Summary

• Oil prices have fallen by more than 40% in H2 2014.
• Inflation expectations will be lowered further.
• U.S. growth should be higher longer term.
• Near term, contagion from the “energy bust” is underestimated by the market.

With the recent collapse in the price of crude oil, it seems appropriate to review the forecasts for inflation and growth in the US. Earlier this week, during an interview with CNBC. Bill Gross — ex-CIO of PIMCO — suggested that US growth would be around 2% going forward rather than the 3% to 4% seen in the recent past. The Atlanta Fed — Now GDP forecast for Q4 2014 was revised up to +2.2% from +2.1% on 11th December. This is higher than the Conference Board — Q4 GDP forecast of 2.0% from 10th December, here is their commentary:

The U.S. growth momentum may pause in the fourth quarter, due to some special circumstances. The outlook for early 2015 shows some upside beyond the 2.5 percent pace. And this is despite continued slow economic growth around the world and a rise in the value of the dollar. The biggest disappointment right now is business spending on equipment which is slowing from an average pace of 11 percent over the past two quarters. But if final demand picks up as expected, business investment might also gain some momentum. One key driver of demand is continued improvement in the labor market. Job growth has been solid for the past year and the signal from the latest reading on The Conference Board Employment Trends Index (ETI) is that it will continue at least over the very near term. In fact, continued employment gains are likely to lead to better gains in wages in the first half of 2015. Job and income growth may provide some moderately positive momentum for the housing market. Low gasoline prices will also further support household spending. Finally, very low interest rates, at both the short and long end of the yield spectrum help consumers and businesses. The strengthening of domestic growth is intensifying pressures to increase the base interest rate, but speed and trajectory remain important questions.

There is a brief mention of the fall in gasoline prices and hopes for increased domestic demand driven by a better quality of jobs. Thus far, official expectations have failed to shift significantly in response to the fall in oil. If the price remains depressed, I expect these forecasts to change. The geographic make-up of US growth is quite skewed. The map below shows the breakdown of GDP growth by state in 2013:

Source: Bureau of Economic Analysis

The predominant feature of many high growth states is strength of their energy sector. One state which has been a major engine of US employment growth in absolute terms, since the Great Recession, is Texas. In 2013, Texas jobs growth slowed from 3.3% to 2.5%. In percentage terms, it slipped into third place behind the stellar growth seen in North Dakota and Florida. Florida is an interesting indication of the process by which the drivers of growth are gradually switching away from the energy-related impetus seen over the past few years. This article from the Dallas Fed - Texas to Remain a Top State for Job Growth in 2014 looks more closely at some nascent growth trends:

Oil- and gas-producing states-leaders in the early years of the U.S. recovery-no longer predominated. This reflects the energy sector’s slowing expansion, although two states with the strongest shale activity, Texas and North Dakota, remained near the top. Meanwhile, several Sunbelt states hit hard by the housing crisis-Florida, Georgia and Arizona, for instance-are beginning to bounce back. In these states, employment remains significantly below the prerecession peak; in Texas, it is significantly above.

Texas is vulnerable, as are other energy rich US states, due to the weakness in the price of oil, however, Texas is also reliant on trade with Mexico for more than half of its exports. The down-turn in Mexican growth due to the weaker oil price, is an additional headwind for the lone star state.

You might expect this to be cause for some relief on the part of Richard Fisher — President of the Dallas Fed, yet, writing in mid-October in the Dallas Fed — Economic Letter — he remained, consistently hawkish on the prospects for inflation:

The point is not that wage growth has been worrisomely high (it hasn’t been) or that we’re in imminent danger of a wage-price spiral (we likely aren’t). Rather, there’s nothing in the behavior of wage inflation over the course of the recovery to suggest that the unemployment rate has been sending misleading signals about our progress toward full employment. A secondary point-a caution, really-is that when trying to draw inferences about labor-market slack from the behavior of wages, it’s important to recognize that wage inflation’s response to slack is both nonlinear and delayed.

. Do we keep the accelerator pedal to the floor right up to the point where we reach our destination? Or do we ease up as we near our goal? The answer depends on an assessment of the costs of possibly delaying achievement of our objectives versus the costs of overshooting those objectives. Proponents of a patient approach to removing accommodation emphasize the risk of having to backtrack on policy, should either real growth or inflation expectations falter. On the other hand, Fed policymakers successfully tapped the brakes in the middle of three of our longest economic expansions (in the 1960s, 1980s and 1990s), slowing-but not ending-the unemployment rate’s decline. By comparison, there are no instances where the Fed has successfully eased the unemployment rate upward after having first overshot full employment: When the economy goes into reverse, it has a pronounced tendency to lurch backward all the way into recession.

The Federal Reserve Bank of San Francisco — The Risks to the Inflation Outlook — November 17th — has a rather different view of the risks of inflation:

Although inflation is currently low, some commentators fear that continued highly accommodative monetary policy may lead to a surge in inflation. However, projections that account for the different policy tools used by the Federal Reserve suggest that inflation will remain low in the near future. Moreover, the relative odds of low inflation outweigh those of high inflation, which is the opposite of historical projections. An important factor continuing to hold down inflation is the persistent effects of the financial crisis.

