The Boao Forum for Asia 2016: Pre-Conference Reflections

US economic impact: Election year reflections

How one views the health of the US economy depends on where one sits. For observers outside the US, the view is impressive.

The US economy continues to grow faster than most other developed economies. Its strong domestic demand continues to fuel exports from the rest of the world. The budget deficit has been reduced from 10% of GDP in 2010 to 2.6% in 2015. Moreover, the strength of its currency partly reflects confidence in the economic future of the US. The relatively high yields on government bonds reflect expectations that a tight labor market will generate higher inflation. Within the US, however, the view is less sanguine. The economy has been growing far more slowly following the last recession than it has historically. That weakness has resulted from several factors. First, it took a long time for the housing market to recover given the huge excess housing investment that had taken place, and given the stress in financial markets. Second, credit market activity stagnated for a long time following the financial crisis. This was due to large amounts of bad debt on the balance sheets of banks. Third, the US has dealt with waves of difficult circumstances. These include the European recession in 2012, a fiscal contraction in 2013, and the rise of the dollar this past year.

Still, it now appears that the US economy has hit its stride. Consumer spending and housing continue to grow at a healthy pace. Consumer have benefited from strong job growth, declining debt, and debt service payments, rising wealth, increasing willingness to take on new debt, nascent acceleration in wages, and lower energy prices. The exceptional strength of the US automotive market also illustrates considerable pent-up demand given the elevated average age of cars on the road. The housing market has been helped by low interest rates, the anticipation of higher rates, and strong job growth. This, in turn, has led to strong demand for durable home goods. In addition, the rebound in housing has contributed to a rise in house prices which has fortified the financial strength of banks. This has helped increase the willingness of banks to extend credit, and played a role in economic recovery. The only significant drawbacks for the US economy are its export weakness — the result of the strong US dollar — and weak business investment, largely due to a sharp cutback in capital spending by energy companies.

What will drive policy?

There is a debate raging about whether, going forward, the US economy will speed up or slow down. Based on strong job growth, high customer demand, and a revived housing market, the Federal Reserve (Fed) governors appear to believe the economy is accelerating. Their view is that the only negatives for the US are weak exports due to a strong dollar and a weak energy sector. The other view is that recent stress in the bond market poses potential trouble, and that this will be exacerbated by tightened monetary policy. The view is that unless the Fed goes slow or is willing to quickly reverse, it risks causing another financial crisis by lifting default rates and suppressing asset values.

What are the factors that will drive the Fed’s policy? The Fed’s leaders have indicated that the economy is on a path of moderate growth and that the factors suppressing inflation are temporary. The Fed has noted that unemployment is very low and that, although wages have not yet seen significant increases, there is reason to expect this to change in the near future. Thus, in anticipation of rising inflationary pressures, it makes sense to begin the process of interest rate normalization. However, the Fed’s leaders have also noted how inflation remains persistently low and how expectations of inflation have even declined in recent months. Moreover, the Fed’s initial increase in interest rates in December 2015 was followed by a period of worrisome financial market volatility. Finally, global events appear to be conspiring to create a more uncertain environment for US monetary policy. These factors will weigh against rapid interest rate normalization. In the end, the Fed’s decisions will be driven by the latest data at the time of each meeting.

Meanwhile, a reasonable forecast for US economic growth is 2.5% in the coming year with continued low inflation. Growth will be disproportionately fueled by consumer spending. Although the Fed has begun a gradual tightening of its monetary policy, this should not have significant negative consequences for the US economy. Moreover, global markets now expect a gradually tightening monetary policy by the Fed. This has led to capital outflows from emerging markets.

What are the risks?

Despite the relatively positive forecast for the US economy, there are risk factors that should not be ignored and that could derail US economic recovery.

