger dollar). Domestic profits were up $7.3 billion, with domestic nonfinancial profits up $15.8 billion.
If the U.S. dollar stabilizes, which it is expected to do sometime in early 2016, then the drag on profits from the rest of the world would ease and result in a substantial swing in overall profits ahead. After all, the impact of a higher federal funds rate on the dollar and in turn the economy, will depend on how longer-term interest rates react. As long as inflation expectations remain subdued, it is unlikely that long-term interest rates will climb in step with short rates. But as the expansion continues and excess capacity is absorbed, inflation expectations are likely to move a tad higher. The FOMC's response will be further hikes in short-term rates. At some point, however, monetary policy will be perceived to have gone far enough, if not too far, to keep inflation in check, causing long-term interest rates to drift lower in anticipation of the FOMC reversing course in an attempt to avoid recession. The timing of this interest rate cycle is unclear, but at the moment it looks as if this cycle ends in 2017 rather than in late 2016.
Finally, the most recent reading of the LQ Asset-Allocation Indicator suggests that it is still okay to be overweight equities in a diversified portfolio, and that it may be okay for at least another six months or so. That being said, the Indicator is far from a screaming buy signal, which suggests a more measured approach to portfolio risk now than certainly seven years ago.
My last forecast is summarized in Table 2. Compared to the old table format, this format has far less detail, both in terms of the number of items listed and the frequency of those items. For the most part, I have tried to present the forecast in a manner similar to how the FOMC presents its projections.
Note: Changes in real gross domestic product and all measures of inflation are percent changes from the fourth quarter of the previous year to the fourth quarter of the year indicated. The unemployment rate and all interest rates are averages for the fourth quarter of the year indicated, as are the WTI oil price and the major currency trade-weighted dollar index. Profits are the total per share for the year indicated.
Sources: Bureau of Economic Analysis, Bureau of Labor Statistics, Standard and Poor's, Federal Reserve Board, Department of Energy, and Federal Home Loan Mortgage Corporation.
You may see this table again. Although the LQ website is essentially being archived, I am not—at least not yet. Hopefully, you will continue to follow my economic analysis on the Stonebridge Capital Advisors website, stonebridgecap.com.
Daniel E. Laufenberg, Ph.D.
1 Press Release, FOMC Statement, Board of Governors of the Federal Reserve System, December
2 Ibid and Press Release, FOMC Statement, Board of Governors of the Federal Reserve System,
October 28, 2015.
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.