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1 WEEKLY ECONOMIC COMMENTARY WEEK OF OCTOBER 30, 2015 The Federal Reserve s policy meeting caused a bit of a stir in the financial markets this week. To be sure, no one expected the Fed to take any overt action on interest rates and, keeping to the script, it left the benchmark short-term rate at near zero, where it has been since December What caused a minor ruckus, however, was the wording of the policy statement, which sent a direct and clear message that a rate hike will be on the table at the next meeting in December. It s highly unusual for the Fed to mention a specific meeting in which a policy shift might take place. Our research shows that the last time the Fed mentioned the next meeting in its forward guidance regarding a policy change was in December What s more, recent developments seemed to lower the odds of a rate hike at the next meeting. The economy s jobs engine downshifted in August and September, global headwinds gathered

2 force paced by the slowdown in China the dollar strengthened, threatening exports, and financial conditions tightened in the third quarter. Meanwhile, there was little indication that inflation would move up to the Fed s 2 percent target, a precondition for a rate increase. Going into the Fed meeting, the financial markets had priced in a less than 50 percent probability that the liftoff date for a rate increase would take place before the end of the year. Needless to say, those odds changed after the Fed meeting, with asset prices now giving a December liftoff date at least a chance of occurring. From our lens, this is another case of intelligent people looking at the same sets of data and coming up with different interpretations. With the recovery, now more than six years old, moving the economy closer to its capacity limits, the downshifting in job growth is neither a surprise nor terribly disappointing to Fed officials. Should the labor market continue to crank out jobs at a rate of more than 200 thousand a month, as had been the case for most of the past two years, the unemployment rate would be driven down below the 4.9 percent to 5.2 percent range the Fed considers to be consistent with a fully-employed economy. According to the Federal Reserve Bank of Atlanta, the economy needs to generate only 112 thousand jobs a month to keep the unemployment rate at its current 5.1 percent. Likewise, the Fed is probably not overly concerned with the slowdown in the economy s overall growth rate in the third quarter. On Thursday, the Commerce Department released its first estimate of GDP for the period, and the headline number looked as awful as expected, if not more so. Growth for the quarter downshifted to a 1.5 percent annual rate from the robust 3.9 percent pace in the second quarter. That was weaker than the 2 percent pace seen by the consensus of economists. But as is often the case, the headline growth rate is not an accurate barometer of the economy s performance. Forget for the moment that the first estimate of GDP is an unreliable reading of what actually happened, since it is derived from partial data and has yet to incorporate significant results for September. There will be two more revisions and the final outcome can look dramatically different from the first estimate. Just look at what happened in the first quarter, when the initial estimate of negative growth morphed into a positive reading in the final revision. More important is that the headline growth rate overstates the weakness in the economy, as the slow-down was due almost entirely to a slower inventory buildup by businesses, something we have warned would happen in recent commentaries. Looking at real final demand, which excludes inventory swings and is more representative of fundamental trends, things do not look bad at all. According to this metric, growth slowed to 3.0 percent from 3.9 percent in the second quarter a

