Outlook and Market Review - Second Quarter 2018

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U.S. real GDP grew at a 4.2% annual rate in the second quarter, according to the revised estimate from the Bureau of Economic Analysis. Second quarter growth was broad based. The only drags to growth came from inventory investment and trade. Analysts expect GDP growth to be about 3% in the third quarter. Inventory investment should provide a slight boost to third quarter growth but the key drag on growth going forward will be the trade war with China. The labor market remains tight with unemployment of only 3.9%, which is likely to be at or below the natural rate of full employment. Wage growth is slowly picking up but only at a moderate 3% annualized rate. Unit labor costs over the past four quarters increased only 1.9%, signaling that wages are not creating inflationary pressure.

The Fed is likely to increase the Fed Fund target to 2.5% before the year is out. Nevertheless, even though the short-term rate continues to climb, the long-term yield remains steady around 3%. The flat yield curve is consistent with a strong dollar, low inflation expectations, and globally attractive long-term U. S. bonds that keep long-term bond prices up and yields down. This condition is likely to continue until global central banks transition away from expansionary policies, allowing stronger currencies and higher yields abroad.

With full employment, inflationary pressures should begin to build. Nevertheless, inflation pressure is not imminent based on capacity utilization data showing the economy well below the 80% utilization rate where price pressure tends to occur. On a year-ago basis the Fed’s preferred measure of inflation, the personal consumption expenditure (PCE), increased 2.3%. The core PCE increased 2% over the same period. While the Fed tolerates some variation from the 2% target, conditions now favor a continuation of the Fed’s policy of gradually increasing the Fed Fund rate. A more aggressive approach might take shape in 2019, especially if food and energy prices spike. The Fed Fund rate could increase another 100 basis points or so after 2018 before achieving the long-term target of about 3.5%.

Global growth remains healthy. Real global GDP grew at a 3.7% annualized rate in the second quarter, following growth of 3.3% and 3.1% in the prior two quarters. Global GDP was up 3.4% on a year-ago basis. Trade disruption poses a threat for growth later in 2018 and early in 2019. The current trade war between the U. S. and China represents a major obstacle to global growth. It appears that a deal will not be forthcoming soon, but negotiations with the Eurozone, Mexico, and Korea proved successful after the initial bluster faded. Another pending crisis is taking shape in emerging markets. Argentina, Turkey, Brazil, and Indonesia are all facing a currency crisis linked to chronic trade deficits, heavy borrowing of dollars, and a strong dollar exchange rate. A contagion spreading to other countries with similar hard currency debt problems could derail growth and foster financial market turmoil.