Monday, October 3, 2016

Promises, Promises.., UCLA Anderson Forecast, September 2016

Presidential candidates Hillary Clinton and Donald
Trump are making all kinds of promises which they believe
will improve the economy for the average person.2 In
very simplified terms Trump wants to substantially reduce
taxes on businesses (including 100% expensing of capital
outlays) and individuals, increase tariffs, deport at least five
million people, increase spending on immigration control,
infrastructure and defense. Needless to say, the federal
deficit would explode should all of his ideas be enacted. In
contrast, Hillary Clinton wants to increase taxes on high
income earners and use the proceeds to enable free tuition
at public colleges for most students, expand social security,
increase healthcare spending, refinance/forgive student debt
and increase spending on infrastructure. Her plan would
modestly increase the deficit, but it is silent on its potential
to make economic growth even slower than it is now. Of
course, whether any or all of these proposals get through
Congress remains an open question.

The problem is that in order to be effective, any economic
plan has to be able to jump start productivity growth
that has been extraordinarily weak for more than a decade.
As our colleague Ed Leamer noted last quarter, it will be
extremely difficult for the U.S. economy to return to a 3% a
year growth path without productivity growth moving from
near zero to about 2%.3 Put bluntly, the growth in real GDP
is a function of the growth in labor hours and the increase in
the output per hour or productivity. Presented below is the
long-trend in the growth in output per hour. (See Figure 1)

Figure 1 Productivity Growth, Output/Hour Worked
Sources: U.S. Department of Commerce, UCLA Anderson Forecast

By simple arithmetic if we posit that the labor force
is growing at around 1% or less per year and if we assume
that the average person is not going to step up the number
of hours worked, then with 1% productivity growth the
steady state growth for real GDP is about 2% a year. This
is, in fact, the history of recent years. Thus the question
before the candidates is how are they going to improve the
outlook for productivity? And note the mass deportation
of workers would reduce hours worked in the short-run.

The answer to this question is not simple. There is no
magic wand and improvements in productivity take time
to implement and are largely dependent on technological
innovation. To economist Robert Gordon, the growth in
productivity experienced by the United States between
1870- 1970 was based on a series of one-off events based
on the internal combustion engine, the harnessing of electromagnetic
energy, indoor plumbing and improvements in
public health. 4. To him our fascination with the computer/
communications technology of today pales in comparison
to the arrival of electricity and the automobile. Perhaps he
is too pessimistic, but the burden of proof is on the technoenthusiasts.

Nevertheless, even if you are a techno-enthusiast, productivity
improvements don’t take place over night. It takes
time for technology to diffuse into the broader economy,
workers have to be educated and trained and new infrastructure
has to be built. Thus, the policies that both Clinton
and Trump are talking about potentially would only have a
limited impact in the short-run. Over a longer time period
an improved infrastructure, a more efficient tax structure
and a better educated workforce will help, but again, in the
fullness of time.

In any event, with both Clinton and Trump calling for
more spending and with tax increases difficult to pass, the
path of the federal deficit will be decidedly higher thereby
reversing the trend of lower deficits in recent years. (See
Figure 2) In the meantime we have modeled in increased
federal spending on infrastructure, a program both candidates
agree on.

The Forecast

Although the inventory correction has taken longer
than what we had previously anticipated, the economy
appears to be rebounding from the 1% growth recorded in
the first half to about 2.7% in the second half. (See Figure
3) Thereafter the growth in real GDP is forecast to run at a
2%- 2.5% clip for the years, 2017 and 2018, respectively.
In other words, it will not be much different from the past
seven years. And to be very explicit, we are assuming
that Hillary Clinton will be elected in November with at
least one house of Congress remaining Republican, the
conventional wisdom as of this writing.

Figure 2 Federal Surplus/Deficit, FY 2000 - FY 2018F
Sources: Office of Management and Budget and UCLA Anderson Forecast

Figure 3 Real GDP Growth
Sources: U.S. Department of Commerce, UCLA Anderson Forecast

With the economy approaching full employment,
employment growth will inevitably slow. After consistently
averaging about 200,000 job gains a month since 2011, employment
growth will slow to about 150,000 jobs a month
in 2017 and 125,000 jobs a month in 2018. Remember
the closer an economy is to full employment the more the
demographics of the work force takes hold. (See Figure 4)
The unemployment rate is forecast to be in a very tight 4.8%
-5.0% range for most of the forecast period as the labor force
participation rate rises modestly.

The modest growth we are forecasting will come from
continued gains in the consumer and housing sectors along
with a rebound in capital spending. Although real consumption
expenditures will not approach the 3.2% increase of
2015, there will be solid gains of 2%+ over the next two
and half years. (See Figure 5) The drop off will largely be
due to a peaking in the automobile market with light vehicle

sales running at about a 17.5 million unit rate. (See Figure 6)

Similarly, housing activity continues to grind higher.
Rising wages, low interest rates and higher rents are underpinning
housing demand with the last factor beginning to
trigger a shift away from rentals towards ownership units.
Although well off peak production, we forecast that housing
starts will increase to 1.19 million units this year and to 1.38
million units and 1.41 million units, in 2017 and 2018, respectively,
up from 1.11 million units in 2015. (See Figure 7)

Figure 4 Unemployment Rate
Sources: Bureau of Labor Statistics and UCLA Anderson Forecast

Figure 5 Real Consumption Expenditures
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 6 Light Vehicle Sales
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 7 Housing Starts
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

With respect to business fixed investment we expect
the declines in both equipment and structures in 2016 to
reverse next year. (See Figures 8 and 9) This reversal of
fortune will largely be due to the end of the collapse in oil
and gas drilling investment and the beginnings of a modest
recovery in that sector. Similarly, the hesitancy in overall
corporate investment experienced in the first half appears
to be waning.

