The US economy continues to grow steadily but modestly, despite the fiscal retrenchment that began after the first debt ...
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Mikio Kumada, Global Strategist at LGT Capital Management
ceiling clash in 2011. At the same time, actual inflation has fallen well below the Federal Reserve’s target over the past two years, and inflation expectations have been sliding this year. Against this background, it would seem more reasonable to expect the Fed to reinforce quantitative easing in coming months, rather than start withdrawing it.
US economy holding up but inflation remains below long-term target
About a month after the end of the US government shutdown, economic data suggests that the US private sector is strong enough to withstand the headwinds from the ongoing fiscal retrenchment – which began shortly after the first major partisan impasse over the US debt ceiling in August 2011 and will probably continue regardless of future political developments. Also, we have had further confirmation that inflation trends remain far more moderate than expected – critically, they point at future levels that are well below the US Federal Reserve’s long-term target of 2%. This is potentially important for markets, because it means that the Fed won’t be in a hurry to start tapering its quantitative easing program.
Modest but steady private sector job creation in the past three years
With regards to growth, the US economy in October added 212,000 private sector jobs, while public sector employment dropped once again. Last month’s gain surpassed the 36-month average of 190,000 jobs and is part of a comparatively modest but robust trend in private job creation since late 2011 (charts, p. 2 in the PDF). Meanwhile, the Institute of Supply Management’s purchasing managing indices have also risen by more than expected and remain clearly above the growth threshold (charts, p.2 in the PDF), suggesting the economy will brighten up in coming months. However, it is important to remember that, as overall growth is modest, these developments hardly provide enough momentum to reduce the unemployment rate to the Fed’s 6.5% threshold within by the middle of next year, from 7.3% at present.
But inflation has been steadily slowing since late summer 2011
This brings us to the next important point – inflation. The Fed’s preferred gauge, the core personal consumption expenditure price index, remains significantly below 2% in annual terms, at 1.2%. It has been declining steadily since March 2012. The annual gain in the regular consumer price index, currently also at 1.2%, has also been falling since September 2011. Moreover, the inflation-linked bond market shows that inflation expectations have been sliding this year (e.g. from 3% to 2.6% for five years out, see charts, p.2 in the PDF).
Fed does not seem on track to hit inflation target
The Fed, meanwhile, has communicated it expects short-term interest rates to remain near-zero as long as unemployment above 6.5%, inflation between in one to two years is projected to be no more than 2.5%, and longer-term inflation expectations remain “well anchored”. But as it happens, inflation expectations are falling, and inflation has been consistently retreating in recent years, even as the unemployment rate fell – which isn’t too surprising if we recall that part of the drop in the unemployment rate is due to many workers exiting the labor market in an economy that is growing only modestly. In addition, the commodity boom ended in 2011, further reducing price pressures (see market performance table, p.3 in the PDF). In any case, the Fed is now well below target both in terms of inflation and employment – if current trends persist, it could even be seen as failing to fulfill its mandate.
Fed taper doubtful unless inflation expectations start surging soon
Tapering, of course, would not per se constitute monetary tightening, but it would be seen as the first step toward future hikes in the short-term Fed fund rate. As such, it would effectively signal monetary tightening, and our point is that the current combination of steady but modest economic growth and persistent disinflation doesn’t make a strong case for any form of monetary withdrawal – be it real or perceived. If anything, in the current situation, it would be more appropriate to expect the Fed’s to reinforce its QE program in some form. Until a few days ago, the market consensus was reportedly expecting a taper in March. That, however, seems unlikely to happen, unless non-farm payrolls start to significantly exceed 200,000 jobs per month and inflation expectations begin to soar – in which case a taper would be totally justified and welcome in terms of its medium-term impact on the markets. In other words, as we have indicated before, tapering could be a win-win situation, because it represents an event that will only happen on credible evidence of a strong, reflating economy.
Source: ETFWorld – LGT Capital Management
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