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By HaleStewart October 16, 2016 7:39 am
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US Bond Market Week in Review: The Fed Again Overshoots Their GDP Predicsion

     On Wednesday, the Fed released the minutes from their September meeting.  As usual, their analysis of the current situation began with a discussion of the labor market, which they viewed positively.  The unemployment rate and the 4-week moving average of unemployment claims are low, the labor force participation rate and employment to population ratio are slightly higher, and wages are rising.  Although some areas of weakness remain (such as the still-high level of people unemployed part-time), the Fed clearly thinks the economy has achieved full employment.

     Consumer spending is strong.  PCEs continue to impress.  However, real retail sales are weakening.

     In contrast, business activity is weak.  Industrial production recently increased, overall manufacturing output is moving sideways and exports are low.  There are several reasons for this: the strong dollar, the still weak oil market, and recession in Canada and Mexico.  Investment, which has been weak in the last 2 GDP reports, looks to be slightly higher in the 3rd quarter.  New orders for non-defense capital goods recently rose as did orders from the oil patch. 

     Financing conditions are accommodative.  Low interest rates mean that corporate bond issuance is strong at the expense of commercial and industrial loans; low mortgage rates led to the strongest residential refinancing activity in 3 years.  Consumer credit card balances are also expanding.

     The report offered the following projection of economic activity:

In the U.S. economic projection prepared by the staff for the September FOMC meeting, the forecast for real GDP growth in 2016 through 2019 was little changed from the one presented in July. The pace of real GDP growth was forecast to be faster over the second half of this year than in the first half, primarily reflecting a modest increase in the rate of growth of private domestic final purchases and a sizable turnaround in inventory investment. The staff continued to project that real GDP would expand at a modestly faster pace than potential output in 2016 through 2019, supported primarily by increases in consumer spending and, to a lesser degree, by somewhat faster growth in business investment beginning next year.

These projections aren’t consistent with the underlying data.  While the NY and Atlanta Fed are projecting 3Q GDP slightly over 2% (2.2% and 1.9%, respectively), the NY Fed is forecasting 4Q growth of 1.2%.  The NY Fed’s projected growth rate is consistent with current data.  The Conference Boards’ LEIs are weak: the 6-month moving average is approaching 0.  The long leading indicators are at best fair.  The financial components (Baa yields and M2 Y/Y change) are OK.  But the activity components are weak: corporate profits have declined in 4 of the last 5 quarters and building permits have moved sideways for about a year.  However, it shouldn’t be surprising that the Fed is predicting a higher growth rate than the numbers warrant; they’re model has done this for most of this recovery.

     The committee was split regarding the timing of rate hikes:

Against the backdrop of their economic projections, participants discussed whether available information warranted taking another step to reduce policy accommodation at this meeting. Participants generally agreed that the case for increasing the target range for the federal funds rate had strengthened in recent months. Many of them, however, expressed the view that recent evidence suggested that some slack remained in the labor market. With inflation continuing to run below the Committee's 2 percent objective and few signs of increased pressure on wages and prices, most of these participants thought it would be appropriate to await further evidence of continued progress toward the Committee's statutory objectives. In contrast, some other participants believed that the economy was at or near full employment and inflation was moving toward 2 percent. They maintained that a further delay in raising the target range would unduly increase the risk of the unemployment rate falling markedly below its longer-run normal level, necessitating a more rapid removal of monetary policy accommodation that could shorten the economic expansion. In addition, several participants expressed concern that continuing to delay an increase in the target range implied a further divergence from policy benchmarks based on the Committee's past behavior or risked eroding its credibility, especially given that recent economic data had largely corroborated the Committee's economic outlook.

Those that wanted to wait to raise rates specifically note that total inflation has yet to hit 2%.  While they did specify that “recent evidence” supported waiting, they didn’t mention specific economic data.  Those that wanted to raise rates are concerned about waiting too long and having the play policy catch-up.

     Given the tenor of the italicized paragraph above, a rate hike seems likely should incoming information point to a stronger economy.




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