Economic Update: 22 September 2017
The Investment Management team round-up some of this week’s news.
On Wednesday, the US Federal Reserve (Fed) announced that it will start to shrink the $4.5 trillion balance sheet of assets accumulated through its quantitative easing (QE) programme. This exercise, introduced to help support economic growth post financial crisis, will go into reverse next month.
The $4.5 trillion portfolio – a combination of US Treasury bonds and mortgage-backed securities will initially be cut by up to $10bn each month. Fed Chair Janet Yellen believes the US economy is ready for less economic stimulus and stated “We feel the economy is performing well and we have confidence in the outlook”. Fed officials are predicting economic growth of 2.4% for 2017, a stronger expansion than they forecast in June.
The chart below shows how the balance sheet has expanded alongside ultra-low interest rates
Fed Balance Sheet and US Interest Rates
Source: Bloomberg, September 2017
Furthermore, despite US inflation (CPI) increasing from 1.7% in July to 1.9% (year-on-year) in August, it was not enough to prompt even hawkish Fed officials to raise rates. Inflation and core inflation (1.4% in August) continue to be below the central bank’s target of 2%. The Fed left benchmark interest rates steady for now but reiterated that they are forecasting one additional rate hike later this year.
Even though investors anticipated the announcement from the Fed to begin the process of reversing QE, the forecast of another interest rate rise this year was a small surprise given that inflation remains subdued. As a result the US dollar strengthened slightly against other major currencies.
UK Retail Sales
On Tuesday the Office for National Statistics released retail sales figures for the month of August. The 1% growth was much higher than the median forecast of 0.1% and UK retail sales, excluding fuel, are now running 2.8% higher than the same time last year.
One aspect that analysts consider when examining retails sales is the difference between the price of goods and the number of goods being sold (volume). In August, the sales from household goods stores fell in money terms by 1.7%, but overall non-store retail sales (e.g. internet, mail order) volumes increased by 5%.
As inflation continues to rise it puts pressure on consumers, especially if wage growth trails behind. However, consumers react in different ways to avoid being squeezed on spending. For example, they can borrow to spend. This is where interest rates play a part. With credit being relatively cheap, and most retail stores now offering 0% finance options, spending using credit remains a desirable option for many. However, for credit to be sustained, it eventually requires support from wage growth. Economic theory also suggests that when real (after inflation) incomes fall consumers look to replace buying luxurious items with cheaper alternatives. This is known as the substitution effect.
In economics, everything has a knock-on effect. If wage growth is lower compared to inflation, and income is squeezed, consumers are likely to spend less. Therefore, retailers and producers suffer a profits hiatus in the short-term but then look at ways to reduce costs (substitute for cheaper labour) in the medium to long-term. This allows them to reduce prices further down the line, feeding lower inflation and allowing real income and spending to eventually pick-up the pace. In reality, there are many exogenous factors affecting prices and the impact that changing prices have on behaviour is not easy to predict.
The short-term effect of stronger sales figures is pleasing. It points to the UK economy remaining resilient and interestingly the likelihood of an interest rate hike following the retail sales numbers has picked up. However, in part this probably reflects the general opinion that such a rise would merely reverse the cut in rates made in the aftermath of the Brexit vote last summer which, in retrospect was unwarranted.
UK Interest Rate Hike Probability by the end of 2017
Source: Bloomberg. Data as of 21 September 2017