US Outlook - higher growth, more Fed tightening, weaker dollar

We maintain our broad view that the Fed wants to get the funds rate to neutral and most likely it can proceed in a gradual manner.

The economy has performed well in the first half of the year, with Q1 growth of 3.8% and the first estimate of Q2 growth of 3.4% (that is likely to be revised higher). Going into H2, the economy has solid momentum behind it. As a result, we are raising our growth forecast for 2005 to 3.6% from 3.5%, with some risk to the upside. For Q3-2005, we have revised our expectation for growth to 3.6% q/q SAAR from 3.0% and we have also raised our forecast for Q4 growth to 3.1% from 2.7%.

For the full year 2006, we have raised our growth outlook to 3.1% from 2.7%. The economy will still have slowed considerably from 4.2% in 2004 to 3.6% in 2005 and 3.1% for 2006. But the outlook for the start of 2006 is better than we previously expected. Our expectation for growth by quarter in 2006 is 3.1%, 3.0%, 2.8%, and 2.7%.

The higher growth will pressure inflation as firms gain pricing power and the labor market tightens. As for inflation, we raise our forecast for the average core PCE deflator to 2.1% for 2005 from 1.9% at present, and raise 2006 core PCE deflator to 2.3% from 2.2%. Also note that the recent upward revisions to core PCE for 2004 to 2.0% from 1.5% and for Q1-05 to 2.4% from 2.0% are significant and will make the Fed more uncomfortable as inflation approaches the upper limit of the Fed's comfort zone.

With the revised growth and inflation forecasts, the appropriate level of 'neutral' fed funds is likely higher than our initial baseline as well. Previously, we argued that the neutral fed funds target rate was between 3% and 4.5%, and based on that we saw the funds rate peaking at 3.75% by end-September 2005. Now, we anticipate additional tightening and expect the fed funds target rate to peak at 4.50% by Q1-2006.

As for the specific timing of higher rates, we continue to expect 3.75% fed funds by end-September based on 25bps hikes in August and September. By year-end, we expect 4.0% fed funds after a 25bps move in November. We do not expect a tightening in December. In 2006, the Fed will continue to raise rates, and we expect +25bps in February (there is no January meeting) and another +25bps in March to hit 4.5% by end-Q1. Based on our forecast of 2.2 to 2.3% core PCE by mid-2006, we then have 2.3% fed funds in real terms which is around the historical average for real fed funds from 1960 - 2000.

Finally, most USD cyclical positives appear to be already in the price. Once the end of the Fed cycle is perceived, the USD will no longer benefit from interest rate differential expectations. Structural negatives have not gone away and as cyclical positives fade, we look for the USD to come under renewed pressure from Q4.

Doug Smith Chief Economist, the Americas
Callum Henderson, Head of FX Strategy