3 slowdown, for sure, but to a rate that still looks quite healthy. Indeed, if there was one surprise in the initial data it is that there was little drag coming from trade. Net exports subtracted a tiny 0.03 percentage points from the overall growth rate, an insignificant haircut considering the global weakness and strength in the dollar. In light of the neutral impact of net trade, the conspicuous absence of concern over global developments in the Fed s latest policy statement, which was prominently featured in the previous statement, becomes somewhat more understandable. Of course as we mentioned above, the GDP data is missing some important pieces for September, and trade figures for the month are among the most notable. The same can be said for inventories. When these pieces do become available, the economic landscape for the third quarter could look significantly stronger or weaker. Taken at face value, however, the Fed s assessment that the economy continues to grow at a moderate pace seems to be supported by the data. Indeed, the drag from the inventory drawdown could actually set the stage for a nice rebound in the fourth quarter if final demand holds up. Then companies would need to replenish their shelves with more merchandise, spurring an increase in orders and production. Whether this turns out to be the case remains to be seen. But the underlying details in the GDP report point in that direction. Household spending, which accounts for about 70 percent of GDP, increased by a solid 3.2 percent annual rate in the third quarter. That s slower than the 3.9 percent pace of the second quarter, but comfortably above the average increase since the Great Recession ended. The second quarter s strength, of course, benefited from pent-up demand generated in the first quarter, when harsh winter weather prevented consumers from going to the malls and shopping centers. But smoothing out the quarterly volatility yields a gentle upward trend in spending. The average growth rate in personal consumption over the first three quarters of the year equals 2.9 percent, which is slightly stronger than the 2.7 percent increase for all of 2014 and twice as strong as the 2013 gain. No doubt, the sturdy pace of consumer spending reflects the steady improvement in the job market, which has put more money in household pockets and drove up confidence. Reinforcing the job gains, households have enjoyed a considerable increase in property values as well as financial assets this year, contributing mightily to stronger balance sheets. And, after a long lag, it appears that households are finally spending the savings from lower gasoline prices. Earlier in the year, most of the gas savings was used to pay down debt or channeled into bank accounts, belying the quick spending kick that economists thought would be brought about by lower gas prices. It may well be that households resisted a spending spree because they feared gas prices would spike higher again before long. Well they haven t and it looks ever more likely that the gas savings is giving a permanent boost to discretionary income. On Friday morning, the Commerce Department provided more information on consumer spending for the month of September, fleshing out the quarterly figures in the GDP report. What the monthly data show is that there was a bulge in August, when real consumption spiked by 0.4 percent, but the surrounding months of July and September posted decent gains of 0.2 percent. Significantly, the September increase was sparked by a 0.6 percent increase in durable goods spending, paced by robust auto sales, which was stronger than the 0.5 percent increase in August. More than anything, the strength in big-ticket purchases, such as autos, is a sign that households feel good about stepping up discretionary spending. Compared to the same month last year, real consumption is up by 3.2 percent and up 6.8 percent for durable goods which is hovering at the upper end of the trend since the Great Recession ended. There s no reason to think that this steady moderate growth rate will falter in the fourth quarter.

4 Meanwhile, housing continued to make a positive contribution to growth in the third quarter, although the 6.1 percent annual rate of increase in residential outlays was smaller than the 9.3 percent increase in the second quarter. We suspect that a major constraint on residential building is coming from a shortage of workers, which is putting a crimp on homebuilding activity. Still, homebuilders remain upbeat and plan to accelerate construction of new homes in coming months. The residential sector is belatedly becoming a tailwind for the economy, but its relative share of overall activity has declined considerably since the housing collapse and thus has become less of a growth driver than it was in previous upturns. That said, the multiplier effects of a reviving housing market through ancillary purchases of furnishings, appliances, remodeling and moving services will resonate throughout the economy. Not everything in the GDP report came up roses. Business investment spending came in on the weak side, dragged down by an outright contraction in spending on structures. This appears to be mainly an artifact of the pullback in the energy sector, where oil rigs are considered structures. While business equipment spending increased by a decent 5.3 percent annual rate, the near-term future does not look promising. New orders for nondefense capital goods excluding aircraft, a leading indicator of capital spending, declined 0.3 percent in September, following a larger 1.3 percent drop in August. The factory sector is the most vulnerable to global headwinds and the strong dollar, which undercut exports of manufactured goods. The Fed clearly believes that manufacturing weakness related to the global slowdown is not severe enough to derail the recovery from its moderate growth path or impede its rate-hiking plans. But if December is still on the table for a possible lift-off, Fed officials will also need to feel reasonably confident that inflation will move up towards its 2 percent target. So far, that seems like a tall order, as the inflation measures are moving in the wrong direction. The Fed s target inflation yardstick, the personal consumption deflator, declined by 0.2 percent in September and the core personal consumption deflator, which excludes volatile food and energy prices, was flat. The annual inflation rate has remained below the 2 percent target for more than three years and the last time it was lower than in September was in October 2009, when the economy was facing an ominous deflation threat. If inflation signals do not turn around by December and the Fed pulls the rate trigger at that month s meeting, it would need to accompany that shift with significant reasoning.

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