News in Charts: The door to a June rate hike remains ‘ajar’ as the BEA confirms another soft Q1

Yesterday’s US GDP data were marginally weaker than expected. According to the advance estimate, the economy expanded at an annualised pace of 0.5% in 2016 Q1, down from a reading of 1.4% in the previous quarter. The consensus had been looking for a figure of 0.7%, while our own forecast was for growth of 0.6%. Our central view remains that we will see a single 25 basis point tightening in the fed funds rate this year, probably in December, though June is an outside prospect.

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Digging a little into the detail, it appears that uncertainty associated with the financial market turmoil earlier this year played at least a part in the slowdown. Consumption of durable goods and private fixed investment both fell, in each case for the first time in around five years. These two components are particularly susceptible to fluctuations in confidence about the economic outlook. It is also fair to say, as we did this time last year, that the Q1 data have looked suspiciously weak for a number of years. In short, the Bureau of Economic Analysis appears to be struggling fully to adjust for those seasonal factors that typically depress economic activity at the start of each year. On that basis alone, some kind of bounce back in Q2 seems likely.

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More broadly, US growth has been disappointingly weak for a number of years. And yet it has been sufficient to produce quite a rapid tightening of the US labour market, because US productivity growth has been weaker still. Over the past five years, US productivity has grown at an average annualised growth of 0.5%. That is not quite the weakest on record, but it is very close to it. As we set out in our Global Economic and Markets Outlook for 2016 Q2, we are becoming increasingly convinced that a long-period of near-zero interest rates has, by preventing the ‘gales of creative destruction’ that would normally drive recovery from recession, begun to harm the supply side of a number of major economies. And that includes the US.

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US monetary policy outlook

Turning to the outlook for US interest rates, Wednesday’s FOMC statement had a little something for everyone. Those expecting an early move will take comfort from the fact that members no longer appear troubled by downside risks from ‘global economic and financial market developments’. Those who believe the Fed is in no hurry to tighten will focus instead on new passages that draw attention to a slowdown in economic activity, and to weaker spending by households. This latter group can also point to ongoing concerns about low inflation breakevens.

In the Committee’s own words, the timing of the next move “… will depend on the economic outlook as informed by incoming data”. And yet, members have very little to say about the framework that is being used to interpret the incoming data. How, for example, do they view mounting evidence that the labour market is tightening rapidly, alongside continued low rates of inflation compensation in financial markets? Which one will dominate, and when? We do not know. On balance, investors took little away from Wednesday’s meeting, with fed funds futures more or less unchanged on the day.

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Our central view remains that the Fed will err on the side of caution, delivering just a single 25 basis point hike this year. While December is perhaps the most likely month, we would not rule out a hike as early as the next meeting, particularly if both public opinion and market pricing continue to move in favour of a ‘remain’ vote in the UK’s EU referendum, due to take place on 23 June, just one week after the Fed’s policy decision. As our chart shows, three-month sterling volatility, relative to other G3 crosses, has dropped off sharply in recent weeks.

The quid pro quo of Fed caution this year is that there will be much to do next year, particularly if China doubles-down. In that environment, both core and non-core inflation will be rising through next year. That is why, again on our central view, the Fed will deliver 100 basis points of tightening in 2017, in line with the March Summary of Economic Projections.