Fed: Hesitancy in lifting rates is not due to the dollar any more - BBH

Research Team at BBH, notes that when the Fed was engaged in asset purchases, before the ECB or BOJ initiated their program, the expansion of the Fed's balance sheet was weighing the dollar.  

Key Quotes

“We were skeptical. Over the past year, the ECB and BOJ's balance sheets have expanded by nearly 50%, while the Fed's balance sheet has contracted by 5%.  During the period, the yen has appreciated by over 22%, while the euro has risen 1.6% against the dollar.   On a real broad trade-weighted basis, which is the most relevant economic measure, it is about 3% higher over the past year.

The Fed's hesitancy in lifting rates is not due to the dollar any more.  At first, policymakers were thrown off balance by the shockingly poor May employment report.  We argued at the time that a statistical quirk was not uncommon, taking place once a year or so.  Of course, confidence in this assessment was only possible because of the June and July employment data.  The two-month average stands at 274k, which is the highest this year, and above all but two months last year.

More recently, the weakness of Q2 GDP shook confidence.  However, investors may be more rattled than policymakers.  Our understanding is that the Fed's leadership tries to focus on the signal and look past the noise.  In terms of GDP, the signal comes from final domestic demand, which excludes inventories and net exports, leaving the components of GDP that monetary policy can directly impact.

The main reason that the initial estimate of Q2 GDP fell well short of market and official expectations was due to the continued liquidation of inventories.  The strong consumption (4.2%), which was nearly three-times larger than the Q1 increase (1.5%), was met by inventories rather than new output.  It was the third consecutive quarterly liquidation, and it appears to have largely run its course.

At the same time, US consumption appears to have begun Q3 on a firm note.  US auto sales rose from an annualized pace of 16.61 mln in June to 17.77 mln in June.  Domestic brands accounted for the lion's share of the increase.  It is the strongest sales since last November.   The industry figures do not always translate into retail sales, but if they do, there may be upside risks to the median forecast of 0.4% for July, which the US data highlight of the week ahead.

The components of retail sales, which are used for GDP calculations, had their strongest quarterly advance in Q2 since Q1 12. After rising 0.5% in May and June, the pace may have slowed to 0.3%.  That would match the 12-month average.  Still, as we approach the middle of the quarter, the Atlanta Fed's GDPNow tracker puts Q3 growth at 3.8%, helped by an 8.8% increase in private sector investment.

An alternative methodology at the NY Fed puts Q3 growth at 2.6%.  Of course, the Atlanta Fed estimate, if true, is preferable.  But even under the NY Fed's less optimistic results, after three-quarters of disappointment, the economy bounces back above trend.  Even if we have struggled to anticipate the quarterly pattern of growth, the important point is that the US economy is re-accelerating as the headwinds from oil (on investment, manufacturing, etc.) and the inventory cycle dissipate, and not entering a recession as so many naysayers warned.  

Incidentally, a GDP tracker has been launched by the Bank of Italy for the eurozone.  The coincident indicator (hence it is dubbed COIN) was updated at the end of July.  It estimates Q3 GDP at 0.31%, up from 0.29% in June.  The initial estimate of 0.3% in Q2 will likely be confirmed this week.”