"Interest Rates Move to the Center Stage," UCLA Anderson Forecast, June 2018

Interest Rates Move to the Center Stage

David Shulman

Senior Economist

UCLA Anderson Forecast

June 2018

The era of ultra-low interest rates is behind us. With the yield on the 10-year U.S. Treasury Note surpassing 3% and with the Federal Reserve set to push up the Fed Funds rate above 2%, interest rates are well on their path to normalization. (See Figure 1) To be sure, we are not forecasting yields to reach their pre-crisis levels of 5%+ for both short-term and long-term rates, but a Fed Funds rate north of 3% and a 10-Year Treasury yield north of 4% for late 2019 will seem awfully high compared to the past decade.

Figure 1. Federal Funds vs. 10-Year U.S. Treasury Bonds, 2008Q1 -2020Q4F

Sources: Federal Reserve Board and UCLA Anderson Forecast

The rise in rates is being propelled by high inflation, higher wages, an exploding federal deficit and the quantitative tightening policy adopted by the Federal Reserve.  An added wrinkle is the sale of fixed income securities by corporations utilizing their newly repatriated cash to buy back stock.

The Italian Job

Our interest rate forecast is largely based on domestic considerations. Now, all of a sudden, a political crisis involving the Euro in Italy along with monetary problems in Argentina and Turkey has triggered a flight to quality causing 10-Year treasury yields to plummet 30 basis points from 3.1% to 2.8% over a two week period. The flight to quality can best be seen in the Euro-area bond markets where over a four week period ending May 29, Italian 10-Year yields spiked by 138 basis points from 1.8% to 3.18% while German yields were cut in half dropping from 58 basis points to 26 basis points.  However, markets calmed down the next day. At this point we do not know how this will work out and it will largely be dependent on the Italian electorate’s position on the Euro. If the electorate decides to leave, we will face a currency/solvency crisis in the heart of Europe bringing with it even lower yields. While if the Italians decide to stay, yields will quickly snap back to where they were before. Because we do not view ourselves as experts on Italian politics we will stick to our U.S. interest rate forecast based on domestic considerations. Recall post-Brexit after dropping precipitously in the summer of 2016, markets quickly normalized.

The Domestic Backdrop for Higher U.S. Interest Rates

With year-over-year inflation as measured by the consumer price index already exceeding 2% and likely to be in the 2.5%-3% range over the forecast period, real bond yields, instead of being negative, will run in the 1%-2% range. (See Figure 2) Further, with the economy operating at full employment, wage increases will break out of the 2.5% recent growth rate to approach 4%. (See Figure 3)

Figure 2. Consumer Price index vs. Core CPI, 2008Q1 -2020Q4F

Sources: Bureau of Labor Statistics and UCLA Anderson Forecast

Figure 3. Employee Compensation, 2008Q1 – 2020Q4F

Sources: Bureau of Labor Statistics and UCLA Anderson Forecast

Further upward pressure on interest rates will come from the Fed’s policy of quantitative tightening as it continues its course to reduce its balance sheet from approximately $4.4 trillion to about $2.8 trillion over the next few years. Thus, instead of buying bonds as it did during 2008 – 2015, the Fed has become a net seller. (See Figure 4) Adding to the supply is the Trump Administration’s all-out fiscal policy of spending hikes and tax cuts layered on a fully employed economy. As a consequence, the federal deficit is forecast to increase from $666 billion in 2017 to $1.06 trillion in 2020. (See Figure 5)

Figure 4. Federal Reserve Assets, 2006 – 23May2018, In $Billions

Source: Federal Reserve Board

Figure 5. Federal Deficit, FY 2008 – FY 2020F

Sources: Office of Management and Budget and UCLA Anderson Forecast

The 3-2-1 Economy

Although we expect real GDP growth to pick up to 3%+ for the balance of the year, up from the first quarter’s 2.3% pace, we expect growth to fade in 2019 and 2020 as higher interest rates take their toll. In round numbers on a fourth quarter-to-fourth quarter basis, think of the economy growing at 3% in 2018, 2% in 2019 and 1% in 2020. (See Figure 6) Another way of looking at it is that a fully employed economy has difficulty growing without substantial increases in productivity.

