While various Fed presidents continue to toe the party line, saying they expect 3 rate hikes in 2017, most recently the Fed’s Kaplan earlier this morning, the firm which not only sets Fed policy but now openly tells the president what to do, Goldman Sachs, is starting to get cold feet, and in a note released overnight, the firm’s chief economist Jan Hatzius says that “we have become a bit less confident about near-term hikes.” The U-turn was to be expected as it comes just days after Goldman threw in the towel on its long-dated strong Dollar call, which traditionally comes hand in hand with revisions to Fed rate guidance.
That said, despite the hinted caution of a possible upcoming cut to its rate hike forecast, Hatzius still maintains his existing call for two more hikes in 2017 and says that while “market pricing of future Fed rate hikes has declined in the wake of weaker GDP and inflation data, signals of an earlier Fed balance sheet runoff, and reduced optimism on fiscal easing” he notes that “markets may be underestimating three factors pointing toward continued steady hikes. First, despite a higher funds rate, our FCI has eased in recent months as global growth now looks more resilient than earlier in the cycle. Second, not only the growth-positive aspects of the Trump agenda but also the growth-negative aspects—especially the specter of protectionism—have receded in recent months. Third, labor market slack has now largely evaporated even when we measure it very broadly.”
That said, his point about financial conditions continuing to ease is notable. As Hatzius points out, “the sensitivity of financial conditions to a higher funds rate is far lower than at the time of the December 2015 hike, probably partly because the global economy looks much healthier than a year ago. The Fed hiked both in December 2016 and March 2017, yet financial conditions are at their easiest levels since August, as shown in Exhibit 1. This has pushed the FCI impulse from deeply negative in 2015 and early 2016 to significantly positive now. Our analysis suggests that the swing in the FCI impulse is a much more important driver of US growth than fiscal policy, at least for 2017.”
In other words, Goldman may well be right that the Fed will hike at least two more times if Yellen’s ultimate intention is not so much to slowdown the economy, which is already doing that on its own, but to prick the financial bubble yet do so in a way that does not force a crash in stocks.
What this means is that if the market wants to avoid a “forced hike”, the S&P will have to drop substantially lower from current levels to remove the “overly easy conditions” overhang.
Here is Hatzius’ full update on what he now expects from the Fed:
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Today we discuss our outlook for Fed policy in Q&A format:
Q: What is your forecast for Fed policy in 2017-2018?
A: We expect hikes at the June and September FOMC meetings, an announcement of balance sheet runoff in December, and a return to quarterly rate hikes in March 2018.
Q: How has your confidence around this forecast changed in recent weeks?
A: We have become a bit less confident about near-term hikes, for two reasons. First, the 0.12% drop in March core CPI was a sizable disappointment. About half of the downside surprise was due to the combination of a one-off change in quality-adjusted telecommunications prices related to the adoption of unlimited data packages by Verizon and a methodological change in how the Bureau of Labor Statistics accounts for such changes. But even the more persistent CPI components—shelter and medical care—fell short, and we shaved our forecast for core PCE inflation in Q4 to 1.9%.
Second, economic growth looks a bit softer than a few weeks ago. While we would attribute much of the weakness in Q1 GDP tracking—our estimate is 1.3% and many others are lower—to seasonal adjustment difficulties, our current activity indicator (CAI) is also coming back down to earth. The preliminary reading for April is 2.9%, still strong in absolute terms but clearly a less buoyant message than in the first quarter when the CAI averaged 3.6%.
These developments have led us to shave our subjective probability of a hike at the June FOMC meeting to 60%, from 70% previously. They have also introduced a bit more risk around our modal forecast of a September hike.
Q: Others seem to have moved their view much more. The market-implied probability of a hike in June stands at only about 40%, little more than one hike is priced for the remainder of 2017, and only somewhat more than two hikes are priced cumulatively through the end of 2018. Why?
A: Our interpretation is that two policy-related worries have exacerbated the impact of the weaker data on bond market sentiment. The first is that an earlier start to balance sheet runoff—relative to expectations at the start of the year—could result in a lengthy pause in the normalization process for the funds rate. The second is that the growth-positive aspects of the Trump agenda have stalled. In particular, the failure of ACA repeal/replace has also hit expectations of fiscal easing, which featured prominently in many market participants’ expectations for stronger growth.
