US Economy Sprinting to the 2014 Finish Line While Fed Tries to Catch Up

Written by: Matt Weller, Senior Technical Analyst with FOREX.com

If we think of 2014 as a track race, the US economy undoubtedly stumbled out of the starting blocks to begin the year. Heading into January, traders and economists were optimistic that 2014 would be the year that the economy would finally be able to stand on its own without the Quantitative Easing crutch that it had relied upon for the past few years. Those optimistic projections were quickly turned on their heads when the much-ballyhooed Polar Vortex drove economic activity to a standstill in Q1; in fact, the economy actually contracted by 2.9% in Q1, the worst GDP reading since the depths of the Great Financial Crisis:


Source: BEA, FOREX.com

Thankfully as we roll into the second half of the year, the US economy appears to catching its stride and even accelerating into a probable strong finish to the year. According to the most recent figures, economic activity bounced back strongly in Q2 on the back of strong growth in the labor and housing markets, and most economists expect second quarter GDP (July 30) to come in around 3.0% annualized, unwinding all of Q1’s disappointing reading.


Source: FRED, FOREX.com

Federal Reserve: The Queen on the Chessboard

Despite the shocking GDP reading, as well as a number of other disappointing economic reports in the first quarter, the Federal Reserve presciently looked past the near-term turmoil and stuck to its prescribed taper path. Now, according to the most recent minutes, the central bank is planning to stop Quantitative Easing with a $15B taper in October, clearing the way for an eventual interest rate hike at some point in 2015.

From a trading perspective, the Fed’s evolving outlook on when to start hiking interest rates will be a dominant theme in the second half of the year. In order to discern what the Fed will do, it’s important to take a step back and note that the Fed’s verdict will hinge on its dual mandate to “…promote effectively the goals of [1] maximum employment, [2] stable prices and moderate long-term interest rates."

On the employment side of the ledger, the news could hardly be better. Heading into the July Non-Farm Payrolls report, the US economy has now created over 200k jobs for five consecutive months, a development we haven’t seen since the run-up to the Tech Bubble in 1999. With the participation rate (the percentage of US adults seeking employment) likely to stay subdued due to demographic trends and baby boomers forced into early retirement, the unemployment rate may continue to grind generally lower in H2 2014. In fact, the unemployment rate fell to just 6.1% in June, within the Federal Reserve’s projected 6.0-6.1% range for end of the year! As long as the unemployment rate remains subdued, the labor market will continue to pressure the Fed toward normalizing rates.


Source: Federal Reserve, FOREX.com

The more nuanced half of the Fed’s dual mandate is undoubtedly inflation. The widely-followed Consumer Price Index (CPI) of inflation is already pressing against the Federal Reserve’s 2.0-2.5% target as this report goes to press, but the Fed preferred Core Personal Consumption Expenditures (PCE) measure is lagging a bit behind at just 1.49% in May. That said, Core PCE has risen nearly 0.5% since the beginning of the year, and if that trend continues, inflation could easily hit the Fed’s target range by the end of this year or early next year.


Source: Federal Reserve, FOREX.com

The current low PCE inflation figure suggests that a loose monetary policy is appropriate, but it’s important to remember that the Fed’s current monetary policy is already unprecedentedly accommodative. Not only is the bank still goosing the economy through its Quantitative Easing program for at least a few more months, but interest rates are also at the zero bound. Contrast the current situation to the Fed’s most recent Summary of Economic Projections, where most officials favored a long-run equilibrium interest rate in the 3.5-4.0% range; this indicates that the Fed could finish tapering QE and increase interest rates by 0.25% eleven separate times (!) and still be seen as dovish relative to their long run equilibrium projections.


Source: Federal Reserve, FOREX.com

With both the unemployment and inflation rate rapidly approaching the Fed’s longer-run target, there is a risk that the central bank will have to raise interest rates sooner and more aggressively than many expect. The impact that this realization could have on the markets in the second half of this year cannot be understated. If traders begin to suspect that the Federal Reserve is behind the curve, the US dollar will catch a bid on rising interest rate expectations, especially at the expense of the euro and yen, which are backed by more dovish central banks. Meanwhile, US equities could see their long-awaited pullback at the prospect of the “era of easy money” coming to an end. The future is never certain, but our crystal ball shows risks that the Federal Reserve will have to tighten more quickly and aggressively than the market expects, assuming the current trends in inflation and unemployment are maintained.