February 1, 2017
Letter to the Acting Secretary
Dear Mr. Acting Secretary:
Real GDP rose at an annual rate of 1.9% in the fourth quarter. Combined with a brisk increase in third-quarter real GDP, the second half of the year delivered notably stronger growth than in the first half of the year. Consumer spending has been solid and the business sector has bounced back. In particular, businesses built inventories in the second half and the recession in equipment investment ended in the fourth quarter. International trade was a sizable subtraction from growth in the fourth quarter, but most of the decline owed to pay back from a jump in agricultural exports in the third quarter. Smoothing through the volatility, real GDP has expanded at a nearly 2% rate over the last four quarters and appears to be on track for a similar increase in the current quarter.
Since the Committee last met in early November, investors digested the outcome of the US elections. Risk appetite was buoyed by the Republican sweep of the Presidential race and unified control of both houses of Congress. Financial conditions overall were mixed as equity prices rose while the exchange value of the US dollar moved up along with borrowing rates. Although the impact of the election on aggregate demand remains to be seen, a wide variety of consumer and business sentiment surveys improved appreciably. For the first time in a considerable period, the risks to the outlook appeared roughly balanced.
Consumer spending grew 2.5% in the fourth quarter, similar to the sturdy pace seen over the prior year. Spending on durable goods remained quite strong with auto sales maintained at very high levels. Non-durable goods spending moved up after a divot in the prior quarter, and outlays on services slowed. Consumer sentiment measures jumped to their highs of the expansion on optimism in the wake of the elections. Household balance sheets have been bolstered by rising home prices, the improvement in equity wealth in recent years, and disciplined debt growth. Those strong fundamentals, combined with ongoing gains in employment and wages, suggests household spending will continue to carry the expansion in the coming quarters.
Nonresidential fixed investment rose at an annual rate of 2.4% in the fourth quarter, reflecting mixed contributions from the major categories. Equipment investment moved up, snapping a dismal streak of four consecutive quarters of declines. Investment in intellectual property continues to expand at a moderate rate. Drilling activity has risen over the past several months and was a positive contribution to structures investment in the fourth quarter, although the category overall dipped as outlays on manufacturing shrank. Looking forward, orders of nondefense capital goods excluding aircraft have improved in recent months, and suggest the corresponding capital goods shipments, which rose at the end of the year, may be carving out a bottom. Residential investment jumped in the fourth quarter after languishing through the middle of the year. Ongoing gains in household formation and still-affordable mortgage rates should support activity going forward, even if high and rising home prices crimp overall affordability. Inventory investment added to growth in the fourth quarter in a sign businesses regained confidence about the outlook for final demand going forward. While large contributions from inventory investment are ultimately unsustainable, stock-building should add somewhat to growth going forward as stocks are realigned with sales.
Foreign trade subtracted from growth in the fourth quarter, mostly because of a one-time decline in agricultural exports that followed a surge in the prior quarter. More broadly, the outlook for global growth, though subdued by pre-recession standards, has improved since the start of 2016. Euro area growth has firmed, the “Brexit” referendum had no discernible effect on UK growth, and activity in China as well as most emerging markets has been well maintained. These factors bode well for foreign trade going forward, provided US dollar appreciation is contained and tensions among trading partners are managed successfully.
Government spending and investment was a small addition to growth in the fourth quarter, paced by state & local investment. On balance, with the modestly positive fiscal impetus expected from fiscal policy over the next year, overall government spending and investment should provide modest support for growth in the coming quarters. The outlook beyond 2017 is impossible to judge precisely given the wide variety of possible changes in federal government policy toward fiscal spending, tax reform, deregulation, and immigration.
The labor market has enjoyed steady improvement. The unemployment rate declined to 4.7% in December, a bit below many analysts’ estimates of full employment. Broader measures of labor market utilization have also improved. Smoothing through some ups and downs, the participation rate has been moving sideways, on net. Nonfarm payroll employment remains solid, despite slowing during the year. Nominal wage inflation appears to be building momentum, with average hourly earnings rising at a cycle high of 2.9% over the last year.
Consumer price inflation has moved higher in recent quarters. The price index for personal consumption expenditures (PCE) rose 1.6% over the last year, as past declines in energy prices put less downward pressure on inflation. Excluding food and energy, core PCE prices rose 1.7% over the same period. That’s a notable improvement from a year earlier, and inching closer to the Federal Open Market Committee’s (FOMC) target of 2.0%. The continuing effect of US dollar appreciation has weighed on core inflation, though the influence appears to be waning. Survey- and market-based measures of inflation expectations have improved recently but remain low by historical comparison.
In the wake of a second rate hike in December, Federal Reserve communications have pointed to a more regular, but still gradual, pace of rate hikes going forward. The Summary of Economic Projections in the December FOMC meeting suggested a median expectation of three rate hikes in 2017. Given the uncertainty about the impact of the Republican policy agenda, monetary policy may have to be more flexible going forward. Nevertheless, policymakers seem intent on proceeding cautiously at this juncture given an asymmetric ability to respond to adverse economic developments because the target federal funds rate remains close to the zero lower bound, and an increasing realization that equilibrium interest rates are historically low, and thus the stance of policy may not be as accommodative as the level of the federal funds rate would have historically implied.