First, in the market for corporate bonds, defaults and near defaults have risen considerably, largely because of troubles in the energy and energy-related sectors. This has led to a drop in corporate bond prices and higher spread of risk. The danger now is that issues in one asset class could spill over into other asset classes, leading to a general flight to safety. A sharp drop in the value of risky assets could have a negative impact on consumer and business spending, hurt bank profitability, and compel the Fed and other central banks to rethink monetary policy. This is clearly an issue to which the Fed will devote attention. There is a fear that too rapid of tightening by the Fed could exacerbate problems in the bond market. Many analysts suggest that the Fed, like other central banks in recent years, could be compelled to reverse course and cut interest rates.

Second, an important source of concern is the market for corporate bonds in emerging countries. During the period of low borrowing costs and high commodity prices, it was relatively cheap for emerging market companies to borrow with abandon in global markets. Debt piled up rapidly, rising fourfold in the past decade. Yet now, with low commodity prices and an elevated dollar, it is increasingly difficult to service these debts. Defaults are rising and emerging markets banks could face trouble. Even western banks could see their profits hit.

Third, the drop in the price of oil, while welcome in terms of its impact on consumer demand, is having a negative effect on investment and threatens to undermine financial stability. Many energy companies have borrowed massively in recent years, both in the US and in emerging markets, in order to finance new capacity. Yet as oil prices have fallen, they now face difficulty in servicing their debts. This fact contributed to the recent sharp decline in the value of high yield bonds in the US. This could spread to other financial assets. In addition, with increased defaults by emerging market energy and mining companies, emerging markets banks are at risk.

Finally, the US economy remains exposed to overseas events, both in terms of actual demand as well as the impact of financial volatility. If the Chinese economy and those of other emerging markets were to slow further, it would have a negative impact on US export growth. If China were to allow its currency to fall rapidly, it would mean exporting deflation from China to the US, and it could have a negative impact on US equity prices due to the potential declines in US corporate profitability. US corporate profits have already been significantly damaged by a rising US dollar.

What is the long term outlook?

Long term, the US economy faces both opportunities and challenges. On the positive side, the US remains the global center for technological innovation, a key factor in driving productivity growth. The centrality of the US stems from strong tertiary educational institutions, a well-functioning system of financial intermediation that makes capital readily available to entrepreneurs, a culture that encourages entrepreneurship and free thinking, and a relatively open immigration system that attracts many of the world’s most creative people. On the negative side, however, the US faces a demographic challenge similar to that faced by many other developed and some emerging countries. The population is aging and the working age population is decelerating. Barring a surge in productivity, this should slow economic growth. It will also impose a great cost on the government, which already has to finance the pension and healthcare needs of an aging population. Still, the US challenge is not as serious as that of some other countries, due to a higher birth rate and more immigration.

Another longer term issue concerns trade. The US, Japan, and 10 other Pacific Rim nations have completed the Trans-Pacific Partnership (TPP), an agreement to liberalize trade and investment in the region. It will not take effect unless approved by US Congress, and it is not likely that Congress will approve the deal until after the election in November. If implemented, the TPP will boost trade and cross-border investment, compel members to liberalize various domestic markets, and potentially shift manufacturing capacity from China to members of the TPP. For the US, the TPP will have a modest positive impact on growth. However, failure to approve the TPP would represent a geopolitical setback for the US. It would undermine the current US “pivot” to Asia, which is meant to enhance US influence in the region.

Finally, this year’s presidential election has the potential to influence economic policy over the next four or eight years. The views of the leading candidates run the gamut, with vast differences between the two major parties, and even significant differences within the parties. Of course it should be kept in mind that the American system of government was intentionally designed to make change slow and difficult. This was done to prevent tyranny and to assure that any significant changes reflect a broad consensus in society. Thus, there is only a low probability that, following the election, a single party will have effective control of both major branches of government. Without such control, radical changes in policy are nearly impossible. Still, there is a growing consensus that certain changes would be favorable for the country. These include tax reform that cuts some rates and expands the tax base, fiscal policy that reduces long-term deficits, increased expenditure on infrastructure, and increases in skilled immigration. It is possible that such changes will be enacted in the next few years. They would have a favorable impact on growth.

Overall, the long term outlook for the US economy should be considered positive.

Ira Kalish
Chief Global Economist
Deloitte Touche Tohmatsu