Looking ahead to the next FOMC meeting in July, the decision on whether or not to raise rates remains far from clear. Whilst US Q2 GDP is tracking around 2.5% (and Q1’s weak print is likely to be revised higher), the labour market which had been solidly improving is now looking mixed. In addition, although inflation has picked up on both headline and core measures, long term inflation expectations continue to weaken, with the University of Michigan survey hitting a record low. Our assessment of the overall health of the US economy leads us to believe that the Fed may be able to raise rates up to two times by the turn of the year but they cannot go too fast or too far. Indeed, the risks to our view are to the downside. “Too fast” may result in a repeat of the financial market stress that greeted us at the start of this year. “Too far” and divergent monetary policy between major central banks will risk a tide of money flowing into the US from the Eurozone and Japan, as well as from EM in general, and China in particular.
So how far can the Fed go? Not very far because growth will be slow and inflation will be low. US trend growth has been falling for a while, due to both lower productivity growth and demographics. The demographic headwinds that we all know about in Japan (where the working population has been shrinking, rather than merely growing more slowly) is beginning to occur in other developed countries too. We put the US’s GDP growth potential no higher than about 1.75%.
Meanwhile the world is also becoming less willing to trade. Outside of recession years, world trade tends to grow, and we believe that stronger global trade tends to go together with stronger global growth. Trade is now shrinking as countries “protect” their own growth by importing less from others. Although the contraction is very recent and still very marginal, the trend is clear:
Let’s now throw in leverage that remains very high in many countries, concerns over global commodities prices, China capital outflow concerns which have eased but not gone away, as well as increasing political risks with US elections this year and Germany’s and France’s next year. Taken together, our view is that the global economic outlook means that the Fed would do well to get Fed Funds up to 2% during this hiking cycle. Indeed we think the risks are that they fall short of this level and this tells us one more thing: real rates, after accounting for inflation, will be at zero or negative.