Don’t pay much attention to front-page headlines: Back in the newspaper’s business section, fundamentals remain solid, and those are what drive corporate investment—and US economic growth. That said, a few storm clouds loom, as always, and the recent hurricanes’ impact on the US economy is as yet unclear.
In recent months, American newspaper readers likely couldn’t help but notice a contrast between the front-page political news and, a bit further back, the economic news. While political headlines have featured sudden and surprising twists and turns, the business section has made for much calmer reading. The US economy has continued to grow steadily—perhaps not as fast as some would prefer but swiftly enough to continue to create jobs at a significant rate.1 Business investment is slowly picking up, and financial conditions appear good, with market volatility measures unusually low. Even better, growth in Europe and China is now supporting the calm domestic scene. True, the numbers aren’t spectacular, and some worrying signs—particularly slow productivity growth—persist. But news readers could find some calm relief from the dizzying pace of political news in the business pages.
Is this surprising? We contend that the connection between the political system and the economy is less strong than many people believe,2 and observers should avoid making extreme projections from the political system to the economy. Especially in today’s partisan climate, too many people are tempted to assume that political developments, dominating evening newscasts and social media conversations, must have large and immediate consequences for economic decision-makers. More likely, few people—and few businesses—make day-to-day economic decisions based on yesterday’s political drama. We believe that economic fundamentals remain the building blocks of business decision-making, and those fundamentals have been and continue to be mildly positive.
Could the turmoil on the front page eventually spill over into the business pages? It’s certainly possible. While most economic policymaking takes time to have an impact, the US government faces two immediate challenges each September. First, Congress needs to raise the debt ceiling so that the Treasury can pay the government’s bills and avoid effectively defaulting on some payment or other.3 Second, Congress needs to fund the government for the fiscal year starting October 1; without funding, much of what the public sector does will simply stop.4 Fortunately, legislators managed to solve both issues, at least for a few months.5
Neither of these would necessarily bring on an immediate recession, but political conflict, if it persists, could certainly slow growth. In fact, part of the reasoning behind our slower growth scenario is precisely that. It’s hardly the only risk that the economy faces. But it would certainly be unfortunate—and unusual—if political dysfunction were to make the business pages more “exciting” than anybody would like.
Our current forecast does not include any estimate of the impact of the early September hurricanes on GDP or prices, since the hurricanes came ashore after our forecast was complete.
Now, natural disasters, even when spectacular, normally have little impact on aggregate economic data. The impact is usually limited in time and location, and lost in the much larger and more diverse national economy. For example, GDP growth in Q3 2005—when Hurricane Katrina devastated New Orleans—was a very healthy 3.4 percent. But Harvey and Irma may be different, for three reasons:
The impact of the hurricanes is therefore likely to be felt in economic data for September that will be released in October, in the following ways:
In the medium term, economists usually expect disasters to push up economic activity, since recovery and rebuilding should add to employment and economic activity.8 In Houston, this is likely to be complicated by the fact that much of the destroyed housing stock lacked flood insurance.9 While this will help keep insurance company losses in check, many households will be unable to afford to repair or replace their houses. Recovery spending may therefore be lower than usual compared to the size of the disaster.
Uninsured households will also likely be forced to default on mortgages on destroyed or damaged houses, leaving lenders to bear the losses. This is unlikely to create a significant risk for the financial system, but financial sector profits may take a hit as the loss is absorbed.
Florida, by contrast, is comparatively accustomed and therefore better prepared for rebuilding wind-damaged property, so spending may ramp up sooner there even though Irma occurred after Harvey.
Finally, reactions to the unusual flooding in Houston are likely to have an impact on the broader US economy in the long run.10 For example, financial institutions faced with losses from uninsured property damage may attempt to require more complete insurance in the future. And regional planners may wish to alter the regulatory framework for construction, which could slow rebuilding in Houston as well as development in other metro areas prone to flooding. The impact of Hurricane Harvey has the potential to be larger, longer, and broader than other well-known natural disasters.
Our scenarios are designed to demonstrate the different paths down which the administration’s policies and congressional action might take the American economy. Foreign risks have not dissipated, and we’ve incorporated them into the scenarios. But for now, we view the greatest uncertainty in the US economy to be that generated within the nation’s borders.
