Economic Monitor – Weekly Commentary
by Scott J. Brown, Ph.D.

Forecasting exchange rates
November 23 – December 4

Currency forecasting is inherently difficult. Getting monetary policy right can help in the short-term, but beyond three months, you can’t do any better than a random walk. That aside, the strong dollar (along with softer global economic growth) has played a major role in the slowdown in U.S. corporate profits this year. What can we expect for 2016?

First, some basics… The exchange rate of the dollar can be thought of as a price, dependent on supply and demand. There are trade flows and capital flows in and out of each country. Exchange rates will adjust to balance them (on net). One often hears complaints about the U.S. having to “borrow money” from the rest of the world. That is a function of the trade deficit, not the government’s budget deficit. Net capital inflows merely balance the net trade outflows in goods and services. Capital flows can react quickly to exchange rate movements, while trade flows respond more slowly. Simply put, global capital can move rapidly, but import and export activity doesn’t turn on a dime. This can lead to some “over-shooting” in exchange rates.

In most advanced economies, the exchange rate of the currency falls under the jurisdiction of the finance ministry (the Treasury Department in the U.S., the Eurogroup in Europe), not the central bank. However, finance ministries (in the advanced economies) have little ability to influence currencies beyond short-term interventions and jaw-boning. Central bankers can have a major influence on exchange rates in the short term, but that is not the goal of monetary policy. Rather, the central bank has to consider the impact of exchange rate movements on domestic growth and inflation. In general, policymakers are not much concerned about the level of the exchange rate. Rather, the speed of adjustment is what’s important. Rapid movements in currency markets can be destabilizing.

Over the last four quarters, U.S. merchandise exports fell 6.6%, but that decline largely reflects a drop in export prices. Merchandise exports fell 1.0% in inflation-adjusted terms – not a large decline. Merchandise imports fell 4.0% (3Q15-over-3Q14), but rose 5.4% adjusting for the drop in import prices. For services, exports rose 2.2% y/y, while imports rose 2.5%. Hence, the impact on GDP growth has been relatively limited (-0.7 percentage points from GDP growth over the last year). There may be some lag involved, so we may not want to write off concerns just yet. Moreover, the stronger dollar and softer global growth has had an impact on corporate profits.

On November 13, IMF Managing Director Christine Lagarde said she supported the staff’s recommendation that the Chinese renminbi be included in the basket of currencies which make up the IMF’s Special Drawing Rights (SDR). The IMF’s Executive Board will take up the issue on November 30 and, if approved, the Chinese currency would be added on October 1, 2016. The Chinese currency is still highly manipulated, but for the IMF the criteria are that it be “freely usable” and “widely used.” Some financial “newsletters” have suggest ed that this is a step in replacing the dollar as the premier reserve currency. However, these “newsletters” are simply selling gold (and this is only the latest excuse, among many, that they have put forth in the last several years). Still, there is a lot of downward pressure on the Chinese currency. Preventing it from falling comes with a cost.

The dollar’s strength against the major currencies reflects relative monetary policy stances, but much of that is likely already baked in. The dollar’s strength against the world’s other currencies reflects concerns about growth in emerging economies. Growth in these economies should eventually pick up, but the pace may be more moderate than we’ve seen in the last decade or two. In any case, Federal Reserve policy is going to be based on what’s happening with the domestic economy.

Fed up
November 16 – November 20

The agonizing over whether the Fed will begin raising short-term interest rates is unlikely to end soon. A 25-basis-point increase shouldn’t have much of an impact on the economy, especially if the Fed makes it clear that it intends to go slow with further rate hikes. However, the financial markets believe this to be a big deal. So it is. Fed officials have continued to signal that it “may be appropriate” to start in December, but they have also continued to signal that this is not a done deal.

Many market participants viewed the October employment data as being the clincher – a clear catalyst for Fed liftoff. However, Fed officials were already leaning hard in that direction before the jobs data. Recall that the Fed came very close to raising rates in September, but delayed, citing possible downside risks from the rest of the world. Those downside risks are still with us, but they appear to be less worrisome than two months ago. The stronger dollar and weaker global economy have restrained U.S. exports, but it hasn’t been a sharp drag.

Domestically, the economy appears to be in relatively good shape, although GDP growth is likely to be somewhat slower in the near term. Retail sales disappointed in October, suggesting less positive momentum for consumer spending into 4Q15, but aggregate wage gains (from the Employment Report) picked up.

Why does the Fed want to raise rates? It’s largely about the job market. Monetary policy affects the economy with a long and variable lag (usually taken to be 12 to 18 months). At the current pace, there will be a lot less slack in the job market a year from now. In early 2014, Fed Chair Yellen highlighted hiring and quit rates as important gauges of the job market’s strength. Hiring and quit rates improved since the start of the economic recovery, but have flattened out over the last year. Although the unemployment rate has declined, there may be a lot more slack in the job market than that figure would suggest.

