Economic Commentary January 2016

Posted on Friday, January 8, 2016

Lift Off, or Crash Landing in 2016?

View as PDF

By Mel Miller, CFA | Chief Economist

During 2015, the financial media was fixated on predicting the date that the Federal Reserve Open Market Committee's (FOMC) would raise short-term interest rates. The Fed Funds Rate, the interest rate member banks pay to borrow from the Federal Reserve, has not changed since December, 2008 when it was lowered from 1% to near zero. This rate forms the foundation for business and consumer loan rates and any increase in the Fed Funds Rate is almost immediately passed on to borrowers.

EC Graphic - Fed FundsOn December 16, 2015, the Fed Funds Rate was raised for the first time in nine years by 0.25%.

Economists wonder if the Fed raised the rate because of fear the economy is overheating. Or, was it worry about rising inflation? Is the Fed concerned about the labor market exceeding full-employment? In my opinion, the answer to all three questions is NO.

GDP (Gross Domestic Product) hardly shows an overheated economy. While we won't have final numbers for
EC Graphic - GPDsome time, all indications are that GDP growth for 2015 was less than the long-term annual average growth rate of 3.2% since 1948, and it could even be lower than the 2.4% growth rate we experience in 2014.

Inflation is also subdued. Year-over-year it is up less than 1%. Low energy and commodity prices have resulted in an across-the-board
benefit to consumers of benign price increases. Some economists are
worried about deflation, not runaway inflation.

EC Graphic - Weekly IncomeThe pressure to raise interest rates was not caused by increasing wages either. Wages adjusted for inflation are
approximately the same as in 2000, and down 3% from the end of the Great Recession. The labor market has
improved, but it's far from overheating.

So, why the increase in short-term rates? In my opinion, Fed Chair, Janet Yellen, and the FOMC want to signal that this longer than average "Tortise" recovery (growth at lower than the long-term average of 3% per year) is gaining momentum and that they will remain diligent.

The rate increase itself will have little impact on the economy. As an example, consumer fixed-rate mortgage loans are priced as a spread to the 10 year treasury rate, which actually declined the day after the announced increase. Many other types of loans based on a spread to the Fed Funds Rate will not increase because they are currently priced at a floor which remains above the formula price.

I believe that the U.S. economy will continue the expansion through 2016, but at a slower pace than 2015. My GDP forecast calls for the U.S. economy to grow between 1.8% and 2.2% versus the current market consensus forecast of 2.5%. This is based on numerous signs that the economy is actually losing momentum.

Even before the FOMC announcement, most economists felt consumers would boost purchases as the price of gasoline declined to levels not seen since the bottom of the last recession. However, retail sales, which comprise nearly 70% of the calculation that goes into GDP, slowed in the second half of the year.

One of my favorite economic predictors is the Chicago National Activity Index which incorporates 85 individual economic indicators. A level between 0 and -0.70 indicates the economy is growing but slower than the long-term growth rate of 3.2%. The Index points to a sub-normal growth rate in the near future.

EC Graphic - CFNAII am also concerned about personal income levels. Real household median income is still below pre-recession levels and 4% below 1999. Unless workers start to experience wage increases greater than inflation, I believe that retail sales growth will be only slightly greater than inflation.

There is no doubt that the labor market has improved since 2009. The unemployment rate has declined from a high of 9.93% in 2009 to the current 5%, yet much of the decline is as a result of the labor participation rate declining from 65.2% to 62.5%. Many workers have become discouraged and have left the labor market. Hopefully, the labor market continues its recovery and the labor participation rate increases.

The U.S. business sector remains extremely cautious. Durable goods orders are down from a year ago. With the uncertainties surrounding the 2016 Presidential election, it is difficult to predict a strong business investment recovery.

Another factor pointing to slower than average economic growth is the rising U.S. dollar. Rising interest rates will continue to place upward pressure on the dollar which is a negative for our exports.

Of course, if the Fed raises short-term interest rates too much too fast, the result could be another recession; but the odds of that are at less than 25%, in my view.

In conclusion, I believe that the "tortoise" recovery which began in 2009 is likely to continue in 2016 and inflation will remain subdued. Happy New Year!

Mel Miller, CFA®is Chief Economist and a member of the First Affirmative Investment Committee. He monitors economic conditions and market movements, and keeps the firm and its network advisors current on economic issues.

NOTE: Indexes are not available for direct investment. Mention of a specific company or security is not a recommendation to buy or sell that security. Past performance is never a guarantee of future results.