The baseline (55 percent probability): Consumer spending continues to grow, and businesses add capacity in response. A pickup in foreign growth helps to tamp down the dollar and increase demand for US exports, adding to demand. With the economy near full employment, the faster GDP growth creates some inflationary pressures. A small increase in trade restrictions adds to business costs in the medium term, but this is offset by lower regulatory costs. Annual growth is in the 2 percent range but gradually falls below that level as the economy reaches capacity and slow labor force growth becomes a constraining factor.
Recession (5 percent): Policy mistakes and risky financial market decisions in the United States, Europe, and China trigger a global financial crisis. The Fed and the European Central Bank act to ease financial conditions, and the financial system recovers relatively rapidly. GDP falls in the last two quarters of 2017 and recovers after 2018.
Slower growth (30 percent): Fiscal year 2018 begins with congressional inaction on the budget and debt ceiling. The resulting issues dampen growth in the first two quarters of the year, and the financial system’s response limits growth beyond the short term. Meanwhile, the administration places significant restrictions on US imports, raising costs and disrupting supply chains. Businesses hold back on investments to restructure their supply chains because of uncertainty about future policy. GDP growth falls to less than 1.5 percent over the forecast period, and the unemployment rate rises to about 6 percent.
Successful policy takeoff (10 percent): The administration takes only symbolic action on trade. Congress compromises on appropriations and passes a large rise in the debt ceiling. With financial and supply chain disruptions off the table, businesses focus on tax cuts that are designed to increase investment spending and the opportunities available from an effective infrastructure plan. Growth remains above 2 percent for the next five years.
The household sector has provided an underpinning of steady growth for the US economy over the past few years. Even while business investment was weak, exports faced substantial headwinds, and housing stalled, consumer spending grew steadily. But that’s not surprising, since job growth has been quite strong. Even with relatively low wage growth, those jobs have helped put money in consumers’ pockets. That has enabled households to continue to up their spending. The continued steady (if modest) growth in house prices has helped, too, since houses are the main form of wealth for most households.
The November election did not change those fundamentals, and that’s the main reason consumer confidence has remained strong. In fact, consumers exhibited willingness to spend even as real disposable personal income took a temporary dip in late 2016. As long as job growth holds up and house prices keep rising, it’s unlikely that consumer confidence will fall significantly—even if the news from Washington sends mixed signals about the policymaking process.
The medium term presents a different picture. Many US consumers spent the 1990s and ’00s trying to maintain spending even as incomes stagnated. After all, excitable pundits kept assuring them that the technology transforming their lives would soon—any day now—make them all wealthy. But now they are wiser (and older, which is another challenge, as many Baby Boomers face imminent retirement with inadequate savings11). That may constrain spending and keep savings elevated.
Although American households generally face fewer obstacles in their pursuit of the good life than just a few years ago, growing income inequality poses a significant challenge for the sector’s long-run health. For more about inequality, see Income inequality in the United States: What do we know and what does it mean?,12 Deloitte’s most recent examination of the issue.
Consumer spending slowed in late spring. In June, real spending on goods declined, and real spending on services hardly rose—the third month in a row of weak services spending. The spending slowdown was not a reflection of confidence, which remained at very high levels.
Revisions to the savings rate for the past few years show a different picture than the earlier data suggested. The newer data shows that the savings rate started to decline from around 6 percent in late 2015. It appears to be holding steady at about 4 percent for most of this year, which is a bit lower than what our previous forecast assumed was the medium-term equilibrium level.
Headline retail sales picked up in June and July, and the pickup was widespread. This suggests that measured consumer spending may pick up, particularly with low inflation continuing.
Every year, thousands of young Americans abandon the nest, happy to leave home and start their own households. But more than usual stayed put after the recession: The number of households didn’t grow nearly enough to account for all the newly minted young adults. We expect those young adults would prefer to live on their own and create new households; as the economy continues to recover, they will likely do exactly that—as previous generations have.
This means some positive fundamentals for housing construction in the short run. Since 2008, the United States has been building fewer new housing units than the population would normally require; in fact, housing construction was hit so hard that the oversupply turned into an undersupply. But the hole is shallower than you might think. Several factors offset each other: If household size returns to levels of the mid-2000s, we would need an additional 3.2 million units; on the other hand, household vacancy rates are much higher than normal. Vacancy returning to normal would make available an additional 2.5 million units—which would fill three-quarters of the pent-up demand for housing units.
But are the existing vacant houses in the right place or condition, or are they the right type, for that pent-up demand? The future of housing may look very different than in the past. Growth in new housing construction has been concentrated in multifamily units. If that persists, we may conclude it is related to young buyers’ growing reluctance to settle in existing single-family units.
