We came into the year optimistic about
pro-growth economic policies being initiated by the incoming Trump
Administration. Those policies included substantial tax cuts, a major
investment in infrastructure and regulatory relief. There has been real
progress on the regulatory front, but nothing has really happened with respect
to tax relief and infrastructure spending. Instead we have witnessed chaos with
respect to immigration, healthcare and trade policies and a loss of confidence
in the Administration over its handling of the neo-Nazi demonstration in
Charlottesville, Virginia and the North Korea nuclear issue. Along the way
there has been a revolving door with respect to the staffing of the White
House. You need a scorecard to keep track of who is in and who is out.
Nevertheless,
notwithstanding the chaos in Washington D.C., the economy continues to plow
ahead with modest growth in real GDP and rather strong gains in employment. (See Figure 1 and 2) The employment gain has been
even more impressive because it is occurring against a backdrop of a
year-over-year decline in retail employment caused by the ongoing restructuring
of that industry as online competition takes its toll. (See Figure 3) We would also note that the only other
times we have witnessed year-over-year declines in retail employment has been
during recessions.
Specifically we forecast that growth
will continue with real GDP increasing by 2.1%, 2.8% and 2.1% in 2017, 2018 and
2019, respectively. The impact of tropical storms Harvey and Irma will modestly
lower growth in the current quarter and possibly the fourth quarter from what
it would have been and increase it in early 2018. Although
not intended the post-hurricane rebuilding, which could amount to $200- $300
billion of governmental and insurance funding, will act as if Congress passed a
formal infrastructure package. Indeed
the dollars will flow far more rapidly compared to Hurricane Katrina in 2005
because FEMA is accepting applications via smart phones. But make no mistake, wealth was destroyed and that destruction is not
measured in GDP. We would note that our 2018 optimism is based on the
belief that Congress will ultimately enact tax cut and a formal infrastructure
package later this year, more on that below. In this environment the
unemployment rate will remain at or below the current 4.4% for the forecast
horizon. (See Figure 4)
Figure 1. Real GDP Growth, 2007Q1 – 2019Q4F
Sources: U.S. Department of Commerce and
UCLA Anderson Forecast
Figure 2. Payroll Employment, 2007Q1 –
2019Q4F
Sources: Bureau of Labor Statistics and
UCLA Anderson Forecast
Figure 3. Retail Trade Employment, 2000
–Aug. 2017, Monthly Data, Change from Year Ago, In Thousands
Source: Bureau of Labor Statistics via
FRED
Figure 4. Unemployment Rate,
2007Q1-2019Q4F
Sources: U.S. Bureau of Labor Statistics
and UCLA Anderson Forecast
Fiscal
and Regulatory Policy
Despite the chaos we cited above we
believe that Congress will pass both a tax and an infrastructure bill this
year. Why? Nothing focuses the minds of
Republican legislators than the thought of losing their majority. Thus the
leadership on tax policy will come from Congress, not the White House. As a
result we are assuming for modeling purposes that Congress will pass a $1.6
trillion tax over 10 years split evenly between corporations and individuals.
Congress will set a 25% corporate tax rate while eliminating several business
deductions and allow for the repatriation of overseas profit at a 10% tax rate.
We would note that the tax reductions outlined here are well below the $5
trillion we were looking for last December. Moreover should President Trump’s
recent dalliance with Democratic leaders Schumer and Pelosi become a longer
term relationship then the cuts would tilt more towards middle and lower income
constituencies than a more traditional Republican plan.
Of course to use an old economist joke,
we are assuming more than a few can openers. Nevertheless President Trump and
the Congress came together on postponing the debt ceiling issue and on an
initial Harvey relief package. Although the debt ceiling agreement expires in
December the temporary lifting of the ceiling will enable the Treasury to
engage in extraordinary measures that will postpone a vote until the spring. Thus
the risk of a government shutdown has been pushed back into next year. However if we are wrong on the tax cuts,
growth in 2018 will be slower than what we are now projecting.
On the spending side we anticipate at
$250 billion infrastructure program and a material increase in defense
appropriations coming from increased global tensions and especially with
respect to North Korea which will make missile defense a top priority. (See Figure 5) The tragedies along the Texas
gulf coast and Florida resulting from the tropical storms will certainly light
a fire underneath the Congress to act on infrastructure. The net result of
these policies will increase the federal deficit to about $700 billion dollars
in 2019. The deficit declines in 2018 because of proceeds from the repatriation
tax. (See Figure 6)
Figure 5. Real Defense Purchases, 2007-2109F
Sources: U.S. Department of Commerce and
UCLA Anderson Forecast
Figure 6. Federal Deficit, FY 2007 – FY
2019F
Office of Management and Budget and UCLA
Anderson Forecast
On the regulatory front the Trump
Administration has started to roll back environmental, energy, financial and
labor regulations. Whether this is good policy or not, it has begun to lift the
regulatory burden on businesses and to be very frank, had there been a Clinton
Administration businesses would have faced with a continuation of the
regulatory onslaught that was characteristic of the Obama Administration.
