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July proved to be an intriguing month for markets. The U.S. dollar slid to levels not seen since early 2016¹ even as the Federal Reserve signaled its intention to begin shrinking its balance sheet “relatively soon”. Real gross domestic product growth rebounded in the second quarter to 2.6%, but inflation remained tepid. Slow inflation raised the specter of the Fed, slowing its current tightening cycle. Globally, the current increase in economic activity appears to have taken hold with some staying power as Europe, China and Japan continue to expand. In general, the economies are performing well. Growth is far from robust, but steady and stable is a positive. The rancor in Washington D.C. has not (yet) become a hindrance to growth.
The U.S. dollar continued to slide in July as both data and Fed policy pushed it lower. This as inflation, the most important number for the future of Fed policy, was weak. And the weakness was spread across a range of items. The June "core" inflation figure (which excludes energy and food) increased 1.7%, the same as the May reading and not too far off the 2% target. Inflation is not the Fed’s friend. Meanwhile, nominal GDP growth (GDP before subtracting out inflation) accelerated from 3.3% to 3.6% in the second quarter. That is an acceleration, but, if anything, it is disappointing. The expected nominal growth rate was closer to 4%. This signals a rather tepid acceleration in fundamental economic activity.
Despite the slower growth, the Fed believes that “[fed funds] would not have to rise all that much further to get to a neutral policy stance." This means removing accommodation, but not tightening monetary policy, a delicate stance. Currently, this neutral rate is estimated to be between a 1.5%-2% fed funds rate. This is the reason the Fed believes it can get its 2% inflation and raise rates too. Until the neutral rate moves higher, the Fed may actually be slowing the rate of hikes.
The recent developments (both news cycle and healthcare) in Washington have pushed expectations for tax reform into 2018. This is a reasonable timeline, but the shift in consensus introduces some risk of a positive surprise in terms of timing. This has not been the case for some time. Risks remain that it will be disappointing (temporarily or not as significant as hoped), but the timeline is now more in line with the speed of Congress than it has been.
Global growth remains steady as China, Japan and Europe continue their recent growth trajectories. In Europe, the growth is robust, particularly in Germany and France. Japan and China are more tepid, but growing. The takeaway from better U.S. data surprises, and a stable global economy? Maybe the global economy is finally in a position to handle less stimulus. The Fed is set to roll-off the balance sheet and there are even rumors that the European Central Bank will lay out its taper plan in October. It has been quite some time since there was less stimulus in the system.
¹According to the Bloomberg Dollar Index
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Quarterly and Monthly Notes
Third Quarter, 2018
Second Quarter, 2018
First Quarter, 2018
Third Quarter, 2017
Second Quarter, 2017
First Quarter, 2017
Fourth Quarter, 2016
Third Quarter, 2016
Second Quarter, 2016
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