Weekly Economic Commentary by Scott J. Brown, Ph.D.
Spotlight on Yellen
February 8 – February 19, 2016
Fed Chair Janet Yellen will present her semi-annual monetary policy testimony to the House Financial Services Committee on Tuesday. She is expected to present a moderately upbeat economic outlook, but she should also note the abundance of downside risks to that outlook. This is an election year, so she is unlikely to receive a warm welcome. If fact, many are likely to criticize the Fed for raising rates in December. She will put up a credible defense, but that’s unlikely to appease the markets.
The Fed has two goals, maximum sustainable employment and stable prices (defined as 2% inflation in the PCE Price Index). It also has to keep an eye on financial stability. The job market has been the key driver of the Fed’s decision to begin raising rates. At 4.9%, the unemployment rate has dropped to a level that was once viewed as “full employment” (consistent with stable prices). The unemployment rate is a bit misleading, as many have dropped out of the labor force. Some of that decline reflects the demographics. However, the decline in labor force participation in recent years can’t be entirely attributed to an aging population. The employment/population ratio has begun to trend more noticeably higher over the last year (and especially in the last few months). Long-term unemployment and the number of people involuntarily working part time (preferring full-time employment) are still not back to “normal” levels, but they are getting close.
The economy added more than 5.7 million jobs in the last two years, nearly twice the pace that would be consistent with the growth in the working-age population. Strong job growth can continue for a while, as slack created in the downturn is taken up, but it will eventually slow to a more sustainable pace. Average hourly earnings rose 2.7% in 2015 (+2.5% over the 12 months ending in January), vs. a 1.9% average for the four previous years. This has caught the Fed’s attention.
The January Employment Report showed gains in manufacturing jobs in both December and January, which strikes many as unusual since other measures of factory sector activity have been soft. Most likely this is a seasonal adjustment issue. Less seasonal hiring in the summer and fall means that we are going to see fewer seasonal layoffs in the winter. Prior to seasonal adjustment, factory payrolls fell by 66,000 in January (+29,000 after seasonal adjustment). Similarly, retailers appear to have added fewer jobs in December – hence, fewer retail job losses in January (-584,000 before adjustment, +57,500 after adjustment). The financial markets are good at nuance, but this illustrates an important point. January data are generally unreliable. Take the numbers with a grain of salt.
Weather and seasonal adjustment make it difficult to judge the underlying strength in the economy in the first couple of months of the year. The data for March, April, and May will be much more critical. Fed policymakers know this.
Chair Yellen is likely to present an outlook that is close to the consensus view. That is, GDP is likely to rise by 2.0-2.5% over the course of this year. At the same time, the risks to that outlook are weighted predominately to the downside. The Fed has to balance the expectation (moderately strong growth) against the risks (slower growth) in setting monetary policy. Yellen should point out the policy is still very accommodative and that the Fed has to be forward-looking. Given the job market outlook, the central bank is still very much in tightening mode, but it is expected to proceed cautiously.
For most of the last few years, the stock market has been in the sweet spot. The economy was improving, but not so much that the Fed would take the punch bowl away. In recent weeks, the financial markets have over-reacted to the Fed, to oil markets, and to global developments, and we may not see investors come to their senses anytime soon.
The growth outlook, near and far
February 1 – February 5, 2016
Real GDP rose at a 0.7% annual rate in the advance estimate for 4Q15, roughly what was expected before the release, but a lot lower than was anticipated at the start of the quarter. It’s not as bad as it looks. Growth was held back by foreign trade and slower inventory growth. Domestic demand was mixed, but moderate. The fourth quarter numbers don’t tell us much about the important question: what’s growth likely to be over the course of this year. More troublesome, there are more important concerns about the economy’s long-term prospects.
Net exports subtracted 0.47 percentage point from fourth quarter GDP growth, according to the advance estimate. Slower inventory growth subtracted 0.45. Private Domestic Final Purchases (consumer spending, business fixed investment, and residential homebuilding) rose at a 1.8% annual rate, vs. a 3.2% increase over the four previous quarters – so we can’t pin fourth quarter softness on the rest of the world alone. Consumer spending slowed. Business fixed investment turned down, with weakness concentrated in structures (mostly energy exploration) and transportation equipment (no detail available).
While GDP growth slowed in the fourth quarter, monthly figures suggest a sharp loss of momentum in November and December. Durable goods orders fell sharply. Consumer spending was disappointing. One possibility is that consumers and businesses may have been reacting to the news. Fear of a slowdown can become self-fulfilling. This is a greater concern for the rest of the world than it is for the U.S., where business can make adjustments as demand picks back up (if the fear is contained and unwarranted). However, it bears watching closely. One of the key elements in the financial crisis was panic. Panic made the housing correction and deleveraging much more sinister. A panic is difficult to predict. Bad news can feed on itself, but it’s hard to gauge the timing and magnitude.
