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The first take on first quarter gross domestic product (GDP) suggested that the U.S. economy barely advanced after a 2.2% increase in the final three months of 2014. This reading included assumptions about net exports and inventories, which since have been shown to be optimistic. It is almost certain that when these components are updated at the end of this month, first quarter real GDP will show a contraction.
Before formulating a bearish assessment of the economy, it is important to note that underperformance in the first quarter was partly the result of some seasonal quirks. Real GDP growth in the first quarter averaged 0.6% during 2010-2014, compared with a 3.0% average in the second quarter during this period. This oddity (which suggests problems with seasonal adjustments), bad weather and the now-resolved strike in West Coast harbors dampened growth in the first quarter. In the absence of these special factors, real GDP is predicted to recover in the second quarter and maintain momentum during the rest of the year.
Key Economic Indicators
Key Elements of Forecast:
- The 2.6% year-over-year increase of the Employment Cost Index in the first quarter is a sign of a pickup in wages as labor market conditions strengthen further. Real disposable income in recent quarters has displayed an accelerating trend. These developments point to an improved trend of consumer spending after a tepid 1.9% increase in the first quarter. The April retail sales numbers were disappointing. But retail sales account for only the goods share of consumer spending, and these estimates are subject to revision. We suspect that future readings will be considerably more robust.
- The Federal Reserve’s Senior Loan Officer Opinion Survey indicates an easing of home mortgage underwriting standards. In addition, the inventory of unsold new and existing homes is below historical norms. The Mortgage Purchase Index continues to advance, and employment conditions remain favorable. Putting these factors together, a moderate increase in housing activity is within reach.
- The sharp drop in oil prices resulted in a significant contraction of investment in the energy industry in the first quarter. Oil prices have retraced some of the loss and reduced the likelihood of the same magnitude of weakness in energy-related investment spending. Non-oil business investment spending is likely to improve. Small business capex plans, a forward-looking index, increased in April compared with the prior month. The latest Business Round Table CEO Outlook Survey shows more members anticipate growth in capital spending.
- The 223,000 increase in payrolls and the 5.4% jobless rate underpin the favorable status of the labor market. Although there were downward revisions of payroll employment reported for February and March, a distinct upward hiring trend is in place. The labor force participation rate has been roughly flat since late 2013, which implies a cyclical improvement, given that baby boomers are retiring and leaving the labor force. The quit rate, a measure of optimism in labor market opportunities, rose one-tenth to 2.0% in March and is approaching the pre-recession level.
- The Federal Open Market Committee’s 2.0% inflation target is stated in terms of the price index of personal consumption expenditures. The year-to-year change of the overall and core (excluding food and energy) price gauges are below the Fed’s target, but there are signs that these price measures are firming. In addition, inflation expectations have risen in the past few weeks. Given predictions of forward economic momentum, inflation should be on track for the Fed to be reasonably confident of movement toward the target.
- The trade-weighted dollar has lost ground after peaking on March 13. A sustained depreciation of the dollar is unlikely, while lagged effects of the strong dollar and growth in U.S. imports will continue to weigh on net exports and trim growth of real GDP.
- As of this writing, the 10-year Treasury bond yield is trading at 2.25%, up nearly 40 basis points in the last 20 trading days. The run-up in interest rates reflects improved economic fundamentals and confidence that inflation will head higher in time.
- First quarter eurozone real GDP advanced 0.4% on a quarter-to-quarter basis and reduced the perceived risk from this region. However, economic data from China continue to portray weak economic conditions, and the Chinese central bank has stepped in with appropriate policy actions to support economic growth. The fragile Chinese financial sector warrants close monitoring.
- Fed rhetoric continues to suggest that policy action is tied to the nature of incoming data. Expectations of continued U.S. economic growth and higher inflation readings later in the year support our prediction of monetary policy tightening in September 2015.