US Views: Looking to 2014 (Hatzius)

US Views: Looking to 2014 (Hatzius)

Published December 10, 2013

1. The economic news remains broadly encouraging. Although we would discount the 3.6% increase in Q3 GDP—which was inflated by a large inventory contribution that is likely to reverse in Q4—other indicators also suggest that growth has accelerated since earlier in the year. Nonfarm payrolls grew a solid 203,000 in November, business surveys are at levels consistent with above-trend growth, and the consumer picture is improving, judging from the latest auto sales and consumer sentiment figures. Taking October and November together to adjust for the government shutdown distortions, our current activity indicator (CAI) has averaged 3% in the past two months, up from around 2% in the first half of 2013. Likewise, our US-MAP surprise index has moved back into positive territory, indicating that the economic activity data are mostly beating consensus forecasts.

2. We continue to expect a sustained pickup to an above-trend growth rate in 2014. Our financial balances model suggests that the positive impulse from the private sector to growth—via continued gains in the housing sector, a pickup in consumption growth, and a rebound in business investment—should remain at around 1½ percentage points. But the negative contribution from the public sector is likely to diminish sharply from 1½-2 percentage points in 2013 to just ½ point in 2014. This suggests that the economy might grow about 1 percentage point above its underlying trend, which we would put at 2%-2½% at present.

3. The risks around our forecast look evenly balanced. On the negative side, the signals on capital spending are still quite mixed, generally firmer in the business surveys but still fairly weak in the durable goods data and the bottom-up anecdotal evidence. Another risk on the negative side is that the lagged effects of the mortgage rate increase over the summer could delay the normalization of housing starts back to the 1½ million range that we have built into our forecast over the next 2-3 years. This risk would increase if we see another Fed tightening scare as the recovery gathers pace and QE tapering gets underway over the next few months. On the positive side, the risks to energy prices are now tilted to the downside, which implies a potential boost to real income growth; the latest stories from DC suggest that a fiscal agreement might include a bit more spending than we had assumed; and better economic news has the potential to feed on itself via greater confidence and higher asset prices.

4. We have incorporated Friday's bigger-than-expected drop into our unemployment rate path and now see the rate hitting 6.5% in mid-2014 and 6% in mid-2015. All of this reflects a lower path for the labor force participation rate. In our new forecast, participation drops slightly further in the next few months to reflect expiration of the Emergency Unemployment Compensation (EUC) at yearend. The White House and Congressional Democrats have stepped up their support for the program in the past week, but our baseline expectation remains that it will not be included in the small fiscal agreement that is currently being hammered out in Congress. On a 2-3 year horizon, our working assumption is that the overall participation rate will be flat at 63%, before resuming its demographically driven decline.

5. We believe that this path is consistent with the results from a new Philadelphia Fed working paper that uses household survey microdata to estimate the sources of the decline in labor force participation since the start of the recession in 2007Q4. The author breaks down the 2.7pp decline in the participation rate since 2007Q4 into retirement (1.1pp), disability (0.6pp), discouragement (0.6pp), and other reasons (0.4pp). Over the past year, retirement accounts for the entire 0.4pp decline, with no significant changes in any of the other categories. The outlook for the overall participation rate depends on how these components evolve. If nonparticipation because of retirement and disability stays on the trend of the last year, the post-crisis increase in nonparticipation because of discouragement or other reasons would need to reverse over a 2-3 year period for the overall participation rate to stay flat over this horizon. Although the uncertainty is considerable, we believe that this is a reasonable set of assumptions.

6. Despite the lower unemployment rate path, we have not made any changes to our forecast for the federal funds rate. One important reason is that it is hard to find signs of labor market tightening in the wage numbers. The three primary indicators—average hourly earnings, the employment cost index, and compensation per hour—all point to nominal labor cost growth of about 2%. Assuming that productivity grows at the 1½% average pace of the expansion so far, this implies unit labor cost inflation of just ½%. This suggests that even at a core inflation rate of just 1.1%, the labor market is still exerting downward pressure on inflation. There are other factors—including the fact that inflation expectations still look well anchored—that argue for a slight upward trend in the core PCE trend over the next year, but the labor cost situation nevertheless increases our confidence that a below-consensus inflation forecast is the right place to be even with an above-consensus growth forecast.

7. The combination of lower headline unemployment with lower wage and price inflation strengthens the case for a reduction in the 6.5% threshold for the first hike in the funds rate. Admittedly, the October 29-30 FOMC minutes showed less support for a reduction in the threshold than we had expected, with only “a couple” (i.e. two) participants advocating such a change. But we still believe that Fed officials will eventually decide that conditions have changed sufficiently since late 2012 to lower the threshold. We do not share the concern—reflected in the October minutes—that such a move would reduce the credibility of the threshold. After all, 6.5% is not a symmetric target for the unemployment rate but instead represents a minimum amount of labor market progress that the committee would need to see to increase the funds rate. If the committee decides, after extensive discussion and a substantial amount of staff research, that it can make this minimum condition somewhat more ambitious, we do not see how this would undermine the credibility of the threshold. On the contrary, it would seem like a good example of cautious and deliberate central banking.

8. We would be surprised by a QE tapering move at the December 17-18 FOMC meeting. Although employment growth has improved, core PCE inflation has fallen further and now stands 90bp below the Fed’s target. Probably partly for this reason, only a minority of forecasters seem to expect tapering in December, which itself raises the hurdle for a move. Sure, Fed officials always have the option of defying market expectations, but we believe they will not want to surprise the markets on the hawkish side with the first tapering move when inflation is as low as it is. We also suspect that the committee has not yet decided on the changes to the forward funds rate guidance that are meant to accompany the tapering announcement—whether it is a lower unemployment threshold, an inflation lower bound, a cut in the interest rate on excess reserves, greater reliance on the “dots,” and/or a more qualitative change. Our central forecast for the first tapering move remains March, although January is possible.

Jan Hatzius - Goldman, Sachs & Co.