While economic growth and job creation may point to strong house sales, higher interest rates may moderate any potential housing boom. Higher inflation and a strong Fed response may drive up mortgage rates more quickly than businesses in the housing sector would like.
Housing permits were over 4 percent above their year-ago level in July. Single-family permits are up 13.0 percent during the year, while multifamily permits are down 9.8 percent. It’s hard to draw conclusions from the decline in multifamily permits, since the category is extremely volatile. But single-family construction may be starting to gain relative to multifamily construction. And at about 1.2 million, permits are still below the level required to make up for the many years of low housing growth.
Contract interest rates have held steady at about 4.0 percent since March. That’s despite the Fed raising short-term rates two times (a half percentage point altogether) over the period.
House prices continue to rise: In February, the Case-Shiller national index was 5.6 percent above the previous year’s level.
Many may blame political uncertainty for lagging investment in 2015 and ’16, but there are other, more fundamental reasons for the weakness in this area. The sudden decline of oil prices in late 2014 shut off domestic oil and gas exploration—a move that, it turned out, reduced use of capital goods. And the dollar’s appreciation in 2015 and ’16 made American companies less competitive.
You might think that the current gyrations of politics and their meaning for economic policy are particularly important for business investment. But—like consumers—business decision-makers mainly pay attention to fundamentals such as demand for the product and the cost of capital. Even a relatively radical tax reform would not likely translate into a very large change in the cost of capital, which also depends on overall financing costs, depreciation rates, and the expected cost of capital structures and equipment in the future.13 And research on business investment indicates that current (and future) demand is the main driver of investment in any event. If consumers spend, eventually businesses will hit capacity constraints and invest. And if consumers aren’t spending, and there is too much capacity, even what appear to be radical changes in the tax regime are likely to have only a small impact on short-run investment behavior.
However, some CEOs may face a painful medium-term problem: deciding whether their businesses need to rebuild their supply chains. Industries such as automobile production have developed intricate networks across North America and reaching into Asia and Europe, based on the longstanding assumption that materials and parts can be moved across borders with little cost or disruption. These capital-intensive industries are likely to want to postpone easily delayed investments in these networks until the administration’s trade policy becomes clearer.
Real business fixed investment rose a significant 5.2 percent in the second quarter (according to the second GDP release). That’s the sector’s second consecutive month of good news. Investment in structures fell slightly, but equipment investment more than offset the decline. Intellectual property investment rose just 1.4 percent and appears to be slowing.
Nondefense capital goods shipments—an effective high-frequency indicator of equipment spending—rose in May and June. Less aircraft, capital goods shipments have been up every month for five months to June, an unusually long streak for this volatile series.
Private nonresidential construction was up in May and again (just barely) in June, reversing a period of decline earlier in the year. Office construction—up 3.4 percent in May and 2.9 percent in June—was the reason. Commercial and manufacturing construction both fell in May and June.
Yields on corporate bonds have been creeping down despite the Fed raising the funds rate twice in the past few months. By July, AAA corporate bonds were yielding around 2.8 percent, down from a high of 3.3 percent in March. Stock indexes continued to make headlines by reaching new highs, notwithstanding the fact that businesses are beginning to view the likelihood of significant tax reform as relatively low.14 Corporate profits after taxes fell 10.0 percent at an annual rate in the first quarter and are up 3.7 percent over the previous year’s level. Profits remain at close to a record share of national income.
Over the past few decades, business—especially manufacturing—has taken advantage of generally open borders and cheap transportation to cut costs and improve global efficiency. The result is a complex matrix of production that makes the traditional measures of imports and exports somewhat misleading. For example, in 2007, 37 percent of Mexico’s exports to the United States consisted of intermediate inputs purchased from . . . the United States.15
Recent events appear to be placing this global manufacturing system at risk. The United Kingdom’s increasingly tenuous post-Brexit position in the European manufacturing ecosystem, along with the suggestion that the United States might cancel or renegotiate its position in the North American Free Trade Agreement (NAFTA),16 may slow the growth of this system or even cause it to unwind.
In the short run, uncertainty about border-crossing costs may reduce investment spending. Businesses may be reluctant to put capital in place when facing the possibility of a sudden shift in costs.
A significant change in border-crossing costs—as would occur if the United States withdrew from NAFTA—would likely reduce the value of capital investment put in place to take advantage of global goods flows. Essentially, the global capital stock would depreciate more quickly than our normal measures would suggest. In practical terms, some US plants and equipment would go idle without the ability to access foreign intermediate products.
