Increase in US inflation following Hurricane Harvey, PMIs picking up in India

Macro Highlights - 10/18/2017

In short
  • Increase in US inflation following Hurricane Harvey, PMIs picking up in India
  • US focus: Economic cycle set to continue in 2018

Key Takeaways of the week with Sophie Casanova, Economist, Central Banks, Lisa Turk, Economist, United States and François Léonet, Economist, Emerging Markets
  • US inflation climbed to 2.2% in September, driven primarily by a 10.6% increase in gasoline prices over the same period, following Hurricane Harvey
  • Core inflation remained stable at 1.7%. We expect it to accelerate again slightly over the coming months, confirming our forecast for a 25 bps Fed Funds rate hike in December
  • In India, the leading indicators are back in economic expansion territory, tending to confirm the temporary nature of the shock linked to the introduction of the goods and services tax

In the US, the price index accelerated from 1.9% in August to 2.2% in September, driven virtually exclusively by the increase in energy prices. Over this period, following Hurricanes Harvey and Irma, gasoline prices increased by 10.6%. While core inflation has remained stable at 1.7%, we expect it to pick up slightly over the coming months. Tensions on the job market are rising, while the increase in import prices following the dollar’s depreciation and the acceleration in producer prices represent additional factors that are expected to put upside pressures on core inflation. Although core inflation has been stable for the past five months, the Fed Funds futures show, at 16 October, a probability of 80.2% for the Federal Reserve hiking its key rate by 25 basis points in December, in line with our forecast.

In India, the leading PMI indicators – for both the manufacturing sector and services – show encouraging trends, in line with the developments observed in August. The manufacturing indicator remains unchanged at 51.2, while the service sector is up from 47.5 to 50.7, in economic expansion territory. This upswing reflects the components relating to employment, as well as business expectations. With the Reserve Bank of India keeping its key rates unchanged at 6% following its 0.25% cut in August, these figures tend to confirm the temporary nature of the negative shock for domestic activity following the introduction of the Goods and Services Tax (GST) in early July. Indian activity levels look set to continue normalising over the coming quarters, on a gradual basis according to the leading indicators, which are still below their levels from before the GST’s introduction and - even more clearly - below the levels from before the demonetisation at the end of 2016.

Lisa Turk, Economist, United States and François Léonet, Economist, Emerging Markets

US focus: Economic cycle set to continue in 2018

  • Some indicators have recently fuelled concerns that the economic cycle is nearing its end, including the low unemployment rate and the slowdown in corporate credit…
  • …but the moderate acceleration in wages, weak inflationary pressures, the good financial position of households and monetary policy are expected to support activity in the short term
  • Alongside this, the dollar’s recent depreciation and the potential tax cuts are also expected to contribute to growth in 2018, which we expect to come in at 2.5%

Recently, several indicators have fuelled concerns surrounding the risk of a recession in the US, with similar trends to those seen at the end of previous cycles. For instance, the US job market has reached full employment, with unemployment at 4.2%, its lowest level for nearly 17 years; car sales have contracted since the start of 2017; debt levels for non-financial businesses are up to an all-time high and growth in business borrowing started to slow down at the beginning of the year. Despite these signs that are traditionally associated with the end of a cycle, we expect growth to continue accelerating in 2017-2018 in light of other factors. Consumption growth trends are positive, households are still in a healthy financial position, the real estate market is proving resilient and the monetary policy is not restrictive. The real Fed Funds rate, i.e. adjusted for inflation, is still negative. In addition, the dollar’s recent depreciation and the prospect of tax cuts being introduced could provide further support for US growth in 2018, which we expect to come in at 2.5%.

