The trend down in real GDP growth is unmistakable; from 4.1% at an annual rate in Q4 of last year, to 2% in Q1 to 1.5% in Q2. At such a pace the U.S. economy is extremely vulnerable to shocks such as the downturn in Europe and the upcoming fiscal retrenchment. According to the Fed minutes, households and businesses are already affected by the looming fiscal uncertainty. Against this backdrop is not surprising that nonfarm payrolls have been notably weak for the past three months. Another sub-100′ on NFP for July would actually be a recessionary signpost. In the past, a four-peat of so weak payroll advances has only occurred in recessionary phases save last summer’s soft patch. While a recession is not necessary going to happen now the economy is fragile and what what we can say with 100% certainty is that it will at some point. From a historical perspective the average length between recessions is around 3,5 years so a downturn late this year is in tune with American economic history. That’s not a forecast but an observation.
With respect to inflation, the key price indexes are both running below the 2% objective; the PCE index is up 1.6% YoY and the core PCE index is running just a touch higher, at 1.8%.
So not only is the labor market is “stuck in the mud”, the economy visibly slowing but inflation is running below the Fed’s goal too. This is why many Fed officials appears increasingly inclined to move unless they see evidence that the economy is picking up on its own. Put differently, the Fed does not need any further deterioration as an excuse to act; the question now is how and when to move in our opinion.
Another round of quantitative easing could come at the August meeting already, or the FOMC might opt for the upcoming meeting in September. The uncertainty is high and if the Committee waits until the September meeting it has two more employment reports to digest. Moreover unlike after the August meeting Bernanke meets the press after the September affair, which perhaps makes it a better choice. But the timing is really a close call not least since markets are looking for decisive action from the ECB and the “shock and awe” effect would be bigger if the Fed eased convincingly at the same juncture as well. But we stick to our forecast that the FOMC will launch QE3 in September. However we expect another extension of the forward guidance tomorrow, to mid-2015 or possibly even further out. Maybe not what some in the marketplace are looking for but monetary easing it still is.
It should be clear by now that escape velocity is very hard to achieve when the economy is in a deleveraging cycle. But keep in mind that we have the most determined Fed in history and it will keep trying. According to Bernanke there are basically for ways to go; 1) another bond buying program (preferably heavy on MBS), 2) lending through the Fed’s discount window, 3) change the communication on the forward guidance or the balance sheet, 4) cut the IOER (interest rate on excess reserves). There are more opaque options floating around but they will not see the light of day anytime soon.
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