Third Quarter 2016 Review

Consumer spending continued to drive the U.S. economy in the third quarter, which probably grew at its fastest pace since the second quarter of 2015. Buoyed by an unemployment rate of 5%, steadily rising real incomes and employment, rising wealth and the lowest overall financial obligations ratio since the early 1980s, spending by consumers remained at high levels, although at a more moderate growth pace than in the second quarter.

Interest rates at historically low levels supported continuation of the housing market recovery and generally strong home price gains. Despite rising home prices, residential construction investment was relatively flat overall during the third quarter.

Modest improvements in exports added to expected GDP growth during the quarter, but export prices declined sharply in August, especially for many commodities.

Private non‐residential construction showed signs of growth during the quarter, although new orders for capital spending on equipment remained below the same quarter of last year. The business goods sector underwent the second consecutive quarter of inventory correction, improving the outlook for next year, but at the expense of industrial growth in the third quarter.

Government spending probably picked up some of the demand slack in the goods sector as defense spending was strong in the third quarter, although state and local spending on infra‐structure slowed.

After what we suspect will be an above‐average third quarter, economic growth is expected to return to a moderate pace below the average of the last 2 years. Even after the third quarter acceleration in the economy, real GDP growth is forecasted to grow only in the 1.5% to 2.0% range this year and next, below the 2.5% average growth during 2014 and 2015.

Although the effectiveness of activist monetary policy probably declines at extremely low interest rate levels, highly activist central banks, virtually worldwide, will likely provide plentiful liquidity to the international economy overall in the next year.

Our forecast incorporates a gradual pick‐up in aggregate inflation with sustained upward movement in services inflation and some eventual price increases in energy and non‐energy commodities.

The Federal Reserve is forecast to raise the Fed Funds rate target in December, when inflation and labor market fundamentals are expected to be somewhat stronger and policy uncertainty somewhat lower. Long‐term interest rates are also expected to edge higher based on the forecast for a modest acceleration in world economic growth and inflation next year. However, slow growth momentum in the U.S. economy overall may make the U.S. somewhat above average in its vulnerability to economic shocks next year.

Highlights of the Economy in the third quarter of 2016:

  • Despite significant volatility from month to month, average monthly payroll growth in the U.S. during the third quarter was a solid 192,000 persons. Average hourly earnings were up a steady 2.6%. The official unemployment edged higher from 4.9% to 5.0% as the labor force participation rate rose somewhat faster than rate at which willing workers were absorbed into the workforce. The U‐6 underemployment rate also remained somewhat elevated at 9.7%. On net, both hawks and doves on the FOMC will likely find points in the third quarter employment reports to support their respective positions, but the direction of labor market conditions was generally upwards.
  • Industrial production, retail sales and the ISM reports on manufacturing and non‐manufacturing showed considerable volatility during the third quarter, but the ISM non‐manufacturing report, largely a reflection of the massive U.S. services sector, finished the quarter on a strong note. While the goods sectors of the economy were largely mixed during the third quarter, services overall sustained the U.S. economic expansion that began in July 2009.
  • Inflation as measured by the CPI remained relatively tame, rising only 1.1% in the year through August. Excluding food and energy, inflation was 2.3% with services inflation putting upward pressure on “core” inflation. A general excess supply of goods in the world economy will likely continue to put downward pressures on tradeable goods prices generally in the next year. However, energy prices should begin to gain some support from OPEC’s first agreement since 2008 to control the supply of petroleum to world markets. The details of the agreement will be released at the formal OPEC meeting in November. The final plan is expected to include only modest supply reductions in total. The ability of OPEC to hold its individual members to production targets will probably also be challenging given the high levels of stress incurred by large oil exporters in the last 2 years. However, if the OPEC efforts revive supply controls, then energy prices could begin to rise measurably from current levels.
  • Brexit imposed a predictable sharp devaluation of the pound, thereby shocking the United Kingdom’s economy and increasing inflation in the island country, but it did not seriously disrupt world financial market functioning. The near term impact on the United Kingdom economy was not as severe as initially expected by the Bank of England, and the sharp devaluation even improved prospects for some of the United Kingdom’s export‐oriented businesses, but monetary policy was ultimately eased to counter the still serious economic shock. Going forward, Brexit may increase the risk that other strong EU countries leave the EU, potentially putting new pressures on a European financial system already stressed by high sovereign debt levels, weak banks in various countries and other long‐term structural economic growth challenges. Long‐term adjustments to the new post‐Brexit order within Europe, including the question of how easily financial companies domiciled in the United Kingdom will be able to operate on the continent, will maintain high levels of uncertainty until they are defined in the coming months and perhaps years. U.K. Prime Minister Mrs. Theresa May has set March 2017 as the deadline for triggering Article 50 to exit the European Union. We expect considerable uncertainty until that time, and potentially afterwards.
  • Our outlook calls for continued modest economic growth, a gradual rise in overall inflation from low rates, and gently increasing short and long‐term interest rates. A total of 2 Fed Funds rate increases totaling no more than 50 basis points are forecasted to occur by the end of next year. Mixed economic data kept the Fed Funds rate target on hold during the quarter, but rising dissents on the FOMC indicate interest rate propensity is probably upwards. Despite this relatively benign forecast, risks emanating from financial markets and the international economy are elevated in the next year. Policy uncertainty catalyzed by a large national election poses another possible dynamic in the economy that will only be determined with time.
  • Struggling with a continuing weak economy and deflation, the Bank of Japan (BOJ) announced a change in its monetary policy towards explicitly targeting the interest rate on long‐term government bonds at zero ‐‐ the first explicit central bank policy targeting of a market determined interest rate in the advanced economies in this millennium. The BOJ holds a large and growing portion of Japan’s government debt, and from its statements is apparently at the point where it is confident that it can target the rates on that debt accurately. In addition to the zero rate target on long‐term bonds, the BOJ also kept its negative interest rate policy in place on high‐powered commercial bank deposits at the central bank, and kept its options open to reduce that controversial policy rate further to meet a highly publicized 2% inflation target. The BOJ is attempting to drive inflation upwards in part by increasing market expectations of higher inflation, but it will likely have enormous difficulty in this effort. Japan’s CPI was at its lowest in July since May 2014.

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