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US slowdown is now a headache for the Fed

Before Friday’s relief rally, the recent severe market turbulence had three distinct phases. It started with concerns about Chinese exchange rate policy. Then came a renewed collapse in oil prices. Finally, last week, came increased fears of a persistent slow-down in the US economy, following weak activity data from the US industrial sector.

The last of these factors is perhaps the most serious for the markets, since it represents the first genuine reason to worry that an important part of the global economy might actually be weakening. Until now, the bear phase in equity markets has not been backed by much evidence of a slow-down in global activity, though our “nowcasts” have been warning for some time that US growth has been out of line with the global aggregate, and is heading in the wrong direction.

The markets have tended to agree with the Federal Reserve in viewing this as a temporary dip, driven largely by specific drags on the US manufacturing sector. But now investors are starting to worry that the slow-down could become much more persistent than previously believed. The drags from oil output, foreign demand and the rising dollar are proving to be more negative for the economy than forecasters, including the Fed, have recognised.

What is the evidence that the US economy is slowing? It is still very mixed, with the robust labour market data providing strong evidence in the other direction. But the Atlanta Fed“nowcast”, which takes full account of the firm growth in employment, has nevertheless been tumbling, and it now reports that the GDP growth rate in 2016 Q4 was only 0.7 per cent. This is broadly in line with the latest Fulcrum “nowcast” for January (graph at right), which shows the underlying growth rate in the economy running at about 1.0-1.3 per cent, down from 2.5 per cent in mid 2015.

The key question is whether the slowdown in growth since mid 2015 is mainly due to temporary factors, in which case the Fed’s continued optimism about the economy will prove justified. One reason for suspecting that there could be a rebound is that inventories have subtracted 0.9 percentage points from GDP growth in Q4, according to the Atlanta nowcast. This follows an inventory drag of 0.7 percentage points in Q3.

Economists tend to regard mid cycle corrections in inventories as temporary factors that self-correct when inventory holdings reach their desired levels. But this latest episode has been fairly prolonged, raising concerns that the decline in inventories may be signalling a more persistent drop in final demand growth. Real consumers’ expenditure is likely to have risen by only 1.8 per cent in Q4, down from an average of 3.2 per cent in the previous four quarters.

The Fulcrum nowcast models are, in principle, designed to filter out temporary factors, with the intention of identifying the underlying growth rate at any point in time. The drop in growth identified by these nowcast models is therefore becoming worrying. It needs to reverse very soon if the Fed’s view, and the consensus view, of the economy is to remain valid.

It is true that much of the weakness in the nowcast is identified by economic variables that relate to the industrial sector. But these variables have, in the past, been very closely correlated with activity in the economy as a whole, and are therefore usually among the best indicators of overall activity. It is dangerous to ignore weakness in these industrial variables that persists for a long period, which is what is happening now.

With or without the industrial variables, the nowcast forecast is much weaker than consensus GDP forecasts for 2016 (below left graph):

The model is also able to generate recession probabilities over the next 12 months. The full model, including the industrial sector data, estimates that the recession probability has been hovering around 15-20 per cent (above right graph), no longer an entirely negligible risk. If the weak industrial data are excluded, on the grounds that they are “transitory” – a word often used by Fed officials – then the recession probability drops to about 10 per cent. But how do we know that these industrial drags are, in fact, transitory?

One drag that is unlikely to be transitory is the effect of the rising real dollar exchange rate. Since mid 2014, the dollar index has risen by 20 per cent, as expected monetary policy in the US has diverged from that in the rest of the world. As a result of this monetary shock, and the slowdown in emerging market economic activity, real export growth in the year ended 2015 Q4 has dropped to zero. This compares with an average growth rate of 4.8 per cent per annum in the previous five years.

Net trade (exports less imports) has subtracted an average of 0.6 percentage points from GDP growth during 2015. Although this drag was expected to start improving around the middle of 2016, the recent rise in the dollar might extend the “transitory” period into 2017, making it harder for the Fed to ignore.

So how will the FOMC react to recent turbulence when it meets this week? It is too early for them to admit the December rate rise was a mistake. They are not likely to show any concern about the plummeting equity market in the official statement, since they will not wish to give any credence to the notion that the stock market is supported by a “Yellen put”. Nor are they likely to say anything about the slowing economy. They will probably stick to their “moderate expansion” language until the labour market slows.

That leaves two options:

• One possibility is to say that they are “monitoring developments abroad”, which was the code they used in September when they postponed the expected rate rise then. That seems quite likely.
• A stronger form of words would be to follow Mario Draghi’s approach lastThursday by mentioning that downside risks to inflation or inflation expectations have increased recently. That is patently the case. But there is already plenty of language about “carefully monitoring inflation” in theDecember FOMC statement, so it may only be slightly tweaked this month.

The FOMC probably views the January meeting as a holding operation, in which they will try to buy some time for their fundamental view on the economy to be proven right.

But the markets have already moved on. Based on recent data, they no longer expect another US rate increase until September at the earliest. For now, the US economy does not support further monetary tightening.