Key points in our US growth and inflation outlook:
- US economic momentum is now ever more reliant on domestic consumption, which has been supported by solid gains in both employment and household sector net wealth
- Our forecasts indicate headline inflation should gradually normalize towards the Federal Open Market Committee (FOMC) Consumer Price Indexes (CPI) inflation target of 2.4% by early 2017. However, there are many risks to this forecast
- Treasury yields should not rise dramatically. We would be surprised to see US 10-year Treasury yields rise above 2.00% in the next six months
Moderate US growth driven by household sector
GDP in the first half of 2016 grew by only around 1.1% annualized. The headline numbers can be deceptive, as a slowdown in inventory accumulation detracted meaningfully from the overall GDP numbers – which means that final domestic demand remained relatively firm. However non-residential investment continued to slow, such that it is no longer contributing meaningfully to GDP growth. This picture of slowing non-residential investment is corroborated by business confidence surveys that show a loss of momentum, which is perhaps unsurprising given the ongoing decline in year-over-year profit growth.
US economic momentum is now ever more reliant on domestic consumption, which has been supported by solid gains in both employment and household sector net wealth. The six-month average for monthly employment gains has declined since February by around 60,000 jobs to 169,000 new jobs per month. This is still a solid pace of employment growth. We expect it to slow towards 100,000 per month in coming quarters.
Exhibit 1: Contributions to GDP growth (4Q moving average)
Source: Federal Reserve Bank of St. Louis as of 30 June 2016
Given the resilience of the labor market so far, the softening of the most recent sales numbers and residential investment activity is worrying. The primary driver of the US economy right now is the household sector. Although households are not overly levered and the cost of credit is low, access to credit is restricted, and consumption is vulnerable to a softening labor market or volatility in financial markets.
US inflation to pick up – but downside risks remain
Inflation prospects look healthier. In late 2015 the FOMC described many of the factors holding back inflation as transitory because of the decline in energy prices and the strength of the USD. The USD has been reasonably stable for months and energy prices rebounded modestly, allowing base effects to work through the data.
Although personal consumption expenditures (PCE) inflation remains below the FOMC’s 2.0% objective, a number of measures of underlying, or ‘core’, inflation continues to gently firm. As of August, year-over-year core PCE was running at 1.70%, trimmed mean PCE at 1.7%, core CPI at 2.3% and sticky CPI at 2.7%. These numbers do not (in our view) allow the FOMC to yet declare victory on its inflation mandate.
Digging into the details of the inflation data shows large divergences between sectors. Shelter service inflation has been strong for some time, but arguably reflects a shortfall of housing inventory due to weak construction activity, limited mortgage financing availability and changes in household preferences on renting versus owning. Goods prices, meanwhile, remain soft as a result of USD strength and declines in internationally-traded commodities prices, and continue to detract from overall inflation.
The best gauge of domestically-generated inflation is the non-shelter services category, which should be most impacted by unit labor costs, which are in turn largely driven by wage pressures. This category has clearly firmed in 2016. Non-shelter services costs – comprising mostly of education, medical care, transport and recreation services – were growing at 2.6% in August 2016, versus a pace of 1.8% year-over-year in March 2016 and 1.13% in May 2015. We need to see this trend continue to offset the deflationary impact of weak core goods prices, and support inflation expectations.
Exhibit 2: Core inflation and services & shelter CPI
Our forecasts indicate headline inflation should gradually normalize towards the FOMC’s inflation target by early 2017.
However, there are many risks to this US growth and inflation outlook including:
• Strengthening of the USD
• Drop in commodity prices
• International shocks
• Below trend US growth such that spare capacity is not further reduced
• Survey and market-based inflation expectations do not reverse their recent softening trend
• Disinflationary pressures from abroad
Expect range bound US Treasury yields
Treasury yields should not rise dramatically. We would be surprised to see US 10-year Treasury yields rise above 2.00% in the next six months, although an unexpected presidential election result could raise term premiums and steepen the yield curve. Our baseline scenario for the next six months is that yields remain low given negative net supply of sovereign bonds and central bank financial repression. FOMC policy rate hikes would likely appreciate the USD, short-circuiting any rise in yields.