Figure 6. Real GDP Growth, 2008Q1 -2020Q4F

Sources: Department of Commerce and UCLA Anderson Forecast

As the economy bumps against its full employment ceiling, job growth will noticeably decelerate over the forecast horizon. For example, employment growth averaged 200,000 jobs/month in 2017; it will average 133,000/month for the remainder of this year and then decline to 85,000/month and 60,000/month in 2019 and 2020, respectively. (See Figure 7) Concomitantly, the unemployment rate will decline from its current 3.9% to 3.4% in mid-2019 and then gradually return to 3.9% by the end of 2020. (See Figure 8)

Figure 7. Payroll Employment, 2008Q1 – 20120Q4, In Millions, SA

Figure 8. Unemployment Rate, 2008Q -2020Q4F, SAAR

Sources: Bureau of Labor Statistics and UCLA Anderson Forecast

Business Investment Drives the Bus

Spurred by a major reduction in corporate tax rates, 100% expensing for equipment purchases and deregulatory policies coming out of Washington, D.C., we forecast business investment to continue to be the driving force in the economy. For both 2018 and 2019, we forecast real investment in both business equipment and structures to increase at an approximate 7% clip. (See Figures 9 and 10) However, growth will slow in 2020 as the effects of 100% expensing wane.

Figure 9. Real Equipment Spending, 2008Q1 – 2020Q4F

Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 10. Real Investment in Business Structures, 2008Q1 -2020Q4

Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Housing Activity Growing, but Less than Robust

Housing activity has been the great disappointment of the economic recovery and expansion that began in 2009. To be sure, housing starts have more than doubled off their moribund lows of 2009-2011, but still remain well below their long-term average and a far cry from the earlier boom periods.[1]  Specifically, we are forecasting housing starts to increase from 1.21 million units in 2017 to 1.34 million units and 1.40 million units in 2018 and 2019, respectively. (See Figure 11) However, we see housing starts declining in 2020 to 1.36 million units as the lagged effects of higher interest rates and a slowing economy inhibit new construction.

Figure 11. Housing Starts, 2008Q1 -2020Q4F

Sources: Bureau of the Census and UCLA Anderson Forecast

Trade Remains the Biggest Downside Risk

Despite all of the bluster, some of which is legitimate, coming out of the Trump Administration decrying the U.S. trade deficit, the trade deficit, in terms of real net exports, is forecast to increase from $622 billion in 2017 to $814 billion in 2020. (See Figure 12) Why? The trade deficit is the result of the U.S. consuming more than it produces which is the result of a very low national savings rate. Thus, in order to reduce the deficit, the U.S. has to save more and/or produce more domestically. Over the near-term it is hard to produce more, but the high deficit fiscal policy of the Trump Administration reduces national savings requiring us to import more. All the Trump Administration can do is move around the trade deficit among our import partners.

Figure 12. Real Net Exports, 2008Q1 -2020Q4F

Source: U.S. Department of Commerce and UCLA Anderson Forecast

The risk to the forecast is that with all of the talk about a trade war with China and repealing NAFTA, we can sleepwalk into a serious economic accident. For example, in 2017 the U.S. imported a total of over $1.3 trillion dollars of goods from China, Mexico, Canada, Japan and Germany. (See Figure 13) A trade war implies higher tariffs and non-tariff barriers that work as a tax on the American people that would raise prices and restrict output. That is hardly the recipe for economic growth. And because it is hard for import using industries to shift sources in the short-run, there exists the threat of very real economic dislocations. Put bluntly, the administration is playing with fire and the recent nervousness in the stock market is beginning to reflect the risks associated with a trade war.

Figure 13.

