Can the US Federal Reserve cope with an economic recovery?

by Shaun Richards

Today is US Federal Reserve day as we wait to see what the world’s main central bank has to say for itself and what policy actions are on the way. There are two themes to this and the first is that it is setting policy for the world’s largest economy and ch-ch-changes as David Bowie would say are on their way.

The New York Fed Staff Nowcast stands at 8.6% for 2021:Q1 and 4.0% for 2021:Q2.

News from the JOLTS, PPI, and CPI releases was small, leaving the nowcast for both quarters broadly unchanged.

As you can see the US is on course for not only a good first half to 2021 if the New York Fed is right but looks set to outperform its peers. The numbers are annualised so for those not used to the system divide by four. Whilst the numbers were unchanged on the week they have been improving as this year has progressed as the forecast for the first quarter was 5.22%.

At those rates of growth the US economy will soon be back to pre pandemic levels.

Real GDP decreased 3.5 percent (from the 2019 annual level to the 2020 annual level), compared with an increase of 2.2 percent in 2019. ( US BEA)

So it willbe back and growing although it will take some extra time to get back the US $686 billion of lost output last year. But the US economy seems to be shrugging it off at a relatively fast pace. For those wondering if the last quarter of 2020 is annualised US GDP is US $21.5 trillion.

Inflation

This is a more awkward issue on several counts. It starts simply as the PCE or Personal Consumption Expenditure index was at 1.5% in January or below target and remember these days they are happy to go above target.

The Committee seeks to achieve maximum employment and inflation at the rate of 2 percent over the longer run. With inflation running persistently below this longerrun goal, the Committee will aim to achieve inflation moderately above 2 percent for some time so that inflation averages 2 percent over time and longer-term inflation
expectations remain well anchored at 2 percent.

So in their terms they have scope to push it higher with a cap maybe not appearing until 3%. This leaves them with a real oddity because they will be pushing for something that they admit on their website hurts people and especially the poor.

It is understandable that higher prices for essential items, such as food, gasoline, and shelter, add to the burdens faced by many families, especially those struggling with lost jobs and incomes.

They get pretty much a free pass on this from the media. Also there is another influence which is back to the Imputed Rent game. They estimate inflation in the cost of owner-occupied housing via the rents they do not pay. That category is 19% of the index but includes utilities and those who do rent. So let’s say the imputed number is 10% that makes a difference if you go from rental inflation which has been 2-3% to house price inflation which is 9-10%

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Also the Fed is supposed to look forwards and doing so in a strong economy brings inflation issues and we can see examples of that around with the new higher oil price leading the way. At US $68.40 a barrel of Brent Crude Oil is 127% higher than a year ago. Copper futures at US $4.09 are up just under 70%. There are signs that this is affecting what people think.

The February 2021 Survey of Consumer Expectations shows sharp increases in the outlook for growth in the cost of rent and gas, with both series reaching new highs. The median expectation regarding changes in the cost of rent increased to 9.0 percent in February from 6.4 percent in January. Similarly, the median year-ahead expected change in gas prices jumped to 9.6 percent from 6.2 percent over the month. The short-term inflation expectation edged up to 3.1 percent, its highest level since July 2014. ( NY Fed)

Also I noted that in spite of the economic growth the survey suggests real wage falls which is the opposite of the official data.

After remaining flat at 2% for the past seven months, median one-year-ahead expected earnings growth increased to 2.2% in February, driven by respondents with more than a high school education. The overall median remains well below its year-ago level of 2.6%.

The problem with the official data is that it has seen more lower paid workers lose their jobs and thus the average has risen.That can happen with nobody getting a pay rise.

Financing the US Government

This is an area which has got more problematic by the day. Like so many central banks the US Fed has ended up implicitly financing its government. It has not been direct monetary financing but so many bonds were bought it meant that bond yields plunged and governments could issue debt very cheaply. The US ten-year yield fell to 0.5% as the Fed bought bonds Kaiser Chiefs style.

Come back stronger than a powered-up Pacman

But now the situation has been described well by Robin Brooks.

Fed QE is running at a pace of 5% of GDP in 2021, while the fiscal deficit will be at least 15%, leaving a 10 percentage point funding gap. So the bond market sell-off isn’t just about “overheating.” It’s about how high yields must go to make US debt an attractive investment…

As I type this the US ten-year yield is 1.63% so yields have gone higher in response to this new situation. This means that the expenditure and deficits are starting to get expensive.

In the U.S., the 2020 fiscal response amounted to $3.3 trillion. Current Covid support approved in late 2020 and proposed spending by the new U.S. administration could add up to another $2.8 trillion to the fiscal bill as of February 2021. And even more is likely on the way in coming years. ( BlackRock)

As you can see we may find ourselves discussing debt costs again,something which some assured us we would not. But the Fed must be under pressure from Janet Yellen at the US Treasury and remember it is already buying US $80 billion a month and half that rate for mortgage backed securities.

For the US economy there is also the impact of the thirty-year yield on fixed-rate mortgages. It is now 2.39%.

Comment

There is a good news story here which is the expected recovery of the US economy which by its size will help others.

The U.S. international trade deficit increased in 2020 according to the U.S. Bureau of Economic Analysis and the U.S. Census Bureau. The deficit increased from $576.9 billion in 2019 to $681.7 billion in 2020, as exports decreased more than imports.

For the US Fed things are more awkward because under past central banking theory they should be singing along with Billy Ocean.

When the going gets tough
The tough get going
When the going gets rough
The tough get rough
Hey, hey,…

The issue is that they have been allowed to get away with something. The concept of independent central banks was that they would be able to make difficult decisions in a way politicians proved unable. That hits several problems now starting with the fact they have become politicians. Next is the way they are supposed to look around 2 years ahead but have managed to shuffle that unopposed to looking at the hear and now. Hence they should be thinking about taking away the punch bowl but as a consequence of their actions they cannot. Indeed things have got really perverse as we see to have interest-rate cuts in the future in response to current expectations!

The Market Is Now Pricing Almost 3 Hikes by the End of 2023, up From 1 at the January Meeting ( @PriapusIQ)

Can they hike then? It is all a gamble on economic growth versus inflation and bond yields. The UK tried it in the early 70s and it backfired.

In terms of the world issue with it being the main central bank there have been elements of a squeeze as it is starting with countries which borrow in US Dollars.That has got more expensive. But there is another issue if the US Fed cannot stop QE what chance does anyone else have?

 

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