Review & Outlook, November 2017

The economy grew somewhat faster in 2017 than we anticipated in our forecast at the beginning of the year. As a result, unemployment fell below levels broadly considered to be full employment. We saw slightly more monetary policy tightening than expected, although inflation has remained below the Federal Reserve's 2% objective. Long-term U.S. Treasury yields remained range-bound in 2017, despite additional policy rate increases. The yield curve flattened, which is typical during monetary tightening cycles.

Moderate Growth to Continue in 2018

The uptick in growth has primarily been driven by improved post-election business and consumer confidence, buoyant financial market conditions and a relaxed spending discipline that increased the federal deficit in fiscal year 2017. Momentum in these factors should sustain near-term growth. Potential changes in tax policy may provide further stimulus, which would likely accelerate monetary tightening beyond what the financial markets currently anticipate.

Momentum Should Sustain Near-Term Growth

The low level of inflation has provided the Federal Reserve (Fed) with significant flexibility throughout the cycle to maintain an exceptionally accommodative monetary policy and begin a prolonged normalization process. This trend continued throughout 2017, though recent data indicates building upward pressure on labor costs. The Employment Cost Index rose at its fastest rate since the financial crisis during the third quarter of 2017, on a four-quarter average basis.

Pressure Is Building on Labor Costs

Data source: Department of Labor, Bureau of Labor Statistics, 12/1/08 - 6/30/17.

Extremely low unemployment suggests continued upward pressure on labor costs. Secular disinflationary forces remain in place on a global basis, but domestic cyclical inflation pressures arising from scarce labor resources should push inflation rates modestly higher in the quarters ahead.

Low Policy Rates Have Distorted Markets

Fed policy actions have been ineffective in tightening financial conditions - the transmission channels through which monetary policy changes are expected to influence economic performance. The Fed may feel pressure to act more forcefully if labor market conditions continue firming. Unemployment is near its lowest level since the 1960s, aside from a brief dip below current levels in 1999-2000. The Fed would like labor demand to moderate, rather than accelerate, as implied by the easing in financial conditions over the past year. Further tightening in labor markets threatens to accelerate inflation beyond the Fed's target, risking a more aggressive and perhaps disruptive monetary policy tightening in response.

From a monetary policy standpoint, the nomination of Jerome Powell as Fed Chair will largely continue the current policy approach. Even with the upcoming change in Fed leadership, the persistence of very accommodative financial conditions suggests the risks surrounding Fed policy are skewed to a more aggressive near-term tightening posture. The protracted period of extremely low policy rates and quantitative easing on a global basis has arguably distorted pricing in financial markets. For example, approximately $9 trillion of global debt exists with negative yields and the Bank of Japan (BOJ) holds a majority of outstanding shares in local exchange-traded funds. Domestically, rising values of homes, equities and other investments has lifted the ratio of household net worth relative to disposable income above the prior peaks in 2000 and 2007. This increase is likely the biggest factor pushing the personal savings rate back near historic lows.

The savings rate has fallen from 6.1% of disposable income in November 2015 to 3.1% of income in September 2017. This decline has lifted economic activity over the past couple of years, but the potential for a further decline in savings appears limited based on historical experience.

Look for stabilizing savings rates to temper the pace of consumption growth in 2018. The savings rate will likely remain sensitive to net worth levels. This implies that tightening financial conditions should lift the savings rate and slow overall economic growth, relieving pressure for additional Fed tightening at some point next year.

Savings Rate Is Sensitive to Net Worth Levels

Data source: Federal Reserve, Department of Commerce, Bureau of Economic Analysis, 3/1/70 - 9/30/17.

Domestic nonfinancial debt outstanding rose to nearly $48 trillion in mid-2017, and sits near a record high as a share of gross domestic product (GDP). Suspending the federal debt ceiling will likely mean this ratio will move to a new high by year end. Tighter mortgage lending standards have restrained the pace of household debt growth since the financial crisis, but that has been more than offset by greater borrowing by businesses and the federal government. Debt servicing costs have been suppressed by monetary policy, but the greater level of debt outstanding suggests increased sensitivity to higher borrowing costs as we proceed through the current interest rate cycle.

Debt Levels Sit at a Record High

Data source: Federal Reserve, Department of Commerce, Bureau of Economic Analysis, 3/1/70 - 3/31/17.

It is difficult to know when tightening monetary policy or higher borrowing costs will begin to restrain financial conditions and economic growth. Our forecast does not anticipate that the upper bound of the policy rate will rise above 2%. This view is based on the high level of debt outstanding, modest underlying economic growth trends, lack of sustained global inflationary pressures and the expected sensitivity of broader financial conditions to additional rate hikes.

The flattening yield curve and fed funds futures prices over the next couple of years are consistent with this view and suggest we are approaching the end of the tightening cycle. This would result in a modest interest rate cycle by historical standards and would be well below the 2.8% anticipated in the Fed's latest summary economic projections. Historically, policy rates have generally reversed within a year after the end of a tightening cycle. This could well be a late 2018 or early 2019 development.

Traditional recession probability models, like the Federal Reserve Bank of New York model based on short- and long-term U.S. Treasury yield spreads, show a low probability of recession in the coming year. But the odds have been rising over the past year and sit at the highest level since the expansion began in 2009. The probability estimates from this type of model can change quickly with unexpected movements in interest rates. We expect long-term interest rates will remain under upward pressure in the near term. The yield curve should continue to flatten as the tightening cycle continues, with an additional interest rate increase in December and additional policy moves next year.

The Probability of a Recession Is Low

Data source: Federal Reserve Bank of New York, National Bureau of Economic Research, 1/1/60 - 9/30/18.

Global Environment Should Remain Favorable

Conditions abroad have supported mild improvement in economic performance this year. Strengthening growth conditions in Europe and Japan contributed to dollar weakness and aided domestic trade. Economic cycles in Europe and Japan remain in earlier stages of their respective expansions than in the U.S. Inflation rates remain below policy objectives in Japan and are expected to remain low in Europe. The European Central Bank (ECB) will further taper its quantitative easing program in January, but continue to ease policy for much of 2018. Meanwhile, the BOJ continues quantitative easing. Thus, the economic and policy environment among major foreign markets should remain favorable through much of next year.

China's policy environment is pivoting toward reform, restructuring and addressing imbalances rather than continuing with the policy of supporting growth that has been in place since early 2016. With more restrictive policy, we anticipate a smaller contribution to global growth from China in the coming year. This should keep global inflationary trends muted.