Source: Barrons

Conclusion

The U.S. economy is leaving behind a very long period of ultra-low interest rates. Interest rates are in the process of normalizing with 10-year U.S Treasury yields reaching 4% and the Fed Funds rate surpassing 3% as economic growth accelerates and inflation exceeds the Fed’s magic 2% level. High fiscal deficits and the Fed’s quantitative tightening policy will put upward pressure on interest rates. Meantime, the economy, spurred by strong business investment, should grow 3% this year. However, growth will slow as the economy bumps against its full employment ceiling and high interest rates work to slow housing in late 2019 and 2020. Our simplified view is that we are in a 3-2-1 economy with growth on a fourth quarter-to-fourth quarter basis will be roughly 3% in 2018, 2% in 2019 and 1% in 2020.  The two major downside risks to the forecast is the potential for a trade war to break out with one or more of our major trading partners and for the uncertainty around Italian politics to broaden into a full-blown Euro-area crisis.

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[1] See Shulman, David, “The Best of Times and the Worst of Times for Housing,” UCLA Anderson Forecast, June 2018

My Article on Zocalo: "The U.S. Can no Longer Remain an Island of Economic Tranquility"

http://www.zocalopublicsquare.org/2016/04/20/the-u-s-can-no-longer-remain-an-island-of-economic-tranquility/ideas/nexus/

How’s the economy?

We have so many indicators to measure, you’d think the answer to that question would be as straightforward as the answer to the question of “How’s the weather?”

It never is, of course, for a number of reasons. The “economy” in the aggregate covers many activities and sectors, some of which can be booming while others are in a rough patch. Similarly, some individuals suffer economic hardship in supposedly good times, while some people manage to thrive in down times, so one’s feelings about “the economy” don’t always correlate with the latest macro statistics and headlines.

But there is a more novel reason for the confusion surrounding how people feel about the economy: the perceived seesaw relationship between the U.S. economy and the rest of the world. For the past decade, our fortunes and those of nations beyond our shores haven’t been moving in tandem. Even more worrisome, in the political realm the two are increasingly described as being in a zero-sum, adversarial relationship.

Go to URL above for the full article.

Disturbances in the Force, UCLA Anderson Forecast, April 2016

The January to February drop in stock prices, down
13% from early December, sent shivers through the economy
engendering fears that a new recession was at hand. (See
Figure 1) The markets were disturbed by fears of a far bigger
slowdown in China, continued stagnation in Europe
and Japan, a break in oil prices to $10 below the financial
crisis levels of 2009 and that the European banking system
was on the brink of a new crisis. (See Figure 2 which uses
the share price of Deutsche Bank as an example) However,
the markets soon calmed down and wiped out much of
their earlier losses as strong data from the consumer side
of the economy indicated that retail sales were solid and
employment growth remained robust. Simply put, aside

Figure 1 S&P 500, March 2015-March 2016
Sources: Standard & Poor's via BigCharts.com

from modest declines in the industrial sector, there was no
recession in the data.

However, there are more disturbances on the horizon.
In June, the United Kingdom will vote on whether or not it
will stay in the European Union, commonly known as the
“Brexit” referendum. Whether leaving the European Union
is a wise move or not, the transition period will likely be
occasioned by increased market volatility. In the U.S. there
are two major presidential candidates who want to “blow
up” the global trading system as we have known it since the
end of World War II. Economists might not know all that
much, but trade wars usually do not lead to prosperity,
quite to the contrary.

