In the wake of the US presidential elections, the prospect of tax cuts, deregulation of the financial sector and infrastructure spending awoke animal spirits. Confidence indicators on the outlook for business among large companies, small business owners and consumers surged.
Yet the pace of economic growth slowed to just 1.4% quarter-on-quarter annualised in the first quarter of 2017 (see Exhibit 1 below). A slowdown is not uncommon in the first quarter as the statisticians often have difficulties with the seasonal adjustment of the data, but the tapering-off in consumption – caused by falling real disposable income – was irrefutable.
However, with a strong and tight labour market and further room for growth in the housing market, the US economy should rebound. Looking at these fundamentals, there is room for a solid growth trend in consumption to resume.
What would drive accelerated growth, given that the economic cycle is well advanced?
Business investment relative to gross domestic product (GDP) has recovered and while S&P 500 companies reported strong earnings in the first quarter, domestic business profits in the national accounts, which include a far broader set of companies, appear to have peaked relative to GDP.
Car sales have slowed and there are tentative signs that the number of problematic car loans is rising. And with a chaotic start by the Trump administration, fiscal stimulus and tax reform looks less likely this year. Whatever the outcome of tax cut negotiations in Congress, any package is hardly likely to result in a permanent rise in potential output, which we estimate to be quite low at 1.5% to 1.75%.
Exhibit 1: US real GDP is expected to increase (the graph shows year-on-year real GDP growth in % change and potential trend GDP growth)
Source: CBO, BEA, BNP Paribas Asset Management, as of January 2017
In this context, we expect GDP growth of 2% this year. However, to date, even such a mediocre pace has been enough to take up what slack there is in the labour market.
In June, the US unemployment rate ticked up to 4.4% (from 4.3% in May, the lowest level in a decade). But, even with this tight labour market, wage growth has not meaningfully accelerated. In June, average hourly earnings rose by just 0.8% YoY after inflation.
As a result, the overall level of inflation has remained low. In June, the core consumer price index was up by just 0.12% month-on-month. On a year-on-year basis, core CPI remains at 1.7% and we believe there is a risk that the core personal consumption expenditure (the Fed’s preferred inflation measure) slips yet lower.
Exhibit 2: Despite the low unemployment rate, wage increases remain moderate
Source: Bloomberg, BNP Paribas Asset Management, as of 06/07/2017
The Federal Reserve (the Fed) and the US economic outlook
After a one-year pause, the Fed raised US policy rates last December and did so again this March and June. It looks set to tighten policy again in December, with most Fed policymakers having expressed a willingness to raise rates at least one more time this year after June.
Currently markets only assign a probability of around 50% to additional rate increases this year. They are more sceptical about the Fed’s median projection of three rate rises in 2018. For now, the US central bank has said it expects the currently slow growth and low inflation to be transitory, but a few officials have said they may change their rate projections if inflation remains below the Fed’s 2% target.
Exhibit 3: The markets do not believe the Fed: the year-end federal funds rate lags the rate projected by policymakers for 2018 and 2019
Source: Federal Reserve, Bloomberg, BNP Paribas Asset Management, as of 06/07/2017
The minutes of the FOMC monetary policy meeting held in early May probably offer a good picture of what is going on in the minds of this group of ‘two-handed economists’.
On the one hand, the discussions by FOMC members confirmed that they were relatively confident in the outlook for the economy and they indicated that an extensive fiscal stimulus plan would probably lead them to tighten policy further.
On the other hand, the FOMC appears to have reached a consensus in the procedure for shrinking the Fed’s crisis-era bloated balance sheet. This will be the next hot topic for Fed watchers in the coming months.
Written on 06/07/2017