Fed I: Balanced MPR. My colleague Melissa Tagg and I read the Federal Reserve’s 71-page semi-annual Monetary Policy Report (MPR) to Congress dated February 7. We concluded that Fed officials believe the U.S. economy is well balanced and that they will keep the federal funds rate in the current range of 1.50%-1.75%. Nevertheless, they are concerned about several global issues, which they are monitoring closely.
Federal Reserve Chair Jerome Powell emphasized during his MPR congressional testimony on February 11 and 12 that the “U.S. economy is in a very good place.” The threat from the coronavirus is something to watch, he said, but too early to understand. Nevertheless, he affirmed that “there is no reason why the expansion can’t continue.”
Below, we review reasons that Fed officials are sanguine about the U.S. economic outlook, followed by the concerns they are monitoring. Most of the issues discussed in the MPR have been around since the current expansion began. The two new exceptions are trade tensions, which started in 2018 but have recently diminished, and the coronavirus, which has been a global risk to health, economic growth, and stock markets only since the start of this year.
Fed II: In a Good Place. Powell first used “in a good place” in reference to inflation during his 9/26/18 press conference. In his 1/30/19 presser, he said, “The U.S. economy is in a good place.” He used “in a good place” to describe the economy and Fed policy four times during his 3/20/19 presser. The four-word phrase appeared again at the following pressers: 5/1/19 (once), 6/19/19 (thrice), 7/31/19 (once), 9/18/19 (nope), 10/30/19 (thrice), and 12/11/19 (once). At his 1/29 presser this year, he said that “household debt is in a good place, a very good place.” In his latest congressional testimony, he upgraded his assessment of the U.S. economy as being in a “very good place.”
We wish he would stop using that expression. Our contrary instincts come out every time he says it. Nevertheless, he is right: The U.S. is currently in a very good place compared to China. Let’s review what’s so good in the good old U.S.A according to the Fed:
(1) U.S. manufacturing slump not severe. After increases in 2017 and 2018, manufacturing output declined in 2019. But do not be alarmed; the report dismissed the decline as too small to “initiate a major downturn for the economy.” The MPR observed that mild slowdowns are not atypical during business-cycle expansions; to signal a broad recession, manufacturing would need to be experiencing a severe downturn. Every recession since 1960 included some months when the 12-month change in industrial production was at least 7 ppts below trend. The recent U.S. data are well above that threshold: 2019 growth averaged 2 ppts below trend (Fig. 1).
(2) Solid labor market gains. Overall, the Fed has been pleased with the pace of gains in the job market. The MPR noted the following supportive data: The average monthly pace of payroll gains in 2019 of 176,000 was slightly below the pace of 2018 but faster than required to allow for net new labor force entrants as the population grows. During December 2019, unemployment fell to the lowest level since 1969, 3.5%, down from 3.9% a year ago. It ticked up just slightly m/m during January to 3.6% (Fig. 2).
Labor force participation increased, including for prime-aged individuals. Wage gains remained moderate. Powell indicated he was pleased to see labor force participation picking up as a result of stronger labor market conditions forcing employers to hire and train less skilled employees (Fig. 3).
(3) Residential investment moving up. “Financing conditions for consumers remain supportive of growth in household spending,” the Fed reported, observing that housing starts and permits for new construction rose to the highest levels in more than 10 years (Fig. 4). Sales of new and existing homes also increased during 2019 despite home price appreciation, reflecting reduced mortgage interest rates.
(4) Consumer spending strong. Strong consumer spending last year was supported by the “relatively high level of aggregate household net worth” as both house prices and U.S. equity prices increased.
(5) Growth for advanced economies stabilizing. Growth in several advanced foreign nations has shown tentative signs of “steadying.” Brexit risk has lessened, but the final resolution of the UK’s divorce from the EU remains to be settled. Economic growth in Japan has deteriorated, but that’s expected to be a transitory effect of the October consumption tax increase. Following the report, Japan’s Q4 GDP was released at an annualized rate of -6.3%, largely attributable to weak private consumption given the sales tax increase to 10% from 8% (Fig. 5). For the U.S., fewer Fed officials “judged the risks to the economic outlook to be tilted to the downside” in their projections made in December versus last June, observed the report.
(6) Trade policy progress made. Uncertainty around trade policy recently “diminished somewhat,” the report highlighted, reflecting progress in the U.S.–China trade negotiations.
(7) Global monetary policy accommodative. The current stance of monetary policy and low level of interest rates remain supportive of global growth. “Amid weak economic activity and dormant inflation pressures, foreign central banks generally adopted a more accommodative policy stance,” according to the report. Long-term interest rates in many advanced economies remained low. Indeed, central bank balance sheets continue to grow. For example, China’s central bank has moved aggressively to combat the coronavirus on the economic front by injecting more liquidity into the credit markets.
(8) Financial stability solid. The Fed believes that the U.S. financial system is “substantially more resilient than it was before the financial crisis,” primarily because leverage in the financial sector and total household debt have moderated.
