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Weekly Commentary by Dr. Scott Brown

The September employment report
October 10 – October 21, 2016

Nonfarm payrolls rose at a moderately strong pace in the initial estimate for September, a bit less than expected, but well within the usual range of uncertainty. The pace of job growth appears to have slowed this year, but we’re still adding jobs beyond a long-term sustainable pace.

With the start of the school year and the end of the summer travel period, seasonality is a major issue in September. One should take the reported the data with a grain of salt. That said, the nonfarm payroll figure (+156,000) was not far off the mark. The impact of noisy data can be reduced by looking at averages. Payroll gains were moderately strong in 3Q16, slower than last year, but we only need about 100,000 per month to be consistent with population growth.

The mild uptick in the unemployment rate (to 5.0%) reflected an increase in labor force participation. There is a long-term downtrend in participation, but we may have recovered much of the cyclical decline, at least for the key age cohort (25-54 yrs.).

Average hourly earnings rose 2.6% from a year ago, still moderate by historical standards, but better than in recent years. Wage gains have varied across industries.

While nominal wage growth has picked up, energy prices have stopped falling, leaving a smaller year-over-year gain in real earnings (and less firepower for consumer spending growth).

Fed officials will look at these data, but each may come away with a different conclusion. The job market is getting tighter, but the pace of improvement appears to have slowed relative to the last couple of years. Slower job growth may be due to tighter labor market conditions. If so, wage growth ought to be picking up. Average hourly earnings are rising at a faster pace relative to the last couple of years (2% per year in 2014 and 2015), but that’s still moderate by historical standards.

Two more job reports arrive before the mid-December Fed policy meeting. We should see evidence of further tightening, but improvement that is not too rapid, consistent with another modest removal of policy accommodation. Of course, there are a lot of other things for the Fed to worry about.

Adjusting the outlook
October 3 – October 7, 2016

Investors place far too much emphasis on the GDP figures. However, digging into the components suggests a less optimistic (not pessimistic) outlook for growth in the near term.

Real GDP rose at a 1.4% annual rate in the 3rd estimate for 2Q16, held back by a slower pace of inventory growth. Recall that GDP is a flow ($/time), while inventories are a stock ($). The change in inventories ($/time) contributes to the level of GDP, which means that the change in the change in inventories contributes to GDP growth. In other words, a slowdown in inventory growth subtracts from GDP growth. That was the case in each of the last four quarters. Real GDP rose 1.3% in the four quarters ending 2Q16, but would have risen 2.6% -- twice as fast – if not for the inventory slowdown. When inventories slow, it’s often unclear why. Firms may be more cautious about future sales or demand may have exceed expectations. Lean inventories (relative to sales) normally bode well for future production as inventories are rebuilt. A large inventory rebuild was expected to propel 3Q16 GDP growth to 3% or more. We now have two months of sketchy inventory figures for the third quarter. Price changes make it difficult to estimate what has happened in real terms, but it looks as if the inventory rebuild will be more moderate than anticipated. Perhaps the inventory rebuild will be shifted into the fourth quarter or into early 2017, but it seems likely that the level of inventories has adjusted to an expected slower long-term trend in overall growth, and will not add as much to GDP as was expected.

Consumer spending accounts for about 69% of GDP. We now have figures for July and August, which suggest some loss of momentum. The household sector fundamentals remain sound. Job growth has remained strong (not quite as robust as in the last two years, but that’s to be expected as labor market slack is taken up). The Conference Board’s Consumer Confidence Index has broken out of its recent range and is back to pre-recession levels. While consumers don’t spend confidence, surveys show that people are more optimistic about current job availability (although they remain generally a bit pessimistic about future jobs). Spending on autos and other consumer durables softened in August and anecdotal reports suggest further weakness in September. Big-ticket purchases are sensitive to expectations. Election-year uncertainty may be a restraining factor. The budgets of middle-class households may be strained by higher rents and healthcare costs. However, spending is normally lumpy, bunching up and slowing down around a longer-term trend. Spending numbers through August suggest a softer quarter than was anticipated earlier. More importantly, the trend appears likely to carry though to 4Q16 (that’s simply the way the monthly-to-quarterly arithmetic works). That doesn’t mean that we are in danger of falling into a recession, but it does imply an adjustment to expectations.

Other GDP components have appeared mixed. Business fixed investment was revised higher in the 3rd estimate for 3Q16, but that largely reflected strength in intellectual property products. Spending on structures and equipment continued to weaken. Shipments of capital goods were weak in the first two months of 3Q16, but orders have been improving (there’s hope). The contraction in energy exploration has ended. We don’t anticipate a sharp rebound in oil and gas well drilling, but an end of the decline should be enough (that is, energy is no longer a subtraction from GDP growth).

