Tim Duy's Fed Watch

FOMC Recap

The FOMC held steady today, as expected. The reaffirmed their basic forecast, but gave a nod to current global economic and financial economic uncertainty. That is all that should have been expected. 

Still, there is a deeper story.

Puzzle over the opening paragraph for a moment (thanks to the WSJ FOMC Statement Tracker):

I feel like I will soon be going down the hall and grabbing an English professor to help me translate these statements. I hate to do this sort of thing, but notice that they brought the labor market forward and pushed the overall economy back? I think there are two things going on here. First is that the FOMC, on average, has a Phillips Curve view of the world. They aren't going to let go of the labor market until it turns. And turns hard given that the unemployment rate is hovering near their estimate of NAIRU. Hence they will tend to emphasize the labor data.

But something else is going on. Next week we get the fourth quarter GDP number. No one is expecting miracles. I would be totally unfazed by a negative print. Considering the normal variance in quarterly GDP numbers in the context of a two percent potential rate of growth, you are going to see more negative prints during expansions. Get over it.

The Fed isn't expecting miracles either. But what they are confused by is that in the first quarter of 2015, GDP growth slowed sharply:

And with it, job growth slowed:

 

Now they have slow GDP growth and fast employment growth. That will make brains explode on Constitution Ave. They don't know what to do with that when unemployment is at 5%. You see where it cuts either way. If the recessionistas are correct, then they already made a mistake in December. If the optimitistas are correct, they will fall behind the curve if they hold in March.

And that is without the uncertainty of the financial markets. Did the Fed release a little steam by shifting into a tightening cycle, the avalanche control of Mark Dow?  Or did they set in motion the next financial crisis? 

And recognize that this is within the context of a no-win political situation. If they miss on the upside with higher inflation, they will be pilloried by the right (and ultimately, I suspect, the left). If they miss on the downside with recession, they will be pilloried by the left and right. Rock, meet hard place.

So, considering all this, you can't really blame the Fed for taking a pass on quantifying the balance of risks. From their perspective, there is no way to answer the question. And that's how the absence of a balance of risks should be interpreted. Neither as a intention to downgrade further in March, nor to upgrade. It is what is it. Pure, absolute uncertainty. White noise.

Yeah, I don't find that comforting either. Get over it.

 So do we know anything more about March? A little. We know from the December SEP is that, on average, the FOMC expected to raise rates in March. What we know now is that they are less certain of that outcome. My guess: If job numbers remain sufficient to put downward pressure on unemployment, first quarter GDP trackers look solid, and financial markets calm, they will hike rates. If only one of those conditions in met, then they will pass. If two, then it is a tossup. Tossups usually go to the doves.

Bottom Line: The Fed got lucky this month. They weren't expected to do anything, which takes the pressure off. But in March they might have a real decision to make. We have only six weeks of data to digest. Even assuming that labor markets hold solid, will that be enough? Doubtful. They will need more.

On The Dispersion, Or Lack Thereof, of Economic Weakness

Gavyn Davies writes:

It is true that much of the weakness in the nowcast is identified by economic variables that relate to the industrial sector. But these variables have, in the past, been very closely correlated with activity in the economy as a whole, and are therefore usually among the best indicators of overall activity. It is dangerous to ignore weakness in these industrial variables that persists for a long period, which is what is happening now....The full model, including the industrial sector data, estimates that the recession probability has been hovering around 15-20 per cent (above right graph), no longer an entirely negligible risk. If the weak industrial data are excluded, on the grounds that they are “transitory” – a word often used by Fed officials – then the recession probability drops to about 10 per cent.

He adds this picture:

Recession odds of just 10% would hardly be worth getting out of bed for. So how much weight should we be placing on the manufacturing data? I often see claims that manufacturing is already in recession. And Andrew Levin, former advisor to Federal Reserve Chair Janet Yellen, places much weight on the industrial production slowdown:

Unfortunately, the latest economic data underscore the risk that the economy may now be heading into another recession. Last Friday, the Federal Reserve Board reported that its index of industrial production sank further in December and was down 1.8% from a year earlier. Indeed, as shown in the accompanying chart, this pace of contraction has only occurred during prior recessionary periods. In some instances, the fall in industrial output was a harbinger at the onset of a recession. In other episodes, the industrial sector had been booming previously and turned downward after a recession was already underway. But since 1970 there has never been a case where the industrial sector shrank nearly 2 percent on a 12-month basis and the broader economy was left unscathed.

