The weather played havoc with the economy in the
first quarter. In a mirror image of the balmy winter of 2012
where unusually warm temperatures temporarily enhanced
economic activity, near record cold weather suppressed it.2
As a result of this year’s polar vortex the states of Illinois, Indiana,
Iowa, Michigan, Minnesota, Missouri, Oklahoma and
Wisconsin experienced among their twelve coldest winters
in the past 119 years. (See Figure 1) The cold weather was
exacerbated by unusually heavy snow falls across the Great
Lakes and into the Northeast. Interestingly, while the middle
of the country was freezing, California was experiencing a
drought along with its warmest winter in recorded history.
Indeed the entire southwest from Texas to California was
experiencing severe drought condition.
Simply put, the seasonal factors the Bureau of Labor
Statistics uses are incapable of fully accounting for extreme
weather conditions. In order to highlight the impact
of weather in January and February of 2012, we note that
payroll employment growth averaged, as initially reported a
robust gain of 256,000 jobs. 2 In contrast, this year job gains
were a far more modest 152,000 for the first two months. As
a result, we expect that first quarter real GDP growth will
come in a sub-par 1.4% annualized rate.
Nevertheless as our title suggests, there will be growth
in the spring as such weather affected activities as factory
production, automobile sales and the construction rebound
from their winter lows leading to real GDP growth of about
3%. Furthermore, as we have argued previously, we continue
to believe that the economy is poised to remain on a 3% or so
growth path through 2016 buoyed by increased housing and
business investments along with gains in consumer spending.
(See Figure 2) In this environment we can visualize the
economy creating between 200,000-250,000 jobs a month
with the unemployment rate dropping to 5.4% by late 2016.
(See Figures 3 and 4) To be sure, total payroll employment
will surpass the prior 2007 peak, but the economy will
remain well below its pre-Great Recession growth path.
Modest Inflation Ahead
While inflation has been quiescent for most of the post-
2009 recovery period, it is about to experience an uptick.
Specifically, we forecast that the core consumer price index
will increase from 1.8% in 2013 to 2.5% in 2016. (See Figure
5) Because of increases in domestic energy production, the
increase in headline inflation will be somewhat more muted.
Admittedly, food prices might pose an upside risk should
drought conditions in the Southwest and political uncertainty
in the Ukrainian breadbasket persist.
As we have written elsewhere, the increase in inflation
will come from the shelter and healthcare components
of price indices. 3 Both measures are now running at a 2.5%
rate along with a general increase in wages. To be sure,
for most Americans, the increase in wages will be most
welcome, but for those wary of inflation it will be signaling
a cautionary yellow light. Specifically, we are forecasting
total compensation per hour to increase by 2.4%, 3.5% and
4% in 2014, 2015 and 2016, respectively, compared to a very
low increase of 1.6% in 2013.
Fed Policy: From Taper to Modest Tightening
The Federal Reserve’s long experiments with zero
interest rates and quantitative easing are slowly coming
to an end. We anticipate that the monthly $85 billion bond
buying program, now down to $55 billion, known as quantitative
easing will be all but wound down by September.
Although most market participants do not expect the Fed
to actually begin to raise rates by mid-2015 at the earliest
and a few anticipate that it will wait until 2016, we believe
that the first overt tightening will begin in the first quarter
of 2015. (See Figure 7) Our view was strengthened at Fed
Chair Yellen’s recent news conference where she defined
“considerable period” as approximating six months as the
time between the end of tapering and the beginning of overt
tightening. Thereafter, we forecast that the Federal Funds
rate will rise, to use “Fedspeak”, at measured pace reaching
3% by the end of 2016. In essence, the “Yellen Fed” will be
very much like the “Bernanke Fed.”
Why? Under the Fed’s dual mandate to maintain
maximum employment and price stability there would be
little intellectual justification for continuing a zero interest
rate policy with a 6% and falling unemployment rate and a
2.5% core inflation run rate in the first quarter of 2015. We
are aware that the Fed’s official inflation target variable are
the core and overall price deflators for personal consumption
expenditures in the GDP accounts will be running somewhat
below the consumer price indices. But at that time, there will
be little doubt as to where they will be heading.
In this environment, long-term interest rates will begin
to normalize. We would not be surprised to see 10-Year U.S.
Treasury rates exceeding 3.7% by yearend and be above
4% thereafter. We would also point out that relative to the
2%-2.5% inflation rate, both the real Fed Funds rate and the
10-year treasury yield would still be well below pre-2007
levels. Our short-term interest rate forecast is broadly consistent
with the higher end of published consensus beliefs of
the open market committee after the March meeting.
Sources of Growth: Housing, Business Investment
As we have noted for the past several years, we believe
that housing construction is in a period of sustained, albeit
moderate recovery. After bottoming at below 600,000 units
a year in 2010, housing starts recovered to 931,000 units
in 2013 and are expected to exceed 1.2 million units this
year and approach 1.5 million units in 2015. (See Figure
8) Thereafter, housing activity is expected to plateau in the
1.4-1.5 million unit range as mortgage rates in excess of
6% exact their toll. As we have noted on many occasions,
multi-family construction will account for about 30% of
overall starts as it has in recent years, up from the 20% that
has characterized the prior decades.
Meantime, investment in business equipment and
software along with nonresidential construction will begin
to experience a sustained pickup. (See Figures 9 and 10)
Real equipment and software spending, which increased at
a very tepid 3.1% in 2013, will likely increase by 6% this
year and 10% next year. The improvement in nonresidential
construction will be even more dramatic where that sector
will rebound from a meager 1.4% growth rate in 2013 to
5.2% this year and 11% by 2016.
The rebound in corporate spending will be caused by
the need to replace aging capital equipment, accelerating
global growth, reduced domestic political uncertainty, the
on-going energy renaissance in the U.S. and “most importantly”
in the words BofA Merrill Lynch, the stock market is
no longer rewarding share buybacks.4 Put bluntly, instead of
spending big bucks on financial engineering, American companies
will step up their spending on physical engineering.
Along with increases in business spending, the long
suffering U.S. consumer will begin to spend more robustly.
The increase in spending will be driven by the improved
employment and wage picture, a very big deal, along with
the $10 trillion increase in wealth that took place in 2013.
Yes, a bull market on Wall Street is largely concentrated
in the upper income brackets, but that is where half the
purchasing power is. Furthermore, last year’s rise in stock
prices will take some of the pressure off the fiscal stress
facing most defined benefit pension plans and individual
retirement accounts. As a result, real consumer spending
gains are expected to approach 3% in 2015 and 2016 well
above the 2% recorded in 2013. (See Figure 11) Even with
the increases in consumer spending we envision the saving
rate after modestly declining in 2014 to 4.3% will be well
above 5% by 2016.
There will be growth in the spring. The economy will
shake-off the weather induced weakness and begin to grow
at a 3% growth track bringing with it rising employment
and wage gains. Growth will be led by housing, business
investment and the consumer. Along the way inflation will
modestly increase causing the Fed to begin increasing rates
in early 2015 and longer-term interest rates will begin to
normalize. Not great, but what’s not to like.
1. With apologies to Chance the Gardener in “Being There” (United Artists, 1979).
2. See Shulman, David, “Curb Your Enthusiasm,” UCLA Anderson Forecast, March 2012.
3. See Shulman, David, “The Inflation to Come in Housing, Healthcare and Wages,” Ziman Economic Letter, January 2014.
4. See “The cap-X factor,” BofA Merrill Lynch Global Research, 11 March 2014.