The real wild card for the next few years involves the
export sector. The dollar has been strong, foreign economies
generally weak and there has been an obvious increase in
protectionist sentiment worldwide. As a result, global trade
has not been a source of growth in recent years. We are
assuming that there will be a modest increase in export volumes
over the next few years after two years of essentially
zero growth. If there is a risk to our forecast you can do no
worse than starting here.

Figure 8 Real Investment in Equipment
Sources: U.S. Department of Commerce, UCLA Anderson Forecast

Figure 9 Real Investment in Nonresidential Structures
Sources: U.S. Department of Commerce, UCLA Anderson Forecast

Figure 10 Real Exports
Sources: U.S. Department of Commerce, UCLA Anderson Forecast
Inflation on the Rise

Although the Fed is reluctant to admit it, the era of
very low inflation is behind us. On a year-over-year basis,
core inflation is already running well above a 2% annual
rate. (See Figure 11) By next year the headline consumer
price increase will approximate 3% as service sector inflation
combines with modestly higher oil prices. And even
the Fed’s preferred gauge for inflation, the chain weighted
deflator for personal consumption expenditures will exceed
2% in both 2017 and 2018.

The rebound in inflation is being fueled by higher
energy prices, coupled with large increases in service prices
especially residential rent and higher wages. The average
worker is in the process of getting a raise as private sector
wage compensation will be increasing at a 4% rate over the
next two years. Simply put, there are growing spot shortages
of labor appearing in many parts of the country and the
July JOLTS data indicated a record amount of job openings.

After years of experimenting with zero interest rates,
quantitative easing, and forward guidance and internationally
with negative interest rates and corporate bond buying,
it now appears that monetary policy is at the end of its rope.
Despite it all, globally, inflation is not budging. There isn’t
much more monetary policy can do except for the central
banks to directly fund government spending by printing
money through the purchase of zero coupon perpetual bonds.
It may come to that and perhaps a field trip to Caracas,
Venezuela is in order where a former bus driver is on the
road to generating quadruple digit inflation. Of course that
would mean the end of central bank independence. Thus,
the answer lies in fiscal policy and that is something that
both Ms. Clinton and Mr. Trump are advocating in their
own unique ways.

As for long-term interest rates, we expect them to
rise in tandem with short rates and the higher inflation we
expect to see. In order for this to happen both Europe and
Japan will have to leave negative interest rates behind and
we are beginning to see the first signs of this. Put bluntly
the Central Banks have run out of bonds to buy and there is
growing recognition that the sustained period of very low
long-term interest rates is creating systemic risk in the form
of bankrupting pension plans and life insurance companies.
This problem is more acute in Europe than the U.S., but the
state and local pension plans of the U.S. are in dire straits
and it is getting worse with each passing day.
Figure 11 Consumer Price Index vs. Core CPI
Sources: U.S. Bureau of Labor Statistics, UCLA Anderson Forecast

Figure 12 Employee Compensation/Hour
Sources: U.S. Bureau of Labor Statistics, UCLA Anderson Forecast

The Fed Begins to Move….Slowly

This was supposed to be the year of three or four
increases in the Fed Funds rate. Instead, the ever data
dependent Fed will likely raise rates only once this year.
However, as transitory worries fade (i.e. Brexit) and the
economy demonstrates its ability to grow at a 2%+ clip, we
anticipate that 2017 could very well bring with it three 25
basis point rate hikes taking the funds rate by yearend to
around 1.5%. (See Figure 13)

Figure 13 Federal Funds Rate vs. 10-Year U.S. Treasury Bond
Sources: Federal Reserve Board, UCLA Anderson Forecast


The economy having survived a first half slowdown
is on track for 2%+ growth over the next few years. Don’t
expect much help from the political system because we
will not see a meaningful improvement in growth unless productivity picks up. Public policy in this regard can be
successful, but it will take time. Meantime, inflation will
pick up modestly in a roughly full employment economy
causing the Fed to gradually raise interest rates.  

1. With apologies to Neil Simon.
2. In the interests of full disclosure I wrote an Op-Ed in support of Hillary Clinton and in opposition to Donald Trump. See Shulman, David, “I’m a
Republican and I Don’t Like Hillary Clinton – but I’m Voting for her.” Los Angeles Times, Op-Ed, August 8, 2016.
3. Leamer, Ed, “It’s not 9.8 Meters per Second Squared Anymore,” UCLA Anderson Forecast, June 2016.
4. See Gordon, Robert J., “The Rise and Fall of American Growth: The U.S. Standard of Living since the Civil War,” Princeton: Princeton University

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