I think it is important to be very cautious with this aggregate data. What makes a recession a recession is that the decline in activity is felt widely throughout the economy. From the National Bureau of Economic Research:

During a recession, a significant decline in economic activity spreads across the economy and can last from a few months to more than a year.

With this in mind, I direct you to my fellow Oregon economist Josh Lehner, who correctly notes that in comparison to past recessions, the decline in manufacturing activity is not well disbursed across the sector. My version of Josh's chart:

The point is that during a recession, the vast majority of manufacturing industries (or all!) are declining. We are nowhere near that point. In other words, even manufacturing - arguably the most distressed sector of the US economy - is not recession. And if manufacturing is not even in recession, it is difficult to see that the US economy is in recession. Or even nearing it.  

Initial unemployment claims across states tells a similar story:

In this version, I count the sates experiencing a 5% or greater change in year-over-year unemployment claims (I used 5% to account for the fact that as the cycle matures, claims will flatten out for more states and thus you would expect a wider dispersion of marginally higher claims). As is evident, recessions are characterized by rising claims across a wide swath of sates. In other words, a recession in Texas does not a US recession make. Note also that the economy can experience a fairly widespread increase in claims but not a recession. See 1995. Which means that while I think initial claims is an excellent leading indicator, it by itself is not infallible. 

Aside from the recession risk, there is another important aspect of Davies's chart - discounting manufacturing, it indicates growth of just 2% in the US. This is fairly close with the Federal Reserve's estimate of potential growth, and I suspect that is the direction we will be heading by the end of the year if not sooner. Key sources of growth, such as autos, multifamily housing, and technology, that helped propel the economy closer to fully employment are likely leveling off. If so, that means the economy is at an inflection point as it transitions back to trend. The Fed expects that process will require addition tightening. The financial markets aren't so confident. 

Bottom Line: The lack of widespread economic weakness across the economy indicates that the US is not currently in recession. It is not even evident manufacturing is in recession. If the economy were heading into recession, expect the dispersion of weakness will spread further across the economy, both geographically and sectorally. 

The Five Scenarios Now Facing the Federal Reserve

Federal Reserve policymakers are likely enjoying this month about as much as market participants are.

Central bankers at the Fed don’t like fast-moving markets to begin with, and they especially won’t like the implication that their supposedly inconsequential 25-basis-point interest rate hike in December was a mistake. The only saving grace for the Fed is that January was off the table for a rate hike anyway, so the volatility on Wall Street will have little impact on this week’s policy outcome, due to be announced on Wednesday...

Continue reading at Bloomberg

So You Think A Recession Is Imminent, Yield Curve Edition

If I had to rely on only two leading indicators of recessions, they would be initial unemployment claims and the yield curve (next in line would be housing). I talked about initial claims in the context of employment data in my last post. This post is about the yield curve.

An inversion of the yield curve has typically given a 12 month or better signal ahead of recessions:

Note also that it is the inversion that is important. The yield curve was fairly flat in the late-90's, a period of supercharged growth in the US economy. So when the Financial Times fueled the recession fears last week with this:

The US government bond market is blowing raspberries at the Federal Reserve. This could indicate trouble ahead for the American economy. 

Last month, the Fed lifted interest rates for the first time in nine years, and short-term bond yields have duly climbed higher. But longer-term Treasury bonds have shrugged, with yields actually falling since the US central bank tightened monetary policy.

I was less concerned. In fact, I don't think the flattening yield curve should be any surprise as that is almost always the case after the Fed tightens policy:

The yield curve typically flattens to a 50bp spread between 10 and 2 year rates within a year of the initial Fed rate hike. Only the 1986 episode is unusual. Not only that, but the flattening begins immediately:

Even after the 1986 tightening the yield curve was flatter after the first 60 days. 

Currently, the flattening of the yield curve - and the lack of any upward movement in 10 year yields at all - is consistent with my long-standing concern that the Federal Reserve's long-run projection of the federal funds rate - 3.5% as of December - is a pipe dream. Also why I was wary about the Fed's determination to raise rates. My preference was the Fed to wait until they were absolutely sure rates could be "normalized."

