A turning point?

Abstract

After the Federal Open Market Committee (FOMC) met on December 13-14, it announced a widely anticipated increase in the Federal-funds rate to the 0.50 to 0.75% range, up from 0.25 to 0.50%, and provided alongside projections of key economic indicators for the upcoming three years. There is some divergence between the Fed’s projections and the market’s expectations. The market is forecasting faster real GDP growth and higher inflation than the Fed. This divergence in these forecasts raises several questions because the incoming US administration will be able to make changes to the Fed’s composition and policy. Changes to the Fed’s composition include two vacant positions on the Board of Governors of the Federal Reserve System that can be filled immediately, with one of these appointees likely to replace Chairwoman Janet Yellen when her term expires in January 2018. Changes in Fed policy will pitch the economic cycle against the political cycle. The Fed’s December 2016 projections call for raising short term interest rate three times in 2017, bringing them to 1.5% by end-2017. The political cycle calls for increasing spending on infrastructure projects, reducing taxes and easing regulations. Can the resulting combination be balanced?

Full text

PolicyWatch
A turning point?
1
,
2
By Carlos B. Cavalcanti @ ResearchGate
December 2016
After the Federal Open Market Committee (FOMC) met on
December 13-14, it announced a widely anticipated increase in the
Federal-funds rate to the 0.50 to 0.75% range, up from 0.25 to 0.50%,
and provided alongside projections of key economic indicators for the
upcoming three years (Figure 1). Since the increase in short term rates was
expected, attention focused on the new projections: were they very different
from the market’s forecast? Consider the market-implied measure of
inflation, given by the difference between yields on regular and inflation-
protected Treasury securities (TIPS), which increased to 1.9% on December
14th, up from 1.7% just before the elections on November 7th (Figure 2).
Although the increase in the spread between these securities was slightly
lower than the trajectory of the consumer price index over the last 12 months
(Figure 3), it was still seen as a turning point.
Source: Board of Governors of the Federal Reserve System.
1
Comments are welcome.
2
Report Number: 10.13140/RG.2.2.12224.12804.
2.1 2.0 1.9
1.5
2.1
2.9
0.0
1.0
2.0
3.0
4.0
5.0
2017 2018 2019
Figure 1: Fed's December 2016 projections,
2017-2019 (%)
Real GDP growth (%) Inflation
Unemployment Federal-funds rate

Source: Federal Reserve Bank of St. Louis.
Source: Bureau of Labor Statistics.
The changes in Treasury securities’ yields reflect the market’s
response to the presidential campaign pledges to increase spending
on infrastructure projects, reduce taxes and ease regulations. These
campaign pledges (if implemented) would lead to an increase in the budget
deficit and, as a result, in the public debt-to-GDP ratio, raising it from its
current 75.5% ratio (Figure 4). Also, the expectation of an increase in short
1.23
1.33
1.43
1.53
1.63
1.73
Figure 2: Difference in Yields on 10-year
regular and inflation protected Treasury
securities (TIPS), June-December 2016
0.0
0.2
0.4
0.6
0.8
1.0
1.2
1.4
1.6
1.8
2.0
Jan' Feb' Mar' Apr' May' Jun' Jul' Ago' Sept' Oct' Nov'
Figure 3: 2016 12-month Accumulated
Consumer Price Index (%)

run interest rate has already prompted an appreciation in the value of the
U.S. dollar (Figure 5). This is important because a stronger dollar makes
money tighter by increasing the cost of borrowing for those outside the U.S.
It can also hit corporate profits and make exports less attractive.
Commodities that are priced in dollars often see their prices fall as the US
dollar gains in value. Tighter financial conditions, however, can constrain
economic activity domestically, creating upheaval in other markets, and
make the Fed more hesitant about lifting rates further.
3
Source: Federal Reserve Bank of Saint Louis.
3
The strengthening dollar and the rising of U.S. interest rates will intensify a chronic funding squeeze in
emerging markets, where dollar borrowing has boomed since the global financial crisis. A withdrawal will
fuel a sharp retreat from stocks, commodities and other riskier assets.
62.0
64.0
66.0
68.0
70.0
72.0
74.0
76.0
78.0
2011-04-01
2011-07-01
2011-10-01
2012-01-01
2012-04-01
2012-07-01
2012-10-01
2013-01-01
2013-04-01
2013-07-01
2013-10-01
2014-01-01
2014-04-01
2014-07-01
2014-10-01
2015-01-01
2015-04-01
2015-07-01
2015-10-01
2016-01-01
2016-04-01
Figure 4: Federal Public Debt-to-GDP ratio,
2011-2016 (%)

