Economics & Strategy
U.S. Outlook – 2019: Next Phase of Monetary Policy Normalization, Political Uncertainty and the Ongoing Trade War
— Ward McCarthy, Chief Financial Economist
The U.S. economy is still in a good place despite some pockets of weakness. The consumer sector remains strong and will continue to be supported by job growth, rising wages, rising disposable income and solid confidence. The job market boasts record job openings and jobless claims near 50-year lows, and measures of aggregate wage growth will continue to creep higher. In addition, the cumulative effects of business deregulation and corporate tax relief continue to foster a business-friendly environment. Importantly, small business confidence remains high, and business formations continue to accelerate.
The trade war has become an impediment, however, and caused some investment spending to be deferred due to uncertainty caused by trade tensions. The trade war has chipped away at U.S. investment activity and will continue to do so until there has been more significant progress on trade issues. We estimate that trade war uncertainty has become a drag of 0.5% on investment spending. Consequently, we have lowered our projection for 2019 GDP growth from 3.4% to 2.9%.
The U.S. housing cycle has stalled but is not over. Housing activity continues to adjust to less attractive affordability and demographics that favor mid-priced housing over the higher-priced end of the market. The limitation of SALT deductions in the 2017 tax legislation has frozen housing markets in high-tax, high-priced housing markets, and more price concessions will be necessary to get sales in those markets moving again.
As measured by the CPI, U.S. inflation averaged about 2.5% in 2018, which compares with an average of 2.2% over the prior twenty years. Inflation was in the process of returning to a normal cyclical pattern, but the trade war was been unmistakably disinflationary over the second half of the year. The tariffs will put modest upward pressure on inflation in early 2019 that partially offsets the disinflationary effect of the trade war. Nonetheless, we expect the average U.S. inflation rate in 2019 to decelerate to 2.0% from 2.5%.
With U.S. monetary policy entering the next phase of normalization, the pace of rate hikes will moderate and there will be more uncertainty about the timing of future rate hikes. With the Fed continuing with the maximum balance sheet roll-offs of Treasury and MBS holdings of as much as $50 billion per month, the size of the balance sheet will shrink by more than $550 billion in 2019.
2018 rate normalization was easy to project for two reasons. First, the fed funds rate was well below the FOMC range of estimates of the neutral fed funds rate, so there was limited opposition to rate hikes by FOMC policymakers. Furthermore, the dual mandate objectives consistently flashed green to quarterly rate hikes because the labor market was strong and inflation matched or surpassed the Fed’s 2% target for most of the year.
The pace and timing of rate hikes in 2019 will be more uncertain for a variety of reasons. Uncertainty about the accuracy of the Fed’s estimates of the neutral fed funds rate argue for the FOMC to moderate the pace of rate hikes as the fed funds rate approaches the Fed’s 2½% to 3½% range of estimates for rate neutrality. As this happens, rate hike decisions will be more data-dependent. Finally, the FOMC will have increased flexibility to make rate changes in 2019 because Jerome Powell will hold a press conference after every FOMC meeting, making every meeting potentially a “live” meeting.
Due to Powell’s comments about increased caution with fed funds neutrality within reach and our projection for a deceleration of U.S. inflation in the first half of the year, we expect the FOMC to raise the fed funds rate twice in 2019.
The transfer of economic stimulus from monetary policy to fiscal policy will continue to be a turbulent process that contributes to market uncertainty. The perpetually poisonous political environment will add a new dimension with a split Congress and rising impeachment pressures. Prolonged fiscal profligacy and the switch from LIBOR as a reference rate are threats to growth prospects longer-term.