Against this economic backdrop, the Committee reviewed Treasury’s February 2017 Quarterly Refunding Presentation to the TBAC. Fiscal year-to-date receipts are $25 billion lower than the same period of the previous year, due mainly to a decrease in Federal Reserve earnings. During the first quarter of FY 2017, outlays were lower in most categories than in the equivalent period in the previous year. However, after adjusting for calendar differences, the budget outlays were somewhat higher, mainly driven by higher interest expenses.
Based on the Quarterly Borrowing Estimate, Treasury’s Office of Fiscal Projections currently projects a net marketable borrowing need of $57 billion for the second quarter of FY 2017, with an end-of-March cash balance of $100 billion. For the third quarter of FY 2017, net marketable borrowing need is projected to be $1 billion, with a cash balance of $200 billion at the end of June. The Committee briefly discussed the desirability for Treasury to update its work on the cash balance framework in the May meeting.
Auction statistics since October were unremarkable as were changes in investor class allotments.
It was noted that the Treasury’s net marketable borrowing could rise significantly if the Federal Reserve allows the Treasury securities held in the SOMA portfolio to mature without reinvesting. As of the December 2016 Survey of Primary Dealers, the median expectation was for SOMA reinvestments to continue until mid-2018. In addition, federal fiscal policy is a source of uncertainty going forward. In FY 2017, OMB projects that borrowing from the public will be $635 billion. The average of the primary dealers’ estimates is similar at $699 billion. However, there was a huge range from $545 billion to $1,160 billion, indicative of a wide variety of projections about tax and spending plans that may be adopted. Given these uncertainties, the Committee noted that there may need to be significant changes in issuance strategy at some later date. However, in the absence of specific guidance about these questions, the group agreed there was no reason to change the current issuance strategy. At a later date, the Committee agreed that it may be necessary to study the implications of any likely changes in the evolution of SOMA holdings or the budget deficit.
The Committee’s charge was to explore how to use quantitative models in order to best finance the government’s borrowing needs at the lowest risk-adjusted cost over time. In particular, the presenting members studied how different financing strategies could affect the interest expense associated with various issuance scenarios. The overall goal was to begin to build a framework to evaluate the implications of various financing choices. Given the preliminary and incomplete nature of the work, the members of the Committee stressed that none of the results presented should be interpreted as a recommendation to change the Treasury’s long-standing debt issuance strategy of extending the weighted average maturity of the debt.
The first presenting member described the historical cost of alternative issuance strategies in the US. The exercise helped build some intuition about what issuance strategies have had the lowest cost historically in the US. In a highly stylized framework, the member showed that shorter-term strategies (e.g., issuing all 2-year notes) performed better as rates decreased, while longer-term strategies performed better as rates increased. The member hastened to point out that this exercise should not be taken literally since it assumed perfect foresight, rather than the inherently uncertain environment that debt managers face when making decisions on a go-forward basis.
Another member summarized the literature and tools used by government debt managers around the world. The member identified several key insights from the published models. First, optimization models often find the most attractive risk reduction per unit of cost by extending from bills to intermediates (e.g., 5-year notes). Second, constraining the optimization to have higher levels of bill issuance (e.g., in order to meet market needs for liquidity or avoid operational disruption) appears to have the largest impact on reducing 10-year and beyond issuance. Finally, setting risk constraints on the volatility of the fiscal balance rather than debt cost volatility generally results in higher levels of short term debt in the optimization. This reflects the negative correlation between interest rates and primary deficits. With the negative correlation, it’s relatively cheap to fund short-term when the primary deficit is cyclically large.
A third member introduced a representative model that can be used to frame debt management choices and trade-offs. The member stressed that his model was a work in progress and just one of many possible approaches. The model simulates a range of outcomes that could take place going forward under various assumptions about the economy and interest rates. It can then be used to explore the sensitivity of debt-management trade-offs to different assumptions about the behavior of the economy and rates.
There were three key preliminary observations. First, the average cost of the debt is upward sloping in the maturity of issuance. The member noted that this result owed importantly to the assumption that the term premium would rise toward its historical mean. Second, the variation in debt costs falls notably as the maturity extends to intermediate horizons. This finding is similar to the result from other countries’ models—that the most considerable reduction in the variability of debt cost is realized by extending from bills out to around the 5-year sector. Finally, the correlation of rates and the business cycle makes issuing shorter-term debt more attractive. In particular, the correlation of interest rates with the economy and primary deficit favors issuing shorter-term debt relative to longer-term debt under this metric.
Following the presentation, several members suggested ways to revise and extend the representative model. It was agreed that this first effort yielded useful insights for framing debt management choices. However, the members stressed that the modeling efforts were not to be taken literally or precisely in terms of quantitative estimates. Instead, the modeling pointed to some of the key working parts that may help policy makers decide on an appropriate debt management strategy. The Committee agreed to continue its efforts on modeling debt management in future meetings.
Jason G. Cummins
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