Is the Fed Behind the Curve?

Julien Acalin (PIIE) and Jan Zilinsky (PIIE)
May 11, 2016 3:00 PM

The US economy may not be firing on all cylinders, but things are also probably not as bad as they look from the latest economic indicators. The bearish narrative is supported by few domestic indicators—the supposed threat to the United States has typically been framed in reference to "global factors" such as the slowdown of the Chinese economy. The Federal Reserve has removed its reference to external risks coming from the global economic environment in its last statement, so domestic economic activity is now the dominant piece of the decision-making process. There are three reasons why the US economy may be stronger than it looks.

First, the current gross domestic product (GDP) data may not necessarily reflect a slower path in annual economic activity. Even after seasonal adjustment, real GDP growth in the first quarter has been consistently weaker than growth in the remainder of the year. As figure 1 shows, Q1 data have been persistently weak for 25 years.

Figure 1

Additionally, consider the recent experience from 2014, when it looked like the United States may have entered a recessionary period. In March 2015, the Bureau of Economic Analysis (BEA) estimated 2014Q1 growth at –2.1 percent. But the economy did not actually shrink that much.  Today, the BEA estimates that 2014Q1 growth was –0.9 percent. When assessing 2014 now, the BEA has revised its Q1 estimates upward substantially, while estimates for third and fourth quarters were revised down somewhat. With this precedent of sizeable upward revision for Q1, any assessment of contemporaneous measurement ought to recognize the possibility of upside risk—the economy may be expanding at a higher rate than data suggest.1

Second, the benefits from the current oil market situation may soon materialize in the United States. The combination of a drop in oil and stock market prices, following the disappointment with a lack of a production freeze agreement in December, and a stronger dollar led the Fed to be cautious and hold on in March. The situation looks more favorable today. The dollar has depreciated recently, boosting exporters' competitiveness, oil prices have returned to their pre-December 2015 levels, increasing oil producers' profitability, and stock market prices have recovered.

However, strong pressures are coming from the supply side, due to increasing incremental capacities and higher efficiency in oil production. According to Goldman Sachs, US shale production has reshaped the global oil market over the past few years (figure 2). Two facts are worth noting. We witness increasing incremental capacities (at a given price) as the curve shifts to the right, and also higher efficiency (i.e., a lower breakeven price for a given incremental production) as the curve flattens. This suggests a ceiling on oil prices, unless you expect a huge increase in the oil demand in the short run. This is good news for the US economy: Low oil prices have a positive impact on consumption through higher real income, and on investment (if the prices remain in their current range).  Yet cheap crude could make the Fed's job more difficult if it drags down long-term inflation expectations, although the reaction of long-term inflation expectations to current movements in oil prices is difficult to explain.

Figure 2

Third, inflation may come back sooner than expected. The US economy is currently experiencing weak but persistent real GDP growth, coupled with minimal improvements in productivity. Some argue productivity growth is underestimated (or will pick up soon), while the opposite camp believes that high peaks were "anomalies" in history and we have to adapt to a new era of low productivity.

If productivity does not pick up and growth persists, the implication would be a fast fall in the unemployment rate. According to Deutsche Bank (figure 3), the unemployment rate could drop below the NAIRU (the unemployment rate consistent with growth at potential and stable inflation) by the end of the year. It could even fall below 3 percent by 2018. If this scenario materializes, inflation may rise sharply as the Philips curve (the negative relation between unemployment and inflation) takes effect. In that case, the Fed could be behind the curve and would even need to rush to raise rates.

Figure 3

Is the Fed going to increase rates in June, before the vote in Britain to exit the European Union and the uncertainty regarding the impact on the US economy? Current implied probability from market participants is about 10 percent (though San Francisco Federal ReservePresident John Williams said he supports a June rate hike). Will we see a rate hike by July (when no press conference is scheduled)? This also seems unlikely, especially if volatility around June 23 takes its toll on financial markets.2 According to Atlanta Federal Reserve President Dennis Lockhart, two rate hikes this year are "certainly possible," so a September move appears to be on the table. However, markets still expect at most one rate hike this year, the implied probability being about 85 percent. This discrepancy between market expectations and comments from the Fed may increase volatility in the coming months. A recent example of an adverse effect of surprises comes from another advanced economy, Japan. The approach of the Bank of Japan—delaying further stimulus during its last meeting and introducing negative rates a few weeks ago—resulted in an appreciation of the yen, a drop in the stock market, and lower odds of recovery.

Overall, while the US economy may be running somewhat hotter than it looks, markets still expect fewer rate hikes than the Fed. Policymakers are still trying to find the right balance between signaling a likely rate increase with enough advance warning and, as has often been the case in recent years, risking a decline in credibility if a promised rate hike is not delivered.

Notes

  1. Of course, the currently projected annualized growth rate of less than 2 percent is hardly impressive. One could say that "slow and steady wins the least ugly contest". (In late April, the Federal Reserve Bank of Atlanta provided a second quarter growth "nowcast" to the public, estimating it at 1.8 percent.)   

2. Dallas Federal Reserve President Robert Kaplan, who does not currently vote on the Federal Open Market Committee (FOMC), said in a recent interview he could back a rise in US interest rates as soon as June or July if economic data firm up, and that financial markets had underestimated the Fed's readiness to follow the last hike with another move.