Phase 1 on China, Brexit and the Fed/Stock Market

A Fed rate cut at the October 29-30 FOMC Meeting is still a good possibility, even with Trump's "Phase 1" deal with China and movement toward Brexit.  The latter two move toward ending the downside risks to the economy identified by Fed Chair Powell.  But, the main consequence of these risks -- global economic slowdown -- remains.     

Evidence that global growth has turned up may be needed to persuade the Fed to stop easing.  There has been some tentative evidence of improvement in Chinese manufacturing survey data.  But, any bottoming in China has not been strong enough to help its major trading partners.  European manufacturing surveys, particularly Germany's, continued to weaken through September, as have those for South Korea and Japan.  This week, consensus looks for further weakness in Germany's October ZEW Economic Sentiment Index and China's Q319 Real GDP reports. 

The short-end of the Treasury market is still building in a 25 BP rate cut in October.  A sell-off there would be the clearest signal that evidence has firmed enough to forestall a Fed rate cut.


This background should be supportive of the stock market.  If the short-end of the curve sells off, it will send a message that the economic risks have improved significantly.  If it does not sell off, the likelihood of a Fed rate cut should cushion and limit the market effects of any negative corporate earnings news.  Moreover, the easing of threats from US/China and Brexit suggest some of the earnings weakness is temporary.   And, the lower threats work to weaken the dollar, which make earnings abroad more valuable in dollar terms.  Even though some analysts point out that the US still may impose new tariffs in December, this is probably too far ahead to be a near-term concern.

Last week's speech by Powell made some important points that bear on monetary policy and politics.  He discussed 3 items -- /1/ The possibility that Productivity is higher than now measured.  /2/ The US macro-effects of oil prices.  /3/ Measuring labor market tightness.  The Productivity issue impacts both monetary policy and political discussions.

Productivity Measurement
Powell focused on the inability of GDP and thus Productivity to capture the technical impact of the internet and free applications on it.  Fed staff work so far developed a simple way of measuring it, using volume of data flow.  It implies that GDP Growth is understated by about 0.5% pt per year since 2007 and by 0.25% pt/year in the prior couple of decades.   A redefinition of GDP along these lines would make the data more in line with common sense observations about the impact of the internet on people's lives.

A redefinition of GDP has significance for the political discussion of income growth and distribution.  Much political angst has spewed forth on the failure of the median household income to rise with economic growth.  This problem will be at least partly eliminated by capturing the technical advances of the internet.  Since the boost is larger after 2007, the inter-temporal comparisons will improve.

A redefinition of GDP is not important for monetary policy.  This is because both measured and potential GDP Growth should be boosted by the same amount.  So, the relationship between the two would not change.  In other words, measures of labor market and economic slack would be unaffected.

More important for monetary policy is the possibility that the trend in productivity growth has improved.  Powell acknowledged the speedup in Productivity Growth over the past couple of years.  He said the Fed is still not sure if it will persist.  But, if officials begin to be convinced that it will, this would be a big positive for the stock and Treasury markets.  It would mean the Fed's view of Potential GDP Growth is higher than the current 1.8-2.0% estimate.  So, officials would be more willing to permit stronger GDP Growth than now.  It also would likely lead the Congressional Budget Office to lift its estimate of longer-run growth, which would make budget projections less troublesome.

Powell highlighted the positive effects of Greenspan's insight into the implications of the technological revolution of the late 1990s -- suggesting it is an important insight into current Fed thinking.  It suggests the Fed will be very tolerant of stronger growth until a noticeable pickup in inflation occurs.

"Chairman Alan Greenspan famously argued that the United States was experiencing the dawn of a new economy, and that potential and actual output were likely understated in official statistics. Where others saw capacity constraints and incipient inflation, Greenspan saw a productivity boom that would leave room for very low unemployment without inflation pressures. In light of the uncertainty it faced, the Federal Open Market Committee (FOMC) judged that the appropriate risk‑management approach called for refraining from interest rate increases unless and until there were clearer signs of rising inflation. Under this policy, unemployment fell near record lows without rising inflation, and later revisions to GDP measurement showed appreciably faster productivity growth."

Oil Prices
Powell acknowledged that the surge in US domestic oil production means that a rise/fall in oil prices will have a little impact on US GDP.  This is in contrast to the past when the US was a large net consumer of oil.  Then, for example, a rise in oil prices had a significant negative impact on the economy as the consumer was hit by essentially a large tax hike.  Now, the hit to the consumer would be offset by a price-induced increase in domestic oil production.

To be sure,there still could be net negative effects on the US economy through the exchange rate -- although not mentioned by Powell.  Higher oil prices boost world demand for dollars, since oil is traded in dollars.  An increase in dollar demand would result in a higher dollar exchange rate, which would hurt US net exports.

Measuring Labor Market Tightness
Powell said the Fed is working with ADP to construct a new measure of job growth.  It was more accurate regarding  job losses during the Great Recession than official data at the time.  But, he was not more specific than that.  He acknowledged that the recent BLS estimate of the benchmark revision to Payrolls would lower m/m Payroll growth.  But, he said the pace would still be strong enough to tighten the labor market:

"Based on a range of data and analysis, including our new measure, we now judge that, even allowing for such a revision, job gains remain above the level required to provide jobs for new entrants to the jobs market over time."