With this loss of productive capacity would come the need to replace it with plants and equipment that would be profitable at the higher border cost. We might expect gross investment to increase once the outline of a new global trading system becomes apparent.
In the longer term, a significant reduction in globalization will result in higher costs. That’s a simple conclusion to be drawn from the fact that globalization was largely driven by businesses trying to cut costs. How those extra costs are distributed depends a great deal on economic policy. For example, central banks can attempt to fight the impact of lower globalization on prices (with a resulting period of high unemployment) or to accommodate it (allowing inflation to pick up).
The current account is determined by global financial flows, not trade costs. Any potential reduction in the current account deficit is likely to be largely offset by a reduction in American competitiveness through higher costs in the United States, lower costs abroad, and a higher dollar. The forecast assumes that the direct impact of trade policy on the current account deficit is nil.
US exports rose 1.0 percent in May, 1.2 percent in June, and have been up four of the five months to June. Imports, by contrast, have fallen in four of the past five months. The trade balance is therefore slowly falling and now stands at about $64 billion on a monthly basis.
The dollar has been depreciating in 2017. The Canadian dollar is now at USD 1.27, the euro up to USD 1.15, and the Mexican peso at USD 0.056. In June and July, the trade-weighted dollar fell 1.3 percent per month, offering some relief to trade-sensitive US businesses.
The Chinese economy is recording satisfactory growth, though many observers remain concerned about the country’s financial system and continuing infrastructure investment. Some analysts focus on signs of strength in China’s consumer and service sectors, suggesting a long-awaited shift to becoming a consumer-driven economy. Others point to now-familiar indications that official Chinese figures may be implausibly high.17 The country’s future remains a large risk for the global economy.
Europe has shown some signs of growth. Euro-area GDP grew 0.6 percent in the second quarter of 2017, the third consecutive quarter of above half-percent growth. However, negotiations over the continuation of aid to Greece remain a potential source of uncertainty for the Eurozone.
The US government budget is now a source of substantial uncertainty. Congress faces two key deadlines at the same time: to raise or suspend the debt ceiling and to pass funding legislation for FY 2018, both by October 1. Congressional leaders confidently promised that legislators would address both of these,18 and negotiations successfully delayed a reckoning until December.19
We expect the most likely outcome, embedded in the baseline scenario, to be a continuation of current policy. We no longer include either significant tax changes or any additional infrastructure spending in the baseline, although we have included such policy changes in the successful policy takeoff scenario. The slower growth scenario assumes that congressional difficulties in raising the debt ceiling and funding the government will contribute to slower growth in the first half of 2018.
After years of belt-tightening, most state and local governments are no longer actively cutting spending. However, many states remain constrained by the need to meet large unfunded pension obligations,20 so state and local spending growth will likely remain low over this forecast’s five-year horizon.
The federal deficit is higher this year than it was last year. As of July, the deficit was 11 percent above the level recorded in the same period in FY 2016. The increase was mainly the result of higher interest payments on public debt (up 11 percent), a re-estimation of the cost of subsidizing federal student loans, and a reduction of payments from the Federal Reserve because these payments were recorded in the previous fiscal year.
Government employment has held steady over the recent past. Federal employment didn’t change significantly in June and July. State and local employment grew 0.2 percent in June, with a corresponding growth in employment in education, but has otherwise been flat in recent months.
If the American economy is to effectively produce more goods and services, it will need more workers, and many potential employees still remain out of the labor force: They left in 2009, when the labor market was terrible. But they have started to return. The labor force participation rate for prime-age workers has been rising since the middle of 2015 as younger people return to the labor force—and older people remain in it for longer. The acceleration in production will likely carry with it a continued acceleration in demand for labor, along with a welcome mild rise in wages. That should help bring even more people back into the labor force.
But a great many people are still on the sidelines and have been out of work for a long time—long enough that their basic work skills may be eroding. Are those people still employable? So far, the answer has been “yes,” as job growth continues to be strong without pushing up wages. Deloitte’s forecast team remains optimistic that improvements in the labor market will continue to prove attractive to potential workers, and labor force participation is likely to continue to improve accordingly.
Despite this, demographics are slowing the growth of the population in prime labor force age. As Boomers age, lagging demographic growth will help slow the potential growth of the economy. That’s why we foresee growth below 2.0 percent by 2021—even with an optimistic view about productivity, it’s expected that slow labor force growth will eventually be felt in lower economic growth.
