Richard Hoey | Chief Economist, BNY Mellon and Dreyfus
Chief Economist Richard Hoey presents his August 2014 Economic Update
While both the global economy and the U.S. economy appear to be at an inflection point in mid-2014 to a somewhat faster growth rate, geopolitical risks do have some potential to disrupt this outlook. After an initial global growth surge early in the expansion reflecting an easing financial crisis and aggressive Chinese stimulus, global growth has been running at a sustained but sluggish pace for several years. This has extended through the first half of 2014 since two major countries (the U.S. and Japan) were roughly flat in the first half of 2014 while the initial phase of the fragile European recovery from its double-dip recession was quite tentative.
Geopolitical turmoil has been occurring in a number of locations and appears to have worsened recently. We are hopeful that a major disruption in the flow of oil from Iraq can be avoided, given the location of the Iraqi oil fields. We do expect that there will be continued worry about the flow of natural gas from Russia to Europe this winter. Those worries could hold back confidence in Europe over the next several months even if a major disruption of natural gas supplies to major European countries this winter can be avoided, which is our expectation.
In China, we expect sustained expansion and a gradual downshift in Chinese trend growth over the coming years rather than the “Chinese financial meltdown scenario” expected by more pessimistic analysts. Japanese growth surged in the first quarter and plunged in the second quarter, due to first the anticipation, and then the implementation, of the VAT increase. When the numbers for the second quarter are released, Japanese real GDP growth should be reported to be roughly flat in the first half of 2014 in a very volatile pattern. We believe that the Japanese expansion is now resuming. Europe’s expansion is very tentative, since the strengthening of the European banking system has lagged behind the pattern in the U.S., domestic demand has been restrained by high unemployment, the euro has been a challenge for peripheral countries until recent weeks and now the Ukraine situation has deteriorated. The Ukraine conflict and associated sanctions should weaken Russian demand for imports from Europe and raise uncertainties about the outlook for the European economy. Nonetheless, the most likely case for Europe is sustained economic recovery at a sluggish pace over the next several years.
There has been a clear improvement in the U.S. labor market in recent months. We expect mid-2015 to represent the transition from five years of U.S. economic growth slightly above 2% to three years of three percent growth in a “three-for-three” pattern. The expected acceleration does not reflect major new sources of strength but rather the fading of several drags, including the fiscal tightening and private sector deleveraging. Thus we continue to expect an “eight-year economic expansion” (2009 to 2017).
U.S. real GDP growth was negative 2.1% in the weather-impacted first quarter and rose at a 4.0% rate in the second quarter (after an inventory swing added to 2.3% final demand growth in the second quarter). Thus U.S. real GDP growth averaged about 1% in the first half of 2014. Since real GDP was strong in the last half of 2013, U.S. real GDP growth has averaged 2.4% in the last four quarters. It was about 2.2% for the economic expansion of the last five years, 2.3% for 2012, and 2.2% for 2013. For 2014 overall, it should come in close to 2% if the average growth rate near 1% in the first half is followed by an average growth rate near 3% in the second half, as we expect.
The U.S. expansion has lasted about as long as the average Postwar expansion, but is younger in age if viewed from the perspective of the inflation cycle, the credit cycle and the monetary policy cycle. The Fed has been worried about inflation, but in a different way than it usually does when the expansion has lasted five years. It has been worried that inflation was below target, not above target. We divide monetary policy into five stages (aggressively stimulative, stimulative, neutral, restrictive and aggressively restrictive). After five years of expansion, monetary policy would normally be restrictive or aggressively restrictive, threatening to generate a financial crisis and a recession. Today, however, the Fed is trying to raise the inflation rate and monetary policy remains quite stimulative, fully supportive of a long economic expansion.
We believe that the price-inflation cycle and the wage-inflation cycle in the U.S. have just passed the bottom of a gradual saucer-shaped cyclical pattern and a gradual rise is beginning. While wage inflation has been stuck near 2% in recent years, leading indicators of future wage inflation have strengthened. For example, the labor market surveys of the National Federation of Independent Business have improved, while the gap between the actual unemployment rate and the full employment rate (NAIRU) has narrowed and the short-term unemployment rate has normalized. We expect that the Administration, the public and the Fed are all likely to prove relatively tolerant of the gradual upward drift in wage inflation and price inflation.
In recent months, there has been movement towards desired levels in both parts of the Fed’s dual mandate (price stability and full employment). The Yellen Fed, with its emphasis on labor market slack, appears to feel that renewed economic weakness would be more of a risk than continued economic strength and potential upward pressure on inflation. Labor market dynamics is the subject of the Jackson Hole conference this month sponsored by the Federal Reserve Bank of Kansas City, so the topic should remain a key focus. However, it will be the actual numbers on wage inflation which will resolve the debate. We expect a gradual drift higher over the next several years, bolstering real income growth and eventually motivating an upward drift in interest rates.
Unless there is a major rise in long-term inflation expectations, we believe that the first rate hike by the Federal Reserve is likely to occur near mid-2015. Initially the Fed may tighten slowly, especially since the functioning of the money markets is undergoing change. This will increase the initial uncertainty at the Fed and in the markets about the effects of the Fed policy tightening.
Long-term rates have been held down by restricted supply. Safe sovereign debt is scarce due to limited net supply from the big four countries (the U.S., UK, Japan and Germany) exacerbated by central bank purchases which have manipulated up sovereign bond prices in some countries. There is likely to be a prolonged normalization of bond yields over the coming years as core sovereign bond markets gradually return to free market pricing with deficits financed by the private sector rather than the central banks. But we expect this to be a gradual process.
With the Bank of England and the Fed destined to tighten, while the ECB and possibly the BOJ may contemplate further ease, the dollar appears to have made a bottom and should drift higher over time. We believe that should help limit the speed of the cyclical rise in inflation in the U.S.
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