(9) Fiscal policy boosting growth. Current fiscal policy is expected to continue to boost growth. The Tax Cuts and Jobs Act of 2017, which lowered personal and business income taxes, and the recent boost in federal purchases have added to growth, the report said—a point Powell reiterated in his testimony. Following the report, news broke that the Trump administration is planning another possible U.S. fiscal stimulus package—including middle-class income and capital-gains-tax cuts—should Trump be reelected.
Fed III: When China Sneezes. The coronavirus has led to unprecedented quarantines throughout China’s Hubei province and several of the country’s major cities. In effect, China has been quarantined from the rest of the world, as international flights have been suspended until the virus stops spreading and goes into remission. As a result, supply chains that go through China are being disrupted. China’s overall GDP, along with consumer demand, could either stop growing or actually turn down as a result of the epidemic. All this was confirmed by Apple’s (NASDAQ:AAPL) warning on Monday that it does not expect to meet its quarterly revenue forecast because of lower iPhone supply globally and lower Chinese demand as a result of the coronavirus outbreak.
Not surprisingly, therefore, the MPR includes the coronavirus on the Fed’s worry list. The report was released to the public on February 7, two weeks after the outbreak hit the headlines. Let’s review the Fed’s worry list:
(1) Weak pace of inflation. According to the Fed, low readings in the U.S. inflation rate were attributed to possible transitory influences, specifically “idiosyncratic” declines in “specific categories such as apparel, used cars, banking services, and portfolio management services.” After briefly rising toward the Fed’s 2.0% inflation goal during 2018, the pace of inflation during 2019 dropped well below that target again. The 12-month change in the PCED (personal consumption expenditures deflator) for both the headline and the core rates were just 1.6% as of December 2019, below year-ago readings for both (Fig. 6). Global inflation also remains subdued. Powell expects U.S. inflation to move closer to 2.0% over the next few months, according to his testimony.
(2) Declines in business investment. The report voiced concerns about the stalling of business investment in structures, equipment, and intangibles last year. Private nonresidential fixed investment in real GDP was flat y/y during Q4, the weakest growth rate since Q1-2016 (Fig. 7). That reflected trade policy uncertainty and weak global growth, according to the Fed’s report, among other factors (including the “suspension of deliveries of the Boeing 737 Max aircraft” and “the continued decline in drilling and mining structures investment”). Going forward, the Fed expects business investment to remain subdued.
(3) Weak productivity trend growth. Wage gains remained moderate despite solid job market improvement. The Fed attributed this to weak productivity growth, partly as a result of “the sharp pullback in capital investment … during the most recent recession” and the slow recovery that followed. “While it is uncertain whether productivity growth will continue to improve,” the Fed said, “a sustained pickup in productivity growth, as well as additional labor market strengthening, would support stronger gains in labor compensation.” Powell said in his testimony that boosting productivity “should remain a national priority.”
Following the report, data covering last year’s productivity growth was released showing a 1.7% gain (Fig. 8). As we see it now, GDP has been growing at a little over 2.0%, so we are getting more of our economic output from productivity, which bodes well for real wages and profit margins (Fig. 9). In other words, we may be able to cross this one off the Fed’s worry list soon.
(4) Weak emerging markets growth. Growth in many Latin American and Asian economies (e.g., China, Hong Kong, and India) has slowed markedly. Social and political unrest in Hong Kong and Latin America have resulted in severe economic disruptions. In India, the “ongoing credit crunch continues to weigh on activity.”
(5) China spillover potential. In China, GDP growth slowed further in 2019 against the backdrop of “increased tariffs on Chinese exports, global weakness in trade and manufacturing, and authorities’ deleveraging campaign that continued to exert a drag on the economy” (Fig. 10). “[S]ignificant distress in China could spill over to U.S. and global markets through a retrenchment of risk appetite, U.S. dollar appreciation, and declines in trade and commodity prices,” the report stated.
(6) Coronavirus possible contagion. Coronavirus was mentioned eight times in the report, including “[M]ore recently, possible spillovers from the effects of the coronavirus in China have presented a new risk to the outlook” and “The recent emergence of the coronavirus … could lead to disruptions in China that spill over to the rest of the global economy.”
(7) Corporate debt and asset valuations elevated. “[A]sset valuations are elevated and have risen since July 2019, as investor risk appetite appears to have increased,” the report observed. Business debt remains elevated as well, whether viewed as a ratio of business assets or growth measures. In addition, that debt has gotten risker: The lowest investment-grade category (triple-B) represents about half of investment-grade-rated debt outstanding; that’s near an all-time high. Economic deterioration could lead to a liquidity crunch in the credit markets.
(8) Uncertainty in setting monetary policy. The report dedicated a box to discussing the Fed’s concern about the future effectiveness of its current approach to conducting monetary policy. The U.S. economy has “changed in ways that matter for monetary policy. For example, the neutral level of the policy interest rate appears to have fallen in the United States and abroad, increasing the risk that the effective lower bound on interest rates will constrain central banks from reducing their policy interest rates enough to effectively support economic activity during downturns.”