Sources
of Modest Strength
Aside
from defense the sources of growth over the next two years will come from
consumption, housing (in 2018) and equipment spending. Real consumption spending is forecast to grow at just
under a 3% clip next year and remain strong into 2019. (See Figure 7) Growth
here is being underpinned by continued job growth, rising wages and tax cuts.
In addition the automobile industry will benefit from the replacing of hundreds
of thousands of cars lost along the Texas/Louisiana gulf coast.
Figure 7. Real Consumption Spending,
2007 – 2019F
Sources: U.S. Department of Commerce and
UCLA Anderson Forecast
Given the economic backdrop housing
activity should be doing much better than it has been. To be sure housing
starts are continuing to increase, but the pace is rather modest. After
recording 1.18 million starts in 2016, activity is forecast to increase to 1.21
million, 1.35 million in 2017 and 2018, respectively, and decline modestly to
1.31 million in 2019 under the weight of higher interest rates. Part of the
sluggishness appears to be due baby boomers staying put in the houses they are
already living in making it harder for millennials to enter the market.
Figure 8. Housing Starts, 2007Q1 – 2019Q4F,
SA
Sources: U.S. Department of Commerce and
UCLA Anderson Forecast
In response to improved global growth, a
rebound in oil drilling activity and the prospect of lower corporate taxation,
real equipment spending is forecast at 4%+ pace though 2019. This will be a
decided improvement over the 3.4% decline
occurred in 2016.(See Figure 9) Further as labor markets continue to
tighten the incentive to substitute capital for labor will increase.
Figure 9. Real Equipment Spending, 2007
-2019F
Sources: U.S. Department of Commerce and
UCLA Anderson Forecast
Gradual
Tightening of Monetary Policy
We have forecast rising inflation over
the past several years. Although we were right in terms of direction, we have
certainly been wrong with respect to the magnitude of the increase. In part the
sluggishness in average compensation growth has been due the fact that higher
paid retiring baby boomer are being replaced by lower paid millennials.
Nevertheless both the monetary and Keynesian Phillips Curve (wage growth being
a negatively correlated with the unemployment rate) explanations have been
found wanting. But with the unemployment
rate as low as it is, we believe that compensation increases will soon surpass
4% and the consumer price index will be increasing at a rate of at or above 2% over the next two and half years. (See
Figures 10 and 11) Simply put all of the kindling is in place to ignite a round
of wage increases that will in turn elevate service sector inflation. It has
just taken longer than we thought.
Figure 10. Compensation per Hour, 2007Q1
-2019Q4
Sources: U.S. Bureau of Labor Statistics
and UCLA Anderson Forecast
Figure 11. Consumer Price Index vs. Core
CPI, 2007Q1 -2019Q4
Sources: U.S. Bureau of Labor Statistics
and UCLA Anderson Forecast
In
response to an economy operating at full employment and with inflation expected
to run at around the Federal Reserve’s target rate of 2%, we expect a
continuation of the moderate tightening policy that began last December. Aside from increasing the federal funds rate the Fed
will be gradually reducing its bloated balance sheet that was created by three
rounds of quantitative easing designed to offset the negative effects of the
Great Recession.
In terms of the federal funds rate we
are forecasting quarterly increases of 25 basis points starting this December,
with a pause in March, and running through 2019. By then the federal funds rate
would reach 3%, up from the current 1.125%. (See Figure 12) Similarly the yield on 10-Year
U.S. Treasury bonds is forecast to be on a path to 4%, up from 2.1% in early
September. Because we have been forecasting a 4% 10-Year U.S. Treasury rate for
a long time to no avail, this forecast is yet again another triumph of hope
over experience. Nevertheless we are hard pressed to visualize say a 3% rate,
in an environment of 4% unemployment, growing GDP, inflation over 2% and a
rising federal deficit.
Figure 12. Federal Funds vs. 10-Year
U.S. Treasury Bonds
Sources: Federal Reserve Board and UCLA
Anderson Forecast
Conclusion
The economy has grown despite chaos in
Washington and will continue to grow at moderate 2+% rate while operating at
full employment. In response to a 2018 tax cut growth will pick up to about 3%
before falling back to 2.5% and lower in 2019.
Growth would be underpinned by higher defense outlays and moderate gains
in consumption, housing and equipment spending. Unemployment will remain at or
below the recent 4.4% over the forecast horizon. Inflation will increase
modestly running at a 2+ percent rate. The combination of full employment and
somewhat higher inflation will put the Fed to continue its modest tightening path
by raising interest rates roughly 25 basis points a quarter into 2019. Should
we be wrong on the tax cuts, growth would be slower. Of course there is always the risk that dysfunction in Washington will
spill over to the real economy.
