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December 7, 2016

NY Fed: Get Used to Lousy Growth AND Rising Rates

By Wolf Richter, Wolf Street

The bond market is already doing the math.

For the year 2016, economic growth is expected to be a miserably slow 1.6%, according to a survey of “professional forecasters,” released by the National Association for Business Economics (NABE).

For next year, the forecasters are more optimistic, but it’s the same lousy optimism that would have been considered rampant pessimism before the Financial Crisis. They lowered their forecasts to 2.2% growth for next year. And as they nearly always do as they get closer to reality, they’ll likely lower that forecast again and again.

So forget “escape velocity.” That concept was officially defenestrated a while ago. The report explained:

[T]he slow pace of growth in recent years may be the “new normal,” as more than 80% of survey panelists estimate that the potential rate of economic growth will be 2.5% or lower over the next five years.
They expect inflation to rise to 2.3% in 2017, despite the lousy economic growth.
And they expect the Fed to hike rates in December – by now, everyone is taking that one for granted – plus two more times next year to bring the midpoint of the target range to 1.125%. That’s the expectation.

But this expectation may be too slow, according to musings by New York Fed President William Dudley. The Fed dove, and one of the most influential policy makers at the Fed, told CNBC this morning, couched in numerous caveats and things “we don’t know,” that more government spending could mean the Federal Reserve would raise interest rates faster.
“But if fiscal policy were to turn more expansive, and that would lend support to economic activity, then the Federal Reserve would probably remove accommodation a little bit more quickly over time.”
Also today, his breakfast speech at The Roosevelt Hotel in New York took a similar course. The economy was in “reasonably good shape” from a cyclical perspective, he said. Consumers were hanging in there, but over “the longer term,” the economy faced “significant challenges.” He named some of the structural issues, including the effects of income inequality:

In particular, productivity growth has been anemic over the past few years, while income inequality has increased and income mobility remains low. As a consequence, the gains in living standards generated by the current business expansion have been modest compared to previous expansions, and these gains have not been widely shared.
He was somber about economic growth. He figured it “averaged about 1.8%” in 2016, and it “seems likely to continue at or slightly above this pace in 2017.”

That 1.8% growth for next year isn’t exactly hot. But inflation is rising, or as he put it, “we are making progress in pushing toward our 2% objective.” And rates will be going up.

“Assuming the economy stays on this trajectory, I would favor making monetary policy somewhat less accommodative over time by gradually pushing up the level of short-term interest rates.
In the markets, this tightening is already happening. He pointed out that bond yields have risen and that the dollar has appreciated: “On balance, it appears that financial market conditions have tightened modestly.”

My personal interpretation of these developments is that market participants now anticipate that fiscal policy will turn more expansionary and that the FOMC will likely respond by tightening monetary policy a bit more quickly than previously anticipated. Assuming this expectation is realized, the recent modest tightening in financial market conditions seems broadly appropriate.
And this “recent shift in financial market conditions” – this tightening in the markets – wasn’t anything “that should prompt great concern,” he said.

It is important to distinguish between a tightening of financial conditions that is driven by an increase in risk aversion from one that is driven by a greater likelihood of stronger near-term aggregate demand and less downside risk to the growth outlook. We experienced the former at the beginning of 2016, while the latter reflects current expectations of greater fiscal policy stimulus.
The jump in bond yields and in mortgage rates and in other interest rates is just a reflection of where the markets think the Fed is going, which he finds “broadly appropriate.” So the Fed isn’t going to refrain from hiking rates just because bonds are cratering, yields are jumping, and mortgage rates are rising.

Thus, the Fed dove laid out a principle: Economic growth has been lousy despite super-low interest rates due to all kinds of structural issues that these super-low rates and even QE could not cure. And so economic growth will likely stay lousy. It’s the “new normal,” as NABE had put it in its survey. So get used to it. But if the economy continues on this track, and given the policies proffered by Trump, interest rates will likely rise “a bit more quickly than previously anticipated.”

Numerous other Fed governors have recently spoken out on the concept of higher rates, including Chicago Fed President Charles Evans who said today, “We are on the cusp of a period of rising interest rates.” That would be a new era for a whole generation on Wall Street, and for homebuyers, commercial real estate investors, and all kinds of other investors and speculators operating on leverage: The math is going to change.

Courtesy of Wolf Richter, Wolf Street

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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