In the October 28 policy statement, the FOMC repeated that it wants to see some further improvement in the labor market, but it also needs to be “reasonably confident” that inflation will move back toward the Fed’s 2% goal. In public speeches, senior Fed officials have repeated the simple logic that inflation should pick up as the impact of low oil prices and low import prices fade. However, over the last couple of weeks, the dollar has strengthened again and commodity prices have dipped. The Producer Price Index showed further downward pressures.

Many see the Fed as being in a box – policymakers can’t raise rates, because the markets won’t let them. Falling share prices and a stronger dollar will further restrain economic growth and put additional downward pressure on inflation. However, a small rate increase should not have much of an impact on the economy and Fed officials have continued to stress that the path of policy tightening will be data-dependent and likely very gradual. We should get a strong, clear signal from Chair Yellen when she delivers her JEC testimony on December 3.

The job market and the Fed
November 9 – November 13

The October Employment Report was stronger than expected, but should be seen in its proper context. That is, while October’s payroll gain far exceeded forecasts, it followed softer figures in August and September. The three-month average was moderate. Financial market participants believe that the report makes a December 16 rate hike a lot more likely. However, the Fed had already been signaling that such a move was likely.

Nonfarm payrolls rose by 271,000 in the initial estimate for October. Seasonal adjustment is often a bit tricky in the late summer and early autumn as the school year gets under way. We added 1.152 million jobs prior to the seasonal adjustment (vs. 1.082 million in October 2014 and 938,000 in October 2013), with about two-thirds of that gain in education. The three-month average for the adjusted payroll gain was +187,000 (a 2.2 million annual rate, vs. 3.0 million jobs added in 2014) – still well beyond the +120,000 monthly pace that would be consistent with population growth.

The unemployment rate was essentially unchanged (5.036%, vs. September’s 5.051%), the lowest since April 2008. The employment/population ratio is trending about flat. Some Fed officials dismiss the e/p as distorted, largely reflecting a demographic change in labor force participation. Yet, it’s also likely that the job market is a lot more flexible than the household survey data would suggest. That is, there are many individuals who could be lured back into the job market if there were a good enough job available. Two gauges that Fed Chair Yellen highlighted, long-term unemployment and the percentage of people involuntarily working part-time, continue to signal improvement, but they still have some way to go.

The Fed is not going to react to any one piece of economic data, including the October Employment Report. However, it should have been clear that officials were already leaning heavily toward a December move. Fed policymakers expect to see a lot less slack in the labor market a year from now. They anticipate that inflation will move back toward the 2% goal as the transitory impacts of low energy prices and lower import prices fade. Recall that the Fed came very close to raising rates in September, but delayed, citing possible restraints on the U.S. from global economic and financial developments. The downside risks from the rest of the world now appear to be a lot less worrisome than they did two months ago. Exports are down, but not terribly so, with most of the year-over-year decline being a reflection of lower prices for food and industrial commodities. A Fed rate hike would put some upward pressure on the dollar in the short term, but the exchange rate of the dollar is the Treasury’s call and the Fed has to do what it has to do for the domestic economy. Still, the impact of a stronger dollar (restraint on exports, lower import prices) suggests that the Fed will likely be very gradual in raising rates over time.

Labor productivity figures bounce around a lot from quarter to quarter, but the trend over the last few years has been disturbingly low (about a 0.5% annual rate). It’s unclear exactly why productivity has slowed, but it does add to concerns about secular stagnation. All else equal, a slower trend in productivity growth implies that the Fed should be quicker in raising rates (as the job market will tighten more rapidly at any given growth rate for GDP), but at the end of the cycle, the central bank should end up raising rates a lot less. That fits in with the idea of a December hike and a gradual pace thereafter.

Stock market participants need not fear a Fed tightening cycle. The initial move will reflect an optimistic economic outlook. Monetary policy will still be very accommodative even after the first couple of rate hikes. Still, we may see some volatility as the markets try to figure it all out. Fed officials can help by simplifying the message.

The opinions offered by Dr. Brown should be considered a part of your overall decision-making process. For more information about this report – to discuss how this outlook may affect your personal situation and/or to learn how this insight may be incorporated into your investment strategy – please contact your financial advisor or use the convenient Office Locator to find our office(s) nearest you today.

All expressions of opinion reflect the judgment of the Research Department of Raymond James & Associates (RJA) at this date and are subject to change. Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete. Other departments of RJA may have information which is not available to the Research Department about companies mentioned in this report. RJA or its affiliates may execute transactions in the securities mentioned in this report which may not be consistent with the report's conclusions. RJA may perform investment banking or other services for, or solicit investment banking business from, any company mentioned in this report. For institutional clients of the European Economic Area (EEA): This document (and any attachments or exhibits hereto) is intended only for EEA Institutional Clients or others to whom it may lawfully be submitted. There is no assurance that any of the trends mentioned will continue in the future. Past performance is not indicative of future results.