After last year’s significant depreciation versus the dollar, the euro has found a new strength. Key factors are the reversal in the current account balance, which after moving into negative territory last year is back into surplus, and, since the autumn of 2022, the narrowing of the 1-year interest rate differential with the US.This reflects the view that the Federal Reserve is approaching the end of its tightening cycle whereas the ECB still has more work to do. We expect that this factor will continue to drive the exchange rate in the coming months. Moreover, there is also a higher likelihood that the Federal Reserve will cut rates before the ECB does
According to the latest indicators, the US labour market continues to progressively slow down. The pace of both job creation and wage growth remains high. The unemployment rate has fallen slightly, whilst the participation rate has increased. Hiring difficulties remain acute, according to the falling but still very high ratio of unfilled job vacancy per unemployed person. The picture painted by confidence surveys is mixed. The gradual nature of the labour market’s slowdown allows the Fed to continue its monetary policy tightening. A further – and probably final – 25bp increase in Fed Funds rates is expected in May.
According to the Atlanta Fed GDPNow Estimate, US growth will remain high in Q1 2023 (annualised quarterly growth rate of 3.2%). News on the labour market front also remains good. Everything would be fine if inflation were not also continuing at a sustained pace, resulting in continuation of the Fed’s rate hikes, the effects of which recently challenged certain banking models. Prior to this, we were expecting the tightening of credit access conditions to lead the economy into recession. Further tightening would weigh even more heavily on activity and ultimately, on inflation. Does this mean to the extent that the Fed will reach its terminal rate faster? This is possible, but the outlook remains very uncertain. Our forecasts for 7 March point to Fed Funds reaching 5
In February, the evolution of business climate survey data was positive. On the other hand, consumer confidence surveys have moved in opposite direction:
The Federal Reserve’s Senior Loan Officer Opinion Survey sheds light on how changes in monetary policy influence banks’ credit standards and expected loan demand. Based on the historical relationships, the latest survey points towards a high likelihood of average negative growth of the volume of company and household investments over the next several quarters. Moreover, recent research shows that since 2009, the maximum impact of monetary policy on inflation may be reached more quickly. Based on the relationship between credit standards, expected credit demand and investments by companies and households, as well as on the possibility that transmission lags have shortened, decisions by the Federal Reserve will more than ever be data-dependent.
Signs from the ISM business climate surveys were contrasting in January, with a further decline in the manufacturing sector index, going deeper into the contraction zone at 47.4, while the non-manufacturing sector made a strong rebound to 55.2, cancelling out almost its entire December fall.
In the US, it seems that the expansion phase of the business cycle, the period of elevated inflation, the monetary tightening cycle and the ‘risk-on’ mindset in markets are all far from over. Ongoing relatively strong growth increases the risk that inflation would stop declining. Market commentators have started referring to such an outcome as the ‘no landing’ scenario. However, judging by the latest data, a ‘delayed landing’ seems the more likely one. Markets now expect a higher terminal rate whereby the policy easing would come later as well. The higher the terminal rate, the bigger the likelihood that the landing would be bumpy after all.
While goods disinflation is expected to increase, or even turn into deflation in the coming months, services inflation is expected to show more inertia (due in particular to the shelter component), slowing the overall decline in inflation.
In the US, the ratio between the job openings rate and the unemployment rate remains very elevated. It is one sign amongst many of a very tight labour market. As growth slows down, this ratio should decline. Historically, this has been accompanied by slower wage growth. It can be argued that this time, this process may take more time due to labour hoarding, which should limit the increase in layoffs and hence the unemployment rate, and the high level of the vacancy rate, which should underpin the creation of new jobs. This means that there is a genuine risk of disinflation to be slow.
While the US labour market has been very tight since the 2021 economic recovery, first signs of a slowdown are emerging. The extent of this slowdown will be key to ensuring the expected disinflation and the gradual return to price stability.
On an annualised basis, US GDP increased 2.9% in the fourth quarter compared to the third. This healthy increase implies only a mild quarterly slowdown. The result was also better than the consensus expectation. However, a detailed analysis shows causes for concern. About half of the increase in GDP reflects inventory rebuilding, although this comes after a negative contribution in the previous two quarters. Personal consumption expenditures have also contributed approximately half of the GDP increase, but investments in structures had a negligible impact and residential investments continue to act as a drag, suffering from high mortgage rates. Moreover, in the final quarter of 2022, GDP only grew 1.0% versus the same quarter of 2021
According to January’s Beige Book published by the Federal Reserve (Fed), economic activity has remained relatively unchanged in all 12 districts since the previous report. However, activity is slowing in the manufacturing sector, despite the mitigation of disruptions in the supply chain. The decline in net real disposable income, combined with higher borrowing costs, is expected to moderate future consumer spending.
The drawdowns of depository institutions from the US Federal Reserve’s (Fed) discount window have intensified over the past year. Their outstandings amounted to USD 4.6 bn on 18 January, certainly far from the USD 110 billion borrowed at the height of the 2008 financial crisis, but well above the USD 360 million borrowed on average for 15 years.
The state of the labour market occupies a central role in the analysis of the business cycle. Historically, the percentage of months over the past 12 months with nonfarm payrolls below the 200K threshold increases in the run-up to a recession. Today, this indicator stands at 0 percent. Although there have been many false signals, a significant increase in this percentage calls for vigilance, necessitating closer monitoring of other data as well to assess the risk of recession. An alternative approach consists of making the link between monthly payrolls and the unemployment rate. However, given the latest data on job creations, a swift increase in the unemployment rate sufficient to trigger a recession signal seems unlikely
In June 2022, the US Federal Reserve kick-started a programme to reduce the size of its balance sheet (QT2). However, banking regulations could hinder its ambitions. The first quantitative tightening (QT1) programme, which was launched by the Fed in October 2017, had already been curtailed early due to the liquidity requirements imposed on banks. Balance sheet constraints could in turn bring QT2 to an early end. The tightened leverage standard is already reducing the ability of banks to act as intermediaries in the secondary markets for US Treasury securities while federal government financing needs continue to grow.
