GDP data for the first quarter raised further concerns about the ability of the US economy to weather a tightening of the policy mix (fiscal contraction and higher interest rates). In particular, it showed that the economy could decelerate sharply if lower public spending came along with slower consumer purchases.
The last time the U.S. economy was in jeopardy was in the wake of QE1 when 10-year U.S. Treasury yields rose sharply (+135 basis points between October 2010 and early February 2011) and gasoline prices soared (+32% during the same period, but +82% in total, reaching 346 USD in late April 2011). As the U.S. dollar fell, import prices excluding petroleum jumped from 2.6% YoY in late 2010 to 5.1% in June.
The chart below shows that the situation is clearly different today. So far, 10-year U.S. Treasury yields have increased at a slightly higher pace but the extent of the hike has so far been capped at 2.66%. More importantly, gasoline prices have fallen by 15% since March and, on a YoY basis, import prices are declining (-0.5%) as the USD appreciates.
Of course, the starting points are different. As can be seen below, when UST 10-year rose in late 2010, the economy was showing a positive growth momentum, while today's momentum is uncertain (hovering close to zero).
However, the inflation picture is similar. In late 2010, inflation surprises were on the downside: the core CPI was at 0.6%, which urged the Fed to carry out an anti-deflationary quantitative easing.
Today's inflation surprises are also on the downside but core inflation stands at 1.7%. As the CPI is biased by its rental component, the core PCE may provide a better gauge. Today's reading of 1.05% is close to the one that prevailed in late 2010).
This raises several questions:
- As growth is slower today and the deflation threat looks similar, why taper? The answer lies in the "bubble" risk that the Fed has identified in many papers released in late April/early May and because it has the ability to reverse the taper in case the economy falters. The combination of a lower inflation, an apparently resilient economy, and a better deficit outlook was also a good way to "test" the market on the sensitive issue of the exit.
- To what extent the U.S. economy can suffer from the exit as, contrary to late 2010, the fiscal policy stance is much more contractionary?
1. Residential Investment: One reason for the strength of the U.S. economy is the rebound of residential investment. My macroeconomic model suggests that a 100 bp rise in 30-year mortgage rates has a 4-5% negative impact on the year-over-year growth rate of residential investment. Given the 120 bp hike in U.S. mortgage rates recorded over the last 2 months, this could lead me to revise my yearly growth forecast for GDP by 2-3 tenths. Yet, the recovery in housing is more supply-driven (low inventories, demographics) than demand-driven (mortgage debt is still declining), which is maximum a -0.2 point impact.
2. Consumption: US households consumption is no longer dependent on credit. The only component of consumer credit that is growing is student loans student loans. For that reason the direct impact of higher UST yields on consumption is not straightforward. In addition, econometrics shows that consumption tends to be positively correlated to yields, not the other way around (long-term yields rise when the economy is in better shape). The yearly growth of consumption is negatively correlated to oil prices (with a lag) and positively to job creation. As oil prices will likely remain muted and NFP will hover around 150K until year end, the net impact of higher yields on U.S. consumption is likely to be quite small.
The downward revision of U.S. GDP for Q1 was more of a warning on the potential risk that the U.S. economy is facing than an early indicator of a forthcoming slowdown. Yet, given the restrictive policy mix, it is worth gauging the potential impact of higher rates on the economy, consumers in particular. It appears that the sensitivity of consumption to interest rates is quite low in a deleveraging world. U.S. consumers are much more affected by the increase in taxation (payroll tax). The good news for the U.S. economy is the disinflation brought on by a stronger USD and lower commodity prices. Given the slow but improving job market, it guarantees a rise in purchasing power that should enable the economy to grow even if UST 10-year yields reach 3% in late 2013.