- Recent GDP readings have been disappointing, but the Fed may not be as concerned as the market might expect.
- We believe the Fed is unlikely to change its rate hike plans despite weak GDP readings because the Fed’s dual mandate doesn’t directly include GDP, its focus is on the medium term and outstanding questions about productivity make it difficult to judge what GDP growth should be.
- Given current market pricing, an unchanged stance on interest rates at the June meeting has the potential to put upward pressure on short-term interest rates.
- We continue to think that interest rate risk will provide a useful diversifier to credit risk.
US GDP data have disappointed yet again. Since mid-March, the Bloomberg consensus forecast for 2015 GDP growth has fallen from 2.8% to 1.9%. It is very likely that the Federal Reserve’s (Fed’s) upcoming forecast, which will be released at the June Federal Open Market Committee meeting, will follow the consensus and show a downward revision to 2015 GDP growth. Thus far, the market’s response to disappointing GDP data has been to downgrade the probability of the Fed hiking rates this year. Is this justified? How much does the Fed actually care about a downward revision to GDP?
There is one very important reason to worry about the disappointment in GDP data—to the extent that it is signaling a broader economic slowdown, the Fed needs to be on guard. However, there are also reasons why the Fed may not be too concerned about the GDP data, or at least reasons why it won’t be compelled to change its plans for interest rate hikes in response. First, the Fed’s mandate is to target price stability and full employment, and as such, does not directly include GDP. Second, citing its focus on the medium term, the Fed may choose to “look through” the most recent GDP data. Third, outstanding questions about productivity make it harder to judge what GDP growth should be.
While acknowledging there is likely to be a close debate on this issue, our view is that the Fed will tend to look past the GDP data at its June meeting. More precisely, even though the Fed’s GDP forecast is likely to be downgraded at the June meeting, we think that the Fed’s outlook for interest rates will remain broadly unchanged. Further, in her press conference Fed Chair Janet Yellen is likely to keep the focus on the labor market and inflation outlook, both of which appear better than the GDP data would imply. Given current market pricing, an unchanged stance on interest rates at the June meeting has the potential to put upward pressure on short-term interest rates.
GDP Is Not Part of the Fed’s Mandate
The Fed has two legislated mandates: price stability and full employment.1 Even though GDP growth is not explicitly included, it clearly has an indirect effect on both mandates. When GDP growth slows, conditions in the labor market usually deteriorate and inflation falls. Conversely, stronger GDP growth is typically associated with an improving labor market and rising inflation. It would be rare for the Fed to make progress toward its mandates if GDP were to move in the wrong direction.
However, the last few months may be one of those rare occurrences. Even as GDP growth has disappointed, the labor market has held its previous gains. Since March, headline job growth has averaged +200,000 per month, the U6 unemployment rate has ticked down and the labor force participation rate has ticked up. More importantly for the Fed, the outlook for inflation has actually improved somewhat. As Western Asset CIO Ken Leech said last month ("Market Commentary” May 2015), the recent retracement in global bond prices may reflect, to some extent, a receding of the deflationary fears that were so persistent late last year. Indeed, the rise in TIPS breakevens suggests that developments since March—including the stability in oil prices, the sideways movement in the US dollar, and the (very slight) improvement in the US price and wage data—have given investors some comfort that deflation will be avoided (Exhibit 1). Fed officials are likely to be similarly reassured.
Over a longer period of time we would expect the normal relationship for GDP growth, the labor market and inflation to reassert itself. But, at its upcoming meeting, the Fed will face the unusual circumstance of marking down its GDP forecast while leaving its outlook for the labor market and inflation unchanged. This raises a slightly awkward choice—should the interest rate forecasts respond to disappointing GDP or to the improvement in the labor market and inflation outlook? Given that the latter two are explicitly included in the Fed’s mandate while GDP is only indirectly included, we think the improvement in the outlook for the labor market and inflation will get the focus, and as such, the interest rate forecasts will be left broadly unchanged.
“Looking Through” GDP Data
Central bankers aspire to set monetary policy based on medium-term considerations and attempt to avoid getting caught up in the day-to-day volatility of financial markets and economic data releases. A focus on the medium term is appropriate, they would argue, given that monetary policy has a delayed impact on real outcomes and such a focus also reduces the chances of over-reacting to inaccurate data. Of course, this is much easier said than done. When economic data disappoint, which was the case in the first few months of this year, it is often difficult to distinguish short-term volatility from a more troubling conclusion that underlying growth has downshifted.
