04 January 2019
The US slowdown we have all been anticipating is clearly here, as evidenced by weaker business and recent consumer surveys, together with the steady deterioration in interest-rate sensitive sectors such as housing and durables, and some cooling in the labour market.
The striking tightening in US financial conditions suggests the theme of slower growth in 2019 is firmly in place. From its trough at the start of the year, the US Financial Condition Index rose by 225 basis points to its peak just before the end of December.
The second leg of this tightening since October was particularly dramatic, amounting to 140 basis points to the peak. This move is of course not nearly as extraordinary as that in second half of 2008, but it is enough to become a significant headwind to US growth this year, if sustained.
It is reasonable to assume that the tightening so far should shave more than one percentage point off US growth in 2019. With fading fiscal stimulus on top, we are looking at the pace of growth at or just above trend, but below 2 per cent in 2019. While this deceleration relative to 2018 is significant, this is not a recessionary environment - it is a return to the average growth rate seen over the last couple of decades.
Can the US consumer prove resilient?
It is easy to be pessimistic on literally all GDP components and I think capex and net exports can produce limited upside on a sustainable basis, but prospects for private consumption are less clear-cut.
There are certainly headwinds for consumers such as higher rates and lower net worth after the sharp falls in equity markets, but what I think is intriguing is the recent acceleration in real wages from both higher nominal wage growth and lower inflation (Chart 1). If real wage growth remains in positive territory for the time being, this should support consumers through the year, perhaps in a similar manner to 2015, when consumption proved resilient despite the broader downturn in the economy.
Source: BLS, BEA/Haver, December 2018
The Fed is not done just yet
I have long held a relatively dovish view on the Fed, expecting just one more rate hike in 2019. While still of this view, I now find myself on the other side of consensus and market pricing. What I think is misunderstood is that this slowdown to trend growth, or just above, is a highly desirable scenario for the Fed which is aiming to prevent overheating. And with the labour market continuing to tighten, the Fed’s focus will be on the unemployment rate and wage growth. As long as the former is falling and the latter is rising, the bias to continue hiking will remain.
As we know, the Fed has never managed to engineer a soft landing through hiking - and my guess is they are aware of that. But until they see signs of stabilisation in the unemployment rate, they are unlikely to be convinced their job for this cycle is done. Estimates suggest the breakeven pace for the monthly payroll growth is around 90-100k. As of November, the 3-month average stands at 170k. We have a long way to go.
In all, in the absence of big shocks, I believe there will be no need for emergency rate cuts through the year, or even possibly in 2020. My base case is one more hike in March or June, with risks skewed towards a later hike, and possibly more hikes. As an aside, this is what I think the Fed’s reaction function will be over the next few months - that’s not necessarily what I think they should be doing.
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