Concerned Optimism

In her congressional testimony, Fed Chair Janet Yellen chose her words carefully. She indicated that if the economic outlook evolves as anticipated (growth picks up, the labor market tightens, and inflation moves toward the Fed’s 2% goal), then the Fed’s asset purchase program (QE3) will likely end in the fourth quarter. However, she refused to be pinned down on when the Fed would begin raising short-term interest rates. Global concerns and the housing sector “will bear close observation.”

Yellen testified that adverse developments abroad are “one prominent risk” to the economic outlook. Heightened geopolitical tensions or increased financial stresses in emerging economies could undermine confidence in the global economic recovery. U.S. trade collapsed in the recession, but soon began to rebound. While monthly trade figures tend to be choppy, the recent trends in imports and exports do not appear to be especially strong. Normally, as the economy improves, imports rise (as does consumption of domestically produced goods). While exchange rates are a factor over the longer term, exports are driven largely by strength abroad. While there has been some sputtering recently, emerging market economies are expected to exhibit strong growth over the next 10 or 20 years. A more prolonged period of financial stresses could dampen that outlook. U.S. export growth could slow or even decline.

Yellen also noted that a more protracted flattening in the housing recovery is another risk. Adverse weather had a negative impact on the housing sector in 1Q14, but details suggest that there is more at work than bad weather. Builders continue to cite supply constraints and reduced affordability. While the high end of the housing market appears to be doing well in most areas of the country, weak average wage growth, continued tight bank credit, and higher student loan burdens are significant restraints for first-time homebuyers.

It’s important to stress that adverse global developments and prolonged softness in housing are risks to outlook. They need not necessarily come to pass. Yellen’s point is that they clearly bear watching in the months ahead. Unfortunately, we may not get much clarity on these issues right away.

The situation in Ukraine is tenuous and developments may intensify in the days and weeks ahead. China faces significant long-term challenges in transitioning to a more balanced economy, but in the short term, its leaders have chosen to weaken the currency to boost exports and revive its manufacturing sector. That may buy some time, but global investors could become antsy if conditions don’t turn around. The World Cup competition gets underway in Brazil on June 12 (ending on July 13), which may put a focus on that country’s political and economic difficulties.

In most of the economic data reports for this spring, strength is likely to be exaggerated due to a rebound from poor weather. However, the housing market’s difficulties could linger for some time. Continued slack in the job market is limiting labor compensation gains, which doesn’t help to improve affordability. In addition, builder costs are a lot higher. Hence, the low end of the housing market is likely to remain relatively soft and we should see fewer households moving up.

As Yellen noted, the outlook for inflation will play a key role in the outlook for monetary policy. In its policy statements, the Federal Open Market Committee has consistently warned that “inflation persistently below 2% could pose risks to economic performance” and Yellen repeated that sentiment last week. Fed officials generally expect that inflation in the PCE Price Index will trend back toward to the 2% target. If it doesn’t, the pace of tapering in QE3 could be slowed and the likely date of the first hike in short-term interest rates would be pushed out. The inflation data will be one more thing to watch.

(c) Raymond James

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