To paraphrase President Warren Harding’s 1920 campaign slogan, the economy is returning to normalcy. To be sure, the economy will not be normal by historical standards, but it will be noticeably better than in recent years. After growing at a revised 2.5% annual rate in the second quarter, we are forecasting real GDP growth of 2.5% for the second half stepping up to the historical 3% trend growth rate in 2014 and 2015. (See Figure 1) However, we must point out that because of the severe recession of 2007-09 and the sluggish growth thereafter, the economy will still be operating well below what would have been expected prior to the recession. Nothing highlights this better than the fact that, according to Sentier Research, median household income remains lower than in June 2009, the ending month of the recession.
Nevertheless, in keeping with a more normal economy we expect that payroll employment growth will be running at a sustained clip of 200,000 jobs a month over the forecast horizon and that the unemployment rate will steadily decline to 6.5% by year-end 2015. (See Figures 2 and 3) Over the near-term, the quantity and quality of the net increase in employment could very well be held back by the adjustments business firms will make to the implementation of the Affordable Care Act. Simply put, there are incentives for firms to convert full-time employees to part-time and for small business to limit their headcount to 50 full time employees.
INTEREST RATES ON THE ROAD TO NORMALIZATION
The era of very low long-term interest rates appears to be over. In response to hints from the Federal Reserve that the quantitative easing program of buying $85 billion a month of treasury and mortgage bonds might be tapered in September, the yield on 10-year U.S. Treasury bonds spiked from 1.6% in mid-May to 2.9% in late August. As one wag put it, the bond market had a "taper tantrum." In our view the Fed will begin to modestly lower its bond purchases in September to about $75 billion a month and continue on a path that would end the program by mid-2014. Simply put with the improved economic outlook and the efficacy of quantitative easing being questioned, it has become a question of when, rather than if the program will be ended. Of course, in response to geopolitical uncertainties, the Fed could very well delay the tapering process until the next Open Market Committee meeting.
Our position is roughly in-line with the market consensus; where we differ is that we think the Fed will actually raise the Fed Funds rate in December 2014, about six months earlier than consensus. Thus, by the end of 2015 we expect the Fed funds rate to be a more normal 2.5% and the 10-year Treasury rate to be 4.3%. (See Figure 4) That would bring the 10-year rate more in-line with the growth rate in nominal GDP which has roughly tracked over a very long time period. (See Figure 5)
Our aggressive view, compared to the current consensus, on interest rates rests on the belief that inflation will not be as benign as many now think. Specifically, as we have outlined before, we believe the full impact of higher rents has yet to be reflected in the official price indexes.1 Moreover, we believe that the recent quiescence in health care inflation is about to be jolted by the new demands placed on the system resulting from the implementation of the Affordable Care Act. These effects could very well be temporary, but we believe that insuring an additional 35 million people
will have, at least, a modest impact on health care inflation in the short-run.
As a result, we anticipate that both headline and core inflation as measured by the consumer price index will be in excess of 2% in both 2014 and 2015. (See Figure 6) Although the Fed targets the chained consumption deflator used in the GDP accounts, even by that measure inflation will be running at its 2% target in 2015. It is for this reason we believe that the Fed will raise the funds rate prior to achieving their 6.5% unemployment target.
THE REAL ECONOMY: HOUSING STILL LEADING
Despite the huge 125 basis backup in the 30-year fixed mortgage rate, we continue to believe that the housing recovery remains underpinned by a five year period of under-building, rising household formations, an improved employment outlook, and still low, by historical standards, mortgage rates. Indeed the sudden backup in mortgage rates could very well have the effect of forcing once hesitant consumers to act quicker once they realize that time is no longer on their side. Simply put, the fear of higher rates in the future makes the current rate environment more attractive. As a result, we are forecasting housing starts to increase to 965,000 units this year compared to 783,000 last year, a reduction from our previous forecast to reflect a slower ramping in production than we had envisioned. For 2014 and 2015 we are forecasting further advances to 1.31 million and 1.55 million units, respectively. (See Figure 7) Consistent with our view for the past year, we believe that multi-family starts will be exceptionally strong throughout the forecast period with starts in excess of 400,000 units in 2014 and 2015.
BUSINESS INVESTMENT AND EXPORTS TO REBOUND
After stalling in 2013, we anticipate that business investment in equipment and structures will begin to grow at a more robust clip in 2014 and 2015. In part, the slowdown in 2013 was almost inevitable as some of the special tax incentives for investment expired at the end of 2012. Investment in equipment which slowed to 4.2% growth rate in 2012 is expected to grow at 8.8% in 7.6% in 2014 and 2015, respectively. (See Figure 8)
After declining in 2013, investment in business structures is expected to rebound by 5.9% and 8.8% in 2014 and 2015, respectively. (See Figure 9) Continued strength in energy related structures (i.e. drilling rigs and distribution facilities) and acceleration in commercial construction will propel the advance.
Export growth which has been sluggish for two years is about to accelerate. Exports have been hampered by the ongoing recession in Europe which now appears to have just ended. While the emerging markets remained strong through 2012, there has been a very noticeable deceleration in growth this year, especially in India, China, Brazil and Turkey. We assume that the waning of the drag from Europe will more than offset the current softness in Asia. As a result, expect export growth to pick up from the sluggish 2% gain this year to about 5% over the next few years, not great, but an improvement. (See Figure 10)
STATE AND LOCAL GOVERNMENT SPENDING GROWING AGAIN WHILE FEDERAL SPENDING CONTRACTS
The long multi-year decline in state and local spending is over. Rising tax receipts coupled with years of austerity have dramatically improved the current fiscal balance of most states and local governments. Thus the way is open for modest increases in spending. (See Figure 11) Nevertheless the longer-term outlook remains cloudy because of increasing liabilities for pension and post-retirement healthcare costs. An extreme example of what can go wrong is the recent bankruptcy filing of the once great city of Detroit.
In contrast, federal purchases are on the decline. Lower defense spending coupled with congressional disagreements have placed a lid on federal purchases. (See Figure 12) Remember in GDP accounting transfer payments do not count as federal purchases. We do note for forecasting federal spending, we assume a compromise will be reached on the fiscal year 2014 budget and the upcoming debt ceiling extension. As a consequence, there will not be a suspension of "non-essential" government functions.
Our forecast calls for a resumption of normal growth on the order of 3% a year in 2014 and 2015, far better than the 2% growth we have been used to since the recession ended in 2009. We also believe that the era of very low interest rates will soon be behind us. The recent dramatic rise in bond yields in all likelihood rang the bell. But make no mistake, as good as a resumption of normal growth is, it still will not be enough to restore the economy back to its pre-recession growth path.
1. See, Shulman, David, "The Housing Recovery: How Strong? How Long?" UCLA Anderson Forecast, June 2013