Although we continue to believe the economy remains
on track for moderate growth, we are not as ebullient as
prior forecasts. The inventory correction we were looking
for last quarter is taking longer than we expected and though
the ramp up in single-family housing starts continues, it is
tracing a shallower path than what we previously thought.
(See Figure 3) For example, inventory accumulation added
$78 billion to real GDP in the fourth quarter of 2015; this
sector will only add $25 billion in this year’s third quarter,
a contraction of $53 billion. Thus, instead of looking for
3.3% growth in real GDP for 2016 on a fourth quarter-

Figure 2 Deutsche Bank Stock Price, March 2006-March 2016
Sources: BigCharts.com

fourth quarter basis we are now calling for a more modest
2.7% growth rate. (See Figure 4)

Despite the slower GDP growth rate, the economy
remains on track to create 2.4 million jobs this year and
1.5 million jobs next year as the economy operates at full
employment. (See Figure 5) Similarly, the unemployment
rate which stood at 4.9% in February, is on track to decline
to 4.6% by yearend. (See Figure 6) The rate of decline will
be slower than in the past few years as for the first time the
labor force participation rate is on the rise, a good thing.

Figure 3 Change in Real Inventory
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 4 Real GDP Growth
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 5 Payroll Employment
Sources: U.S. Bureau of Labor Statistics and UCLA Anderson Forecast

Figure 6 Unemployment Rate
Sources: U.S. Bureau of Labor Statistics and UCLA Anderson Forecast

Monetary Policy: From ZIRP to NIRP

While the Federal Reserve left its zero interest rate
policy (ZIRP) behind last December, the European and
Japanese central banks have embarked on a negative interest
rate policy (NIRP) with unknowable consequences. Apparently
the $12.5 trillion of bond buying that the global central
banks embarked upon since 2008 hasn’t been enough to pull
both Europe and Japan out of the quagmire they now find
themselves in. In a negative rate regime instead of paying
interest the borrower receives interest and lender pays interest.
It is truly an “Alice in Wonderland” world. Reflective
of the dour outlook, negative yields are common in many
developed markets. (See Figure 7)

The obvious problem with NIRP is that it will destroy
the business models of life insurance companies and pension
plans and has the potential to do the same for the banking
system. We don’t know how much lower negative interest
rates can go and we don’t know whether it would be legal
for the Federal Reserve to undertake such a policy if it is
deemed necessary.

Meantime, the Fed appears to be ready and willing
to raise interest rates this year. Consistent with the March
Fed statement, we expect two or maybe three increases
in the Fed Funds rate this year with the first one likely
to be in June. (See Figure 8) Thereafter, we expect gradual
increases with the Fed Funds Rate ending 2017 at about 2%.
With much of the world in NIRP territory, policy rates will
be constrained in the U.S. The same holds true for longerterm
rates where we forecast the 10-Year Treasury to end
2016 at about 2.6% and end 2017 at about 3.6% compared
to a mid-March rate of 1.9%.

Figure 7 Government Bond Yields in Selected Countries,
March 18, 2016
Sources: The Wall Street Journal

Figure 8 Federal Funds vs. 10-Year U.S. Treasury Bonds
Sources: Federal Reserve Board and UCLA Anderson Forecast

Figure 9 Consumer Price Index vs. Core CPI
Sources: U.S. Bureau of Labor Statistics and UCLA Anderson Forecast

Nevertheless, the Fed will be under pressure to raise
interest rates because it is about to get the inflation it has
been praying for. Specifically, as of February, the year-over-year
increase in core consumer prices was 2.3% and it is
forecast to approach 3% by 2017. (See Figure 9) Similarly,
with oil prices likely to have bottomed earlier this year, and
with the tightening labor market finally working its way
into employee compensation, headline consumer prices will
be rising at a 3% clip by the end of 2016. (See Figures 10
and 11) We would note that as of mid-March the price of
oil was tracking above our forecast and whether that trend
continues could very well depend upon an OPEC/Russia
meeting scheduled for April 17.


The U.S. Consumer is in Good Shape

Despite issues concerning the distribution of income
and debt burdens, the U.S. consumer remains in good shape
overall. Consumption will continue to be on a 3% growth
path throughout 2016 and it will be accompanied by a saving
rate in excess of 5%. (See Figures 12 and 13) Where
previously we thought that much of the consumer benefits
flowing from lower gasoline prices would be spent, a goodly
portion of it was saved. That being said, the lower gasoline
prices seem to have found their way into generating near
record automobile sales.

