US economy: Plenty to be cheerful about in 2016

As we get ready to bid goodbye to 2015, it is a perfect time to reflect on how the U.S. economy fared this year relative to the expectations, and on what's in store for 2016. Annual growth is expected to average closer to the 2% mark - largely matching the gradual pace of recovery. Indeed, the economic drag from the double-whammy of the higher dollar and the slowdown in the energy sector has proven to be surprisingly strong. Coming on the heels of a 9% appreciation in 2014, the U.S. dollar continued to climb this year, gaining another 9% in trade-weighted terms. On top of already soft global demand, this represented a further headwind to US exporters, with net exports subtracting 0.6 percentage points from growth in 2015. A higher greenback, rapidly rising inventories and weaker global demand continued to weigh on oil prices this year, leading to an additional 35% decline since last December. As a result, investment in the oil and gas sector has tumbled by more than half, shaving 0.4% from growth. 

The good news is that much of this painful adjustment is largely behind us now, which should clear the way for faster and steadier growth in 2016. The oil and gas sector is now half of its former size, meaning that any potential future declines will have less impact. Pressure on producers should also begin to subside, with supply-demand imbalances likely beginning to ease. Past cuts to investment and moderately-stronger global economic growth should allow oil prices in the U.S. to recover to $55 by the end of 2016. And, while the greenback is expected to remain elevated in 2016, another leg up is unlikely given that monetary policy divergence between the U.S. and its peers has been largely priced in. 

Most importantly, while weakness in externally-oriented sectors clouded the economic picture this year, U.S. domestic demand showed remarkable strength. Job creation continued to fare well, with payrolls expanding at an average pace of 210k per month, leading to the highest annual tally since 2000. Brisk employment growth, rising incomes and significant savings at the pump have boosted consumer spending, which is on track to advance by 3.1% this year - bang on the forecast from a year ago. Better yet, consumers are expected to remain active next year, as these tailwinds continue to play out. 

The confidence in the resilience of domestic demand and anticipation that inflation will gradually begin to move back to target was behind the call that the Fed would raise its target rate in the second half of 2015. The Fed delivered a 25 basis points rate increase at its meeting earlier this month, bringing an end to seven years of zero interest rate policy. While the Fed has embarked on a path of policy normalization, it will continue to tread lightly. The fed funds rate is expected to rise by only 75 points in 2016 (to 1.25%) - less than half the pace of previous tightening cycles. 

Longer-term yields will rise even more modestly, with only a 20 bps increase projected for 10-year Treasury notes. As such, monetary policy will remain accommodative for some time, enabling the economy to absorb any remaining labor market slack and to keep the inflation needle moving toward the 2% target. It should also continue to nurture the ongoing recovery in the housing market. All in all, lesser drag from external headwinds, robust domestic demand and still-accommodative monetary policy should give the U.S. economy plenty to be cheerful about in the new year.