US: Tighter Policy to Keep Lower Speed Limit
- In recent months the cyclical picture in the US has been improving. Our long-held view that the US economy was not heading towards a recession, but merely living through a mid-cycle slowdown, has been confirmed. Going forward, we expect US growth to reaccelerate from 2% in H1 to around 3% in H2 with the expansion continuing into 2008.
- While a reacceleration to 3% growth might not seem problematic, it will bring the economy above its current speed limit. Recent data indicate that the potential growth rate of the economy has slowed to about 2.5%, maybe even lower. This is the result of not only a slowdown in productivity growth but also in the potential growth rate for working hours.
- As the economy already operates close to its full potential a reacceleration of growth to around 3% will lead to renewed pressure on the economy's resources. The unemployment rate will begin to decline again from an already low level and production capacity in general will become even tighter.
- Combined with several signs of increasing price pressure in the inflation pipeline, this will lead to increased inflationary risks. Going forward, core inflation is more likely to move slightly up than continue its recent descent.
- The essence of this outlook is that Fed will eventually have to take US monetary policy to a tighter level. We believe that the Fed will begin to prepare the grounds for such a move during H2, as more unambiguous signs of stabilisation in the housing market materialise and core inflation fails to moderate further. Consequently, we mark up our 12-month fed funds forecast to 5.50%, while emphasising the risk of even further tightening.
Fed to tighten in 2008
Merely a mid-cycle slowdown
For many quarters the sentiment around the US economy has been rather pessimistic. However, over the last couple of months, data have been telling a different story. The positive flow of data has confirmed our long-held view that the US economy was not heading towards a recession, but merely living through a mid-cycle slowdown.
In fact the picture has changed a notch faster and stronger than we initially expected. Firstly, US service and manufacturing confidence has rebounded very fast and now points to above 3% growth in H2. Secondly, the US consumer has been less damaged by the hefty rise in US gasoline prices than we initially feared. Thirdly, there is no visible dramatic spillover yet to households from the housing market and the labour market has been impressively resilient to the slowdown in growth. In reality this leaves the housing market as the only remaining Achilles' heel of the economy with a continued flow of mixed-to-soft data.
Indeed the markets have been taking their cue from these developments reducing the odds of a Fed cut in the coming 12 months, c.f. the chart below.
With the tug-of-war about monetary policy in H2 07 settling around a flat path for the Fed funds rate, focus will soon move to the course of monetary policy in 2008. We believe that the debate in the market and among analysts will change from a question about cut-or-not to a question about hike-or-not, as we enter H2.
As emphasised in Global Scenarios, June 2006, we expect that growth will reaccelerate to around 3% in H2 and that the expansion will continue into 2008. This view embeds an ISM index at 55-57 in H2, a continuing resilience of US households, a recovery in US business spending and stronger signs that the housing market is bottoming out during H2.
At first glance a growth rate around 3% does not seem problematic. However, as emphasised below growth is very likely to be above the current speed limit of the economy - not because 3% growth is unusually fast, but because the speed limit of the economy is currently unusually low.
Since last summer when the Fed ceased fire, the core CPI inflation has eased from 2.9% to now 2.2%. In the wake of this development, one might think that Fed is willing to live with the economy running "too fast" - at least for a while.
However, despite the notable improvement in core inflation, significant inflationary pressure remains in the inflation pipeline. As emphasised in "Research USA: Inflation risks are rising", June 20 2007, there are several signs that these pressures are on the verge of popping the surface. From our point of view, this implies that core inflation is more likely to move slightly up than to continue its recent descent.
With growth faster than the speed limit and core inflation flat or drifting slightly up, inflationary concerns will become more pronounced in the coming quarters. Hence, we think that the Fed will have to step up its rhetoric gradually during H2 to prepare the grounds for some additional tightening in 2008.
This leads us to mark up our 12-monht forecast from 5.25% to 5.50%, while emphasising the risk of even further tightening.
Lower potential
The speed limit has slowed...