Optimally, my concerns will prove to be unwarranted. The economy may progress better than expected, productivity rises, the Fed pares down its stock of fixed income assets, the term premium rises, and the entire yield curve shifts up and the secular stagnation story dies. We are back in Kansas. No more flying monkeys. That is a perfectly acceptable, well-reasoned forecast and one I am sympathetic to, but I am not yet seeing it realized. What I am seeing at the moment is that the global pull of zero interest rates is sufficient to limit the ability of the Federal Reserve to "normalize" policy. We are stuck in Oz.

There is a school of thought that the yield curve is irrelevant now that we are near the zero bound. After all, you can't invert the yield curve very easily! And just look at Japan. Clearly the Japanese economy still experiences recession. If we are heading down the Japanese path, then I would expect longer term yield US yields to plunge below 1%. That is not my baseline, I don't think it is very likely, but I can't discount the possibility entirely.   

Bottom Line: Don't discount the yield curve just yet. I think it is signaling something important about the limits of monetary policy "normalization." But it is also a signal that recession concerns are overblown. Even in a zero short rate world, the long end needs to plunge much deeper before the yield curve becomes a concern.

 

So You Think A Recession Is Imminent, Employment Edition

The recession drumbeat grows louder. This is not unexpected. Most forecasters have an asymmetric loss function; the cost of being wrong by missing a recession exceeds the cost of being wrong on a recession call. Hence economists tend to over-predict recessions. Eight of the last four recessions or so the joke goes. And while I don't believe a recession is imminent, there are perfectly good reasons to be wary that a recession will bear down on the economy in the not-so-distant future. Historically, when the Fed begins a tightening cycle, the clock is ticking for the expansion. By that time, the economy is typically in a late-mid to late-stage expansion, and you are looking at two to three years before the cycle turns, four at the outside.

Of course there are some not so good reasons for worrying about a recession. Like listening to an investor talking their book. Or someone who needs to whip up a never ending stream of apocalyptic visions to hawk gold.

So what I am looking for when it comes to a recession? It's not a recession until you see it economy wide in the labor markets. When it's there, you will see it everywhere. Clearly, we weren't seeing it in the final quarter of last year. But, you say, employment is a lagging indicator, so last quarter tells you nothing. Not nothing, I would say, but a fair point nonetheless. One would need to look for the leading indicators within the employment data.

First, since the manufacturing sector is the proximate cause of these recession concerns, we would look to leading indicators in that sector. One I watch is hours worked:

Hours worked are off their peak, just as prior to the 1900 and 2001 recessions, but not the 2007 recession (lagging indicator that time). But hours also dropped in 1994, 1998, 2002, and 2005. And that would be an extra four recessions that didn't happen. To add a bit more confusion, hours works are coming off a peak not seen since, sit down for this, World War II:

That caught me by surprise; I am thinking the surge in hours worked was not sustainable in any event. Overtime hours worked holds a bit more promise:

OK, not much more promise. Best as a leading indicator ahead of 2001, not counting 1994 and and 1998. Not particularly useful for 1990 and somewhat useful ahead of 2007. On balance, I would say manufacturing hours worked data is necessary but not sufficient for a recession call.

Perhaps the JOLTS data offers something more:

Unfortunately we a working with only two cycles here, and then only barely so. But it seems reasonable that manufacturing hires might be a coincident indicator (maybe leading by the few data points ahead of the 2001 recession) and layoffs/discharges a lagging indicator. But if a manufacturing "recession" were underway, then we would expect hiring to drop off quickly here. 

Quits, however looks like a leading indicator:

Looks like quits in manufacturing dropped sharply ahead of 2001, modestly during 2007, but were still rising at the end of 2015. If quit rates aren't dropping among those at the front lines, the pain can't be reaching recessionary levels just yet.

But manufacturing is just one sector of the economy - just 8.8% of employment. The real hypothesis the recessionists are proposing is that manufacturing is an indicator of an economy wide shock. Here I would say the JOLTS data is less supportive:

If we are entering a recession, firms are a minimum should be pulling back on the pace of hiring. We are not seeing that yet. And workers should be wary of quitting:

Again, the workers are on the front lines of the economy. If the economy is in trouble, they know it, and quit rates start declining. Not there yet. 

I also have a soft spot for the temporary help series as it as rolled over twelve months or more ahead of the last two recessions:

So if we were to see temporary help roll over now, we would still not see recession until 2017.