Housing starts continue to improve, albeit at a slower
pace than we previously thought. After reaching 1.106
million units in 2015, we forecast starts to increase to 1.24
million units and 1.43 million units in 2016 and 2017, respectively.
(See Figure 14) Our prior forecast for 2016 was
for 1.4 million units, but the forecast for 2017 is much the
same as before. Homebuilders did not ramp up single-family
production as fast as we thought and they concentrated their
activity on the higher end of the market. There is now anecdotal
evidence that the builders are shifting their emphasis
towards starter homes where there is real pent-up demand
coming from increased household formation, modest income
growth and rising rents. Our prior forecast for multi-family
starts of in excess of 400,000 units a year remains on track.

Figure 10 Oil Prices, West Texas Intermediate
Sources: Commodity Research Bureau and UCLA Anderson Forecast

Figure 11 Employee Compensation
Sources: U.S. Bureau of Labor Statistics and UCLA Anderson Forecast

Figure 12 Real Consumption Expenditures
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 13 Savings Rate
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 17 Real Private Gross Domestic Investment in
Commercial Buildings
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 16 Real Gross Private Domestic Investment in
Mines and Wells
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Capital Spending Growth Remains Tepid

With the industrial economy in a shallow recession and
oil exploration capital spending dropping below the nadir
of 2009, we should be thankful for the modest increases in
capital spending we are witnessing. Specifically, we forecast
that equipment capital spending will increase at a 4-5% pace
over the next few years, not great, but certainly not a recession.
(See Figure 15) On the other hand, investment spending
on structures is in the midst of a two-year decline triggered
by the collapse in oil exploration spending. (See Figure 16)
Specifically, real investment in mines and wells will have

Figure 14 Housing Starts
Sources: Bureau of the Census and w Anderson Forecast

Figure 15 Real Gross Private Investment in Equipment
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

declined by 60% from $137 billion in the fourth quarter
of 2014 to a forecast $56 billion in the first quarter of
2016. Most people don’t realize that construction in the oil
exploration and production sector was far larger than the
entire commercial construction sector, no more.

On the other hand, commercial construction is gaining
strength. Improved fundamentals for office and industrial
construction are driving spending in this sector that is being
fueled by an abundance of capital seeking modest yields in
a low-yield world. (See Figure 17) In contrast, spending on
retail structures is now being driven by negative fundamentals brought about by e-commerce. Major malls are seeking
to remain relevant by making huge investments in renovation
on the order of $500-$800 million per mall at the high end.

Exports Remain a Real Risk

With a strong dollar and weak economic growth in
Europe, Japan, Canada, China, Brazil and the Middle East,
the U.S. export sector remains under pressure. We are still
forecasting minimal growth this year, but the real risk is that
we can very easily have a decline. (See Figure 18) If you
want to tell a story about a U.S. recession it would have to
begin in this sector, but even with a modest decline it would
not be enough to put the U.S. into a recession.

Figure 18 Real Exports
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Government: A Modest Positive

After several years of decline, federal purchases are
once again on the rise. Whether federal spending continues
to rise over the intermediate term will largely be dependent on how this year’s election turns out. (See Figure 19) The
increase this year is due to the temporary lifting of the
sequester that has been in place since 2013. Similarly, the
much larger state and local sector has been growing since
2014, but it will once again face the twin pressures of higher
pension and Medicaid outlays as the decade ends.

Conclusion

We don’t see a recession this year or next and we do
envision inflation rising above the Fed’s 2% target. As a
result, we are forecasting slow and steady increases in the
Federal Funds rate over the next few years. And although
we have continued growth in 2018, a forecast that far out is a
conjecture. Growth will be driven by increases in consumer
spending and housing along with the end of the inventory
correction we are now going through. The risks we envision
largely come from outside of the U.S. domestic economy
where disturbances in Europe and Asia along with domestic

politics have the potential to cast a pall over the economy.