In a research note published on Friday, Deutsche Bank strategists, led by Dominic Konstam, say the Federal Reserve risks a “big policy error” if it hikes interest rates in September as the latest GDP numbers mark an imminent labor market-driven slowdown for the US economy.
The world’s largest economy expanded by just 1.2% in the second quarter while first-quarter expansion was revised down to 0.8% from an initial 1.1% estimate. The second-quarter rate of expansion was less than half the advance forecast by economists in a Bloomberg survey.
“If the economy can only muster growth in the vicinity of 1% when the labor market is at full employment, one must take the secular stagnation thesis more seriously,” the Deutsche Bank analysts write.
“In other words, perhaps the 2.1% average growth rate of the present cycle has been an over-performance. If productivity continues to underwhelm, we will likely see downward revisions to potential growth, telling us after the fact that we have been closing the output gap faster than we thought.”
Secular stagnation is the contentious view that economic growth and the natural rate of interest for the US economy is structurally low or in negative territory, and promoting full employment—in the absence of sustainable final demand—risks financial stability.
The Deutsche strategists paint a negative picture on US productivity prospects, noting that the “non-consumer portion of the economy is shrinking not only in real terms but also in nominal terms”.
Labor Market Slowdown
With real GDP growing at just 1.2% over the last four quarters, the strategists reckon a labor market slowdown—in which low productivity forces firms to defend profit margins by firing workers, who are also consumers—is near. This would depress aggregate demand, and further constrain margins for businesses, the analysts write.
The odds of a September rate hike, according to federal funds futures contracts, have dropped to 18% compared with 28% before the second-quarter read. A traditional driver for US monetary tightening economy—as the labor market tightens, wage inflation should eventually increase, Deutsche strategists write, forecasting no rate hikes this year.
Underscoring the divergence between Fed officials and market expectations for US growth and policy rates—with the 10-year US Treasury yield on a downtrend since mid-2015—Deutsche analysts conclude “there is little evidence that productivity is ready to do the heavy lifting in terms of stimulating faster growth”, with labor-input growth now yielding diminishing returns on output growth.
“In the four quarters ending in the first quarter of 2016, productivity has grown at just 0.7%. Meanwhile, aggregate hours growth slowed from a cyclical peak of 2.8% in first quarter of 2015 to just 1.5% a year later.”
Since labor-input growth will probably slow to 1%, “productivity will have to accelerate several tenths in order to maintain ‘trend’ growth”.