Source: Federal Reserve Bank of Saint Louis.
Growth forecasts. The yields on TIPS also reflect the market’s expected
growth forecast, with the TIPS’ yield mirroring the demand for money, which
is a function of the growth rate (Figure 6). When the yields on the 10-year
TIPS reached 0.60% on December 14, compared to 0.11% on November 1st,
it signaled that the market was forecasting stronger growth, raising the
demand for money beyond the expected inflation rate.
Source: Federal Reserve Bank of Saint Louis.
117.0000
119.0000
121.0000
123.0000
125.0000
127.0000
129.0000
Figure 5: US Trade Weighted Dollar Index,
January-December 2016
0.00
0.10
0.20
0.30
0.40
0.50
0.60
0.70
9/8/2016 10/8/2016 11/8/2016 12/8/2016
Figure 6: Yields on 10-year Treasury Inflation-
Protected Securities,
September-December 2016 (%)

Although headline numbers derived from yields on TIPS provide
an indication of the market’s short term growth expectations, they
do not offer the more granular information available from the final estimate
for real GDP growth in the third quarter of 2016 released by Bureau of
Economic Analysis on November 29th. According to that release, US growth
stemmed primarily from increased consumption and business
nonresidential fixed investments on structures (Table 1). Growth in fixed
investment in structures masks, however, the decline in spending on
equipment (-4.8%), and explains the sluggish growth in productivity. While
output increased, productivity growth remains low (Figure 7). As a result,
while the 3rd quarter real GDP growth was revised upward to 3.9%, the
outcome for the whole year will likely end up closer to the 2% range because
of the weaker growth performance recorded during the first half of 2016
(1.1%).
Table 1: 2016 Real Growth Domestic Product and its components
(% Annual Change)
I
II
IIIe
IIIf
Gross domestic product (GDP)
0.8
1.4
2.9
3.2
o/w Personal consumption
expenditures
1.6
4.3
2.1
2.8
o/w Gross private domestic
investment
-3.3
-7.9
3.1
2.1
Fixed investment
-0.9
-1.1
-0.6
-0.9
Nonresidential
-3.4
1.0
1.2
0.1
Structures
0.1
-2.1
5.4
10.1
Intellectual property
3.7
9.0
4.0
1.0
Exports
-0.7
1.8
10.0
10.1
Imports
-0.6
0.2
2.3
2.1
Government Consumption &
Investment
1.6
-1.7
0.5
0.2
Source: Bureau of Economic Analysis.
e) Estimate.
f) Final.

Source: Bureau of Labor Statistics.
Will economic growth continue on the post-election surge? The
S&P stock market index has risen by around 20% since the elections and, to
the extent that this index reflect the country’s economic strength, the outlook
for the economy is encouraging. What will happen next, however, depends
on the economy’s position relative to the real GDP gap. This gap measures
difference between the current and potential US real GDP, where the
estimates for potential GDP is a trend forecast of the current real GDP. The
gap narrows, and eventually diapers, when real GDP expands above its long
term potential and the opposite happens when real GDP is growing below its
potential. During the 2001-2008 period real GDP was expanding above
potential GDP and since the 2008-2009 great recession the economy is
growing slightly below its long run potential (Figure 8). While there is room
to ramp up growth, thanks to the end of the political gridlock in Washington,
which will allow a stronger fiscal expansion, the US economy is still facing
headwinds. The economy is already at full employment and productivity is
growing slowly. As the psychologist Daniel Kahneman reminds us, failing to
process uncertainty correctly leads us to attach too much importance to a
small a number of observations. Failing to understand that regression to the
mean is a ubiquitous source of prediction errors, often leads to sanguine
projections.
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
III III IV III III IV III III
2014 2015 2016
Figure 7: Labor Market Indicators for the
business sector - 2014-16 (% change from
corresponding quarter previous year)
Labor productivity Output Unit labor cost

Sources: Bureau of Economic Statistics and the author’s calculations.
Conclusion. There is some divergence between the Fed’s projections and
the market’s expectations. The market is forecasting faster real GDP growth
and higher inflation than the Fed. This divergence in these forecasts raises
several questions because the incoming US administration will be able to
make changes to the Fed’s composition and policy. Changes to the Fed’s
composition include two vacant positions on the Board of Governors of the
Federal Reserve System that can be filled immediately, with one of these
appointees likely to replace Chairwoman Janet Yellen when her term
expires in January 2018. Changes in Fed policy will pitch the economic
cycle against the political cycle. The Fed’s December 2016 projections call
for raising short term interest rate three times in 2017, bringing them to
1.5% by end-2017. The political cycle calls for increasing spending on
infrastructure projects, reducing taxes and easing regulations. Can the
resulting combination be balanced?
6000.0
8000.0
10000.0
12000.0
14000.0
16000.0
18000.0
20000.0
Figure 8: Real GDP, 1981-2017
(US Dollar Million)