And finally, there is initial jobless claims, which typically lead a recession by six to twelve months:

Not seeing it. If claims started rising now, and continued rising for six months, then the probability of recession would rise sharply, and if they rose continuously for twelve months, the probability of recession would approach 1. But now? Nothing to fear.

Bottom Line: From a labor market perspective, I am not seeing conclusive evidence of an impending recession in manufacturing, let alone the overall economy. Might be at the tip of one, but even that will take a year to evolve. I have more sympathy for the view that the economy has evolved into a mid-late to late stage of the cycle, and the transition and associated uncertainty results in some not-surprising volatility in financial markets.

Update:  Greg Ip calls me out on the direction of forecast accuracy: 

"economists tend to over-predict recessions." I thought the opposite was true. @TimDuy https://t.co/AU7z5Pv9oq

— Greg Ip (@greg_ip) January 14, 2016

I was thinking of the frequency of recession scares - 1995, 1998, Y2K, 2012, now - on top of actual recessions.  In 1998 I remember a forecast from JPMorgan calling for a recession due to a trade blow from the Asian Financial Crisis. I remember a particular dark forecast from Deutsche Bank for 2000 due to a Y2K. Then the ECRI 2012 recession call.  Calculated Risk describes the last six years as an "an endless parade of incorrect recession calls."

That said, if you were to tell me that these recession callers were not on average "economists" I would concede the point. And forecasts from official agencies such as the IMF and the Federal Reserve always miss recessions (a point Larry Summers makes with regard to the IMF here.) So Ip's point is well taken.

Despite Inflation Unease, Fed Still Talks Big On Rates

The minutes of the December FOMC meeting were released today. The minutes were considered to have a dovish tone, although I would be wary of thinking there is much new information to be found. Labor market conditions had improved sufficiently to justify a certain degree of confidence in the inflation outlook:

Regarding the medium-term outlook, inflation was projected to increase gradually as energy prices and prices of non-energy imports stabilized and the labor market strengthened. Overall, taking into account economic developments and the outlook for economic activity and the labor market, the Committee was now reasonably confident in its expectation that inflation would rise, over the medium term, to its 2 percent objective. 

but many members retained concerns about the downside risks:

However, for some members, the risks attending their inflation forecasts remained considerable. Among those risks was the possibility that additional downward shocks to prices of oil and other commodities or a sustained rise in the exchange value of the dollar could delay or diminish the expected upturn in inflation. A couple also worried that a further strengthening of the labor market might not prove sufficient to offset the downward pressures from global disinflationary forces. And several expressed unease with indications that inflation expectations may have moved down slightly. In view of these risks and the shortfall of inflation from 2 percent, members expressed their intention to carefully monitor actual and expected progress toward the Committee's inflation goal.

Why hike rates? It is all about setting the stage for a gradual path of subsequent rates hikes:

If the Committee waited to begin removing accommodation until it was closer to achieving its dual-mandate objectives, it might need to tighten policy abruptly, which could risk disrupting economic activity.

And while they ultimately pulled the trigger on higher rates in an unanimous vote, the doves were left with a bitter taste in their mouths:

However, some members said that their decision to raise the target range was a close call, particularly given the uncertainty about inflation dynamics, and emphasized the need to monitor the progress of inflation closely.

They intend to hold true to their "gradualist" scripture:

Based on their current forecasts for economic activity, the labor market, and inflation, as well as their expectation that the neutral short-term real interest rate will rise slowly over the next few years, members expected economic conditions would evolve in a manner that would warrant only gradual increases in the federal funds rate. 

Actual outcomes are of course data dependent, but the Fed called out one piece of data as especially important:

In the current situation, because of their significant concern about still-low readings on actual inflation and the uncertainty and risks present in the inflation outlook, they agreed to indicate that the Committee would carefully monitor actual and expected progress toward its inflation goal. In determining the size and timing of further adjustments to monetary policy, some members emphasized the importance of confirming that inflation would rise as projected and of maintaining the credibility of the Committee's inflation objective. Based on their current economic outlook, they continued to anticipate that the federal funds rate was likely to remain, for some time, below levels that the Committee expected to prevail in the longer run.

Yes, this line from the December statement was not to be ignored:

In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal.

