Better U.S. growth and just muddling along both point to low rates for longer

June 10, 2014

UFaith that the U.S. economy may finally be at a turning point for the better appears to be on the rise, as many ramp up expectations for a better Q2 and second half of the year.

But that does not mean that interest rates are likely to rise any sooner.

Goldman Sachs’s Jan Hatzius, one of the most dovish economists on when the Federal Reserve will eventually raise rates, has lifted his growth outlook but stuck to the view that the first interest rate rise off the near-zero floor won’t come for nearly two years, in early 2016.

The latest Reuters poll of Wall Street dealers on Friday still points to the second half of next year at least before the Fed, which is still printing tens of billions of dollars monthly as it winds down the third installment of its QE program, will start raising rates from 0-0.25 percent.

That may be too soon.

U.S. economic growth accelerated to 3.4 percent annualized in May according to Goldman’s calculations, an impressive rebound from 1.0 percent contraction in the first. Nobody, including Goldman, which had a 3 percent growth forecast for Q1 at the start of the year, correctly predicted how bad the first three months of the year would turn out.

But with solid jobs growth and room for the housing market to improve now that Treasury yields have plunged nearly half a percentage point since the start of the year, Hatzius says the economy has picked up to above-trend growth.

The latest Reuters poll of private economists showed a handful forecasting above 4 percent growth in the current quarter, with a few close to and at 6 percent. That was taken even before solid data from the Institute for Supply Management on manufacturing and services suggesting the recovery was not thrown off course by a dismal start to the year.

So what will hold the Fed back from raising rates?

In two words, low inflation. There is enough slack still in the labor market to keep pay growth restrained. Core PCE inflation, which the Fed watches closely, has risen to 1.4 percent, but shows no sign of taking off.

But the restraint may also come from one area which has not shown a lot of it: financial markets.

Volatility has crashed to its lowest in nearly a decade as stock prices are near record highs and bond yields are near record lows, at least in most of the developed world. That has many investors feeling nervous. But it also means that any correction will do the Fed’s financial tightening for it, according to Hatzius:

… the forecasts from our strategists—higher bond yields, softer equity prices, and a stronger dollar—suggest that conditions should tighten modestly in coming quarters. If that happens, and if the economy evolves as we expect, our current forecast for monetary policy liftoff still feels about right. But if financial conditions continue to ease while the economy makes further progress toward the Fed’s goals, a somewhat earlier liftoff for the funds rate may end up looking more appropriate.

Morgan Stanley, with a much more modest growth outlook, predicts 2.7 percent GDP growth over the coming six quarters starting in the second half of this year. They, like Goldman, are also of the view that the Fed is in no hurry to raise rates.

Vincent Reinhart and colleagues wrote in a note:

… the Fed may find it increasingly difficult to defend both the date of the first move and the shallowness of subsequent expected rate hikes. At some point we expect the bond market to reprice for a steeper rise in rates and Yellen’s Fed to push the date of first tightening to early 2016 so as to limit the tightening of financial conditions.

Either way, it points to rates lower for longer — not the other way around.

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