US economic outlook: gearing up

New York, 17 Jan 2017

The US economy is expected to gather pace in 2017, helped by stronger consumption and investment, a potential increase in fiscal stimulus and an accommodative stance from the Federal Reserve.

However, the risk of the US economy overheating has increased, says Macquarie Securities North America economist David Doyle.

With gross domestic product expected to grow by 2.5 per cent, compared with 2 per cent last year, Doyle forecasts the Federal Reserve will raise the key interest rate twice to 1-1.25 per cent during 2017, one hike less than the central bank’s own expectations.

"US growth will be above trend and above consensus over the coming 12 to 18 months," says Doyle. "The positive forces underpinning our forecast are strengthening. But so are upside risks."

US growth will be above trend and above consensus over the coming 12 to 18 months."

Rates on the rise

Investors are most concerned about the pace of interest rate increases and the effect this will have on the economy and bond markets.

In December, Federal Reserve Chair Janet Yellen surprised markets by forecasting three rate increases in 2017, up from two previously.

Doyle believes the Federal Reserve will refrain from making three increases in 2017, given its overall preference to support the strengthening economy.

Another factor is the changing composition of the Federal Reserve Open Market Committee (FOMC), with a number of new appointments to the rate-setting committee this year.

The Federal Reserve may also be held back as productivity remains in a low-growth pattern driven by demographic factors, he adds.

"The FOMC is driven to ensure that the current expansion lasts as long as possible," says Doyle. "For now, they are likely to continue to err on the side of caution."

Higher borrowing costs

US equities, bond yields and the dollar jumped following the election of Donald Trump as US President in November 2016, on expectations the new administration will increase spending, cut taxes and deregulate key industries such as banking.

Yields on benchmark 10-year Treasury bonds have climbed to 2.53 per cent, from 1.36 per cent in July, ending a two-decade cycle of record low yields.

The start of a reflationary trend in the US economy may sustain these market developments in 2017.

The jump in yields since November is not just reflective of expectations for the Trump administration, says Doyle.

"Rather, the yields are catching up with an economy that had already been picking up steam," he says. Macquarie estimates 10-year Treasury bond yields will move only marginally higher, reaching a high for the current economic cycle of 2.7 per cent, even as the Federal Reserve increases rates.

Risk of overheating emerges

However, increasing consumer confidence and faster inflation may cause the Federal Reserve to increase rates three times, he says.

Many policies of the incoming Trump administration, as well as the extent of a pledged fiscal stimulus, are yet to be fully articulated.

In particular, fiscal stimulus could alter the expansion’s trajectory, says Doyle, boosting growth initially but forcing tighter monetary policy in the medium term.

Oil prices gain leverage

A more important variable for the pace of expansion may come from higher energy prices, which have placed downward pressure on the US economy in previous decades.

New and expanded domestic energy production means higher oil prices now provide an economic benefit, through increased capital expenditure in the US energy industry.

Macquarie analysts forecast oil prices may climb 19 per cent through 2018 to $US63 a barrel.

At higher range forecasts of $US80 a barrel, investments and wage costs could become excessive and cause inflation to accelerate.

"At first, the FOMC would be likely to maintain its slow and cautious approach," says Doyle. "But eventually, it would respond to such a scenario with a faster pace of rate hikes that could lead Treasury bond yields to exceed our estimate."

Investment environment

For the first time in many years, the US economy presents the risk of growing too fast. However, such a situation is unlikely to fully emerge in 2017.

In the meantime, faster growth coupled with accommodative monetary policy may provide businesses and investors with an ideal background after years of a tepid expansion.

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