So we now know pretty much what we did going into the minutes: The inflation situation is making FOMC members nervous and thus holding them back from a more aggressive path of rate hikes. Hence progress on the inflation mandate is necessary to accelerate the pace of rate increases. Note too the emphasis on not just actual, but expected progress. That is where the labor report comes in. If jobs keep growing at 200k a month in the first part of the year, the unemployment rate pushes toward 4.5%, and wage growth accelerates, they will will compelled to raise rates further. Actual progress on inflation would accelerate that timeline.

And that is how you get to Vice Chair Stanley Fischer's CNBC comments today:

"We watch what the market thinks, but we can't be led by what the market thinks," Fischer told CNBC's "Squawk Box." He added that market expectations of the number of future rate hikes are "too low."

Fischer expects four rate hikes this year. But that is a data dependent forecast. Financial markets have a different forecast. It is worth recognizing that when it comes to forecasting the path of short rates, financial markets have had something of an upper hand of late.

Separately, ISM services came in below consensus but remains within a solid range. Internals pointed to rising orders and employment as well. It remains a story of two economies:  The trade deficit narrowed slightly in November, modestly boosting tracking indicators for fourth quarter GDP. And the ADP numbers game in at a solid 257k December increase in private payrolls, raising expectations  for the actual employment release Friday. Consensus is 200k for nonfarm payrolls. I am taking the over.

Bottom Line: Financial markets are stumbling into the new year. The Fed is sticking to its story. Given that January is off the table for a rate hike, we have two and a half months of data - including three employment reports! - to see if the Fed has it right this time.

Fed Speakers Confident, Market Less So

Federal Reserve officials remain confident as markets began 2016 on a tumultuous note. Cleveland Federal Reserve President Loretta Mester told Reuters that although she is "pretty comfortable with the median path" of roughly four rate hikes this year, she would prefers a somewhat more aggressive forecast. That is less hawkish than it might seem given that Mester has a more optimistic economic outlook:

"Mester expects the U.S. economy to grow at a 2.5 percent to 2.75 percent pace this year, slightly stronger than the 2.4-percent rate median forecast of her colleagues. That optimism allows her to view more than four rate hikes as appropriate, she said."

In the old days, that would not be considered a particularly optimistic forecast. A somewhat less optimistic San Fransisco Federal Reserve President John Williams today told Steve Leisman at CNBC that he thought the Fed was on track for 3-5 rate hikes. From CNBC's transcript:

LIESMAN: AND THAT'S THE KIND OF GDP GROWTH THAT LEADS YOU TO A MEDIAN RATE HIKE NUMBER, RIGHT? WHICH IS THAT THE 2% GROWTH WAS WHAT THE OVERALL FED IS LOOKING FOR AND THAT WOULD BE COMMENSURATE WITH THE FOUR RATE HIKES? 

WILLIAMS: SO NOW I'M GOING TO GIVE MY NORMAL DISCLAIMER THAT I AM SPEAKING ABOUT MY OWN VIEWS, BUT YES. A GROWTH PATH OF 2, 2.25% GDP GROWTH, UNEMPLOYMENT EDGING DOWN IN MY VIEW BELOW 5% THIS YEAR. AND INFLATION CERTAINLY TO MOVE GRADUALLY BACK TO 2% THIS YEAR – ARE THE KIND OF INGREDIENTS I SEE AS FEEDING INTO, YOU KNOW, 3 TO 5 RATE HIKES THIS YEAR. BUT, AGAIN, YOU KNOW, WE'LL WATCH THE DATA.

As Leisman alluded to just before this exchange:

LIESMAN: EXCUSE ME WHILE I YAWN, RIGHT? I MEAN –

Williams forecast is about as dull as it gets. But dull is not such a bad thing. Williams sees this as the slightly above trend growth number that sets the economy on a glide path to a sustainable pace of activity. 2%. It's the new 4%. The reduced estimates of potential growth have lowered the Fed's expectations for growth such that numbers which in the past might be called "stall speed" are now considered good news.

Separately, over the weekend Federal Reserve Board Vice-Chair Stanley Fischer opined on the persistence of low equilibrium real interest rate:

Whatever the cause, other things being equal, a lower level of the long-run equilibrium real rate suggests that the frequency and duration of future episodes in which monetary policy is constrained by the ZLB will be higher than in the past. Prior to the crisis, some research suggested that such episodes were likely to be relatively infrequent and generally short lived. The past several years certainly require us to reconsider that basic assumption.