Several factors point at a lower speed limit, i.e. a lower potential growth rate, in the economy. This means that it will take less growth than usual to bring unemployment down further. That potential growth has slowed is rather clear from the fact that the unemployment rate has remained stable despite an average GDP growth rate below 2% over the recent four quarters.
The relationship between growth and changes in unemployment - also known as Okun's law - can be applied to estimate how much the economy's potential has slowed (see box 1 below). The Okun-estimation clearly reveals that the growth rate in potential GDP has been declining over the last couple of years (see the chart below).
More specifically, it indicates a slowdown in potential growth from around 3.25-3.50% in the period 1995-2001 to now 2-2.50%. Interestingly, this slowdown in the potential growth rate does not seem to be cyclically driven (i.e. related to the recent growth slowdown) as it took place already during 2004-2005.
Note: See box below for details about the estimation
Box 1: Estimating potential GDP growth from Okun's law
Okun's law relates changes in unemployment to the difference between GDP growth and potential GDP growth:
Change in unemployment rate = beta*(GDP growth - potential GDP growth)
By shuffling the terms the growth rate of potential GDP can be backed out from Okun's law as:
Potential GDP growth = (Change in unemployment rate - beta*GDP growth)/beta
To empirically determine the potential GDP growth the following auto regressive equation is estimated:
Change in unemployment rate (t) = constant + beta0*GDP growth (t) + beta1*GDP growth (t-1) + error term (t) (*)
Note that a one-quarter lag is included to account for the empirical lag between employment and GDP growth. From this equation potential GDP growth is determined as:
Potential GDP growth (t) = (Constant+ error term (t))/(beta0+beta1)
The model (*) is estimated by simple OLS for the period 1949 to present on a quarterly basis. The results are presented in the table below:
Note: A second lag of GDP growth has been left out, as it is only borderline significant, with a coefficient of -0.04 and a t-value of -2.06. |
These results are supported by the official data for non-farm labour productivity, published by the BLS. The productivity data reveal that non-farm labour productivity growth has been slowing notably over the recent quarters to around 1.75% - even when adjusting for the usual cyclicality in the data. This corresponds to a slowdown in the labour productivity growth for the overall economy (this is usually 0.25%-point lower than non-farm productivity growth) to approximately 1.50%.
However, the slowdown in potential growth is not only due to slower productivity growth. The potential growth rate in working hours has also slowed (see box 2). This has happened because of a slow-down in the growth rate of the working age population, but also because labour force participation seems to have peaked and is beginning to move down.
With overall productivity growth of 1.50% and a growth rate in potential working hours of 0.75-1.00% the total potential growth rate is close to 2.25-2.50%.
Hence, the conclusions from Okun's law and productivity/labour force data are largely consistent. Interestingly, the cyclically adjusted non-farm labour productivity growth and the potential growth rate deducted from Okun's law have moved more or less in tandem over the last 20 years. Hence, from this point of view the conclusion of a slowdown in the economy's potential seems relatively robust.
Box 2: Lower potential in working hours
Potential working hours can be divided in three sub-categories: Potential labour force, the participation rate and average workweek.
Potential labour force: As the baby boomers retire and the smaller, younger generation enters the workforce, potential labour force growth will slow. Immigration policies etc. affect the potential workforce as well.
The table below summarises estimates of labour force growth from the Congressional Budget Office (CBO), The Bureau of Labour Statistics (BLS) and the Social Security Administration (SSA). The estimates from these agencies show that trend in potential labour force growth will slow currently 1.0-1.1% to 0.5-0.8% until 2015. Moreover, a study by researchers in the Board of Governors of the Federal Reserve System from 2006 (see the source below the table) suggests that potential labour force growth may be as low as 0.8% already in 2007 and will decline to 0.2% in 2015.
Source: "The Recent Decline in the Labor Force Participation Rate and its Implications" by Stephanie Aaronson, Bruce Fallick, Andrew Figura, Jonathan Pingle, and William Wascher, Board of Governors of the Federal Reserve System. Published in Brookings Papers on Economic Activity, 2006-1. "Fed-authors" denotes the projections from the authors of the article.
