US: And off she goes

by: Peter de Bruin

140205-US.pdf ()

The economy has started to grow above its potential growth rate during the past half year and should continue to do so during our forecasting horizon. This reflects that the fiscal drag has waned considerably, which should allow the private sector recovery to keep on gaining momentum. Indeed, a strengthening labour market recovery and improved households´ balanced sheets should underpin consumer spending, while historically high profit margins are likely to prompt companies to invest more. Finally, the supply-demand balance of the housing market remains very favourable and residential investment should soon start to make sound contributions to growth again. Against this background, the Fed should continue to gradually unwind its QE-programme, though policy will remain accommodative, with rates not set to rise before the middle of 2015.

Above trend growth for the second quarter in a row

After the economy grew by 4.1% qoq saar in 2013Q3, it posted another solid gain in the fourth quarter of last year. Indeed, consumer spending growth accelerated to 3.3% from 2.0%, the strongest reading since 2010Q4, as households shrugged off the rise in taxes that we saw in the beginning of 2013. Moreover, there was a sharp pickup in investment in durable equipment, which jumped by 6.9%, up from 0.2% in 2013Q3. Despite these impressive gains, final domestic demand rose by just 1.4% in Q4, down from 2.3% in Q3. This reflected that net exports contributed 1.3 pp to growth, while inventories added 0.4 pp to growth. Both of these categories can be volatile, though. Moreover, there was a 4.9% drop in federal government outlays. This partly reflected the government shutdown, which shaved 0.3 pp off growth. Finally, both residential and investment in structures declined, suggesting that construction activity slowed in the final quarter of last year. All in all, the economy grew by 3.2%, which marked the second consecutive quarter of above trend growth (which we estimate around 2.5%).

Falling fiscal drag…

We expect that this marks the beginning of a trend and that we will continue to see quarterly growth rates of around 3.5% – 4.0% during 2014. The main reason why we think that we are heading for a sustained period of above trend growth is that the fiscal drag will be substantially lower in 2014 than in 2013. As already briefly mentioned before, last year consumers had to deal with a $180bn rise in the payroll tax and income tax rate. Together with a $74bn reduction in real federal spending related to the automatic spending cuts, this brought the total pace of fiscal consolidation at the federal level to an impressive 1.8% of GDP. In 2014, fiscal headwinds will be considerably less powerful. The recent budget deal that will fund the federal government until the end of September greatly reduces the impact of the automatic spending cuts. Indeed, discretionary spending, the part of federal outlays that drive government consumption and investment in the national accounts, is set to fall by just $12bn in 2014, less than 0.1% of GDP. Granted, most likely Congress will not extend measures that prompted companies to invest more by allowing them to let their machinery and equipment depreciate at an accelerated pace (worth around $50bn or 0.3% of GDP). But as these incentives only had the effect of shifting the total tax burden to the future, we suspect that their effect on investment has been small, if not negligible. That leaves in place around $20bn (worth 0.1% of GDP) of emergency unemployment benefits that expired in the beginning of 2014 as the biggest source of fiscal consolidation. While this will dampen consumption growth a bit in Q1, the effects should be small.

…and rising state and local government outlays…

But rising state and local government outlays should also help to underpin the recovery. State and local government outlays started to increase again from 2013Q2 onwards, and judging from the gains in state and local government revenues, this trend has further to go. We estimate that state and local government outlays will provide a fiscal lift of around $30bn this year, up from around $6bn last year. All this suggests that the total pace of fiscal consolidation – that is the actions from federal, state and local governments together – will drop to around 0.3% of GDP, sharply down from 1.7% last year


…should help consumers to loosen their purse strings…

This should allow the private sector recovery to significantly gain pace in 2014, with consumption doing particularly well. Apart from December, when adverse winter weather temporarily hindered the labour market recovery, average gains in nonfarm payrolls have been comfortably exceeding 200K over the past months, suggesting that the labour market recovery is gradually gaining momentum. This should help the unemployment rate to continue to trend downwards. In turn, this should start to exert modest upward pressure on wages, which so far have only been growing moderately at around 2% yoy. What is more, in the past year, a booming stock and housing market boosted the asset side of households’ balance sheets. As a result, we estimate that in 2013, net worth (households’ assets minus liabilities) grew by around $8 trillion (almost 50% of GDP). This will reduce the necessity of households to save, leading to a further decline in the savings rate, and allowing a greater share of income to be consumed.

