- The US economy has made a slow start this year. Retail sales growth has been noticeably weak. We think this is temporary and we expect US consumers to lift economic activity in the course of the year. Meanwhile, the rapid pace of the dollar appreciation is having mixed effects. It will be a drag on US exports, but household consumption will eventually be further boosted through lower import prices. Nevertheless, due to the soft data at the start of the year and the more rapid appreciation of the dollar than we had anticipated, we have adjusted our GDP forecast to 3.2% from 3.8% in 2015.
- As employment approaches the Fed’s mandate, it will likely want to see inflation picking up before it tightens monetary policy. After low core inflation in the coming few months, we expect it to start moving to the 2% goal towards the end of this year. This prospect is supportive of our expectation that the Fed will start raising rates in June. A later start cannot be ruled out if soft economic data were to persist or if inflation were to undersshoot our expectations.
Consumption getting ready for liftoff…
GDP growth in the second half of 2014 averaged an annualised pace of 3.6%. In this period, consumer spending was the main driver (average contribution 2.5 ppts), boosted mainly by the continuing improvement in the labour market. Gains in real personal income from lower gasoline prices have already given an impulse. Indeed, real disposable income rose 3% at an annual rate in the second half of last year, roughly double the average recorded in the past five years. As a result, consumer confidence has been surging to pre-crisis levels.
…as conditions for consumers improve
Consumer spending has been weaker than expected in the first quarter, partly as a result of bad weather. This likely explains the higher savings rate in the past few months. As consumers realise that the extraordinary income gain from lower oil prices is more “long lasting”, we expect that households will favour consumption more decisively and that the savings rate will fall a bit. On top of this the economic environment is generally improving for consumers. Capital gains on equity holdings have sharply raised the wealth of many households. For home owners, rising house prices has increased the value of their homes. The strong dollar is reducing the price of imports, which will gradually be passed to lower prices on the shelves. Finally, a strong labour market has already been a positive for consumer spending.
Business investment strong, despite grey clouds
Business capital spending grew strongly in 2014. Investment in equipment grew 5.4% yoy, while investment in structures grew 7.4% yoy. More recently lower energy prices have started weighing on business investment in the energy sector. Indeed, US energy investments are falling quickly, even if it is in the least productive projects. Our estimates suggest that energy sector capital spending cuts will represent a drag of around 0.2 ppts of GDP in 2015.
Residential investment a slow start in 2015
Housing demand picked up with a slower pace than expected in 2014, partly as a result of slightly higher mortgage rates at the end of 2013. Meanwhile, the supply of homes has been declining, which has slowly put upward pressure on house prices. This all led to a lower housing affordability in the first half of 2014, which partly explains the subdued residential investment. Total residential investment rose only 2.5% in 2014 and it remains well below its pre-recession peak. On top of this, severe weather conditions in the North East have supressed construction growth in the first quarter. But affordability has been improving lately. Moreover, we see the housing market as being less vulnerable than in the past to interest rate hikes. Households have been reducing their leverage and have benefitted from lower mortgage rates for a considerable time. We don’t expect credit conditions to tighten in the near future, as we think the Fed rate will increase rates only gradually.
Export growth slows, stronger dollar partly to blame
In the fourth quarter, net trade weakened, subtracting a bit more than 1 ppt from growth. This is partly explained by the impact of a stronger US dollar on export growth. Indeed, the trade weighted value of the US dollar, one of the metrics which compares the exchange rate of a country against that of its major trading partners has appreciated by 18% in the past year. This represents a loss of competitiveness for US exporting firms. According to the S&P Dow Jones indices, about 40% of US firms’ revenues come from abroad. Manufacturing activity, which accounts for a large chunk of US exports, has been feeling some of the pressure already and manufacturing surveys have been softer in the past few months. We expect that some firms will adjust prices at the cost of their own profit margins, reducing in this way some of the impact of a stronger dollar.
Economy remains strong, despite slow start
Although we have been seeing softer data in the first quarter, we think that this is a temporary dip. Firms will gradually adjust to the stronger dollar and lower oil prices, consumers will dig into their purses as weather conditions improve and there could even be some payback in the coming months for the slow start. We have estimated that the gains in consumption resulting from lower oil prices will far exceed the drag on energy related investments in the coming months, amounting to around 0.8ppts of GDP, which were largely priced in our forecasts. Nonetheless, the faster than expected dollar appreciation will be a drag for the economy. The strong dollar has negative implications for the trade balance and for the investments of firms doing business abroad. We have adjusted our GDP forecast to 3.2% from 3.8% in 2015.
Inflation to move to target, stronger dollar a downside risk
One of the major concerns is whether the decline in oil prices and a stronger dollar will affect inflation or even raise the risks of deflation. CPI has been running below the Fed target of 2%, mainly as a result of lower oil prices. And while we expect a gradual pickup in wage inflation, in the near term the impact of a stronger dollar and lower commodity prices are likely to offset upward pressure on prices in the short run. As a result, we expect core inflation to be stable or slightly lower in the coming months. Meanwhile, inflation expectations seem to be less of a concern now. These measures have been picking up lately, influenced mainly by increasing oil prices. FOMC members have “generally anticipated that inflation will rise gradually toward the Committee’s 2 percent objective as the labour market imporved further and the transitory effect of lower energy prices and other factors disspitated”. All in all, we expect core inflation to increase gradually in the second half of the year, reaching the 2% target in 2016. This is in line with the Fed’s objective.
Fed’s view: rate hike getting closer
The discussion of FOMC members is now centred on the appropriate path for monetary policy as labour market slack is diminishing and it is unclear what impact this will have on inflation. Indeed, the dispersion of participants projections for the unemployment rate is now narrower, while that for inflation remains very wide and the mid point forecast was recently adjusted downward. For most FOMC members, lower inflation is seen as transitory and it should gradually return to the Fed’s long-term target. Most support raising rates this year. The few members that think that higher inflation isn’t around the corner are supporting a rate hike in 2016. We maintain our view that the Fed will start gradually hiking rates from the middle this year onwards through most of 2016, but there are downside risks that this could be postponed as a result of lower inflation or soft economic data.
 This US Quarterly covers the content of the US section of our former Global Macro View.