Bumps in the road
20 February 2018
The US economy opened 2018 in seemingly good health, with growth running above trend, forward-looking activity indicators pointing to continuing strong momentum and the labour market adding new jobs at a solid clip. Moreover, while we remain sceptical around the timing and longer-term merits of the Republican tax plan, this will undoubtedly add further short term impetus to growth. Risk assets had been responding very favourably in this environment. However, February delivered a bumpier ride as equities sold off, credit spreads widened and the dollar appreciated (see Chart 2). While some of this pullback has retraced, the episode serves as an opportunity to reassess the outlook. Indeed, there has been market commentary that this shock reflects fears over a resurgence in inflation following an upside surprise in January wage data. These concerns were exacerbated by an unusually large increase in core inflation last week. While these trends warrant monitoring, we do not yet see sufficient evidence to suggest the inflation environment is rapidly shifting. Indeed, part of the increases in pay reflect stronger labour productivity, while January inflation data look to have been flattered by outsized moves in volatile components. Stepping away from fundamentals, the recent market correction looks less shocking when placed in the context of a long period of robust returns. Indeed, while the S&P 500 Index is broadly flat over 2018, it stands some 16% higher than this time last year.
While short-term inflation data grabbed headlines, more impactful news came on the fiscal front. The bipartisan budget agreement, passed in early February, represents another material loosening in fiscal policy. The act increases caps on defence and non-defence spending by close to $300bn in total over the next two fiscal years. The act also included some $84bn in disaster relief funding, alongside a range of smaller revenue and expenditure measures. In aggregate, the Congressional Budget Office estimates these measures will add some $41bn to the budget in the current fiscal year and a whopping $161bn in the next. Alongside corporate and personal tax cuts, this represent further unnecessary late-cycle stimulus, which will lead to stronger growth and a quicker acceleration in inflationary pressures. This largesse will also exacerbate the budget deficit, which could widen to not far off 6% of GDP next year – an unprecedented development at this stage of the economic cycle (see Chart 3).
The Fed will have been watching these developments closely. It is likely to be sanguine over the recent bout of volatility. While these episodes of financial stress can weigh on growth, the latest iteration was not severe or long-lasting enough to shift the dial. Moreover, with the economy operating close to full capacity, and further above trend growth on the way, the Fed may be less inclined to offset these disruptions with easier policy. Indeed, this is where the new fiscal legislation may be more pertinent. We expect this additional late-cycle impulse to prompt a faster pace of policy normalisation from the central bank to prevent the economy from overheating. This is likely to clearly exceed the five hikes that the Fed is currently signalling this year and next. We could even see more hawkish signals start to emerge at the March FOMC meeting, as policymakers incorporate this new fiscal landscape into their projections.