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  • 2014 GDP growth: 2 percent, but U.S. economy mostly moving sideways, while financial markets too exuberant.
  • The average year-to-date 214,000 monthly job gains below the 250,000 needed for more than 3% GDP growth.
  • Too much exuberance in financial markets mistaking how long the Federal Reserve will take to raise rates.

Michelle Girard is a managing director and chief economist at Royal Bank of Scotland.

Harlan Levy: What do you think will be the effect on the U.S. economy of the ouster of Republican House Majority Leader Eric Cantor and what seems to be the resurgence of an uglier, more polarized and paralyzed Congress?

Michelle Girard: I think at this point we aren't expecting any significant economic fallout. The fact is that we're weren't getting much out of Washington to support the economy and any expectations for policy shifts continue to be low. Clearly people are looking ahead to the 2014 mid-term elections and more so to 2016 and trying to extrapolate what this might mean for the outcome of the presidential elections and what that might mean for policy.

But I think it's too soon to really draw any firm conclusions. At this point we continue to expect fiscal policy to be sidelined and any support for the economy will continue to come from the Federal Reserve and the impact of Cantor's loss on the economy is negligible. But I am equally disgusted with both Republicans and Democrats. Both parties have certainly contributed to the problem.

Q: How much economic disruption do you see coming from the exploding Iraq and Syrian situations?

A: I think that too ultimately depends on how things play out. The most direct impact clearly might be in terms of what it does for energy prices. I've actually seen some suggestions that we might get more supply, not less. It doesn't seem to be having much of an impact on the financial markets. We're in a wait-and-see mode. But so far, the fallout seems limited.

Q: What do you get from Friday's lower Michigan consumer confidence number?

A: The consumer confidence number - 81.2 down from 81.9 in May - simply underscores that we continue to be in a very low inflation environment. I actually thought the sentiment figures were a bit more interesting, though there too it's more important to see what consumers actually do in terms of spending rather than what they say about how they feel.

But it is surprising that even with the unemployment rate coming down and the economy improving off the harsh winter, that sentiment hasn't been able to move higher. It just argues more for our view that we're looking at an economy that's mostly moving sideways as opposed to accelerating sharply higher. It's not weak, but it's disappointing to those who were optimistic coming into the year that 2014 was going to be a lot better than 2013.

Q: What do you think of the most recent jobs data - more initial jobless claims and 217,000 new jobs in May?

A: This is exactly the same story. When you look at the payroll changes in May, it suggests that once the weather payback was complete job growth settled back to its previous trend. Year-to-date payroll gains are averaging around 214,000 a month, which is somewhat better than what we saw in 2012 and 2013, but it is far short of the kind of job growth of 250,000 or more that you need to expect a sustained, better than 3 percent Gross Domestic Product growth rate.

Q: What do you think of the weak retail sales report?

A: In fact I didn't think the retail sales figures were as weak as others thought. We did have upward revisions to April, which offset some of the softness we saw in May. Here, too, if you look at the average increase over April and May, it's in line with its average gain over the prior 12 months.

So all of these data keep sending the same message, which is that conditions are more or less the same as they have been. It's good news that they're not weakening, but we're continuing to grow at about a 2.5 percent pace, which is really too weak for people in general to actually "feel" that the economy is doing better. People look around and say, "Things are still lousy," but they acknowledge that things are much better than the depths of the recession although they're not as good as they were before the crisis.

Q: Is the housing recovery slowing as mortgage rates rise?

A: We definitely have seen a cooling in the pace of the housing recovery as a result of the fact that mortgage rates have moved higher, but in our view the real problem is still tight credit. It's very difficult for potential home buyers to secure a mortgage.

The other issue is the supply of homes available for sale is relatively low. Both factors explain why the rebound in housing this spring after the winter weather's hit has been disappointing. In our view the recovery in housing will continue but only at a gradual pace.

That's one of the reasons why we have been skeptical of the sharp acceleration in economic activity this year. A lot of people were optimistic about business investment and housing picking up noticeably this year and pushing the overall economy to a faster growth rate. We pushed back against that view, arguing that the growth in both of these sectors would continue to be modest.

Q: How do you rate manufacturing?

A: The manufacturing sector is continuing to advance. It's benefiting from the energy revolution and higher labor costs overseas. As a result of those two factors you are seeing more companies bringing production back to the U.S.

The sector in general seems to be growing at a slightly faster pace than the economy overall, but I still wouldn't characterize the expansion pace in that sector as vigorous.

Q: Where is the economy going?

A: The economy will have contracted about 2 percent in the first quarter when all the revisions are taken into account. We'll probably rebound by about 3 percent in the second quarter. So growth over the first half of the year has been very soft, averaging at around half a percent at an annualized rate. The most important question now is how fast does the economy advance in the second half. We are sticking with our theme of better but no spectacular growth. Our forecast is for growth to average between 2.5 and 3 percent in the second half of 2014. Still, for the year overall, growth is likely to be only around 2 percent on a fourth-quarter-to-fourth-quarter basis.

Q: What headwinds are persisting?

A: Although we have the continued gradual improvement in labor market conditions. We're not seeing the sharp pick-up in hiring or business spending that would propel the economy. But I'm not sure the declining labor force participation rate is a sign of economic weakness. In our view it's mostly driven by an older population. Older workers are choosing to retire and are leaving the labor force, and many of these individuals are unlikely to return to work, even if the economy improves. We actually think there is less slack in the labor market than Federal Reserve Chairman Janet Yellen has suggested.

Q: Is there anything worrying you?

A: The one development in financial markets that we are watching is the continuing improvement in some asset classes to levels that might suggest overvaluation. Part of this might be because markets are extrapolating the Fed's "lower rates for longer" too far. Right now markets look to be pricing in even less tightening than the Fed members have guided in their forecasts for the federal funds rate. So we think there is risk here of some disappointment, in particular if stronger data leads markets to rethink the outlook for the Fed. There might be too much exuberance.

The Fed this week might not validate what markets have priced in in terms of future interest rates. Eurodollar futures imply that the fed funds rate will be 1.8 percent at the end of 2016, and the Fed forecast has the rate closer to 2.33 percent. There's a disconnect there. If the Fed doesn't validate where the market is, there could be some disappointment this week. Financial markets might be in for disappointment this week if the Fed doesn't validate interest rate exuberance.

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Source: RBS Chief Economist Michelle Girard: Economy Moves Sideways, Financial Markets Too Exuberant