Potholes could be dead ahead in the road soon after Fed rate hike

November 20, 2015

Patches on top of patches covering potholes litter a road in Sonoma County, California, May 9, 2013. Harrison, a local resident and attorney, is part of a grass-roots campaign to fix the crumbling roads of Sonoma County, which is struggling with the same type of government financial crisis that has driven California cities such as Stockton and San Bernardino into bankruptcy. Picture taken May 9, 2013.   REUTERS/Beck Diefenbach   (UNITED STATES - Tags: BUSINESS TRAVEL) - RTX1053C

The Federal Reserve’s planned smooth and gradual rate hike path may be bumpier than anticipated if U.S. economic growth over the next several months and punishingly cold winter weather follow a well-established recent pattern.

Over the last two years, economists have failed spectacularly to accurately predict first-quarter GDP growth in the U.S., with forecasts proving overly optimistic in all Reuters polls conducted before data releases in both years, with the assumptions made in the prior November particularly off the mark.

In 2014, a failure to account for severe weather led nearly all analysts astray, as consumer spending, business investment and trade data disappointed. Unusually heavy snowfall and labor disputes at West Coast ports hampered exports the following winter, again well short of initial projections, which led to a further delay to expectations for the first Fed tightening.

US GDP Q1 2014 vs2

US GDP Q1 2015 vs2

The margin of error on these predictions narrowed as the months went by and concerns about the effects of brutal winters became more widespread. But forecasts still remained well above the actual outcome, even just a week before the government released the actual data.

In October this year, Fed Chair Janet Yellen indicated a move before the end of the year was a “live possibility.” Other Fed policymakers have since followed suit, flagging December as the month when interest rates will likely go up for the first time in nearly a decade.

If the polls are correct, and the Fed does decide on a pre-holiday season hike as the weather turns cold and the usual snowstorms blow in, attention will once again turn to growth, and whether or not statisticians have got troubles with seasonal adjustments all worked out.

The consensus view from the latest Reuters poll suggests that the economy will expand at a steady 2.5-2.6 percent annualized pace over each quarter of 2016 — something it has not managed to do at any time since the financial crisis. This time last year, economists thought GDP growth would be slightly better over the same period, 2.8 percent.

Growth rates significantly below that would call into question why the central bank is tapping the brakes.

For now at least, the case for a hike next month is strong.

The economy has added an average of around 200,000 jobs each month this year, with a particularly strong 271,000 reported for October. Wage inflation has begun to pick up a bit and unemployment has fallen to 5 percent, the lowest it’s been since before the global financial crisis.

The housing market remains on a path to recovery and the dollar has rallied by about a fifth since the middle of last year.

Markets have turned around from pricing out the likelihood of a rate hike this year to an around 70 percent chance of a December move, something that economists in Reuters polls have consistently predicted since the Fed held policy steady in September.

If they do go ahead and raise, much will depend very soon afterward on this being the moment when forecasters, including those at the Fed, got the growth outlook right.

Graphics by Sarmista Sen

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