Fed rates: Who’s afraid of the external wolf?

After a soft Q4, in which the Bureau of Economic Analysis (BEA) now estimates that the economy grew at a 1.4% seasonally adjusted annualised rate, Q1 is likely to be even weaker.

After a big drop in March, light vehicle sales were down in the first quarter as a whole, leaving personal spending on track to grow just 1.5%; well down on last year’s pace and the weakest outturn since Q1 2014 (see Chart 2).

Sluggish consumption growth is a problem because there are few other drivers of growth to be found. Net exports will weigh on growth again in Q1, while the trend in non-structures capex spending remains flat, though investment in structures is growing at a healthy clip. March did see a healthy rise in the manufacturing ISM, led by a surge
in new orders, but the Markit PMI edged up more modestly and the combination of soft consumption, weak external demand and elevated inventories suggest that new orders will drop back gain in the coming months.

As has been the case for some time, the healthiest economic signals are coming from the labour market. Nonfarm payrolls continued to increase at an above-200k pace in
March, while the upward trend in the employment-to-population rate was maintained, propelled by another increase in labour force participation (see Chart 3). The only disappointment was that implied trend productivity growth remains anaemic.

Despite the continued strong performance of the labour market, Federal Reserve (Fed) chair Janet Yellen gave a wide-ranging policy speech last week, which revealed that she has become more concerned about downside risks from the global economy and financial markets, justifying a more accommodative path for interest rates. She also elaborated on the rationale for the Fed’s cautious view on core inflation, observing that short-term developments can be volatile.

With further pass-through from earlier dollar appreciation likely and some measures of inflation expectations running low, medium-term inflation risks are tilted to
the downside. Yellen also chose not to push back against the market’s dovish expectations for Fed policy, instead pointing out how lower market rates had helped shield the economy from recent shocks. She then went on to argue that the current stance of monetary policy was sufficiently accommodative because the neutral real interest rate (that which is neither expansionary nor contractionary) – which the Fed currently estimates is close to zero – remains above the actual real rate – which is -1.25% once core PCE inflation is subtracted from the federal funds rate.

This implies that the economy should continue to growth modestly above potential, ensuring further progress on the Fed’s employment and inflation goals. Further out, her view is that that the neutral rate will gradually rise over time to around 1%, allowing the Fed to lift rates while still maintaining a modestly accommodative stance. If
neutral real rates do not increase, the terminal fed funds rate will naturally be much lower.

Overall, it was hard to detect any urgency in the speech about lifting interest rates. April is almost certainly off the table, meaning that a rate rise will not come into play until at least June. For now, we maintain our view that two rate hikes are still possible, but external and financial risks will need to dampen, alongside an improvement in domestic growth indicators. A healthier labour market is clearly a necessary, but not sufficient, condition for tighter monetary policy.

Jeremy Lawson, chief economist at Standard Life Investments

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