Significant immigration restrictions and/or deportation might have a marginal impact on the labor force. According to the Pew Research Center, undocumented immigrants make up about 5 percent of the total American labor force.21 Removal of all such workers would clearly have a significant impact on the labor force and on the economy—but such a dramatic change is unlikely to happen. Any removal of undocumented workers, however, could create labor shortages in certain industries (such as agriculture, in which some 17 percent of workers are unauthorized, and construction, in which an estimated 13 percent of workers are unauthorized).22 But that would likely have little significant impact at the aggregate level.
Initial claims for unemployment insurance have fallen from the 260,000 monthly range last summer to the 240,000 range for most of this year. That’s very low, especially considering that the US labor force and total employment continue to grow over time. Job openings picked up in June to a record 6.1 million. Quits (voluntary separations) have remained at about 3.1 million. The large number of voluntary quits suggests that labor demand remains strong.
Payroll employment rose at an average rate of 195,000 per month during May–July. That’s almost twice as much as would be required by the growth of the labor force, although slower than the rate recorded during 2014–15.
Interest rates are among the most difficult economic variables to forecast because movements depend on news—and if we knew it ahead of time, it wouldn’t be news. The Deloitte interest rate forecast is designed to show a path for rates consistent with the forecast for the real economy. But the potential risk for different interest rate movements is higher here than in other parts of our forecast.
Global financial markets are now in a highly unusual state. A substantial amount of government debt is still trading at negative interest rates, although the total is declining as euro-area interest rates creep up. The existence of negative interest rates is unprecedented, and the fact that even large countries (such as Germany) are borrowing on these terms indicates that global financial markets have, in general, not fully recovered from the problems of the previous decade.
The forecast sees both long- and short-term interest rates headed up—maybe not this week, or this month, but sometime in the future. The Fed currently is assuming that the economy is near full employment and would therefore likely react to the additional infrastructure stimulus assumed in the baseline. For that reason, the current baseline assumes an aggressive Fed reaction, with the Fed raising rates at every other Federal Open Market Committee meeting for the next few years. However, we have lowered our baseline long-term view of the stable Fed funds rate to be consistent with our assumption of a smaller demand-side policy impact. Long-term interest rates will likely move up as the economy returns to full employment and some inflationary pressures appear. (The impact of hurricanes Harvey and Irma adds a variable that both the Fed and forecasters will be evaluating in the coming weeks.)
Speculation about the future of the Fed will likely continue to grow over the next year. The administration has an immediate chance to make an impression on the central bank by filling at least three open slots on the board of governors and appointing a new chairman in February 2018. (Janet Yellen, the current chair, could retain her board seat even after her term ends.)
Long-term bonds were relatively stable in the spring and summer, despite two Fed hikes (equal to 50 basis points on the Fed funds rate). AAA corporate bonds fell to a spread of 65 basis points over treasuries (down from 80 basis points in February). The junk-bond spread remained about 2.0 points over AAA bonds.
Stock prices continued to rise. There is considerable debate about whether stocks are overpriced, since P/E ratios are high.23
It’s been a long time since inflation has posed a problem for American policymakers. The US economy has functioned below potential since 2008, and even before then there were a few signs of significant inflation. With so much slack, neither workers nor businesses have had the ability to raise prices much.
Some observers believe that the economy is approaching full employment,24 although the Deloitte forecast suggests the labor market still retains some slack. Thus, the fiscal stimulus of infrastructure spending might create some shortages in both labor and product markets and, as a result, some inflation. A return to 1970s-style inflation is unlikely, but it would not be surprising in those circumstances to see the core CPI running as high as 3.0 percent—or perhaps even a little higher. The forecast expects timely Fed action to prevent inflation from rising too much, but the price (of course) is higher interest rates.
The overall CPI is now at less than 2.0 percent on a year-over-year basis, after rising above that level early in the year because of higher energy prices. Core CPI was up 1.7 percent in July. Inflationary pressures in the pipeline remain mild, but deflation no longer appears to be a realistic possibility—and there is some risk that inflation could break out of the healthy 2.0 percent range.
Final demand producer price index has been flat over the three months through July. Earlier signs of firming producer prices appear to have been misleading.
The hourly wage grew just 2.4 percent in the year to April, lower than the average growth recorded in the previous recovery. Some measures of pay, such as the employment cost index, are beginning to show signs of acceleration. If that continues, it may well indicate that the economy is nearing full employment, and that policymakers may need to begin to lean against economic growth.