News In Charts: The Fed Must Ignore The Siren Voices

The Fed chose to adopt a watching brief in its January policy meeting, which was held after a volatile start to the year for financial markets. That decision seems entirely sensible, although the direct impact of China’s slowdown on the US economy is likely to be small. Today’s advance estimate of US GDP revealed that economic growth had slowed to 0.7% in the fourth quarter of last year.  Net trade exerted the greatest drag, followed by destocking, as a strong US dollar continued to weigh on exports. Growth in consumers’ expenditure came in at a more solid 2.2%. However, it was reportedly depressed somewhat by unseasonably mild weather, and so some bounce back seems likely in Q1, particularly in light of continued strength in the labour market and further falls in the price of oil.

The gap between the FOMC’s December ‘dots’ chart and market pricing has widened substantially in recent weeks. At least one set of expectations must adjust, and soon. Many who fear the worst for the US economy point to the manufacturing ISM survey, which has fallen below 50. But this is mainly due to the strong dollar, which should boost consumer spending and with it the non-manufacturing sector. One month after the first policy tightening in almost ten years, some are already calling for the Fed to reverse engines. We see little prospect of this. The risks to market pricing lie firmly to the upside.

As we anticipated, the FOMC kept policy on hold in its January meeting, with the interest in the detail of the policy statement. Within this, the FOMC chose to acknowledge the current market turmoil stemming from China by stating that it is “closely monitoring global economic and financial developments and is assessing their implications for the labor market and inflation, and for the balance of risks to the outlook”.

From our perspective, the potential for China’s slowdown to affect the rest of the world directly has been overstated, but the decision by the Fed to adopt a watching brief seems sensible. The wording was not as strong as in September of last year when the Fed warned global developments “may restrain economic activity”. The Committee also remained fairly optimistic about the state of the US economy, while acknowledging that there had been some slowing in activity.

Mind the gap

The gap between the FOMC’s latest projections for the fed funds rate and the path implied by market pricing has widened substantially since the turn of the year. Back in December, the FOMC expected to implement four 25 basis point increases this year. Investors are now looking for just one.

In our view, the Fed must perform a delicate balancing act between below-target inflation and the risk of fueling asset price bubbles by maintaining loose monetary policy. However, we find that the underlying rate of inflation is not actually that low, and the usual domestic inflation process has not broken down. As our chart reveals, while headline inflation is below target, other measures which strip out the most volatile price components are not that far below their 1998-07 average.

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In the analysis carried out for our latest Global Economic and Markets Outlook, we found that a one percentage point decline in the unemployment rate adds 0.5 percentage points to wage inflation over a one-year period — the Phillips curve lives on! Due to an ageing population putting downward pressure on the participation rate, we find that payrolls of just 100 thousand are consistent with a tightening of the labour market. At the current pace of job expansion, in the region of 200 thousand or more per month, the unemployment rate should fall by over one percentage point over the course of next year.

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How worried should we be by a slowdown in US manufacturing?

From a peak of 63.1 in August 2014, the production component of the US manufacturing ISM has since fallen more than 13 index points to stand at 49.8 in December 2015. On occasion, a sudden deterioration in US manufacturing output has provided an early warning of broader trouble ahead. That may explain why some commentators have watched this long-established survey with a growing sense of alarm. But how right are they to be concerned?

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The more timely, though less well-established Markit survey should provide a few crumbs of comfort. In January, the output component of the US manufacturing PMI stood at a relatively healthy 54.0. But for any long term analysis, we must rely on the ISM survey which stretches back almost 70 years. We have examined episodes where the manufacturing ISM has fallen below the neutral 50 level in conjunction with the peaks and troughs in US output identified by the NBER’s business cycle dating committee. We find that a run of sub-50 readings on the manufacturing ISM is followed by a recession within a twelve-month period on almost exactly 50% of occasions. On the remaining occasions it is not – the manufacturing ISM moves safely above the neutral 50 level, and the economy does not enter recession for at least twelve months. When recessions do occur, the manufacturing ISM falls substantially below its current reading of 49.8. On average it troughs at 36.1.

With evidence seemingly split down the middle, we have tried to be a little more scientific. Specifically, we have estimated a simple econometric model in an attempt to capture interdependencies between: the manufacturing and non-manufacturing ISMs; the exchange rate; the fed funds rate; and the global PMI. Our analysis suggests that the cause of any sudden turnaround in the manufacturing ISM is crucial. If the underlying shock is a sharp appreciation of the US dollar then, although the manufacturing sector takes a hit, the rest of the economy benefits from a stronger US consumer. In real effective terms, the US dollar has risen almost 20% since the summer of 2014. By itself, we believe that this can account for around two thirds of the decline in the manufacturing ISM. We would view the remainder as no more than a modest correction. Indeed, at 63.1, the index was well above its long-run average of 55.9 during the summer of 2014. It is notable that, in spite of the decline in the manufacturing ISM, the non-manufacturing ISM has held up well.

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Just one month after the Fed tightened policy for the first time in almost a decade, some are already calling for an about-turn. We see little prospect of this. In our latest quarterly forecast, finalised at the beginning of this year, we judged that the Fed would tighten by a total of 50 basis points this year. We stick to that view. The risks to market pricing lie even more firmly to the upside.