Putting the components together suggests that GDP growth is likely to be in the 2.0-2.5% range, lower than the 3+% expectations of a few weeks ago. The outlook for 4Q16 has come down as well, to about a 1.5-2.0% annual rate. That’s not terrible, but it is consistent with a lower trend rate of growth in the near term (slower labor force growth combined with a sluggish rate of productivity growth).

Who’s confused, the Fed or the markets?
September 26 – September 30, 2016

The Federal Reserve provides a lot more information than it used to. The central bank issues policy statements, it makes public its economic projections and policy expectations, and the Fed chair holds regular press conferences to explain things. However, despite this added clarity, financial market participants appear to be more confused than ever. Last week was no exception. It’s really rather simple.

In August, the Fed appeared to be well on its way to a September rate increase. Eight of the 12 Federal Reserve district banks were pushing for higher interest rates in late July. In their public comments, most senior Fed officials seemed open to a move. In her Jackson Hole speech, Chair Yellen said that “the case for an increase in the federal funds rate has strengthened.” It doesn’t get much clearer than that. However, she also left herself an out: “of course, our decisions always depend on the degree to which incoming data continues to confirm the FOMC's outlook.”

The economic data arriving since Yellen’s Jackson Hole speech have been mixed, but generally on the soft side of expectations. These data, as we all know, are fuzzy. Figures are based on statistical samples (with their inherent uncertainty) and seasonal adjustment is hard to get precisely right (especially when seasonal patterns are shifting, which they appear to be doing). Numbers bounce around from month to month and quarter to quarter. This makes it difficult to judge whether there is a change in trend or whether we’re just looking at noise. The Fed does not consider economic data alone, but also relies on anecdotal information from around the country.

So why didn’t the Fed raise rates? Chair Yellen said that “our decision does not reflect a lack of confidence in the economy.” The job market is strengthening, and the Fed expects that to continue – and while inflation is low, policymakers are confident that it will move back to the 2% target (as measured by the PCE Price Index). However, with the slack in the labor market being taken up at a somewhat slower pace, and inflation still trending below target, “we chose to wait for further evidence of continued progress toward our objectives.” Yellen also emphasized the asymmetry of policy errors. With rates already close to zero, “we can more effectively respond to surprisingly strong inflation pressures in the future by raising rates than to a weakening labor market and falling inflation by cutting rates.”

Simply put, the Fed can afford to wait awhile longer. The more interesting outcome from the Fed’s meeting was in the Summary of Economic Projections. At every other Fed policy meeting, senior Fed officials (the five governors and 12 district bank presidents) submit forecasts of growth, unemployment, and inflation. They also submit their expectations of the appropriate year-end level of the federal funds target for each of the next few years (now out to 2019). This is the infamous “dot plot.” The dots in the dot plot were expected to drift lower, much as they have consistently quarter after quarter. However, this time, the shift in the expected glide path of rates was much shallower than anticipated. Fed official remain optimistic about the economy, but they also generally lowered their expectations for future tightening. What gives?

Bear in mind, that the dots in the dot plot are expectations, not an actual plan of action. There is considerable uncertainty surrounding each of the dots. The pace of actual rate increases will almost certainly be faster or slower than expected. This does not mean that the Fed doesn’t know what it is doing. Rather, the outlook for monetary policy reflects the uncertainty in how the economy will evolve in the months and quarters ahead. When the Fed says that future policy decisions will be data-dependent, they mean it. Note that the Fed does not react to the economic data per se. Rather, policymakers react to what the economic data inform them about the future – and the focus remains on the amount of slack in the job market and the likely path of inflation in the months ahead.

The drifting of the dots does reflect a shift in the overall economic outlook. Slower labor force growth (as the job market approaches it long-term equilibrium) combined with a slower trend in productivity growth means that potential GDP growth will be a lot slower (about 2%) than what we grew up with (3.5% or so). That’s simply demographics (two forces propelled GDP growth in the last four decades of the 1900s: the arrival of the baby-boomers and increased female labor force participation).

“I know you think you understand what you thought I said but I'm not sure you realize that what you heard is not what I mean.” – Alan Greenspan

The opinions offered by Dr. Brown should be considered a part of your overall decision-making process. For more information about this report – to discuss how this outlook may affect your personal situation and/or to learn how this insight may be incorporated into your investment strategy – please contact your financial advisor or use the convenient Office Locator to find our office(s) nearest you today.

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