Weekly Economic Commentary • Principal Global Investors
Covering the week ended May 23, 2014 — Published on May 30, 2014
Federal Reserve (Fed) to Markets: the Exit Is Coming.
We've seen this movie before; the Fed talks about policy normalization early in the year only to get cold feet as growth prospects fade in the summer heat. The minutes from the April Federal Open Market Committee (FOMC) meeting noted significant discussion about exit strategy; but, as Chair Yellen keeps insisting, the timing and pace of the return to normal will be driven by actual and projected progress toward the Fed's dual mandates of full employment and 2% inflation. So, where's the beef?
There wasn't much. The minutes did make it clear that the Fed viewed the weak first-quarter data as driven mostly by bad weather; members still expected a growth recovery the rest of the year, even though concern was expressed about the strength of housing. There was considerable debate on the degree of slack in the labor market and how that slack or its lack would impact wage growth in coming months. Yellen has argued consistently that there is plenty of slack, pointing to the many part-time workers wanting full-time work and the very large number of long-term unemployed. The unemployment rate did fall to 6.3% last month, but Yellen says that doesn't indicate a tightening labor market; there are many who are no longer looking for work and not counted in the work force, but who will return as prospects improve. Her views were challenged at the meeting amid much debate, but she may have won the argument as most participants agreed that the unemployment rate overstated the labor market improvement.
So, when does the Fed normalize?
Not for a while. As might be expected, there were lengthy discussions about the issue of raising rates. While the Fed gave no hint of the timing of any rate hikes, the fact that discussions could no longer be deferred is itself a signal that the exit from extraordinary Fed policy is on the horizon. Both the market consensus and the Fed's March projections suggest the first hike in the Fed funds rate will happen in the middle or the second half of next year. Given the potential for above trend growth yet this year, there is a non-zero probability of a move earlier than that, say, the first or second quarter.
How does the Fed normalize?
Carefully; the Fed will, when its bond purchases end in November, hold about $4.1 trillion in assets, after having injected $2.7 trillion or so of bank reserves into the financial system. The consensus believes that the historic approach of simply draining bank reserves to push up interest rates won't be viable, as it might hurt banks, especially smaller ones, their customers, and in particular the housing sector. For this reason, the Fed anticipates extensive use of overnight repurchase agreements along with increases in the interest paid on excess reserves plus term deposits (longer than overnight) held for banks at the Fed as its primary policy tools.
At its June 2011 meeting, the Fed discussed several principles for "normalizing the stance and conduct of monetary policy," widely interpreted to be general guidelines to normalize the Fed's balance sheet. One guideline was that the Fed would stop reinvesting the principal payments on bond holdings in the Fed's SOMA (System Open Market Account) before hiking rates. At that time, the Fed was purchasing only direct agency mortgage-backed securities (MBS). Lately, of course, the Fed has been buying both MBS and Treasuries. In a speech before the New York Association for Business Economics, New York Fed President Dudley (also Vice Chairman of the Board of Governors and permanent, voting FOMC member) said that he believes the 2011 "exit principles" language needs to be revisited. He favors raising the policy rate before stopping reinvestment of principal payments. This is justified, he said, because removing reinvestment prior to a rate hike would lead markets to anticipate the rate increase, thereby raising interest rates before the Fed intended. While Dudley, and perhaps Fed policy-makers themselves, want to exit the zero-interest-rate policy as soon as possible, they also want to preserve as much flexibility as they can. To be restricted by the need to stop reinvesting the principal before raising interest rates takes away some of that latitude.
Will U.S. Growth Ever Pick Up?
At the end of last year, there was an almost 100% consensus on two macroeconomic themes: U.S. interest rates had to rise and U.S. growth would accelerate to a 3% plus range in 2014. Optimism abounded. Yields on 10-year U.S. Treasuries had practically doubled from early May last year to over 3% at year-end, and the faster growth about which the consensus was so sure would keep the uptrend going.
But, the surge in rates and souring liquidity brought another bout of emerging market worry; bond investors reversed course pushing Treasuries higher and yields lower. Then, early first-quarter data showed a pronounced U.S. slowdown, likely succumbing to the widespread rotten winter weather. So, the early optimism began to fade since the slowdown might have been from a too weak economy and not just the bad weather. Caution became the new watchword, stock markets consolidated and waited.
Recent data does indeed show that growth is picking up. The index of leading economic indicators of the Conference Board hit the highest level since December 2007, a month after the peak of the business cycle. Weekly U.S. jobless claims are near the lowest since early 2008; job growth has been coming back. Consumer confidence is rising and not too far below past expansion averages; small business confidence is at cycle highs and by one measure, the best in six years. Regional and national purchasing manager indices are at solid levels indicating above trend growth. Consumer balance sheets are in much better shape; delinquency rates are very low or near record lows; interest expense as a portion of disposable personal income at 5% is a record low number. Housing has recovered some from the winter doldrums; single family housing is still not showing the expected pent-up demand, but multifamily construction is exploding.
Well, how does the U.S. economy achieve over 3% growth even for a few quarters? Better consumer spending and more investment by business. Why might that happen? For consumers, with the financial crisis five years in the rearview mirror, the widespread fears of relapse and depression that kept discretionary spending minimal are fading. Job growth is picking up; payroll gains averaged 238,000 over the last three months, nearly the best since 2006. Household net worth has hit new highs with the stock market at new records and house prices rising double digits over the last year. Average hourly earnings are up 2.3% over the last year and more small businesses either have raised or are expecting to increase wages.
For these reasons, we expect U.S. economic growth to reach 3% to 3.5% for the rest of 2014. The expansion should continue, although at a slightly slower pace, the first half of next year. At some point, the Fed will start to exit its extraordinary monetary policy. Higher rates and slowing liquidity provisions will then become a headwind.
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