Many point to the data as evidence that the Fed made a mistake by raising rates in December. Hindsight is a wonderful thing. However, the Fed would likely have faced greater market adjustments if it waited. Postponing a rate hike in September led to further undue risk-taking. The Fed’s focus is on the job market (slack still being reduced) and the inflation outlook (likely to move back toward the 2% goal as oil prices stabilize). The Fed did not cause January’s stock market weakness (which was more sentiment than fundamentally driven). Investors were disappointed with the January 27 policy statement. The Fed simply signaled that it was keeping its options open. Investors were hoping for a strong signal that rate hikes would be on hold for the foreseeable future. By stressing the job market in the policy statement, the Fed implied that a March rate hike was still on the table (although widely seen as not very likely).
While investors have been fearful that the U.S. economy will not escape the pull of slower global growth, there are more important long-term concerns. Slow fourth quarter growth, combined with strong job market improvement, means that productivity (output per work-hour) likely fell in 4Q15. These figures are erratic (large quarterly swings and sizable revisions), but the trend over the last few years has been poor (about a 0.6% annual rate). The weak trend adds support to the view that we’ve entered a period of secular stagnation.
Labor costs are an important part of the inflation outlook, but you need to account for what you’re getting for that added labor expense. That’s were productivity comes in. Unit Labor Costs (labor expense per unit of output) are trending at a higher rate. This could show up as higher inflation if firms can pass the higher costs along, or it could show up as a squeeze on corporate profits if they can’t. Nobody knows if the productivity slowdown will be temporary or longer lasting. However, a more permanent slowdown would have far reaching implications for the longer-term economic outlook.
Will the tail wag the dog?
January 25 – January 29, 2016
Global economic conditions do not appear to be severe enough to justify this year’s adverse market action. However, the adverse market action may pose a risk to the global economic outlook. While the global financial system may currently seem a bit unstable, it’s unlikely that fear will become a self-fulfilling prophecy. At least, that’s the hope.
Currency attacks on individual countries are a well-known phenomenon. Something bad happens. Investors start pulling their money out of the country. That puts downward pressure on the currency, creating more incentive for investors to pull their money out. Central banks can try to break the cycle and keep capital from fleeing by raising interest rates, but that slows the economy. This pattern was repeated across several countries during the Asian financial crisis of 1997. China is seeing such a run now. The country still has a large trade surplus, but outflows have exceeded that, putting downward pressure on the yuan. Most of this appears to be due to Chinese investors looking to put more of their money overseas (seemingly justified by expectations that the central bank will allow the currency to depreciate). China has capital controls to limit that, but most of the capital outflow appears to be funneled through Hong Kong and disguised. The central bank has plenty of reserves to defend the currency, but it has been burning through those rapidly. Last month’s decision to begin referencing the yuan against a basket of major currencies, rather than against the U.S. dollar alone, was taken as a signal that the currency will depreciate. Indeed, a lot of China’s financial woes have been self-inflicted. Authorities have been sending mixed messages.
The price of oil, as anyone who passed Econ 1 can tell you, is dependent on supply and demand. The U.S. is producing more (and importing less). The lifting of Iranian sanctions will lead to more supply. Reports have indicated a large number of filled tankers in the Gulf waiting to go somewhere. Concerns about a lack of available storage have become an issue. Where are we going to put all this oil? However, in recent weeks, financial market participants have acted as if the price of oil were more a reflection of global demand. This logic can be circular. Stocks are down because the price of oil is down, but the price of oil is down because stocks are down.
The benefit of lower oil prices to energy consumers usually outweighs the pain for energy producers. However, we have not seen as much of a boost from lower gasoline prices as we would have in the past. Consumers may have been saving a large part of the windfall, doubtful that gasoline prices would stay low. Another possible explanation is that the U.S. is simply less dependent on imported oil and domestic producers will take a hit. Energy exploration is capital-intensive and has been supported by debt in recent years. With the price of oil having fallen further, there are increased concerns in the fixed income market of widespread defaults. Data also suggest that energy-related debt has increased even more as the price of oil has declined. Pain has been felt, and will continue to be felt, by those who own that debt, but this doesn’t appear likely to be a systemic problem for the overall U.S. economy.
Last week, the International Monetary Fund lowered its outlook for global growth by a whopping 0.2 percentage points – not a huge change. However, the IMF noted increased downside risks to the outlook. These included the possibility of a sharper-than-expected slowdown in China (with more international spillover and downward pressure on commodity prices), adverse corporate balance sheet effects and funding challenges related to the tightening of Fed policy (further dollar appreciation and tighter global financial conditions), a sudden rise in risk aversion (sharper depreciations and possible financial strains in emerging economies), and an escalation of ongoing political tensions. Sounds scary, but it’s important to remember that these are risks, not the IMF’s expectations.
The global financial system appears to be much more fragile. Of Friday, the Bank for International Settlements put out a note on fixed income liquidity. To date, “the effects of ongoing regulatory, technology and market structure changes do not appear to have had large, persistent effects on the price of liquidity services for most major asset classes, but rather have been reflected in increasingly fragile liquidity conditions.”
Okay, we have nothing to fear but fear itself. While a more serious global slowdown is not expected, it remains a possibility, perhaps hastened by a fragile global financial system. After the last few weeks, investors may have more moderate expectations for 2016, but it’s the greater risk than matters.
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