Ahead of the Curve: Is the US Fed falling behind the curve?...

Neil Williams, Chief Economist for Hermes’ Global Government & Inflation Bonds team believes that, as the economy expands against such an accommodative policy backdrop, speculation will build that the Fed is letting rip on inflation. This would rekindle memories of 1994, when the Fed’s sudden raising of interest rates, from 3 to 6% over 18 months, triggered a bear leg in bonds and sell off in equity markets. However, a recurrence does not look imminent.

Our base case remains that the US economy, while expanding (real GDP in Q4 2011 finally surpassed its pre-2007 level), is likely to remain too fragile to be taken fully off the policy ‘steroids’ that caused it. This should leave most of the past four years’ monetary and fiscal stimuli in place, with the Fed deferring any meaningful rate tightening till 2014, maybe longer.

First, after three years of recovery, the economic strains are still visible. The fact that conditions are now much weaker than in 1994 helps justify the Fed’s caution. Nevertheless, with weaker fundamentals already reflected by a much looser policy stance, ‘normalisation’ when it comes may have to be more severe. Our ‘Policy Looseness Analysis’ supplements the Taylor Rule used by the Fed for setting rates, by taking explicit account of the fiscal stance and QE.

However, we’re not there yet. Americans are dis-saving at a time when 46½ million (one in seven) are on food stamps, house prices are still falling, and unemployment falls may become staggered, especially as the growing longer-term unemployed become disenfranchised, and if the typical lags from higher real oil prices persist.

Unemployment will be stickier than before. April’s rate of 8.1% compares with 5½% at this stage of recovery from the 2001 recession, and 6½-7½% for the previous three (1980, 1981-82 and 1990-91). Getting it down to these levels by November’s elections is do-able if the current underlying pace of payrolls gain can be roughly sustained, but progress will be slow and provide a drag on inflation.

Then there’s the euro-zone, though the threat here is more from default risk than direct from trade flows. The US’s overall export dependence (just 14% of GDP) is relatively low. On the basis that the EU accounts for a fifth of the US’s full-year exports, it accounts directly for no more that 3% of US GDP. Compare that with the vulnerability of the UK’s 16%, where recession looked inevitable.

Second is the still benign inflation outlook. The Fed expects core PCE (its preferred inflation measure) to average less than +2%yoy to 2015. Admittedly, this may be stymied if oil-price rises are sustained, but even if they are, core inflation should stay tame.

Inflationists worry because core CPI at +2.3%yoy has more than trebled from last October’s record low +0.6%. However, reflecting depressed home sales, shelter/rent (42% of the core CPI) has accounted for much of this, and should be diluted if housing recovers and other components stay capped by subdued wage pressures and a wide output gap. Core inflation should thus stay low relative to the same stage of most previous recoveries.

Fiscal hit
Then, critically, is the risk of a hefty 3 to 5%-of-GDP fiscal tightening from 2013, if the (new) president/Congress are too log-jammed to prevent automatic government spending cuts kicking in, on top of pipeline austerity from the expiry of the Bush tax cuts and later payroll subsidies and tax-cut extensions.

There has been much largesse already, so with the raters aware the US is running behind other OECD economies in cutting its deficit, an offsetting fiscal stimulus is not an option. In which case, the Fed in 2013 may again be facing a slowing economy - no matter how low interest rates are. So, better then to keep them down.


For further information, please contact:

Jean Dumas, Hermes Fund Managers Press Office

Tel: +44 (0)20 7680 2152    Email: j.dumas@hermes.co.uk