We live in an uncertain world. Policymakers have to sift through a wide range of data, much of which is subject to statistical error and measurement difficulties. Financial market participants deal with much of the same data, but also have to account for the uncertainty in how policymakers will interpret the data and respond. There are longer-term questions, which won’t be resolved anytime soon. So where do we stand now?
On April 29, Federal Reserve officials will meet again to set monetary policy. That morning, the Bureau of Economic Analysis will release its initial estimate of 1Q15 GDP growth. There’s always a lot of uncertainty in the advance GDP estimate. The BEA does not have a complete picture of the component data – and as we’ve seen over the last several quarters, subsequent revisions can be very large. Rather than focus on the headline GDP figure, investors would do better to consider the key details. Consumer spending accounts for 70% of GDP. Job growth has been supportive, but wage growth has been relatively lackluster over the last several quarters. The drop in gasoline prices has pushed consumer price inflation close to zero (the CPI fell 0.1% over the 12 months ending in March), resulting in a sharp rise in real wages. That should help drive consumer spending in the near term. Spending was soft in December, January, and February. Inflation-adjusted spending appears to be on track for about a 2.0% annual rate in 1Q15, down from a 4.4% pace in 4Q14 (reflecting unusual strength in October and November). Spending in 2Q15 should pick up.
The sharp drop in energy prices has led to a significant contraction in oil and gas exploration. While locally severe, the loss of jobs should be small on a national level. The bigger impact on GDP will come through the drop in business structures. That decline will be magnified in the GDP calculation. Growth is reported at an annual rate. So a sharp decline in a single quarter will appear much larger. It’s hard to put a precise number on it, but the decline in business structures is likely to help push the headline GDP figure close to zero (or a bit negative) in the first quarter. Note that while energy exploration has contracted, energy extraction is still going strong, helping to keep energy prices low.
The negative impact of lower energy prices should be more front-loaded, while the benefits (to the consumer) are likely to build over time. In the advance GDP estimate, there is also the usual uncertainty surrounding inventories and net exports.
The Fed generated some confusion by saying it would begin debating rate increases in June. That doesn’t mean that the Fed will begin to raise rates at that time. Rather, it’s simply a return to business as usual for the Fed (less reliance on the forward guidance). While officials have continued to indicate that conditions are likely to warrant a rate hike by the end of the year, they have also suggested that the pace of increases (after the first) will be much more important, and likely very gradual.
U.S. investors are not the only ones interested in the Fed policy outlook. We saw significant global reactions in the “taper tantrum” of 2013. The reaction in emerging market economies to the initial Fed rate hike could be just as severe or greater.
Greece has been a reoccurring worry for investors here and abroad. We’ve been through this a number of times, and it usually ends with the can kicked down the road. However, the length of these “kicks” has gotten shorter and the calls for a Greek exit from the euro have grown louder. Both sides have been reported to be preparing plans for a Grexit, but there will be enormous challenges for policymakers if that happens.
The financial markets appear to be searching for a direction. Stocks often climb a wall of worry, but a lot of good news (a 2Q15 rebound in GDP growth, a Federal Reserve not in any hurry to tighten policy) is already factored in.
The good news is that the output gap, the difference between real Gross Domestic Product and its potential, has narrowed. The bad news is that’s largely because potential GDP has declined. The big question now is whether the economy is on a permanently lower track. The answer is not so clear.
We like to say that the 2008-09 economic downturn was not your father’s recession. It was more like your grandfather’s depression. This was not the typical Fed-induced recession. This was a collapse of a housing bubble combined with a huge deleveraging within the financial system. More than eight years after the initial downturn and nearly six years into the economic recovery, the borrowing situation appears to be in better balance. That doesn’t mean that everything is okay, but we are on better footing and poised for improvement.
It’s an odd fact that GDP growth has averaged about 3% per year over the last several decades. Through that time, we’ve had variations in labor growth (increased female labor force participation in the 1960s, 70s, and 80s) and changes in productivity growth. This trend may go back well before the turn of the last century, as suggested by some historical analysis (GDP, as a concept, did not exist back then). GDP deviated from the trend during the Great Depression, but returned to it after World War II. There is no good theoretical reason to expect 3% GDP growth over a long period of time. Output is equal to labor times the productivity of that labor. Why would labor growth and productivity growth sum to 3% on average?
Potential GDP can be defined to be the level of economic activity consistent with steady inflation (2%) over time – not too hot, not too cold. There are some challenges in forecasting it. The standard approach is to project labor input (considering population growth and the removal of current slack) and apply that to an estimate of productivity growth. Estimating the amount of slack in the labor market isn’t terribly difficult, but there are uncertainties. Population growth is slowing, so the longer-term trend in labor input should be slowing accordingly. The estimate of productivity growth will depend on the pace of capital investment. The main reason that the Congressional Budget Office’s projection of potential GDP has come down in recent years is that business fixed investment has been subdued through most of the recovery.
