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Fed tightening is supposed to be painful, says Jim O'Sullivan

MARKETWATCH 9:44 AM ET 11/12/2018

Low unemployment raises risks of hard landing, says MarketWatch Forecaster of the Month

The Federal Reserve needs to keep raising interest rates until job growth slows to a sustainable pace of around 100,000 per month, said Jim O'Sullivan, chief U.S. economist for High Frequency Economics and the 22-time winner of the Forecaster of the Month contest.

With the unemployment rate at a 49-year low of 3.7% and with "no evidence that employment growth has slowed," the Fed has received a "pretty clear signal that they need to keep tightening," O'Sullivan said in an interview. He figures the unemployment rate will hit 3.3% by the middle of next year, which would be the lowest since 1953.

Also read:Fed on course for more gradual rate hikes (http://www.marketwatch.com/story/fed-holds-rates-steady-and- stays-on-course-for-more-gradual-hikes-2018-11-08)

O'Sullivan doesn't worry -- yet -- that the Fed will throw the economy into a recession by raising rates too far. The expansion will probably set a record for longevity next year, "and I don't see the end as imminent," he said.

He figures the Fed will raise rates once a quarter through the end of next year and one more time in 2020, bringing the federal funds rate up from 2% to 2.25% now to about 3.5% to 3.75%. "I certainly don't think they are there yet."

"They expect some pain," O'Sullivan said of Fed policy makers. But then, "Fed tightening is supposed to be painful."

Already the tight labor market is "unambigously" pushing wages higher. "Bargaining power is shifting toward workers," he said.

"We expect wages to keep accelerating, putting upward pressure on inflation and downward pressure on profit margins in the year ahead," he wrote to clients this week. Investors might consider the impact on their portfolios of the Fed not tightening enough, because lower profit margins could hurt stock valuations.

Either inflation picks up or productivity does, he said. Unfortunately, there's no sign yet that output per hour has shifted into a higher phase, which was one stated goal of the tax cut.

Fiscal stimulus, including higher government spending, has boosted growth in gross domestic product over the past two quarters, but O'Sullivan expects growth to slow a bit quarter-by-quarter until the economy reverts back to its 2% potential by the end of 2019. He expects just 1.7% growth in 2020.

O'Sullivan's forecasts Number as reported* ISM 59.0% 59.8% Nonfarm payrolls 160,000 134,000 Trade deficit -$53.7 billion -$53.2 billion Retail sales 0.4% 0.1% Industrial production 0.1% 0.3% Consumer price index 0.1% 0.1% Housing starts 1.190 million 1.201 million Durable goods orders -2.0% 0.8% Consumer confidence index 137.5 137.9 New home sales 635,000 585,000 Gross domestic product 3.8% 3.5% *Subject to revisions
O'Sullivan won the October contest with a prescient change in his forecast for the consumer price index the day before the report was released. He was one of only two economists who predicted the 0.1% rise. However, a last-minute revision in his forecast for GDP from 3.5% to 3.8% the day before didn't turn out as well.

On six of the 11 indicators we track in the contest, O'Sullivan had six forecasts -- for the CPI, nonfarm payrolls, retail sales, consumer confidence, the trade deficit and industrial production -- that were among the top 10 most accurate among 45 forecasting teams.

O'Sullivan has been a dominant force in our contest since we started it in 2003, winning the monthly award a record 22 times and winning the Forecaster of the Year crown (http://www.marketwatch.com/story/jim-osullivan-is-top-economic- forecaster-for-seventh-year-in-a-row-2018-01-11)10 times in total and seven times in a row. If winning were just a matter of luck, such a feat would have happened one time in the history of the universe.

He leads again in the 2018 contest.

In October, the runners up in the contest were Michael Moran of Daiwa Capital Markets, Spencer Staples of EconAlpha, Michael Gapen's team at Barclays and Ellen Zentner's team at Morgan Stanley.

The MarketWatch median consensus published in our Economic Calendar (http://www.marketwatch.com/Economy-Politics/ Calendars/Economic) includes the predictions of the 15 forecasters who have earned the most points in our contest over the past 12 months, plus the forecast of the most recent winner of the monthly contest.

When they differed, the MarketWatch consensus was more accurate than the closely followed Bloomberg consensus 65% of the time in 2017. O'Sullivan was more accurate than the Bloomberg consensus 57% of the time.

The top forecasters over the past year are Jim O'Sullivan of High Frequency Economics, Christophe Barraud of Market Securities, Joerg Angele of Raiffeisen Bank International, Ryan Sweet of Moody's Analytics, Peter Morici of the University of Maryland, Avery Shenfeld's team at CIBC, Brian Wesbury and Bob Stein of First Trust, Spencer Staples of EconAlpha, Richard Moody of Regions Financial, Michelle Girard's team at NatWest Markets, Pat O'Hare of Briefing.com, Jan Hatzius's team at Goldman Sachs, Gus Faucher of PNC Financial, Ian Shepherdson of Pantheon Macro and Michael Feroli at J.P. Morgan Chase.

-Rex Nutting; 415-439-6400; [e-mail]


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