We believe the Fed may resume its tightening trend in order to fight greater upside inflation risk going forward
In hindsight, the pessimists must be perplexed. Despite the market's focus on downside risk through most of this year, the U.S. economy posted 3.3% growth in 2006—if we see the 2% gain that most expect in Q4. While the housing sector retreated from 2005's froth—and U.S. automakers stalled—the rest of the economy remained remarkably resilient.
Looking ahead, the economy is poised for 2.5% to 3% growth in 2007. With strength continuing, we at Action Economics think markets will increasingly zero in on the Federal Reserve's late-cycle inflation fighting strategy.
The persistent growth in the U.S. economy through 2006 can be attributed to the aggressive buying habits of the U.S. consumer, and rapid growth in profit-financed business investment in both plant and equipment.
Happy New Year
For the consumer, substantial gains in real (adjusted for inflation) spending are likely in the fourth quarter and 2007 first quarter. This is due to sharp price declines at the start of the fourth quarter, and a robust path for real consumption through the most recent November retail sales report that all but assures a winning fourth quarter and probably a solid first quarter as well, as consumers redeem holiday gift cards.
High levels of consumer confidence by most measures, and solid holiday sales, are consistent with the recent evidence that consumer spending is entering the new year on a robust note. We expect this strength in spending to dovetail through the remainder of the new year.
Meanwhile, the savings rate, which has been trending steadily downward since 1992—as real spending consumes an increasing proportion of real income—has done an about-face recently, turning higher thanks to the recent drop in commodity prices overall, and gasoline in particular. But this is already poised to reverse itself in November, and should continue to "correct" to its trend through December and January, as sales catch up with income, and as gasoline prices are now bouncing.
Housing Correction Over
The housing sector correction in 2006 has taken a big chunk out of total fixed investment through the year, as seen in the slowdown over the last two quarters, and the big downside pop we now assume for the fourth quarter.
But we believe the bulk of the direct impact of the housing correction on gross domestic product via residential investment will be behind us as the fourth quarter closes, even though a related factory inventory correction should persist into the first quarter, and an inventory overhang in the real estate markets should weigh on home prices through midyear. Persistent strength in business spending should allow the aggregate fixed investment growth figures to bounce back above GDP growth as 2007 unfolds.
If the more pessimistic outlooks for U.S. aggregate demand growth in the markets prove correct, it will be hard for these effects to "drop down" to U.S. GDP growth, as the pattern will be fought by trade deficit improvement—especially since a weak U.S. economy would likely be accompanied by dollar weakness as well, given the large net trade deficit that the U.S. runs.
Not Just Demand
When we break down the U.S. trade deficit into its "real" goods exports and imports components, which are the most cyclical, we find particularly encouraging trends. Import growth has been persistent through the four high-growth years of this expansion ending in 2006, but is likely to experience moderating growth into 2007 as U.S. inventory accumulation and demand growth subsides. But, exports are exhibiting a robust 9% to 10% growth trajectory that is unlikely to abate in 2007, as world economic growth remains strong, and the dollar continues its long-term correction.
In short, trade deficit improvement will be driven both by accelerating exports and moderating imports, and is not entirely dependent on diminishing U.S. demand for foreign goods.
A big problem for the Fed is the degree to which six years of robust headline inflation and gradually upward-trending core price inflation will fuel the uptrend in wage growth and aggregate measures like the employment cost index in 2007, exacerbating the good old "wage-price spiral." The ECI has been well behaved in recent years, thanks largely to a big downside correction in benefit costs, which has thus far countered the wage uptrend. Unfortunately, this good luck with benefits has probably played itself out, hence leaving the ECI poised to trend upward in 2007, alongside other wage measures.
We expect productivity growth to hover in the 1.5% to 2.5% range through 2007, as gradually moderating payroll growth from what will prove to be a "revised" solid performance in 2006, and a modest bounce in headline GDP growth from the depressed rates of the last three quarters, will allow quarterly productivity growth to revert to trend.
Note that the Fed has received good news on the headline inflation front in recent months from the big commodity price correction of September and October, but this benefit is proving short-lived. Rising gasoline prices in December will likely allow the consumer price index to post a headline gain of 0.4% in December, and seasonal strength in the U.S. inflation reports in the first quarter will likely plague the Fed as we enter the new year.
In total we do expect core CPI inflation to slowly drift back toward the upper end of the Fed's 1.5% to 2.5% comfort zone by May. But, this rate should likely continue to linger in the upper half of the Fed's range. As downside risks to the economy subside through the year, as we expect, the Fed will increasingly be pressured to respond to persistent gains in the various inflation measures, given their clear rhetorical commitment to hitting the mid-points rather than the upper ends of their stated ranges.
Gradual Dollar Depreciation
The Fed's inflation objectives will also be aggravated by the long-term downtrend evident in the dollar, which will likely continue if China's central bank continues its policy of gradual yuan appreciation, with the likely commensurate appreciation of the other major Asian currencies. The Fed is likely comfortable with this pattern, though it is one more reason why Bernanke & Co. is facing a likely persistent inflation risk in 2007.
Gradual dollar depreciation is likely to translate to the usual upward trend in the trade price indexes. And with 17% of domestic purchases of goods and services now imported, and 11% of U.S. production exported, these up-trends should have a measurable impact on U.S. inflation.
Our best guess remains that the Fed will tighten again before this cycle is over, and we are currently assuming that this modest tightening cycle begins in the second half of 2007, with the Fed funds rate rising to a year-end rate of 5.75%. Though this is the opposite direction as signaled by the Fed funds futures market, we see such a year-end rate is easily supported by underlying fundamentals, and right in line with past cyclical experience.
When the Smoke Clears
In total, 2006 was a solid year for economic growth in the U.S., though the big upside first-quarter gross domestic product growth surprise was followed by lean gains in the ensuing periods that disproportionately switched the market's focus to the risks of economic weakness. But, the Federal Reserve kept its eye on the inflation ball throughout the year.
As the dust settles in the first quarter of 2007, we believe it will be clear that the central bank faces greater upside inflation risk, going forward, than downside economic risk. At that point, the Fed may be pressured to resume its tightening trend, even if the ensuing rate hikes are still small by historic markers. This switch in Fed risks should boost U.S. yields, provide some floor to the dollar, and put pressure on U.S. stocks.