Portfolio Strategy Analyst
As another year of up and down growth draws to a close, modest but sustained growth remains the story in the United States. Despite the volatility in quarterly GDP growth and a few pockets of weakness that clouds the outlook, the U.S. economy appears to be maintaining good underlying momentum due to strengthening domestic fundamentals and fading post-recession headwinds that have had hobbled demand earlier in the recovery. Indeed, many cyclical indicators suggest that the U.S. economy is still only in the middle stages of what could be one of the longest expansions in its history.
One reason this expansion has already lasted so long is the low level of inflation, the lowest in over a half century. In fact, the Fed is in the unusual position of wanting more inflation. When the Fed is accommodative, the use of leverage or debt becomes more pervasive. However, the financial crisis has given birth to a new, more prudent consumer that is very sensitive to the cost of debt and is cautious about taking on more debt to fund consumption.
Private sector borrowing is just now beginning to return to normal by historical standards relative to economic growth. Meanwhile, due to the preceding deleveraging cycle and low interest rate environment, household debt service costs have plummeted to levels last seen about 35 years ago. From this perspective, consumers have a lot of room to expand the scope of their spending as job growth, income gains, and easing credit conditions support big ticket purchases that spur even greater economic growth.
Indeed, households already appear to have turned the corner to better spending rates. Notable are the stages of upward progress in the year-over-year path of real consumption. Over the last five quarters the pace of consumption has increased to around 3% from just less than the 1.5% average pace three years ago (Figure 1). While that is tame compared to the expansions of the 1980s and 1990s when real consumer spending accelerated to over 5% – a more moderate consumer spending cycle with limited excesses, increases the odds that this business cycle will last longer than it otherwise would have.
The persistent improvement in the consumer sector is underscored by the strength of the labor market. Solid, steady job growth has been the one constant amid the ebbs and flows of the economy’s current expansion (the economy is on track to create another 2.5 million jobs this year, about the same gain as in the previous three years). The headline jobless rate is now effectively at a level the Fed considers natural or full employment, and other indicators suggest labor slack is rapidly diminishing.
Re-achieving full employment will be a significant accomplishment, considering it has been nearly a decade since the economy was last operating at a full tilt. Until recently, most real consumer spending growth has been driven by solid gains in real income and the recent decline in energy prices. But now, with the fast tightening job market, wages appear to finally be picking up. This suggests that the so-called Phillips Wage Curve may finally be kicking in, foreshadowing larger increases in consumer confidence and disposable income that will help further support better spending.
Full employment and stronger wage growth should also be the catalyst for more household formations, which slowed sharply with the onset of the Great Recession. From mid-2007 to mid-2012, formations averaged a poor 500,000 per year, far below the 1.15 million that would be expected in a typical year given U.S. population growth and demographics. However, that trend appears to be reversing with formations on track to top 1.25 million this year. Housing momentum tends to peak before recessions, but new home starts still need to rise at least 50% to get back to normal, suggesting the housing recovery is still in the early stages.
With less than a month to the December Federal Open Market Committee (FOMC) meeting, policymakers appear on the verge of raising interest rates for the first time in nearly a decade. Monetary policy is one of the main drivers of the business cycle, but a couple rate hikes over the next year are unlikely to put the brakes on growth, considering that policy will remain historically accommodative. Indeed, every recession over the past 50 years has been preceded by an inverted yield curve once the Fed has raised the short‐term rate above the ten‐year yield. We are a long way from that and, with inflation historically low and the economy still operating below capacity; the Fed can be expected to take a go-slow approach.
Of course, there is potential for risk. Ongoing weakness abroad should continue to lap onto America’s shores and low trend growth will leave the economy vulnerable to unforeseen global shocks. But improving domestic fundamentals should carry the day, helping to insulate the U.S. economy enough from international distresses to underpin continued modest growth. Beyond those concerns, the economy just does not seem to be harboring the kinds of significant excesses and fragilities that set the stage for the last recession, like private sector overindulgence, or capacity strains and inflation pressures. Although the U.S. expansion is about to enter its seventh year, it is aging well and appears to have plenty of room to run.
Will they, or won’t they? It is agonizing trying to forecast if the Fed will begin raising short-term interest rates at its mid-December meeting (they have been at the near-zero rate since December 2008) (Figure 2). The economy is as strong now as it was in September and should be able to handle the increase (a mere 25 bps). In September, the Fed delayed the increase due to global risks, but since then, global financial market volatility has largely abated. Inflation is expected to stay firm due to last year’s drop in energy prices offsetting the calculations. The unemployment rate is near full employment, indicating that employment is strong and has been for some time. At the recent FOMC meeting, the tone of the FOMC statement was very hawkish, similar to speeches made by many Fed officials recently. As such, we think that the FOMC will raise rates in December.
October’s labor report was strong across the board, offsetting the weaker reports of the two previous months. Due to the volatility of the monthly numbers, we look at the three-month average gain in payrolls, which was up 187,000. While this growth rate is slower than it was earlier in the year, it can easily be explained by the tightening in the labor market, which has pushed the unemployment rate down to 5% (the lowest level since April 2008). This tightness is also showing up in the average hourly earnings report, now at $25.20 which is up 2.5% in the past year, and at a breakout level (the yearly change has been hovering around 2% for the past three years) (Figure 3). All of this data might suggest that employers are having a harder time finding qualified workers.
The rate of the underemployed is 9.8%; this is the first time it has been below 10% since 2008. The underemployed rate is a measurement of those unemployed whom have had their hours of work cut back or have given up looking for a job. The variance between this and the unemployment rate has narrowed to just 4.8%, down from 7.3% back in 2010. This is yet another proxy for showing the tightness in the labor market.
Consumer prices edged up last month following two consecutive months of declines. This gives the Federal Reserve a sign that stabilization in prices may be occurring and that prices may move back toward the Fed’s target of 2% inflation. One of the main drivers pushing the inflation level up is not the potential of higher prices on the horizon, but rather the calculation of the Consumer Price Index (CPI). Back in June of 2014, the yearly change in CPI was 2.1%, and oil was over $100 a barrel. Over the course of the remainder of the year, oil prices were cut in half (Figure 4). This helped engineer a precipitous drop in CPI, which ended up falling to -0.2% (a 2.3 percentage point swing in just 10 months). It is now a year later, and those yearly calculations will start to fall off. As a result, oil prices are now lower than they were a year ago but the percentage drop is not nearly as great.
The two major components of CPI continue to show a significant divergence between the service sector and the goods sector of the economy. Service inflation has increased 2.4% over the past year ahead of the Fed’s target rate of inflation. However, the goods sector, in part reflecting the drop in oil prices, has fallen 3.6% over the past year. The recent spur in the value of the dollar will probably help keep the goods portion of CPI low for the next several months.
After many years of fits and starts, housing is finally emerging from the doldrums of the Great Recession. Spurred by low mortgage rates and a relatively high level of affordability, the demand for housing has blossomed with the strength and breadth of the labor market (the labor force has added 13 million jobs since the lows of 2010). This has resulted in a spike of household formations (Figure 5). The change in demographics is altering the type of homes that are being built. The demand for single-family structures has been muted in this recovery, while the demand for multi-family dwellings has been robust. This is due to the demand of first-time home buyers and retirees. As for geographic location, demand has been considerably strong in the West and the South, especially in metropolitan areas that have been experiencing strong employment growth (Los Angeles, Dallas, San Francisco, and Atlanta primarily).
For the Fed, this improvement has been a silver lining as it is helping to offset the slowdown in the manufacturing sector. After billions of dollars of quantitative easing helped push down interest rates, this is a welcome reward.
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