Right now, economic data surprises are diminishing. And so the synchronized global growth spurt may be decelerating. Nevertheless, many economists are talking about US growth through 2019 and a 3% unemployment rate. Goldman Sachs chief economist Jan Hatzius is one of them. The fly in the ointment is the Fed and its accelerated rate hike timetable.
The bullish US economic scenario
Now Goldman isn’t the only one talking up the US unemployment rate falling to 3%. So are JPMorgan Chase, Deutsche Bank and Moody’s Analytics. The danger is overheating, as Moody’s Mark Zandi signalled when the latest jobs report came out. He says that the US economy could grow 2.9% this year. But potential growth in his view is only 1.75%.
Nevertheless, continued US growth could mean great things for the labor force. Hatzius told Bloomberg via email, “We have unemployment at 3.25 percent by the end of 2019.” He wrote “a decline below 3 percent at some point is obviously possible.”
Moreover, there is considerable hidden unemployment as many people have dropped out of the labor force this cycle. But the labor force participation rate among prime age adults had been declining since 1998. The Great Recession impeded an increase in the 2000s. The severity of that recession brought prime-age labor force participation to new lows.
Source: St. Louis Fed
And while a sustained turnaround began late in 2015, we have a long way to go to reach the levels that prevailed in the late 1990s.
It is very possible we could see continued job growth without an increase in inflation for various factors. But the normalization of the prime age labor force participation rate is a big factor.
The Fed’s Timetable
Meanwhile the Fed has turned hawkish. And that creates a problem. Right now the Fed is guiding the market toward three 2018 increases in the federal funds rate. A fourth rate hike is also now on the table. That would put the federal funds rate just 30 basis points below what Fed officials consider neutral, 2.8%. But Fed Chairman Jerome Powell recently signalled the likelihood of 2019 rate increases. That means official Fed policy guidance shows monetary policy turning from accommodative to restrictive early in 2019.
So, the flipside of Zandi’s risk of overheating is the risk of Fed overtightening.
Late in 2017 and early this year, my timetable called for global and US growth to weaken toward mid-year. And I predicted that would result in curve flattening. For example, last month I wrote:
My baseline is that the economic acceleration starts to unwind mid-year, with the curve beginning to flatten by then. But acceleration could last longer — and that would invite a larger tightening cycle — and greater chance of a hard landing.
I had seen long rates rates climbing from here. This would mean less chance of the Fed overtightening. But 10-year yields are stuck around 2.85%, the level that caused equity markets to correct in February. And that’s because the data are already starting to weaken. And the curve is already starting to flatten.
The yield spread between 5- and 30-year Treasuries touched the lowest since Feb. 2 on Tuesday after the latest consumer price data came in as expected, with the core measure remaining below 2 percent. What’s more, weak elements of the report suggest the prospect of softening inflation may be a bigger concern than fears of an acceleration.
Market gauges of inflation expectations fell on the data, giving investors confidence at Treasury’s auction of 30-year bonds, which drew a lower-than-expected yield. And unlike recent U.S. debt sales, it was deemed “strong” by Wall Street strategists. Longer maturities extended a rally while shorter tenors were little changed.
So now the questions become:
- Is the decline in upside data surprises a head fake? Or is global growth already weakening again?
- How data dependent is the Fed? Does it stick to three rate hikes if the data weaken? Does it stick to them if inflation data strengthen?
The Fed will make or break this economy
The Fed is the key here. All of the palaver about bond vigilantes forcing the Fed to do its bidding is proving misguided. Instead the Fed is moving markets to its position. Six-month Treasury yields are up 99 basis points to 1.90% in the past year. And two-year Treasury yields are now 2.25%, up 88 basis points in a year’s time. Yet long-term rates are moving to the beat of a different drummer. The 10-year is up only 24 basis points in that time frame. And it’s down 7 in the last week.
The implication is that the Fed’s 2019 turn toward restrictive policy will eventually get unwound. A flattening yield curve is a sign that the Fed’s bullying the market at the short end isn’t feeding through at the long end. And the primary reason is that bond traders are predicting an unwind — one usually precipitated by economic weakness.
This is make or break time for the Fed. In the past, the Fed has indeed proved data dependent. when the economy weakened in 2016 and 2017, it paused. If the economy weakens again in 2018, will it pause? Traders are less sure. Flattening tells you that.
But flattening is not inversion. We are still a long way from inversion, almost 60 basis points. But, inversion is not just a signal of weakness. It’s how the Fed creates the next recession.