The Fed may pull the plug on our robust economy too soon

The Fed may pull the plug on our robust economy too soon
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The economy grew 3.5 percent at an annualized rate last quarter after having risen 4.2 percent previously. Over the past year, real GDP expanded by 3.0 percent. The current quarter should see a similar pace. If so, the economy will register its best showing since 2005. Moreover, there is good reason to expect this trend to continue.

The hottest part of the economy is the consumer sector. Households lifted their spending growth to 4.0 percent last quarter. With the unemployment rate below 4 percent and hovering near a five-decade low, it is no wonder consumer confidence is so high.

The personal savings rate remains elevated, too, at above 6 percent. All of this is likely to translate into further rapid gains in spending.

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Given the significant weight of consumption, which accounts for 70 percent of the broader economy, expect households to continue to lead the growth going forward. However, there are some potential storm clouds gathering in the future that are worth highlighting.

For starters, changes in stock prices can have an adverse effect on spending, at least in the short-term. Consequently, if the recent market swoon persists, consumer spending could slow over the next few months with negative effects on retail sales and GDP growth.

More troubling is the weakness in investment spending, both on the business and on residential front. Nonresidential fixed investment, which covers a panoply of firm-wide expenditures, increased less than 1 percent last quarter. This was its worst showing in nearly two-years despite tailwinds from the recently enacted corporate tax cut.

Furthermore, if not for a relatively healthy 8-percent gain in hi-tech outlays, business investment would have fallen almost 3 percent in the quarter. Yet, investment weakness was not limited to just the corporate sector.

Residential investment fell 4.0 percent, its third-consecutive decline and fifth decline in the last six quarters. This is housing’s worst performance since the Great Recession. So what gives?

The answer is interest rates. They are almost at their highest level since 2011, and this has a considerably negative impact on investment spending. Despite this, rising interest rates are also the primary reason why the stock market has entered into correction territory.

We have not seen any weakness in consumer spending (yet) because the stock market correction is a recent development, and labor market strength should continue to be a powerful offset.

Yet, we doubt these trends can persist if the Fed continues to hike interest rates. After all, the stock and housing markets are leading indicators of longer-term economic trends. While the Q3 GDP data were encouraging and while the full year’s growth rate will be robust, monetary policy works with a lag.

Hence, there is little doubt that Fed-engineered tightening is dampening parts of the economy and the financial markets that are most sensitive to higher interest rates. For these reasons, it would be prudent for Fed policymakers to be forward-looking and slow the pace of rate hikes as outlined in their official forecasts.

Joseph LaVorgna is the chief economist for the Americas at Natixis, an international corporate and investment banking, asset management, insurance and financial services arm of Groupe BPCE, the 2nd-largest banking group in France with 31.2 million clients spread over two retail banking networks, Banque Populaire and Caisse d’Epargne.