Modest GDP Growth Calls For Modest Pace Of Rate Hikes

U.S. GDP is growing at a modest pace and the economic expansion is expected to continue, albeit, slowly. The recession signals are benign and the economy is not over heating. This combination supports an environment for cautious and gradual Fed Funds rate hikes.

Economy Continues To Expand

Chart 1

After coming out of the global financial crisis induced Great Recession in June 2009, the United States has recovered most of the lost ground (Chart 1).

The Real GDP, in inflation adjusted terms, was 12.1% higher in Q4 2016 from the pre-recession level in Q4 2007. Total employment is 5% above the pre-recession level and the retail sales is 9.1% higher. In January 2017, the unemployment rate was 4.7%, which is lower than December 2007 level of 5.0%. One disappointing area is Industrial Production, which is 0.9% below pre-recession level.

Is A Recession Coming?

Chart 2

Chart 3

U.S. Industrial production declined by -0.3% year-over-year in January 2017. Since May 2015, in 19 months, it was above zero only three times – July 2015, August 2015 and December 2016.

Since 1920 only once the industrial production was below zero for few months without the economy being either in recession or just exiting it. In 1934, the industrial production was below zero for four months – from July to October – and the economy was not in recession (Chart 2). The previous recession had ended in January 1933 and the next one did not start till April 1937.

Hence the current streak of below zero industrial production does not look good. However, some other indicators are not flashing danger signs. During a recession or before an impending one, the year-over-year employment and retail sales also decline. That has not happened this time so far (Chart 3).

10-Year and 2-Year Treasury Spread

Chart 4

In January, we noted that “Few months before the onset of any recession in the U.S.A – at least since 1980 – the spread between the 10-Year Treasury Constant Maturity and the 2-Year Treasury Constant Maturity has fallen below zero”.

The spread between these two is still above zero (Chart 4). It is declining since the start of 2014. It turned up in the middle of 2016 and has broken above the downtrend line.

The 2-year Treasury yields are still rising faster than 10-year yields. If this continues then the spread will again resume its downward movement.

Fed Funds Rate

Chart 5

Chart 6

The unemployment rate is very low, which supports the view that the Federal Reserve should raise its Fed-Funds rate. There are some factors involved in determining this – labor market slack, earnings growth etc. – that we will not dwell on now. We will take a look at couple of other factors.

The inflations expectations, although on the rise, are at low levels (Chart 5) now, relative to the start of Great Recession and the last Fed Funds rate hike, before December 2015, in June 2006.

The University of Michigan Inflation Expectation was 2.2% in January 2017. It was 3.4% on December 2007 and 3.3% on June 2006.

The 5-Year, 5-Year Forward Inflation Expectation Rate was 2.06% in January. In December 2007 it was 2.43% and 2.5% in June 2006. The is a measure of expected inflation (on average) over the five year period that begins five years from now.

The 10-Year Breakeven Rate was 1.94% in January. it was 2.28% on December 2007 and 2.58% on June 2006. This represents a measure of expected inflation derived from 10-Year Treasury Constant Maturity Securities. The 10-Year Treasury yields have risen to 2.424% from a low of 1.366% at the beginning of July 2016 but they seem to have hit a resistance zone (Chart 6). The current chart pattern is a symmetric triangle, which can break up, down or sideways.

Slower Rate Hike

Chart 7

Chart 8

The second factor that we will look at is even more subjective, how hot the economy would get to before the Fed starts to apply brakes. Chart 1 and Chart 3 show that the economy is expanding but they do not show that its rate too much or steep.

Since the end of recession the effective fund rates level is below the GDP growth rate. This hasn’t happened, for such an extended period, before. This supports the argument for raising the Fed Funds rate. A counter argument is that, at least since 1970, Fed Funds rate hike follow a rising GDP rate. The U.S. GDP grew by 1.9% in Q4 2016 (Chart 7). The rate of growth over the last few years is well within a narrow band – bounded by a high of 3.31% in Q1 2015 and a low of 1.04% in Q2 2013.

Bottom line is that even though the conditions are favoring for rate hike, they are not that good to show that the rates will rise faster and higher. Based upon CME Group 30-Day Fed Fund futures prices, the probability of a 25 basis point hike in March is 77.9%. This expectation hasn’t changed much since the November 2016 (Chart 8).

Central Banks Maintain Policy Positions For Now

From FactSet:

In January, the European Central Bank (ECB) and the Bank of Japan (BoJ) left their quantitative easing programs in place and policy rates unchanged at their scheduled meetings. Similarly, both the Federal Reserve and the Bank of England (BoE) maintained monetary policy stances at their respective meetings earlier this month.

On Bank Of Japan:

The overall consumer price index slipped by 0.1% in 2016, while the core index (excluding volatile fresh food prices) dipped by 0.3%.

With an inflation target of 2%, it will be some time before the BoJ will actually need to tighten monetary policy.

On Bank Of England

The 1.8% year-over-year increase is still below the BoE’s stated inflation target of 2%, but the trend points to continued upward price pressures due to the sharply weaker pound in the wake of the Brexit vote in June 2016. The BoE’s most recent Monetary Policy Summary indicates that the Monetary Policy Committee (MPC) is fine with allowing inflation to edge above the target

On European Central Bank

However, inflation picked up sharply in the last two months, with prices jumping 1.8% year-over-year in January and 1.1% in December. Even if this trend continues, it is highly unlikely that the ECB will be tightening monetary policy in 2017 under the cloud of the ongoing economic turmoil.

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