NGDP Outlook Update – February 2019 A look at the Treasury Market

Let’s do a recap of the recent history of NGDP expectations. At the End of Q3 2018, the NGDP outlook was nearly fantastic. Throughout Q3, year-ahead expected NGDP, as interpreted by out market-driven forecast engine was holding around 5%. When Q4 began, there was a small dip in the year-ahead expectation, arising from the shift to a new four-quarter window in our calculation of YoY growth, not data.  The quarter started out fine, with expectations hitting 4.6% on November 7, 2018. Things went south from there; following a series bearish Fed actions and non-actions, in the face of flailing markets and some sour data, NGDP expectations sank as low as 3.2% at the end of December.

Someone seems to have had a talk with Powell, and January saw a reprieve, a partial unwinding of the screws the Chairman had previously tightened. The outlook has recovered somewhat, and NGDP expectations are now at about 3.5%. This seems a meager number after the thrilling growth seen in 2018. It is tempting to second guess the model here, considering the most recent US jobs report, showing strong hiring in December and January, but a perusal of the markets sadly corroborates the model’s general tone.

Market Data

5-year TIPS spreads are weak, at 1.7%. Some write off TIPS spreads because a proportion of the variance in the CPI is due to changes in oil prices. This argument is uncompelling for a few reasons: Firstly, Gasoline has about a 4% weight in the CPI, it hardly matters, diesel prices (not in the CPI) affect other retail prices, but these effects are attenuated by the proportion to which retailers bear them. Further, abundant oil, which along with a weaker global economy has kept prices low, should be seen as a positive supply shock. Positive supply shocks don’t compel a central bank to depress a half-decade worth of inflation, as though the supply tailwind never happened. If a central bank is expected to fail to hit its target over a 5-year horizon, it’s failing.

The yield curve too is pessimistic about sustained strong NGDP growth. The 5-year/3-month spread is still stuck at about the lowest point since early 2009, the 5-year/2-year spread (Blue line) is at roughly 0, the lowest since 2008. Whatever spread you care to look at, the picture is much the same. This means the market expects little change in the Fed funds rate for years, which can be extrapolated to mean the Fed is not expected to be ‘chasing’ a hot economy.

There’s been talk about “Fed Puts” and “Powell capitulating”, following dovish statements by the Fed Chair. Implicit in such observations is often a claim that the Fed is in some way working to boost stock prices, at the expense of the rest of the economy. This is nonsense, and you only have to look at the bond market to see it. The Fed is supposed to have a “put”, that’s called not causing a recession. Stock prices rose in January, it is true, but this was because expected NGDP, or something approximating that measure, rose a bit. Looking only at yields and spreads, you’d predict a period of policy rate stability and nominal growth insufficient to hit inflation targets.

A recession is not a big risk given current facts. Powell can’t possibly flip hawk again any time soon and retain credibility, but the outlook is not great for 2019. Expect a solid Q4 GDP number and probably a decent Q1 number in the GDP releases. Our forecast engine predicts this at least. For 2019 to be salvaged, and the economy to run closer to its sustainable capacity, we’ll need to see something from the Fed, say allowing a few good data releases to come out without talking down markets.

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