Despite the ongoing good pace of job creation and slower wage increases, which through its impact on inflation could influence future Fed policy, there is enough ambiguity in the recent data to fuel the debate on whether the US will end up in recession or not. The survey of professional forecasters points towards heightened recession risk and so do the inversion of the yield curve and the downtrend of the Conference Board’s index of leading economic indicators. If this index were to decline further, one would expect, based on the past relationship, a significant weakening in the monthly payroll numbers whereby the narrative that a recession is around the corner would gather force.
US growth recovered significantly during Q3, but is expected to slow down during Q4 according to our forecasts. The labour market is still tight, but early signs of a slowdown are emerging. Headline inflation appears to have peaked, but core disinflation remains to be confirmed, which would forced the Federal Reserve (Fed) to continue its monetary policy tightening, even if it means pushing the economy into a recession in 2023. Looking at the budget, compromise will be key when the next deadlines approach, given the divided Congress following the mid-term elections.
According to the latest estimate by the Atlanta Federal Reserve (GDPnow) on 1st December, quarterly annualised growth in US GDP could be 2.8% in Q4 2022, which would be hardly different from the Q3 performance (+2.9% q/q), but well above the first two quarters (-1.6% in Q1 and -0.6% in Q2). This latest estimate strengthens the idea that the US economy is resilient and is not expected to enter a recession in 2022.
Economic forecasting in the run-up to and during recessions is particularly challenging. An analysis of the Federal Reserve of Philadelphia’s survey of professional forecasters shows that, since 1968, forecast errors during recessions are significantly higher than during non-recession periods. Moreover, forecast errors during recessions are predominantly positive, so forecasts tend to be too optimistic, even if they concern the next quarter. At the current juncture, there is broad consensus, if not unanimity, that downside risks to growth dominate due to the multiple headwinds and uncertainties. The historical forecast record is another reason to be mindful of these risks.
Inflation seems to have peaked in June in the United States. The continuation of the momentum and the pace of disinflation will depend to some extent on easing of the tightness in the labour market, which continues to support wages. In October, the slight increase in the unemployment rate and the slowdown in nonfarm payrolls gains could well indicate the beginning of such easing. What about wage dynamics? According to the Atlanta Federal Reserve’s Wage Growth Tracker, the first signs of a slowdown are emerging. This indicator measures, on a three-month rolling average, the median percent change in the hourly wage of individuals observed 12 months apart. According to this indicator a slowdown in wage growth seems to be emerging, although this is still to be confirmed
The US consumer price data for October have reinforced the view that disinflation -the narrowing of the gap between observed inflation and the central bank’s inflation target- has started. That conclusion seems clear as far as headline inflation is concerned -it has peaked in June- but we need confirmation that the decline in core inflation from the September peak is not a one-off. Core goods inflation has been moving down but core services inflation remains stubbornly high on the back of transportation services and shelter. What matters now for the economy and financial markets is the speed of disinflation because this will influence Fed policy, the level of the terminal rate and how long the federal funds rate will stay there
At which level will the Federal Reserve stop hiking the federal funds rate? The question is hugely important for activity and demand in the US economy as well as for financial markets. During his recent press conference, Fed Chair Jerome Powell remained vague about the reaction function of the FOMC but he did mention that they would be looking at real interest rates. This raises the question which inflation measure to use to move from nominal to real rates. A possible solution is to use the term structure of inflation expectations that is calculated by the Federal Reserve Bank of Cleveland. Despite its significant recent increase, the real one-year Treasury yield is still below that reached during previous tightening cycles, with the exception of 2018
According to the preliminary estimate by the Bureau of Economic Analysis (BEA), annualised quarterly growth in US GDP rebounded sharply in Q3 to 2.6%, following two quarters of negative growth (respectively -1.6% in Q1 and -0.6% in Q2). The upturn in growth was driven mainly by the significant contribution from foreign trade (2.8 percentage points), which was based on the very strong increase in exports of goods and services (+14.4%), while imports fell sharply (-6.9%). Consumer spending (contribution of one percentage point) is holding up quite well given the extent of the inflationary shock. On the other hand, residential fixed investment continued to fall (for the sixth consecutive quarter) and the downward trend was accentuated (negative contribution of -1.4 percentage points).
Liquidity in the US Treasuries market has deteriorated significantly since the start of the year. Against the backdrop of monetary tightening and fears of recession, the strengthening of the dollar and the high volatility in yields are discouraging investors, whether US or foreign, while the Fed has started to reduce its portfolio. Given the size of the debt to be financed (23,000 billion US dollars of marketable debt at the end of June 2022), the prudential constraints limiting the intermediation capacities of primary dealers are an aggravating factor. For many years now the attractiveness of US Treasuries for foreign investors has been in decline. The weighting of their holdings in marketable US federal debt stood at 32% at the end of June 2022 compared with 57% at the end of 2008
Persistent inflation and the rapid and sustained rises in interest rates are hitting the US economy hard. However, business climate surveys are recovering, albeit modestly, and consumer confidence has improved for the second consecutive month. Business climate indices rebounded in September, although without moving back into growth territory. The composite PMI recovered significantly (+4.7 points compared to August) to stand at 49.3, mainly driven by the strong growth in the services sector PMI (+5.5 points, to 49.2) and, to a lesser extent, by a slight improvement in the manufacturing PMI (+0.2 points, to 51.8).