The chart below shows the wide range of PCE forecasts, interestingly the IMF WEO forecast is 1.8% for 2015:

Source: FRBSF

The author goes on to conclude:

Overall, this Letter suggests that inflation is not expected to surge in the near future. According to this model, the risks to the inflation outlook remain tilted to the downside. The financial crisis disrupted the credit market, leading to lower investment and underutilization of resources in the economy, causing slower growth, which in turn put downward pressure on inflation. My analysis suggests that these effects from the crisis explain a substantial part of the outlook for inflation. Monetary policy has played a stabilizing role in the recent past, preventing inflation from falling further below its 2% target. Moreover, the analysis suggests that monetary policy is not contributing to the risk of inflation being above the median projection in the near future.

The risk of high inflation in the next one to two years remains very low by historical standards. The analysis suggests that the factors keeping inflation low are expected to be transitory. However, differences between projected and realized inflation in the recent past suggest that those factors may in reality be more persistent than implied by the model.

It would appear that even before the recent decline in the price of oil the Fed was not expecting a significant increase in inflationary pressure. What should they do in the current environment where the US$ continues to appreciate against its major trading partners and if the price of oil remains at or below $60/barrel? These are one-off external price shocks which are a boon to the consumer, however they make exports uncompetitive and undermine the longer-term attractiveness of investment in the domestic energy sector. IHS Global Insight produced the following forecast for the Wall Street Journal earlier this month:

Source: IHS Global Insight and WSJ

My concerns are two-fold; firstly, what if the oil price rebounds? The latest IEA report noted that global demand for oil increased 0.75% between 2013 and 2014 and is running 3.6% above the average level of the last five years (2009 — 2013) this leaves additional supply as the main culprit of the oil price decline. With oil at $60/barrel, it is becoming uneconomic to extract oil from many of the new concessions — over-supply may swiftly be reversed. Secondly, the unbridled boon to the wider economy of a lower oil price is likely to be deferred by the process of rebalancing the economy away from an excessive reliance on the energy sector. In an excellent paper in their Power and Growth Initiative series, the Manhattan Institute — Where The Jobs Are: Small Businesses Unleash Energy Employment Boom- February 2014 conclude:

According to a recent poll from the Washington Post Miller Center, American workers’ anxiety over jobs is at a four-decade record high. Meanwhile, the hydrocarbon sector’s contributions to America’s job picture and the role of its small businesses in keeping the nation out of a long recession are not widely recognized. Another recent survey found that only 16 percent of people know that an oil & gas boom has increased U.S. energy production-collaterally creating jobs both directly and indirectly.

America’s future, of course, is not exclusively associated with hydrocarbons or energy in general. Over the long term, innovation and new technologies across all sectors of the economy will revitalize the nation and create a new cycle of job growth, almost certainly in unexpected ways. But the depth and magnitude of job destruction from the Great Recession means that creating jobs in the near-term is vital. As former chair of the Council of Economic Advisers and Harvard professor Martin Feldstein recently wrote: The United States certainly needs a new strategy to increase economic growth and employment. The U.S. growth rate has fallen to less than 2%, and total employment is a smaller share of the population now than it was five years ago.

In a new report evaluating five game changers for growth, the McKinsey Global Institute concluded that the hydrocarbon sector has the greatest potential for increasing the U.S. GDP and adding jobs-with an impact twice as great as big data by 2020. McKinsey forecasts that the expanding shale production can add nearly $700 billion to the GDP and almost 2 million jobs over the next six years.

Other analysts looking out over 15 years see 3-4 million more jobs that could come from accelerating domestic hydrocarbon energy production. Even these forecasts underestimate what would be possible in a political environment that embraced growth-centric policies.

In November 2013, President Obama delivered a speech in Ohio on jobs and the benefits from greater domestic energy production. The president highlighted the role of improved energy efficiency and alternative fuels. But as the facts show, no part of the U.S. economy has had as dramatic an impact on short-term job creation as the small businesses at the core of the American oil & gas boom. And much more can be done.

A recent report by Deutsche Bank - Sinking Oil May Push Energy Sector to the Brink — estimated that of $2.8trln annual US private investment, $1.6trln is spent on equipment and software and $700bln on non-residential construction. Of the equipment and software sector, 25%-30% is investment in industrial equipment for energy, utilities and agriculture. Non-residential construction is 30% energy related. With oil below $60/barrel much of that private investment will be postponed or cancelled. That could amount to a reduction in private investment of $500bln in 2015. This process is already underway; according to Reuters. new oil permits plummeted 40% in November.

Since 2007 shale producing states have added 1.36mln jobs whilst the non-shale states have shed 424,000 jobs. The table below shows the scale of employment within the energy sector for key states:

Hydro-carbon jobs 000’s