US economy improving: but how much?

Published: May 2014

In all likelihood, Q1 growth in the US has been below rather than above 1.5%. However, this weakness occurred in the months of January and February, precisely when there was a cold snap hindering economic activity. To some degree, destocking may also have played a part. The March US payroll report, however, was encouraging. Around 190,000 jobs were created while the number of working hours rose substantially. This amounts to approximately one million extra jobs. Of course, job creation had declined sharply in previous months but this development is evidence that the economy is resilient and shows growth accelerated markedly in March.

On top of this, several indicators point to significantly higher job creation in April than in March. We think this shows that little has changed, relative to the second half of last year. During that period, growth was slightly below 3.5%, notwithstanding the government shutdown and the bad weather in December (without these factors, it might have been higher than 4%). At the time, analysts took a sceptical view because incomes were not rising much and consumers were deleveraging.

For the coming year, most economists assume that growth will be close to 3%. Conversely, we believe there is a fairly high chance it will be (substantially) higher, since:

  • The easing off of fiscal drag will add around 1.5% to growth in the course of 2014.
  • Monetary stimulus tends to have an effect on growth after an extensive delay. We think that will be the case this time too. After all, the process unfolds in different stages. Firstly, asset prices need to go up. Secondly, balance sheets need to improve until consumers and businesses feel sufficiently secure to borrow and spend more. Based on various confidence gauges, by now this has finally started to happen. Not to mention that many consumer balance sheets have strengthened so much that deleveraging may be coming to an end.
  • Various signals point to rising wage increases. In combination with higher employment, this is boosting purchasing power.
  • The expanding oil and gas exploitation is boosting US economic growth and US competitiveness has improved markedly.
  • Surveys in the business sector indicate that many companies may be about to invest. In the recent past, businesses have often been hesitant, largely because of the turbulent political situation in the US and the uncertain economic prospects. In some ways, these factors have changed for the better.

Spotlight on policy

The next question is what does this mean for Fed policy? The central bank is not against higher growth as long as inflation risks are contained. If we consider the low rate of inflation of the past period, at first glance this threat seems minimal. Some Fed members are even worried about deflation. However, in our view, the risk of inflation should be taken more seriously.

In recent years, the Fed has created massive amounts of money. Normally, hyperinflation would have loomed a long time ago but not this time. The reason is that the money multiplier and money velocity were much lower because credit was tight, as result of the financial crisis. Presently (underlying) economic growth has exceeded 3% for a number of quarters whereas incomes are only increasing marginally. This has to mean that borrowing is picking up. In that case, the money multiplier and the rate of money circulation are on their way up.

Chart 1: US economy becomes less dependant on oil imports as domestic gas and oil production become more important substitutes
Chart 1: US economy becomes less dependant on oil imports as domestic gas and oil production become more important substitutes

Source: Thomson Reuters Datastream/ECR

Furthermore, US banks, businesses, and consumers have seen considerable improvements to their balance sheets. In addition, nominal economic growth is around 5% while the short-term interest rate is zero. The implication is that, for the moment, borrowing is attractive and very profitable indeed. All the more so as credit spreads are very narrow.

How quickly inflation will become a threat (as credit continues to ease) depends on the degree of spare capacity in the economy. As it increases, inflation risks ease. This reserve capacity is connected to the capacity utilisation in the business sector and the tightness of the labour market. If economic growth is just below 3% – and many economists are assuming this will be the case in the near future – capacity will remain underutilised. Especially as it is hoped that higher investment will increase productivity. On the other hand, the outlook will change dramatically if growth is well above 3%. Next, business capacity utilisation will rise rapidly as the labour market continues to tighten.

Rate expectations

With this in mind, the Fed’s forecasts are fascinating (but let’s not forget that the central bank’s projections have often been off the mark). For 2014, the central bank anticipates growth of around 3% which is supposed to accelerate to 3.4% in 2015. On top of this, the Fed does not expect any labour market tightness for the foreseeable future and it maintains that the neutral interest rate is around 4%. (That is to say, a level where interest rates will neither boost nor hamper the economy). The Fed expects to implement a quarter-point rate hike every three months, starting from mid-2015. If so, its key interest rate will be neutral in 2019. Until then, the central bank thinks it can hold its benchmark rate at a level where it will continue to boost economic growth, albeit to a decreasing extent.

Chart 2: Central banks worldwide created far more liquidity than the economy could absorb
Chart 2: Central banks worldwide created far more liquidity than the economy could absorb

Source: Thomson Reuters Datastream/ECR

Naturally, the Fed has to contain interest rate expectations. As long as it thinks that inflation is not a threat, the central bank has every reason to keep interest rates as low as possible as this will ensure maximum economic growth. Everyone benefits if spare capacity disappears as soon as possible (first of all from the labour market).

Many economists think that inflation will be minimal for some time. As a result, analysts assume that bond yields will only rise by a few percentage points as economic growth picks up. If long-term interest rates rose by more, they would soon act as a drag on the economy. This is also reflected in the interest rate forecasts of the Fed and Bank of England members.

In some ways, this situation is reminiscent of the early 1980s. However, at that time, after decades of rising inflation, virtually no one believed the rate would drop sharply. It was considered a success if inflation did not rise further. In our view, the opposite applies now. We expect more, not fewer, rate hikes in the future. And not just because we believe growth will exceed 3%. In addition:

  • The US job market appears to be fairly tight already. There is a substantial mismatch between the education and skills that businesses need and the actual competencies of many jobseekers. An ageing population aggravates this problem. Admittedly, so far wage increases do not point to a tightening job market as they are comparatively low. We expect major changes in the coming months, as it becomes clear that growth will be considerably higher than 3%. In the course of the year the labour market could tighten rapidly and wages will rise faster; especially for highly educated employees.
  • As the nominal US growth rate is now rising to 5%, an unchanged Fed funds rate of near 0% will provide extra monetary stimulus for the economy in the year ahead.
  • The Fed hopes that more investment will increase productivity. This would contain unit labour costs and thereby inflation. If experience is a guide, such developments cannot be predicted with any accuracy. The real outcome could be very different.

In our view, the yield on ten-year US Treasury Bonds could climb to 3.5%-4% by the end of the year as economic growth and inflation risks will rise more than most economists currently expect. In its wake, the yield on ten-year German government bonds may rise to 2%-2.25%.

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