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Monday, January 04, 2016

Fed Watch: A Look Ahead Into 2016

Tim Duy:

A Look Ahead Into 2016, by Tim Duy: What do I expect to see in 2016? Briefly, here are my baseline expectations for the year:
1.) No recession. I think that fears of recession in 2016 are overblown. Softness in the manufacturing sector is the primary motivation for such fears, but this ignores the declining economic importance of manufacturing in the US economy. Manufacturing now accounts for just 8.6% of jobs. I think people are falling into a trap of overemphasizing the importance of manufacturing as a cyclical indicator. A broader perspective indicates little reason to be worried of recession in 2016:


Also note that initial unemployment claims, one of our better leading indicators, shows no indication of a recession brewing:


I expect manufacturing indicators will look better by the end of the year as the energy sector and external economy stabilize.
2.) Economic growth will soften. Overall growth will slow toward trend growth, around 2%, this year. Growth accelerated in 2013 as the economy normalized:


Overall GDP growth hit a high point for this cycle in 2014 and began to taper off in 2015. Still, looking through the data further, we see that recent softness in top-line numbers are primarily related to the external sector and inventory correction. The external sector has been particularly important in moderating the pace of US growth. Note that the underlying domestic economy remains solid:


Recent growth has relied on upward trends in technology, automobile production, and multifamily housing. With at least the last two reaching their peak (I suspect), expect some moderation in overall growth in 2016. The Fed will see such moderation as necessary to contain inflationary pressures.
3.) The pace of job growth will decelerate. The underlying trend in job growth appears to have peaked in 2014, and is slowing trending down.


Moreover, the Federal Reserve will become increasingly uncomfortable as the unemployment rate pushes toward 4.5 percent. We are already near their expectations of full employment:


Monetary policymakers would like unemployment to stabilize somewhat below the natural rate for some time in order to support further reduction in underemployment. Such stabilization will require that job growth moderates to the pace of labor force growth. The Fed tends to thinks this is the 100-150k range. This expectation assumes that labor force participation rates remain fairly stagnate. Faster employment growth would be supported if a tighter labor market and higher wages succeed in drawing more workers into the labor market.
4.) Wage growth will accelerate. As the unemployment rate falls below 5%, age growth will accelerate further. I think the Atlanta Federal Reserve wage tracker indicates that the forces of supply and demand still apply in the labor market:


5.) Inflation will accelerate. I think 2016 will be the year that economic resources become sufficiently scarce to push inflation back to the Fed's target. I know this may seem like a wildly optimistic call given the persistence of low inflation during this cycle:


I simply don't think that economic slack had yet to diminish sufficiently to force greater price pressures. But I think we will be at that point this year.
6.) Oil will end the year higher than it began. Oil prices have been all over the place during the past ten years, hence any forecast is subject to great uncertainty. Given that producers are already giving the stuff away, I suspect we are close to the point that production will moderate sufficiently to stabilize prices and lead them higher this year.
7.) Stocks up, yield curve flattens, and the dollar is flat to declining. These baseline expectations are based entirely on past behavior of financial markets in the first year following a Federal Reserve rate hike:




I am most confident that the yield curve expectation, and least confident in the dollar expectation. I would expect any equity gains to be fairly modest.
8.) Single family housing will take center stage. Multifamily housing accelerated to a fairly high pace of activity between 2009 and 2015 while gains in single family housing have been less impressive:


I anticipate that the next stage in the normalization of housing activity will take the form of single family growth, supported by a solid job market and higher wages.
9.) The Federal Reserve will continue to hike rates, slowly. I expect that economic conditions will be sufficient for the Federal Reserve to justify 100bp of rate hikes in 2016. Although the Fed will not want to appear mechanical in its normalization process, they will likely find themselves hiking every other meeting beginning in January. They will be slow to begin the process of "normalizing" the balance sheet, although I expect that they will be fully engaged in that conversation by the middle of the year. That conversation will take on more urgency if they have difficulty controlling short rates with their new tools.
10.) Productivity is a wildcard. Declining productivity growth, combined with slow labor force growth, drives down estimates of potential growth. Might this story change this year? Perhaps, if tighter labor markets and higher wages forces firms to identify additional labor saving technology. Such an outcome would support stronger than expected growth, higher real wages, and still low inflation.
Bottom Line: By recent standards, a fairly optimistic baseline expectation for 2016. That said, nothing spectacular either, just a continued normalization of economy around trend growth. Expectations of recession remain premature. The most likely cause of the next recession will be a monetary mistake. The still-patient Fed hence argues against a recession in the foreseeable future.

    Posted by on Monday, January 4, 2016 at 12:15 AM in Economics, Fed Watch, Monetary Policy | Permalink  Comments (27)


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