Regime Change, Risk Factors, and a Really Strong Start for 2018
St. Louis Federal Reserve Bank President Jim Bullard is talking about regime change. Not political regimes, but economic regimes. Bullard is focused on the factors that drive monetary policy, but his broad concept of regime change is very useful now when thinking about the overall U.S. economy.
Within the world of monetary policy it is easy to see that we are in a new regime. The Federal Reserve went into crisis mode in late 2006 when it dropped the fed funds rate to near zero. It took until the end of 2015 to change that. In the meantime, the Fed initiated three rounds of asset purchases and expanded their balance sheet from about $1 trillion, to $4.5 trillion. Not only did the Fed press short-term interest rates to historical lows during that nine-year period, they also exerted significant influence over the long-end of the yield curve through asset purchases. In the new regime, the Fed is pushing up short-term rates with increases in the fed funds rate, at the same time that it is winding down its balance sheet, putting some upward pressure on the long end of the yield curve.
In addition to the U.S. Federal Reserve trying to normalize U.S. monetary policy, the European Central Bank is also gradually winding down its extraordinary policy. As the ECB further reduces their asset purchases this year, they too will put upward pressure on bond yields.
The fiscal policy regime has also changed. The recently signed two-year federal budget deal, along with tax reform, is expected to push out the federal budget gap. Most neutral sources estimate that the new fiscal regime will widen the federal deficit over the long term. This would require the Treasury Department to issue more bonds, putting upward pressure on interest rates as bond supply increases.
Inflation indicators are warming up gradually. As they do, financial market volatility is increasing. The historically low financial market volatility of 2017 may already be a thing of the past.
The Trump Administration is also disrupting trade regimes. A more assertive trade policy from the Trump Administration may yet bring countermeasures by our trading partners.
Finally, as we discussed previously, we are now more than 10 years out from the start of the Great Recession. Historically, that demarcation is associated with a regime change toward improved economic performance.
Even with a strong start to 2018, economic risk factors remain. By this May, we will be in the second longest U.S. economic expansion ever as we reach 107 months. By many metrics, this feels like a mid-to-late cycle economy.
However, the labor market is not cooling off. For a few years now, the consensus view among macroeconomists was that labor demand would gradually ease by this point in time, to something on the order of 100,000 to 120,000 net new jobs per month, or less. In the February labor data we saw the opposite. Payroll job growth was robust, up 313,000 for the month. Net revisions to December and January were +54,000, to bring average payroll job growth for the last three months to over 242,000 per month. Sizeable increases in the household employment survey and in the labor force kept the unemployment rate at 4.1 percent for the fifth consecutive month. We still expect the unemployment rate to drop below 4 percent this year, but the pace of declines appears to be slowing, yet another sign of economic regime change. Wages increased only moderately, by 0.1 percent in February, after jumping by 0.3 percent in January.
For a PDF version of this report click here: USEconomicOutlook-0218.
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