Broader Growth Across US Economy Provides Solid Backdrop for Further Interest-Rate Hikes
Recent signs of a better balance to the growth seen across the US economy strengthen the foundations of the current expansion, in our view. They also enhance the case for a return to a more neutral monetary policy. With the economy performing solidly, we expect the Fed to continue moving incrementally toward normalizing interest rates. But, judging from recent messaging, Fed policymakers have yet to see compelling evidence of an acceleration in overall activity, viewing growth as set to remain at around trend rates, and are reluctant to factor in any significant impact from the Trump administration’s future policies. The Fed’s statement following its March meeting suggested to us it was unlikely to be hurried into any further interest-rate hikes by a single piece of inflation or employment data crossing a particular threshold and instead would make a wider judgement on the appropriate setting for monetary policy, based on a range of readings across the economy and financial markets.
After market participants appeared largely prepared for a hawkish update from the Fed in March, to accompany a well-flagged 25 basis-point rise in the fed funds target rate, some were surprised by the restrained tone of its statement. Rather than stressing vigilance about future inflationary risks, Fed policymakers re-iterated their view that core inflation was likely to rise only gradually, eventually stabilizing around their 2% target level. The Fed’s longer-term growth estimate for the US economy was left unchanged at 1.8%, underlining caution among policymakers in light of political uncertainty about potential policy shifts under the Trump administration. Benchmark Treasury yields, which had risen ahead of the Fed meeting, quickly turned lower. They later fell to the lower end of their trading band so far this year, after the retraction of President Trump’s health care reform legislation magnified concerns that planned tax reforms might face similar problems.
Despite the Fed’s caution, there were signs growth in the economy might be broadening, with an increased contribution from segments that were previously more subdued. Data from the corporate sector generally remained firm, suggesting the prior optimism might be translating into a sustained improvement. In both January and February, manufacturing output registered a 0.5% monthly rise, the largest since mid-2015 and marking a run of six consecutive monthly increases, amid further expansion in capacity utilization among manufacturers. Spending on construction also sharply rebounded in February from an upwardly revised drop in the previous month.
Sentiment among corporations remained upbeat as well, with impressive levels of new orders continuing in March’s Institute for Supply Management purchasing managers’ index (PMI) for manufacturing. The PMI component for export orders was another notable area of strength, indicating overseas demand had not been impacted so far by the sharp rise in the US dollar in late 2016. Elsewhere, a leading quarterly survey of US chief financial officers showed confidence at its highest level for more than a decade. Another index—based on a poll of chief executive officers’ projections for sales, capital spending and hiring over the next six months—increased by the most since 2009.
In contrast, while surveys of consumer confidence generally remained close to recent highs, these sentiment indicators were somewhat at odds with underlying levels of economic activity. February saw another relatively weak reading for consumer spending, in the wake of January’s soft data, and was followed in March by a drop in auto sales, marking a third consecutive monthly fall. Spending on autos was a key element of growth for the economy in 2016, with sales reaching record levels, but the latest figures again fell short of market expectations, despite rising inventories leading to heavy discounting by manufacturers. Overall, these indicators pointed to the likelihood of a modest slowdown in the contribution to growth from consumers over the first quarter—arguably, a welcome development, given consumers’ outsized impact in the final quarter of 2016. Partly as a result, first-quarter gross domestic product forecasts mostly remained subdued. Moreover, for reasons that have yet to be fully understood, historically the first quarter has often seen uncharacteristically slow US growth, prior to a pick-up in activity later in the year.
The labor market was another area of the economy where there were signs of consolidation at the end of the first quarter, after it had previously outperformed expectations for several months. March’s nonfarm payrolls came in well short of consensus estimates, with an increase of only 98,000 jobs, together with small downward revisions to previous readings. Weather may have played a part in the weaker numbers. Additionally, there was another large decrease in retail positions, underlining the pressure on brick-and-mortar stores, as customers continued to move online. Construction, a significant positive in the February report, saw its contribution dwindle. The rest of the March report showed the unemployment rate unexpectedly falling by 0.2% to 4.5%, the lowest rate since 2007, while wage growth also dipped, by 0.1% to 2.7%, compared with a year earlier.