The key question is whether the lower track in potential GDP is permanent or secular (persisting over an indefinitely long period). One can imagine a scenario where population growth slows further (Europe is turning Japanese and the U.S. may not be far behind). This is a very important issue. At 1% GDP growth, the economy will be 34% larger in 30 years. At 3%, it will be 143% larger. Even a 0.5% difference in long-term growth will matter a lot for the outlook for the standard of living and for funding government entitlement programs.
Secular stagnation is not simply a concern for the U.S. In the analytic chapters of its World Economic Outlook, the IMF reports that “potential output growth across advanced and emerging market economies has declined in recent years.” For the advanced economies, the slowdown in potential GDP began well before the financial crisis, but the pace should pick up “as some crisis-related effects wear off (yet will still remain below the pre-recession trend). For emerging economies, the slowdown happened after the crisis. However, the slowdown in potential GDP for emerging economies is likely to continue, as their populations age and productivity slows as they “catch up to the technology frontier.” China has had phenomenal growth over the last few decades, but may have a tough time meeting current (lower) growth targets.
Investors tend to focus on the short term, but they would be wise to pay attention to the debate about the long term.
The nonfarm payroll data for March were disappointing. Job growth was substantially less than expected and figures for the first two months of the year were revised lower. These data fit in with the general theme of other recent economic reports. Growth slowed in the first quarter, reflecting bad weather and the negative impacts of a stronger dollar and lower oil prices. Growth is still widely expected to pick up in the spring, but for investors, that may begin to feel more a matter of faith.
Payrolls advanced by 126,000 in the initial estimate for March, about half the expected gain. Simply looking at the payroll graph suggests that we may be seeing a statistical moderation. There’s a fair amount of statistical uncertainty in the payroll figures. The monthly estimate is reported accurate to ±105,000 (for those of you who stayed awake in your statistics class, that is a 90% confidence interval). It’s not unusual to see the payroll figures bunch a bit higher or lower than the underlying trend. In other words, a strong quarter of payroll growth is often followed by a softer quarter. That doesn’t mean that job growth has necessarily “slowed.”
The impact of the weather can seem a bit quirky in the payroll reports. The payroll survey covers the pay period that includes the 12th of the month. That can vary from firm to firm (depending on whether workers are paid weekly or semi-monthly). The BLS noted that the survey period dodged the bad weather in February, but was not so lucky in March. The household survey, which covers the week of the 12th, showed that 328,000 people could not get to work due to bad weather in February, compared to a 387,000 average over the 10 previous Februarys. In March, 182,000 could not get to work due to bad weather, versus a 150,000 average over the past 10 years). So we went from better-than-normal weather in February to worse-than-normal weather in March. That may explains some of the shortfall in payrolls for March. Note that these are unadjusted figures from a different survey and are not directly comparable to the nonfarm payroll data, but suggest that we may see a weather-related rebound in April payrolls.
The stronger dollar and the decline in oil prices have both positive and negative effects on the economy. It’s likely that the negative effects are showing up more quickly than the benefits. The decrease in energy exploration is seen in the drop in mining payrolls (-11,100 in March, -11,100 in February, -7,400 in January). While perhaps devastating to local economies (these are high-paying jobs that are being lost), it is tiny on a national scale (about 0.02% of total payrolls). Even accounting for multiplier effects, the impact on total payrolls is small. The bigger impact from the retreat in energy exploration will come in capital spending. Note that the stronger dollar has hit corporate profits. Corporate profits are a key driver of capital spending and new hiring. This will show more at larger firms. Unlike the official BLS data, the ADP estimate of private-sector payrolls provides a breakout by size of firm. The March report showed a sharp slowing in job gains at large firms, but continued strength in hiring for small and medium-sized firms.
Job growth has been strong over the last year (over 3.1 million, or 2.3%). Combined with the increase in purchasing power from lower gasoline prices, consumer spending should be picking up. Consumer spending accounts for 70% of Gross Domestic Product, so the benefits of lower gasoline prices should offset the negative effects of the stronger dollar.
The general theme of recent data reports should make Fed policymakers less inclined to raise short-term interest rates this summer. The Fed is still justified to plan for policy normalization and to return to “business as usual” in June (that is, considering whether to raise rates on a meeting-by-meeting basis). However, the monetary policy outlook will depend critically on the upcoming economic data and signs of a spring awakening.
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