The Fed bias remains toward tightening
I don’t think we got any new information from the economy or the Fed yesterday. While the GDP report was below expectations, it was exactly where the Atlanta Fed said it would be. And the Fed has not altered its stance. It is prepared to look through the data and make a hike decision based on incoming data this spring and summer. Some thoughts below
First, if you go back to early April, I was asking the question we are still asking “Should the Fed look through weak Q1 consumption data?” I pointed to two data points that I called in real time as harbingers of weakness. The first was the weather, which I said in February already would make Q1 a disaster. The second was the Atlanta Fed’s GDPNow forecast model, which I pointed to in late March as suggesting much worse than anticipated numbers for Q1. So the concept that the data were “a surprise” doesn’t really hold water. Yes, Wall Street was too optimistic, but it was clear that the data would be poor and it was equally clear that bad weather had a lot to do with it.
We are asking the ‘look through’ question because it is still not apparent how much of the poor data is a trend and how much is a passing mid-cycle pause due to Fed tightening and how much is an aberration due to weather. I would suggest that all three factors are at play and that the Fed is right to remain data dependent as a result. First, on the trend, I have been saying for about four months that we should expect non-residential capital investment data to be weak because of the drop in oil prices. And the data for Q1 showed that non residential fixed investment subtracted 0.75 percentage points from real GDP growth. We should expect this trend to continue through 2015.
But the weakness in oil is in part a reflection of a strong dollar that is also a reflection of the Fed’s tightening bias in the face of loosening policy, interest rate cuts, quantitative easing, and negative interest rates elsewhere in the world. So, this has had a negative impact on net exports as well, leading to a -1.25 percentage point subtraction from Q1 2015 GDP, with exports accounting for -0.96 percentage points of this.
So right there, you have more than two full percentage points missing from GDP. Add in some inventory drawdown and weather and you have no growth. And one could argue, as I have, that this is a direct result of policy divergence and tightening, with 1994 as an upside base comparison for how this could proceed going forward.
At the same time, however, jobless claims have remained below 300,000. The JOLTS data have been good and non-farm payrolls have been good despite last months setback. And the data on wages and disposable income have been good for the last year. All of this supports consumption growth. This is why the Fed is looking through Q1 and concentrating on April and May data that we will get in May and June. If the data show weakness lasting into Q2, then we have a serious slowdown that threatens recession down the line and will forestall tightening. On the other hand, given the Fed’s tightening bias, if the data perk up, the Fed will feel compelled to raise rates. I see 5.0-5.5% unemployment as sort of a red line because those are the data points in terms of the Fed’s dual mandate that are closest to triggering a response.
Warren Mosler spoke to us at Boom Bust last week about the situation and he made some interesting observations about downside risk I thought I would pass along. Just as I have been saying the data won’t immediately capture the capital expenditure cuts and that there would be downward revisions, Warren is saying that personal income data is not capturing lost income from these cuts either. His view is that the pass through from income loss due to the decline in oil prices will be felt more substantially than is commonly believed and that the decline in oil prices will not be the net positive that many people believe. I think this downside risk bears watching. Nevertheless, I am in the camp that says consumers with the greatest spend marginal propensity are net beneficiaries of oil price declines, and this is good for near-term consumption growth.
Overall then, the Fed remains poised to pull the trigger on hikes. It could be a one and done scenario as there is no indication that we have a campaign of subsequent hikes ahead of us. Even here, we will have to see what the data hold. But given the bias, decent data mean hikes eventually, whereas we would need to see significant continuing economic weakness for the Fed not to raise rates at least once. My bet is on a hike this summer because I believe the data will be good enough for this to happen.