Economic Outlook 

April 31, 2019

Several months of “not-too-high, not-too-low” inflation readings afford the Federal Reserve to be patient and not shift monetary policy.  Also allowing the Fed to stay in wait-and-see mode has been tepid global growth as the economies worked through a first quarter soft patch.  However, the risks of a prolonged deceleration may have been overblown with some signs not signaling an imminent global recession that had darkened the outlook earlier this year.  In fact, there are even some early signs that the worst may be behind us.

GDP vs Initial Jobless Claims

In spite of fiscal stimulus from the Tax Cuts and Jobs Act beginning to fade, the federal government shutdown, inclement winter and early spring weather, residual effects of the late 2018 stock and commodities’ sell-off and trade tensions causing headwinds, U.S. economic fundamentals remain broadly healthy.  Importantly, the first quarter ended on a relatively firm note, which was considered inconceivable in January and February.  The first estimate of real GDP for the first quarter posted a 3.2% annualized quarterly gain.  The headline number was well above expectations, sizeable growth contributions from a larger investment in inventories and an unsustainable narrower trade deficit (exports add, imports subtract), had outsized contributions that according to economists, made growth not quite as strong as the headline rate suggests.

Initial Unemployment Cliams

The stock market has recovered from its devastating late 2018 loss, mitigating the negative wealth effect that undermined consumer and business confidence and behavior.  The upbeat March retail sales report went a long way in propping up quarter GDP figures.  The rebound in consumer spending was also underpinned by a strong job market and wages continuing to firm.  March’s rebound in job growth and the downward trend in jobless claims give evidence that the employment picture remains positive and should continue in the near term.  The Institute for Supply Management (ISM) Purchasing Managers Indexes for the manufacturing and non-manufacturing has decelerated from last year’s highs but both remain firmly in expansion territory.

Retail Inventory Sales Ratio

Although global growth is showing signs of stabilizing, both upside and downside risks to the outlook persists.  While not to the degree of earlier this year, the interest rate markets are still priced as if the economy is facing more headwinds than tailwinds.  The shift by the Fed to a more “dovish” policy prompted market participants to believe that the next policy move will be to cut rates.  Political and geo-political risks remain elevated but the largest perceived risks are the outcome of trade negotiations between the U.S. and China and between the U.S. and the European Union.  Unless a policy mistake is in the offing or an external shock hits home, the U.S. economy should motor on, although not at the elevated speed of the past few years as the economy needs to work off an inventory overhang, as illustrated in the graphs.

Manufacturing Inventory

The soft growth and inflation will most likely keep the Fed on the sidelines for the rest of this year.  Also keeping the Fed on hold is a desire to see evidence of whether the Phillips Curve is alive or dead.  In simple terms, the Phillips Curve describes a historical inverse relationship between rates of unemployment and corresponding rates of rise in wages.  In turn, rising wages should result in higher prices or inflation as more money chases few goods.  The fly in the ointment for the Fed is that household inflation expectations have weakened, a surprising development in light of rising wages and the recent rebound in gasoline prices.  Our base case is that the laws of supply and demand have not and cannot be repealed, and the Fed will wait to see the whites of inflation’s eyes before tweaking rates higher, likely next year.

Average Hourly Earnings vs Targeted Fed Funds