Bank of America Merrill Lynch: Stop Saying U.S. Economy is Fragile

No doubt Wall Street’s been barraged by data on every part of the U.S. economy from monthly jobs data to quarterly GDP growth. And the focus on the tick-by-tick only grows more intense the closer the Federal Reserve comes to raising short-term interest rates for the first time in nearly a decade.  As the decision looms, analysts wonder if indeed the economy can withstand higher borrowing costs.

While skepticism flies, Ethan Harris, co-head of global economics research at Bank of America Merrill Lynch, said at a global outlook event on Tuesday, people look at the U.S. economy as though it’s a “fragile victim of the crisis, and even the slightest shock could send it back to rehab.” But he said that’s simply not the case.

Rather, Harris suggests looking at the economy in the context of the last seven years, and understanding that recoveries of this scale and magnitude take years to be fully realized.

Bank of America Merrill Lynch sees the Fed raising rates by a quarter of a percent, or 25 basis points, at next week’s Federal Open Market Committee meeting, and then three to four more increases of the same amount in each of the next two years.

“We think a 1 percentage-point increase isn’t very far,” Harris elaborated. “These initial hikes are a reflection of the fact the patient [the U.S. economy] is not in the emergency room anymore, and doesn’t need to be on intravenous fluids forever.”

Harris and his team of U.S. economists, see GDP growth of 2.5% in 2016 as unemployment continues to decrease to 4.5% by the end of next year, and core inflation moves up to 1.6%.

To prove that, they point to a slew of recent data including the economic impact of the strong U.S. dollar, and oil prices that recently traded to lows not seen since February 2009 during the depths of the financial crisis. Michelle Mayer, deputy head of U.S. Economics at BAML, said without those factors, we would have seen a “much healthier economy.”

“The good news is, [those factors] seem to be fading. Obviously the drop in oil prices recently could derail this if it continues, but based on the base-line forecasts, it seems the majority of this has passed,” she said.

Mayer also pointed to the latest figures from the Institute for Supply Management, which show a divergence in factory jobs and service-sector employment. As the chart illustrates, the services side of the economy has held up, while goods have suffered.

Still, she said that decline in factory activity hasn’t had much of a spillover effect on the labor market. She said about 10,000 jobs per month have been sliced off mining payrolls, but it's sufficiently offset with other areas of the labor market which have helped bring the underlying job-creation trend to 200,000 jobs a month.

“If you take a long-term perspective on how much progress has been made, we lost 8.7 million jobs during the economic downturn, but we’ve gained 13 million back thus far. The labor-market recovery has been impressive, and that’s very much what the Fed is referring back to when thinking about progress the economy has made,” Mayer said.

Finally, the team made the point that what kept the Fed from moving forward with rate hikes – and what spooked global equity markets, sending them into a tailspin over the summer – was a seemingly sudden devaluation of the yuan by China. That made investors stop to ponder whether a so-called hard landing was coming, and analyze what potential effects could be on the global economy.

Michael Hanson, senior global economist, said rather, the move to hold off on a rate hike until , most likely, later in the year, was essentially a “tactical delay” to ensure China was on relatively solid footing, and the U.S. economy itself could sustain higher rates.

“The Fed is not hiking to try to slow the economy down. The Fed is not hiking to try to bring inflation lower. The Fed is hiking because they feel the economy has made significant progress, and now we can normalize rates as the economy normalizes at the same time,” he said.