U.S. Bond Market Week In Review: Rosengren Gets It Wrong, Edition

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When the Fed raised rates in the fourth quarter, it appeared the economy was on track to continue growing at fairly stable rates. 3Q top-line growth was 3%; personal consumption expenditures (PCEs) increased 3% Q/Q and residential construction was up a strong 8.2%. Best of all for the Fed, employment growth was consistently solid. With the exception of labor utilization, labor market indicators showed a strong hiring environment. While investment was down .7%, this was its first quarter of contraction since 1Q14. And it was easy to rationalize the problem as being localized to the oil and gas sector. Although wage growth was disappointing, one could easily argue that increases were right around the corner. Finally, once oil started to rise - and weak 2015/2016 Y/Y comparisons kicked in - CPI would start to head towards the Fed's 2% target.

Then came the initial 4Q report of a smaller than expected .8% Q/Q growth. While the BEA eventually revised that figure to 1.4%, it's still disappointing. PCEs remained positive, printing at 2.4% Q/Q. Business investment was the primary reason for the drop; overall investment declined 1%, with three subcategories contracting. And thanks to a strong dollar and weaker overseas economies, goods exports declined again, this time by a larger 5.4%.

And now we have continued weaker economic readings from two coincident indicators. Real retail sales (blue line) have moved sideways for the last year and industrial production (red line) is declining:

Job growth - a third coincident indicator - remains positive. But it's hard to see the recent growth continuing with corporate profits (a long leading indicator) declining:

And this week building permits - another long leading indicator - decreased 7.7% M/M, continuing their recent sideways trend:

All of this explains the recent decline in the Atlanta Fed's GDPNow 1Q projection to a mere .3% increase in growth.

These numbers are in stark contrast to Fed President Rosengren's speech this week, where he observed:

Incoming economic data for the first quarter suggest that growth in the quarter was disappointing, with real GDP likely to have advanced at a pace well below most estimates of potential growth, about 2 percent. However, I will point out that weakness in the first quarter has been a consistent pattern in recent years, and to date, that weakness has generally been offset in subsequent quarters, as the economy has continued to improve slowly. Certainly the March unemployment report showing 215,000 jobs created, along with an increase in the labor force participation rate to 63 percent, is supportive of a more optimistic reading of the GDP numbers.

Additionally, the core PCE inflation rate is now at 1.7 percent, much closer to the Federal Reserve's 2 percent target than were the core PCE readings in 2015.


While I believe that gradual federal funds rate increases are absolutely appropriate, I do not see that the risks are so elevated, nor the outlook so pessimistic, as to justify the exceptionally shallow interest rate path currently reflected in financial futures markets. The forecast for economic variables contained in the most recent Fed policymakers' Summary of Economic Projections is consistent with my own estimate - GDP growth slightly above potential and a continued slow decline in the unemployment rate.

Furthermore, I would point out that the extremely shallow rate path reflected in the market for federal funds futures seems at odds with forecasts by private sector economists and by financial firms that serve as counterparties to the Federal Reserve (the so-called primary dealers), as well as my own forecast for the U.S. economy. Most of these forecasts envision a much healthier U.S. economy than is implied by that unusually shallow path of the funds rate, and many of the major private forecasters expect short-term rates to rise more rapidly than implied by financial futures.

While recent strong employment growth supports Rosengren's argument, his remaining supporting evidence is very weak. He first argues that the US economy will follow a similar growth path as previous years: a weak first quarter followed by a stronger second half. The above-cited weakness in retail sales, industrial production, corporate profits and building permits make that a very unlikely scenario. And he forgets that forecasters - especially those at the Fed - have consistently overestimated US growth prospects since this expansion. Given those facts, it seems highly unlikely that Rosengren's projections will come to pass.

Hale Stewart, XE.com