Certain signs, identified at the end of previous cycles, have been observed: job market maturity, high corporate debt levels and falling car sales

  • The US has reached full employment since the last quarter of 2016 according to the Congressional Budget Office. Unemployment was 4.2% in September 2017, while underemployment, which counts discouraged jobseekers and part-time employees for economic reasons, dropped from 9.4% in January to 8.3% in September 2017. Surplus capacity on the job market has therefore decreased significantly this year. In addition, the number of job openings has continued to rise and more than 50% of small businesses are struggling to find qualified candidates, an all-time high. The job market is moving close to the levels usually seen when an economy nears the end of its cycle.  
  • Alongside this, levels of debt among non-financial businesses are now significantly higher than their pre-crisis levels. In the second quarter of 2017, their debt reached USD 13,909 billion, representing 72.3% of GDP, compared with an all-time high of 73.7% during the financial crisis. While the recent slowdown in growth in bank lending for businesses may have caused concern as a sign of an economic downturn, our analysis shows that this could, on the contrary, accelerate again over the coming months. While banks relaxed their lending conditions in the second quarter of 2017 for industrial and commercial loans, the recent upturn in business investment could also boost borrowing. Nevertheless, businesses still have high debt ratios and their ability to borrow could be limited a few quarters from here, which could by then impact investment.
  • Lastly, the sharp contraction in car sales has led to concerns surrounding the outlook for consumption. However, the drop in the number of vehicles sold is expected to be perceived as a return to normal following an excessive level of sales. In 2016, 17.5 million sales were recorded, an all-time high. The particularly flexible credit conditions available encouraged households, even those with limited solvency, to take out vehicle loans. While the level of late payments is rising, banks are tightening up their lending conditions for vehicle loans, which is having negative impacts on this market.

However, growth is still being supported by certain factors: an upturn in consumption growth, a healthy financial position for US households, accommodating monetary conditions and a high level of confidence on the real estate market

  • While consumption growth remained stable over the first half of 2017, we expect it to accelerate slightly over the second half of the year and in 2018. Full employment has been reached, wages are accelerating slightly, inflationary pressures are low and household debt levels as a percentage of their disposable income are significantly lower than before the crisis. Nominal wages climbed to 2.9% year-on-year in September and this improvement looks set to continue, factoring in the situation on the job market. Moreover, core inflation remains under control. While we expect it to accelerate again slightly before the end of the year, driven by higher producer prices and an increase in import prices following the dollar’s depreciation by 8% since the start of the year, the increase in inflation is expected to remain under control. As a result, real household wages are not expected to see any significant deterioration. Lastly, household debt, at USD 14,855 billion, is still lower than its pre-crisis levels in relative terms: it represents 103.8% of disposable household income (versus 132.2% at the start of 2008, and 77.1% of GDP (versus 97.5% at the start of 2008), its lowest level since the crisis. 
  • Monetary conditions are not restrictive: the real Fed Funds rate is still negative, at  -0.54% in September 2017. This level is significantly lower than the long-term neutral rate, which the Fed estimates at 0.75%. Furthermore, since we expect the Fed Funds rate to gradually rise, the yield curve is set to gradually flatten, although without reversing . We are maintaining our forecast for a 2-year Treasury yield of 2.10% and a 10-year Treasury yield of 2.85% for the end of the first half of 2018.
  • Despite a slowdown in construction growth over the past three years, house prices remain high, confidence indexes are showing positive trends and late payments are continuing to fall. The real estate market continues to show positive trends..

Implications

  • However, a number of economic indicators have not yet reached an equivalent level to the end of a cycle, reducing the probability of a recession for 2017-2018.
  • Consumption trends are positive. Wages are accelerating slightly, inflationary pressures are low and households are in a good financial position. Alongside this, monetary conditions are still accommodating and confidence on the real estate market is high.
  • While the introduction of the tax cuts may be put back to the second quarter of 2018, the increase in exports following the dollar’s depreciation is expected to support growth at the start of 2018. We expect GDP growth to reach 2.1% in 2017, before accelerating to 2.5% next year.
  • The job market’s maturity and high levels of debt for non-financial corporates are at similar levels to those seen in the past before the end of cycles.

Lisa Turk, Economist, United States