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In August, US economic data was generally positive. At the beginning of the month, the strong July jobs report showed the US continued to generate employment, further negating May’s slow down. Yet US productivity is still lagging, and this places more pressure on employment gains to power US growth. The downward trend in productivity is not a recent development, and its weakness will constrain US growth to the 2% range unless it significantly accelerates. July retail sales were flat from June, but comfortably higher from a year ago even as department stores remain under pressure. However, online sales remain robust. The consumer drove the entirety of second quarter GDP growth, and continues to carry the weight into the second half of the year. If the consumer falters, US economic growth will be weaker than currently estimated in the second half, further befuddling the Fed.
Ex-food and energy, inflation was +2.2% year over year. A consistent theme with the CPI has been, and continues to be, the increase in the price of shelter. At a 33% weight, its +3.3% reading is contributing approximately 1.5% to the core. This means there is little pressure coming from anything else, and shelter gains show few signs of slowing.
Moderate inflation, the pace of employment gains, a steady consumer and modest inflation pressure keep a December Fed move on the table for the moment, but eventually productivity will need to follow the job gains in order to sustainably raise rates.
Following the United Kingdom’s vote to leave the EU, the Bank of England eased policy significantly in August by cutting rates to 0.25%, increasing its government bond purchase program by £60B, and announced that it will begin buying pound denominated corporate bonds with a £10B monthly mandate. The Bank of England stated that it was willing to overshoot its inflation target in the near-term in order to stabilize prices in the medium to longer-term. The overshoot on inflation would be a result of the fall in the pound, which will prove eventually transitory. Additionally, most members of the policy committee see rates being cut further at its next meeting. When asked about negative interest rates, the Governor of the Bank of England, Marc Carney, responded that negative rates were not his preferred tool, and there were plenty of other options. Most of those other options are increases in bond purchases, specifically on the corporate side.
Though certainly not growing at a rapid rate, Europe does not appear to be falling apart economically at the moment. Instead, steady manufacturing and services data indicate more of the same malaise—no acceleration, but no deceleration either. Services appeared to improve modestly while manufacturing remained stable.
Chinese trade data was somewhat confusing. In Chinese yuan terms, the export data recovered, but in US dollar terms, it remained negative. Given the devaluation of the yuan over the past year, this dynamic makes sense. The weaker yuan causes imports to be more expensive which naturally dampens demand for external goods. Much of the decline was also commodity related as oil imports hit a 6-month low, and imports from Australia, which are heavily commodity related, were down 22%. China's economy remains stable, but has been on a debt binge lately that will make incremental growth difficult to come by next year.
San Francisco Fed President Williams recently stated that the Fed’s 2% inflation target required some rethinking and likely needed to be higher in a slow growth environment. The reasoning? In theory, a higher inflation target implies a higher long run fed funds rate. The Fed needs a higher fed funds rate to combat future recessions and shocks (unless it wishes to use unconventional tactics—which it will, according to Chair Yellen). This follows the recent step back by St. Louis’ Fed President Bullard to his “regime-based” model, which implies that the Fed should only hike once over the next two years. With two Fed presidents vocally stating that monetary policy needs to be rethought (and both in exceedingly dovish ways), market participants must pay attention. Changes to policy targets and style do not happen quickly, but—if the trend is moving in the direction of Bullard/Williams—the Fed will be much lower for much longer and absorb much higher inflation without worry.
The much talked about and anticipated Jackson Hole Fed symposium took place at the end of August, with all eyes on Yellen’s speech. The title of her speech, “The Federal Reserve's Monetary Policy Toolkit: Past, Present, and Future”, raised some eyebrows given comments by other Fed officials recently. However, her speech was not the guiding light many were looking for from the Fed in terms of when the Fed will move. Yellen does lean dovish, but her speech kept her predominately neutral. Given the forward looking nature of her speech, however, the tools described leaned toward dovishness by showing the Fed still has firepower to combat the next downturn.
Yellen’s speech was more focused on what the Fed will do next time, and the message was clear: more QE, buy a wider range of assets, and repeat. Instead, comments from Vice Chair Fischer were interpreted as particularly hawkish, and he went so far as to suggest the possibility remains for two hikes in 2016 in an interview. In his speech, he cited inflation projections and stability of inflation expectations as reasons for believing the Fed is coming close to reaching its target. Fischer also mentioned that the Fed was paying attention to international developments from China and elsewhere. He also cited US dollar strength as one reason inflation has been particularly low, and produced a chart of the effects of dollar appreciation. The effects are substantial, and it is worth remembering that raising rates likely raises the dollar, hitting inflation, and GDP growth.
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Quarterly and Monthly Notes
Third Quarterly, 2017
Second Quarterly, 2017
First Quarter, 2017
Fourth Quarter, 2016
Third Quarter, 2016
Second Quarter, 2016
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The opinions expressed herein are those of Avalon Advisors, LLC investment professionals at the time the comments were made and may not be reflective of their current opinions. Nothing herein shall be construed as investment advice or a solicitation or offer to purchase or sell any securities.