Participation rate: For decades the civilian participation rate has been rising as a trend, primarily due to more women joining the workforce. However, since 2000 the structural upward trend in the participation rate has disappeared. While some of the decline since 2000 is most likely cyclical, it is noteworthy that a renewed uptrend has not re-emerged during this expansion.
The study by researchers in the Board of Governors of the Federal Reserve System from 2006 points to several demographic and structural factors explaining this development. Firstly, the general aging of the working population implies lower participation rates, as older people tend to participate less. Secondly, participation rates for younger women are flattening out. Thirdly, longer education of teenagers and young people lowers the participation rate in this segment. However, there is one offsetting factor in terms of later retirement. As the estimates below show the participation rate is set to decline further in the years ahead.
Average work-week: This has been declining for several years, but has recently stabilised. However, a renewed downward move in the average work-week could pose a downside risk to potential working hours as well.
Adding the pieces together suggest that the trend in potential working hours has been softening and will soften significantly further. In 2014 the estimates of potential growth in working hours range from -0.1 to 0.8%. The average 2007/08 estimates range from 0.4% to 1.0%. |
... and there is limited room to exceed it
Not only has the speed limit of the economy slowed, the economy already operates close to or even above full capacity. This is visible in the labour market where resources are relatively stretched, with an unemployment rate of 4.5%.
As the chart below indicates the labour market has already been in inflationary territory for a while, with the unemployment rate below NAIRU (Non-Accelerating Inflation Rate of Unemployment). The economy is not only facing a lower speed limit, but there is also very limited room for exceeding it without creating increasing wage pressures.
Given a potential growth rate close to 2.5% our 3% growth forecast implies that unemployment will begin to move down again during H2. When applying the estimation results of Okun's law above, a potential growth rate of 2.5%, and our projected growth path we end up with an unemployment rate reaching 4% during 2008, which will lead to intensifying underlying wage pressures.
Fed to resume tightening in 2008
In our view the slowing of potential growth in combination with a tight labour market leaves the Fed relatively sensitive to a positive growth surprise. This has also much to do with the Fed's (i.e. Bernanke's) perception of the inflationary process, as being fundamentally anchored to the labour market and wage dynamics.
From this viewpoint a play out of our forecast of 3% GDP growth in H2 07 and into 2008 (c.f. Global Scenarios, June 2007) implying a renewed decline in the unemployment rate, will definitely cause some increasing concerns at the Fed.
Further, as we emphasised in "Research USA: Inflationary risks are rising", June 20, 2007 we do not see significant room for further slowing core inflation. Contrarily, we see a risk that the core PCE index will begin to move slightly upwards in H2.
Provided that the housing market shows more unambiguous signs of stabilisation, we think that the case for further Fed tightening will build up during the coming six months. Hence, we mark up our 12-month Fed funds forecast from 5.25% to 5.50%. We also emphasise the risk that Fed will need to take policy to an even tighter level in the longer term.
Danske Bank
http://www.danskebank.com/danskeresearch
Disclaimer
This publication has been prepared by Danske Markets for information purposes only. It is not an offer or solicitation of any offer to purchase or sell any financial instrument. Whilst reasonable care has been taken to ensure that its contents are not untrue or misleading, no representation is made as to its accuracy or completeness and no liability is accepted for any loss arising from reliance on it. Danske Bank, its affiliates or staff, may perform services for, solicit business from, hold long or short positions in, or otherwise be interested in the investments (including derivatives), of any issuer mentioned herein. Danske Markets´ research analysts are not permitted to invest in securities under coverage in their research sector. This publication is not intended for private customers in the UK or any person in the US. Danske Markets is a division of Danske Bank A/S, which is regulated by FSA for the conduct of designated investment business in the UK and is a member of the London Stock Exchange. Copyright (©) Danske Bank A/S. All rights reserved. This publication is protected by copyright and may not be reproduced in whole or in part without permission.
|