We take a somewhat more sanguine view. On balance sheet runoff, we expect only a limited impact on bond yields and financial conditions, equivalent to only about 5bp in terms of the funds rate. Our view is consistent with the very benign market reaction to the recent FOMC discussion about earlier balance sheet runoff. On tax cuts, we think the read-across from the failure of health care reform is limited. It is politically much easier to deliver a net benefit to the electorate via tax cuts than to take away health care coverage. Thus, we still see a tax cut of around 1% of GDP as likely.
Q: But would you agree that the news—even if not decisive—has been incrementally negative for the prospects of further rate hikes pretty much across the board?
A: Not really. In fact, there are three areas where developments have been more positive than we would have expected at the beginning of the year.
First, the sensitivity of financial conditions to a higher funds rate is far lower than at the time of the December 2015 hike, probably partly because the global economy looks much healthier than a year ago. The Fed hiked both in December 2016 and March 2017, yet financial conditions are at their easiest levels since August, as shown in Exhibit 1. This has pushed the FCI impulse from deeply negative in 2015 and early 2016 to significantly positive now. Our analysis suggests that the swing in the FCI impulse is a much more important driver of US growth than fiscal policy, at least for 2017.
Exhibit 1: FCI Has Eased Despite Fed Hikes
Source: Goldman Sachs Global Investment Research
Second, while the growth-positive aspects of the Trump agenda have hit rougher air, the growth-negative aspects also look less concerning. In particular, the specter of protectionism—a major source of concern during the transition especially for trade with China and Mexico—has clearly receded in recent months.
Third, the US economy has made substantial further headway in reducing labor market slack in recent months. This is not only true for the unemployment rate, which is now 0.2pp below the FOMC’s estimate of its structural level, but also for broader measures of slack. To illustrate this, Exhibit 2 plots the unemployment rate U3, the underemployment rate U6, and a demographically adjusted version of the employment/population ratio which holds the age/gender composition of the population constant at its December 2007 level and thereby removes the impact of the aging of the population. We standardize the data by subtracting the level of each variable in the fourth quarter of 2005, when the economy was generally seen to be at full employment, dividing by the standard deviation of each series, and inverting the U3 and U6 series for comparability. The chart shows that even the broad measures now show the labor market at or very close to full employment.
Exhibit 2: Labor Market at Full Employment
Source: Department of Labor, Goldman Sachs Global Investment Research
Q: If the economy is at full employment, why has wage growth picked up so little? The employment cost index is up just 2.2% year-on-year.
A: That’s true, but the overall ECI can be noisy because of its inclusion of incentive-paid occupations, where pay is lumpy, and because of the ups and downs of benefit costs. Exhibit 3 shows that our wage tracker—a weighted average of the ECI for wages and salaries excluding incentive-paid occupations, average hourly earnings, compensation per hour in the nonfarm business sector, and the Atlanta Fed’s wage growth tracker calculated from the household survey—has risen to 2.9%. This is still a few tenths short of our 3¼% estimate of its full-employment level, which we calculate as the Fed’s 2% inflation target plus our 1¼% assumption for trend whole-economy productivity growth. But part of the gap probably reflects the recent, apparently cyclical, weakness in productivity as well as the lagged weakness in headline inflation. If we focus on unit labor costs as an alternative indicator of (productivity-adjusted) wage pressures, this has been running at or above the Fed’s 2% inflation target for a couple of years now.
Exhibit 3: A Gradual but Persistent Acceleration in Wage Growth
Source: Department of Labor, Federal Reserve Bank of Atlanta, Goldman Sachs Global Investment Research
Q: What is the risk to the economy if the FOMC does less than you forecast? Do you worry about a big inflation overshoot?
A: Not much. Partly because inflation expectations seem so well anchored, we think the probability of a big inflation overshoot is limited. Moreover, we agree with the notion that a move in core PCE inflation to modestly above 2% over the next few years can be justified in the context of a fully symmetric inflation target and an economy subject to infrequent but large negative shocks.
So what is the problem? Essentially, that continued above-trend growth could push the labor market decisively beyond full employment before too long. This would raise the risk of recession down the road because unemployment significantly below its structural level is not sustainable indefinitely—eventually, inflation probably would pick up more substantially, even if it takes a long time, or other economic imbalances would develop. But history says that pushing up the unemployment rate gradually is difficult. After all, there has never been a rise of more than 0.3-0.4pp that was not associated with a recession. While that is a historical regularity rather than an economic law of nature, we think the FOMC should not and will not want to take the chance of a big employment overshoot.
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