Growth in the US economy will improve in the second half of 2018, as the Federal Reserve tries to control inflation by raising interest rates
The US economy is growing at a healthy pace, and the outlook for the remainder of this year and 2019 look promising. Growth slowed slightly at the start of 2018, but this should prove temporary. The nearly nine-year expansion is now tied for the second longest in US history. The unemployment rate has declined below 4%, and odds are good that it will fall into the low 3% range by 2020. Growth is set to improve in the second half of this year given the deficit-financed tax cuts and the substantial increase in federal government spending. Real GDP in the second quarter is set to bounce back from the first quarter’s 2.2% level to an expected increase of 3.5%.
Consumers have more income to spend due to tax reform
Consumer spending has recovered from its weak start in the first quarter and is set to contribute strongly to second quarter GDP growth. Real consumer spending has now posted two months of strong growth (0.4% in April preceded by 0.5% in March) after starting the year with declines. Consumers are feeling the positive effects of tax cuts through higher levels of disposable income. On a year-ago basis, nominal disposable income increased 3.9%, which is an improvement from last year’s 2.7% reading and close to the fastest year-over-year growth rate since late 2015.
Confidence remains high as wages rise and household wealth improves
Helping build consumer confidence, the labor market continues to add jobs at a strong pace and wage growth is gradually accelerating. The Employment Cost Index for private workers shows wage growth approaching 3% on a year-ago basis. This is consistent with average labor productivity at 1.2% and the Federal Reserve’s 2% inflation target. There are strong signs that wage growth will improve this year as businesses attempt to fill an overabundance of job openings with a limited supply of qualified workers. For the first time on record, the number of job openings exceeds the number of unemployed people actively looking for work.
Household wealth is expanding as home values rise and investment returns grow. Net worth of the nation’s households and nonprofits rose over $100 trillion for the first time ever in the first quarter. The gains in the housing market, along with the improving jobs market, have put households in a strong financial position. Net worth is 6.8 times higher than disposable personal income, which is close to the highest level in history. Furthermore, households have significant financial flexibility with debt burdens near long-term lows. Household debt service payments as a percent of personal income – which includes mortgage payments and consumer debt payments – is slightly above 10%, significantly below the ratio seen ten years ago when it was over 13%.
Consumer prices are rising with energy costs, while effects of tariffs have thus far been minimal
Consumers have benefited from low-to-moderate levels of inflation over the past several years. Now, inflationary pressures are developing with higher energy prices impacting headline consumer prices. The Consumer Price Index (CPI) for May advanced by 2.7% from a year ago, while Core CPI (excluding food and energy) increased by a less threatening rate of 2.2%. The impact of higher energy prices is strongest at the producer level, driving May’s Producer Price Index for Final Demand (PPI) up 3.1% from a year ago. This is the highest level in six years. Core PPI also reached a six-year high of 2.5% and reflects price pressure from a new risk – tariff wars. Prices for steel jumped 4.3% in May and 3.2% in April. Aluminum prices surged 5.0% in May following April’s 1.8% climb. Although gains in metal prices are located at the intermediate level, finished good prices rose by a solid 1.0% in May. The inflation impact of steel and aluminum tariffs will hit even harder on finished goods later this year, while the arrival of new tariffs levied by the US and its trading partners will eventually filter through to consumer prices.
The Fed is growing increasingly concerned as inflation rises
The Federal Reserve has increased interest rates twice this year in 25 basis point increments with the current target range of the fed funds rate between 1.75% and 2.0%. The Fed is forecasting two more rate increases in 2018 as monetary policy attempts to head-off the risk of inflation. Due to higher oil prices, inflation is likely to run above the Fed’s 2% target this summer. Fed anxieties may only grow larger as labor shortages cause wage growth to accelerate. Furthermore, lower tax rates and fiscal stimulus measures are driving-up the demand for goods and services (i.e., applying upward pressure on prices) and tariffs are hurting the supply-side by causing input prices (e.g., aluminum and steel) to rise.
The Fed carefully watches inflationary expectations. Current readings are rising but have yet to reach alarming levels. Year-ahead expectations at the consumer level as seen in the University of Michigan Consumer Sentiment report are at a three-year high of 2.9%. Expectations at the business level, as tracked by the Atlanta Fed, hit a seven-year high of 2.3% earlier this year when tariffs were initially announced in March. Both measures are trending higher and further acceleration could cause Fed policy members to ramp-up their current pace of measured interest rate increases.
Years of disinflation have contained inflation expectations over the past decade. Now, there are emerging macro-factors that are aggravating inflation and changing the Fed’s long-term perceptions. Secular trends that are impacting inflation include: aging demographics reducing the size of the labor force as baby boomers retire; growing deficits and debt that are changing policy dynamics; and global trade wars that are triggering goods and labor costs to rise.
While the Fed is becoming more concerned with longer-term inflationary influences, other major central banks remain lenient. The European Central Bank (ECB) is holding its key interest rates at ground level: the benchmark refi rate is 0%, the deposit rate is -0.4% and the market lending facility rate is 0.25%. The ECB expects interest rates to remain steady at least through the first half of 2019. The Bank of Japan (BOJ) is focused on expanding the monetary base until the annual CPI (excluding fresh food) meets their inflation target of 2%. The BOJ’s policy framework is to hold its short-term policy rate at -0.1% while targeting the long-term 10-year yield near 0%.
The US dollar is strengthening as US interest rates rise, but fiscal spending is a risk
The discrepancy in monetary policy of the US and other advanced economies is a tailwind for the US dollar. While the Fed raises rates and shrinks its central bank balance sheet, the ECB and BOJ are adding liquidity and holding interest rates at artificially low levels. While there are many influences on currency movements, investors are currently focused on central bank policy divergences and variances in economic growth among countries. At some point, however, rising fiscal spending by the US government will come into play to the detriment of the dollar. Tax cuts by Congress in December and the passing of the omnibus spending bill in March are causing the US budget deficit to climb. The federal government is issuing larger amounts of Treasury bonds to meet funding needs. As the US economy’s debt-to-GDP ratio rises over time, bond holders will want larger interest payments (i.e., higher yields) to compensate for rising repayment risk. If foreign buyers are not compensated appropriately, they will become cautious and reduce their holdings in US Treasurys causing the value of the US dollar to decline.
Sources: Moody’s Analytics, Capital Economics, Wall Street Journal, Fidelity Investments, Federal Reserve Bank of St. Louis, Federal Reserve Bank of Atlanta, University of Michigan Survey of Consumers, thebalance.com, econoday.com
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