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Question of the Week - March 6, 2017

Question of the Week - March 6, 2017

Guest Post - Monday, March 06, 2017

Is the Economy Running 'Hot' Yet?

Probably not, but it's all relative. That reference was a previous quote from Janet Yellen, in regard to her willingness to let the economy overheat a bit more than typical in an effort to err towards higher growth. This can be a tricky balance, of course, from a monetary standpoint, as the purpose of raising interest rates and other types of restrictive policies in the first place is to keep economies from running overly hot. 'Hot' economies tend to be characterized by over-exuberance, too much risk-taking and taking on credit risk until a peak hits—when there's not much margin for error from smaller economic hiccups, that can lead to defaults and subsequently lead to a dramatic reversal of the previously bullish sentiment. This is the nature of the process, and is hard to circumvent completely, although officials do their best to 'manage' the severity of these cycles as much as they can. This was generally successful over the past few decades (2008 excluded), with ongoing debate about how much an economy can be managed using just these tools.

Conditions have improved in several areas, which is a positive, although it's taken almost a decade to get here—far longer than normal. There has been a good recovery in labor markets from the standpoint of broad unemployment numbers, although discussion continues about the 'quality' of jobs produced and an increased economic bifurcation between the haves and have-nots. This isn't a U.S.-only phenomenon, and has led to populist political sentiment here and in Europe. Businesses had been reluctant to spend, but this appears to be improving a bit, perhaps due to improved confidence in the new administration's anti-regulatory mindset. Real estate and investment markets have experienced gains, which tends to be a key factor behind consumer sentiment and, ultimately, spending, which has also been decent (with online shopping being a big winner to the detriment of physical stores).

Despite all this improvement, overall economic growth isn't outstanding, and looks to be pegged in the 2-3 percent range per year unless conditions radically improve from a business side. While we could see such improvement, especially if fiscal stimulus ends up being implemented (tax plans and/or infrastructure, although the progress here seems to have stalled as of late) growth hasn't been as strong historically this late in the cycle and other factors like demographics continue to act as a longer-term headwind.

Also included in the discussion is the Fed's balance sheet, which includes ongoing reinvestments of maturing debt into more treasury and agency mortgage-backed bonds. At some point, this will be an area the Fed will also have to decide about pulling back further on, to get the books back to more normal levels and leave 'dry powder' if such buying is needed down the road during another downturn. Why the bother with these types of purchases? One benefit of using bond-buying techniques, whether it be quantitative easing programs or just reinvestments is that it allows targeting of certain areas of the yield curve (such as the 10-year treasury, a segment traditionally pegged to U.S. mortgage rates) as opposed to just the fed funds rate, which lies at the extreme short end.

That said, conditions may not be growing fast enough for extreme rate hikes, but a gradual 'normalization' higher from very low accommodative levels appears to be a likely Fed path—and one they've communicated extensively. (Usually extreme rate hikes have been due to more unusual influences such as hyperinflation or 'too fast' growth—neither of which appears the case today.) Whether a hike occurs in March or June may not matter all that much, assuming expectations remain as they've been and the pace is gradual.

Read our Weekly Review for March 6, 2017.

Read the previous Question of the Week for February 13, 2017.

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