As Economic Performance Advances, the Fed Lags Behind
Moving into 2015, the U.S. economy is fundamentally sound. Key factors suggest that the economy is shifting gears toward sustained stronger growth, and that the supply-side nature of the lower oil prices will provide a big boost to economic performance in 2015. But the Federal Reserve’s monetary policy is wildly inconsistent with healthy economic growth.
The Fed’s latest forward guidance that it can be “patient” in hiking rates—a nuanced change from its earlier “considerable time” language-- misses the broader point that interest rates not only should be higher, but that economic performance will benefit and be better balanced when the Fed normalizes monetary policy. This suggests that the Fed should begin to hike rates sooner rather than later.
Most sectors of the economy are set to improve in 2015-2016. Strengthening year-over-year growth in private sector employment (2.3%) and real disposable income (2.5%), high rates of personal saving and large increases in household net worth, along with rising borrowing, will support stronger consumption. Business fixed investment has accelerated in the last two quarters and the pickup in aggregate demand, strong profits and cash flows and very low borrowing costs will support further gains.
Although the economy is in its sixth year of expansion since the 2009 recession, its real and financial sectors do not show any of the troublesome excesses that tend to emerge during the later stages of expansions. Along with the Fed’s unprecedented monetary stimulus, this suggests that the expansion has a long ways to go.
In the real sector, the capital stock is low relative to output. Business inventories are low. Increases in employment have lowered the unemployment rate close to its natural rate, and wages are rising modestly. Unit labor costs are low and below those in most industrialized nations. Excess housing inventories have been reduced. Nominal GDP growth has been moderate (3.9 percent average since the second quarter of 2009), consistent with healthy real growth and inflation modestly below the Fed’s long-run 2 percent target.
In the financial sector, household balance sheets have improved significantly, with sizeable reductions in outstanding debt and debt service burdens relative to disposable income, lower mortgage delinquencies, solid increases in household incomes and record-breaking household net worth. Nonfinancial businesses debt service costs are low, and many have locked in low interest rates into the future. Banks have recapitalized, shed non-performing and non-core assets and their credit quality has improved dramatically. Consumer and business lending is growing in a typical cyclical fashion.
The elongated period of slow growth following the financial crisis and the deep recession of 2008-2009 stemmed from necessary adjustments in the finances of households and businesses as payback to the prior unsustainable debt and housing bubbles (along with reductions in government), and those adjustments have largely ended. Increasing momentum in outstanding consumer credit, double digit growth in business commercial and industrial loans, and vastly improved credit quality strongly suggest that the deleveraging process has ended. As the headwinds have dissipated, economic growth has accelerated. Combined with the tailwinds of extended monetary stimulus and the oil price decline, the outlook for stronger growth in 2015-2106 is very favorable.
In contrast, the recovery in housing has been disappointing. Residential investment’s 3.1 percent share of GDP remains one-half of its prior 6.2 percent peak level. In part this can be explained by tight mortgage credit that has resulted from excess regulatory burdens and the adversarial role of the GSEs toward mortgage originators (primarily banks). Favorable underlying fundamentals and easing credit point toward improving housing. The net export deficit will widen as imports rise faster than exports, and this will modestly reduce GDP relative to the strengthening domestic demand; this is a typical cyclical trend and not a concern.
Because of the dramatic decline in oil prices caused by an increase in the supply, the boost to real growth will be larger than consensus estimates. In the 1970s, two negative oil supply shocks contributed heavily to a decade of poor economic performance with several recessions, high inflation, flat real profits, misguided economic policies, and dismal stock and bond markets. Bond yields soared, stocks declined in real terms, and price/earnings ratios fell into single digits. In sharp contrast, the current positive oil supply shock will propel real growth, temporarily lower inflation, and lift real wages and profits.
Standard macroeconomic models may underestimate the positive effect of the lower oil prices to the extent they understate the sizeable positive supply responses. In addition to increasing real purchasing power, lower business operating costs will boost margins and cash flows, leading to increased production, employment and capital spending. Negative effects on the energy sector will be overwhelmed by benefits to non-energy industries and consumers. America’s oil-importing trading partners, including Europe, Japan, China and India will also benefit. Moreover, municipal and state governments will enjoy lower operating costs at the same time their tax receipts are accelerating, freeing resources for rehiring and infrastructure projects that have been on hold since the financial crisis. This will add directly to GDP and will contribute to private construction jobs.
In the Fed’s latest quarterly forecasts released in mid-December, Federal Open Market Committee members revised down their inflation forecasts in response to lower oil prices, but did not revise up their 2.6 percent to 3.0 percent real GDP growth forecast for 2015. Presumably this reflects the Fed’s assessment that the drag on exports from the stronger US dollar and weak global conditions will offset the positive effect of lower oil prices on domestic activity. My strong hunch is that growth of 3.25 percent to 3.5 percent will handily exceed these forecasts, setting the Fed up for a surprise. It will (temporarily?) quell the downbeat prognostications of the stagflationsists.
The Fed has become too comfortable with the expanded scope of monetary policy that was necessary to tackle the financial crisis, and too fearful that rate hikes will damage economic performance. Real rates naturally fluctuate up and down with business cycles, falling during recessions and rising during expansions. Presently, the negative real Federal funds rate is inconsistent with healthy growth.
Hiking rates consistent with the rise in the natural rate associated with the improving economy would simply maintain monetary accommodation and would not harm economic activity. This is particularly true since the real funds rate would remain negative during the first several hikes, the $2.7 trillion of excess bank reserves and extraordinarily low bond yields. Recent history demonstrates that during prior expansions, when the Fed hiked rates—even during far earlier stages than presently—economic growth continued and subsequently strengthened.
In its Policy Statement following the December 17, 2014 FOMC meeting, the Fed stated that the economy was improving and expressed confidence that labor market indicators were moving toward levels consistent with its dual mandate. It also noted that it expects inflation to rise gradually toward its 2 percent long-run target. Why, then, does the Fed continue to rely so heavily on forward guidance that attempts to keep interest rates artificially low when it is no longer necessary, and involves mounting risks and distortions?
Economic common sense suggests the Fed should proceed enthusiastically toward hiking rates and refocus attention on the benefits of normalizing monetary policy.
Mickey Levy is chief economist of Blenheim Capital Management and a member of the Shadow Open Market Committee.