US economic outlook: expect lower inflation near term - Nomura

Analysts at Nomura explained that the FOMC is poised to start reducing its balance sheet while the next rate hike, which they expect in December, will depend on the progress on inflation. 

Key Quotes:

Economic activity: The US economy continues to grow slightly above potential, a trend we expect to continue. Consumer spending has been growing modestly and investment has picked up from 2016. Job gains remain strong, well above the sustainable pace, pushing the unemployment rate to levels not seen since 2001 (Low Unemployment: Not as Low as it Seems, 16 June 2017). Productivity growth in H1 averaged an anemic 0.5%, held down by structural declines in the underlying dynamism of the economy (e.g., the rate of new business formation, churn within existing businesses, and workers changing jobs). We expect these declines to also to weigh down wage growth despite the low unemployment rate (The Nomura Labor Turnover Index: A Timely Indicator of US Business Dynamics, 9 August 2017). Moreover, we expect only modest fiscal stimulus in the form of tax cuts in late 2017 as the Republicans face looming deficits and thin, diverse majorities in Congress. 

Inflation: We expect lower inflation in the near term. Transitory factors that contributed to recent weakness such as prices of wireless telecom services and medical care commodities largely reverted, but other enduring factors such as new and used car prices and rents may constrain near-term core inflation. Yet, over the medium term we expect inflation to pick up gradually as labor markets tighten and the economy operates above potential. Against this backdrop, we think core inflation will grow in 2018 and 2019. Core PCE inflation may gradually pick up slightly faster than core CPI as healthcare service inflation accelerates while rent inflation slows. 

Policy: We expect the FOMC to continue on its gradual policy accommodation removal by raising short-term interest rates again in December. In the interim, we expect the FOMC to announce the decision to begin the balance sheet roll off at its September meeting. We continue to expect two more hikes in 2018 to a terminal rate of 2%. 

Risks: Financial conditions have eased considerably so far despite four Fed hikes since December 2015, but they could turn quickly in response to the Fed’s balance sheet policy or to an external geopolitical event. Further, the debt limit ceiling is fast approaching with no clear path forward, which may cause market angst (Debt Ceiling: Calm Seas but Storms Possible, 28 July 2017). Additionally, at some point the Trump administration may pursue more aggressive trade policies that could result in retaliatory actions by trading partners."