Fischer considers four potential actions to respond to there zero lower bound: Raise the inflation target (although he worries you can't have higher inflation without more variable inflation), implement negative interest rates (which I suspect is would be political suicide for the Fed), raise the equilibrium real rate (though the primary tool here is fiscal policy), and eliminate physical currency (he argues not practical in the United States). In other words, the tools exist, but implementation is a challenge. 

Fischer adds that a sustained low interest rate environment has the potential risk of creating financial instability. He notes that policymakers generally argue that "macroprudential tools" should be the first line of defense against such instability. Fischer however adds:

Despite the tools that the Fed can use to support financial stability, including the Fed's authority to impose margin requirements on secured financing transactions, the Fed has fewer macroprudential tools at its command than some other central banks, particularly with respect to real estate. Regulators in many countries facing or anticipating problems with rising real estate prices often turn to controls over loan-to-value or debt-to-income ratios. Such measures are potentially important, as the real estate sector is the most common source of the beginnings of financial instability. In the United States, responding to such problems with these tools would require interagency coordination, which could make their use cumbersome at critical moments.

Lack of sufficient macroprudential tools thus may require a monetary response instead:

The effective lack of such tools has two important consequences. First, it requires placing greater weight on the ability of financial institutions and the financial system as a whole to withstand financial shocks without the authorities having to use macroprudential instruments--that is to say, on structural reforms to the financial system. Second, in such instances, one could consider using monetary policy--the short term policy interest rate--to lean against the wind of financial stability risks.

Still, the central bank can't raise interest rates for just every potential bubble that comes along:

I would like to conclude on this issue by saying that the issue is a bit more complicated than suggested so far--for, given that financial variables are a critical part of the transmission mechanism of monetary policy, when policymakers say the economy is overheating, they may well be considering the behavior of asset prices as a critical part of that phenomenon and part of the reason to tighten monetary policy. Thus, I believe that the real issue of whether adjustments in interest rates should be used to deal with problems of potential financial instability is macroeconomic, and that if asset prices across the economy--that is, taking all financial markets into account--are thought to be excessively high, raising the interest rate may be the appropriate step. 

This sounds to me like Fischer believes that interest rate hikes to counter asset bubbles are only justified if the excessive pricing is widespread throughout the economy. Nonetheless, Greg Robb at MarketWatch reports on speculation that Fischer fueled the negative mood on Wall Street this morning:

A hawkish tone from a key U.S. central banker could be adding to the market’s poor start to 2016.

On Sunday, Fed Vice Chairman Stanley Fischer said the U.S. central bank should be open, in the future, to raising interest rates to ward off potential asset bubbles.

How much financial stability concerns should play in monetary policy remains an unsettled policy at the U.S. central bank. Prior to the crisis, the Fed’s leadership did not support hiking rates to ward off asset bubbles. 

In a note to clients, David Rosenberg, chief economist at Gluskin Sheff, said Fischer’s “hint of more rate adjustments” may be adding to “the market angst.”  

Maybe. Maybe not. The down day on Wall Street appears to have had it's proximate cause in the shellacking delivered to the Chinese stock market overnight. Or a reaction to weak Chinese manufacturing data. Or the return of cold weather to the east coast. Or whatever - I am a little wary of attributing to much of any daily move to any one story.

 

The year's first major data release was decidedly weak. The ISM report on manufacturing came in below expectations at 48.2 for December. The internals were soft as well: 

I don't think this report should have come as much of a surprise - manufacturing is the primary weak spot int he economy at the moment. Is this a repeat of 2012? Or 2007? I tend to think the former. The numbers helped drag down the Atlanta Federal Reserve's estimate of 4th quarter GDP:

 

If true, not exactly an auspicious end to 2015. More important for policymakers, however, will be the Friday release of the December employment report. Fed officials will downplay weak headline GDP numbers if a.) underlying domestic demand looks solid and b.) the job market holds steady.  

 

Bottom Line: Fed officials begin the year with their own vision of optimism, one centered on the diminished expectations of low potential GDP growth. While in their view the situation calls for higher rates, not dramatically higher. Dramatically higher does not seem possible given the persistence of the overall low rate environment. Any rate forecast is data dependent. Although the early data is on the weak side, I don't know that it comes as a surprise to policymakers.

 

A Look Ahead Into 2016

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 March. 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.