Today some Fed members appear confident that the recent slowdown in growth is “transitory” and more likely to reflect “statistical noise” rather than a change in trend. They argue that a number of one-time factors have held down growth. For example, following the plunge in oil prices in 2014, activity in the oil sector collapsed in the first quarter of this year. The Baker Hughes active rig count—a useful proxy for oil-related investment—fell by nearly 40% in 1Q15 (Exhibit 2). Importantly, the pace of declines in the rig count has slowed since March, and the most recent data suggest that the decline in activity may be ending. To be sure, oil prices still remain low and activity in this sector is unlikely to return to its mid-2014 levels anytime soon. However, changes in activity are what matter for GDP accounting and on that account, the drag from oil activity is unlikely to weigh on GDP growth in the second half of the year to the same extent it did in the first quarter.
There are good reasons to be skeptical of the Fed’s confidence that the recent slowdown is transitory. The weakness in the incoming economic data has been broad-based, including in some sectors not immediately impacted by identifiable one-time factors. And, even if one-time factors are responsible for some of the slowdown, the repeated lesson from the past few years is that any subsequent bounce-back is often slower and smaller than expected. Finally, with hopes largely fading for lower gas prices leading to higher consumption, it remains unclear what catalyst could possibly jump-start US growth in the coming quarters. While we may have some sympathy with those who are more concerned about the GDP data, for the purposes of understanding the Fed’s outlook, we put more weight on comments from Chair Yellen and she appears to be unconcerned.2
Productivity Makes This More Complicated
At the same time that the Fed is trying to navigate month-to-month fluctuations in the incoming economic data, it is also being forced to recalibrate its estimates of what underlying GDP growth should be. At a very high level, GDP growth is determined by two things: growth in the labor force and improvements in labor productivity. Labor force growth has received a disproportionate amount of attention recently because of uncertainty about the participation rate, but over a longer time horizon, growth in the labor force is largely a function of demographics, and as such, is relatively predictable. In contrast, labor productivity is nearly impossible to predict. Lacking a workable forecasting model, many economists simply use their estimate of the historical trend. And recently, the historical trend of labor productivity growth is not encouraging.
It appears that the relatively rapid productivity growth of the 1990s is now well behind us. Productivity growth since 2004 has been tepid and the most recent data have been even weaker (Exhibit 3). There are a wide range of possible explanations for the slowdown, including a less efficient labor market due to lower worker turnover, slower capital accumulation due to capex only barely outpacing depreciation, and US workers moving to sectors with relatively low productivity (e.g. health care and education).
The topic of productivity usually comes up in discussions regarding long-term potential growth or debates about the “terminal rate” for fed funds. However, at some point, discussions about the long term also become relevant for the short term. If trend productivity growth is in fact lower than previously expected, then perhaps the recent GDP data haven’t been as disappointing as initially thought. Of course, it is very difficult to have strong conviction on this when productivity itself is so hard to measure, but the question is likely to be part of the discussion and may make GDP somewhat less important as a result.
Conclusion and Market Implications
Current market pricing suggests that many investors believe the Fed is likely to wait until December or later to raise interest rates. This pricing reflects, in part, a view that disappointing GDP growth will force the Fed to delay. For the reasons stated above, we think GDP data are relatively less important in today’s environment, and we expect that the Fed will reiterate its intention to start the hiking cycle in September. In that case, short-term interest rates may be overvalued and could come under some pressure. We have reduced exposure on the very front part of the yield curve accordingly.
Our view on short-term interest rates does not extend to valuations for medium- or longer-term interest rates. In the last few weeks, the market pricing for the pace of rate hikes has actually steepened somewhat. This steepening is at odds with recent comments from Fed speakers—notably Vice Chair Stanley Fischer—emphasizing that once the hiking cycle starts, they will be exceptionally careful and gradual. We would go further and suggest that persistent concerns about growth and inflation will keep the Fed’s stance decidedly dovish during the hiking cycle, meaning it will tend to be quicker to pause hikes than to accelerate them. As a consequence, even though the start of the hiking cycle may be mispriced, our view on the full hiking cycle is not necessarily more bearish than current market pricing.
Finally, and perhaps most importantly, we continue to think that interest rate risk will provide a useful diversifier to credit risk. This has been a consistent theme in our portfolios, and the recent repricing in global bond markets has made this proposition somewhat more compelling. Our diversifying positions have a flattening bias as the long end of the curve is likely to be less vulnerable in an environment of low inflation, mild growth and heavy global monetary policy intervention.
- The Humphrey Hawkins Act of 1978 actually includes a third mandate of “moderate long-term interest rates” but it is rarely mentioned, perhaps because it is redundant with the other two mandates.
- For example, in a June 2 speech, Fed Governor Lael Brainard expressed concern and said “the string of soft data in the first quarter raises some questions about the contours of the outlook.” In contrast, in a May 22 speech, Chair Yellen largely dismissed the 1Q15 GDP data and said “…some of this apparent weakness may just be statistical noise. I therefore expect the economic data to strengthen.” We are inclined to put more weight on Yellen’s comments.