…while the outlook for investment brightens…

Meanwhile, we are also positive about the outlook for corporate investment. Indeed, the share of profits in GDP rose to 12.6% in 2013Q3, which marks the highest level since 1950Q4. Against a background of historically high profit margins and a sustained acceleration in growth, companies are likely to want to seize more investment opportunities.

…and the housing recovery has further to go

Finally, we think that residential investment will remain an important source of growth. Admittedly, the recent rise in mortgage rates has taken some of the wind out of the sails of the housing market recovery, but housing starts stood at just 999 thousand units in December of last year, still well-below the long-term average of 1.3 – 1.5 million units that starts need to rise to in order to catch up with population growth. As such, the supply-demand situation for housing starts remains very favourable and we should continue to see rapid gains in residential investment during our forecasting horizon.

Inflation set to creep up, but only modestly

Encouragingly, inflationary pressures are likely to remain modest. Although inflation should gradually creep up over the coming two years, it should remain at relatively low levels. The main upside force should come from stronger services inflation, reflecting that a gradually tightening labour market slowly starts to exert upward pressure on wages. This should be partly offset by lower shelter inflation though, as increased building activity will bolster the supply of rental apartments, reducing gains in rents. In addition, commodity prices should remain subdued.

The Fed’s tapering blow…

The Fed decided to gradually start to unwind its QE programmes during its December meeting, reducing its monthly purchases by $10bn. This reflects that the Fed has more confidence in the strength of the economic recovery. As expected, during the January meeting, the Fed trimmed down its QE programmes by another $10bn to $65bn (made up of $30bn mortgage backed securities and $35bn of Treasuries). Given our scenario for the labour market and inflation, we expect the Fed to continue to reduce its asset purchases by $10bn at subsequent meetings, and to completely wind down its programmes with a final $15bn cutback at its October meeting. This still leaves in place a considerate amount of stimulus though. Indeed, under the scheme, the Fed is on track to purchase $450bn of longer-term assets this year, only $150bn short of the $600bn assets bought under QE-2.

…was softened by a strengthening of its forward guidance

Moreover, the FOMC has softened the tapering blow by strengthening its forward guidance. Although it kept the unemployment rate threshold at 6.5%, it reduced its importance by anticipating that the federal funds rate will remain on hold ‘well past´ the time that the unemployment rate declines below 6.5%. This reflects its assessment of other labour market variables apart from the unemployment rate, as well as indicators of inflation that seem to suggest that the Fed thinks it is necessary to wait even longer before raising rates.

US Treasury yield set to rise, eventually

US Treasuries have seen a strong start of the year, reflecting ongoing safe haven demand because of worries surrounding emerging markets. We think that emerging markets will avoid a crisis, while the global economy should strengthen in coming months. These factors should lead to a moderate rise in yields on the 3m horizon. Yields should continue to rise later in 2014 and 2015. This reflects our above-consensus call on US growth for this year, and our related view that the unemployment rate will fall to 6% in the fourth quarter, which is faster than the Fed projects. This should prompt the Fed to start raising rates in the middle of next year. This is earlier than what financial markets are currently expecting. We therefore think that rate hike expectations for 2015 – particularly in the second half of the year – will rise, which should push up yields.

This publication is part of the Quarterly publication “Global Market View 2014Q1”

Deze publicatie is onderdeel van de kwartaal publicatie “Macro Visie 1e kwartaal 2014”