The new tax bill will probably boost GDP growth, as intended—but that boost could make the US economy more fragile. Our new forecast, then, suggests that recession is more likely than before. But it’s still a long shot: The chances remain good that the economy will stay strong this year and next.
This quarter’s forecast may remind users of that old line about there being good news and bad news. In this case, the good news is the fiscal stimulus from the Tax Cuts and Jobs Act and the Bipartisan Budget Act of 2018, since more money in the pockets of households and businesses leads to more spending. That means faster GDP growth over the next two years.
But a large fiscal stimulus might increase the economy’s fragility. Recessions are born out of economic and financial imbalances that get out of hand. That might, in the end, be the outcome of the large increase in government borrowing over the next few years.
This quarter’s baseline forecast does indeed show faster GDP growth in the next two years. But we’ve also raised the likelihood of recession, which reflects growing financial imbalances—not only in the United States, by the way. It also reflects the difficulty that the Fed could face in making monetary policy, and a rather larger chance than we saw last year that the Fed might misjudge the state of the economy.
Impact of steel and aluminum tariffs
After we completed this forecast, and just before publication, the president announced the administration’s intention of imposing tariffs on imports of steel and aluminum, though it is not yet clear whether the eventual levels will match the figures he initially stated. Whatever the symbolic impact of these tariffs, their direct effects would not alter our forecast substantially, since primary metal production accounts for less than 1 percent of US GDP. However, the tariff does increase the risk of a broad trade war that could cover products accounting for a significant share of US production.1 Such a trade war could disrupt existing supply chains and raise business costs substantially, perhaps then causing central banks to raise interest rates to prevent inflation. This remains part of the forces driving our low scenario, for which we have placed a relatively high probability of 20 percent. A trade war would also increase financial fragility in companies affected by the rise in costs and therefore underlines our judgment that the probability of a recession is higher than it was a few months ago.
Extra demand will likely lead to more production and revenues—indeed, the official congressional scorekeepers estimate the additional demand to be almost 1 percent of GDP.2 That’s enough to raise GDP growth (in 2018) to over 3.0 percent.
Granted, this probably overstates the impact, for several reasons. First, the economy is probably near full employment. That means that some of the impact will be felt in higher inflation rather than more real activity.
Second, interest rates are likely to rise faster than we previously expected as demand heats up. That will moderate demand for debt-financed goods and services such as houses and cars.
Finally, capital costs have been very low for a long time. Despite this, investment growth has been modest, suggesting that capital costs are not a factor in holding back investment. The business tax cuts may help keep the cost of capital low, but the impact on investment may be lower than pre-Great Recession research might have suggested.
For these reasons, the baseline Deloitte forecast shows a jump of only about half a percent in GDP in 2018 (compared to the previous baseline). That’s still pretty substantial. Businesses are unlikely to complain about short-run revenue growth in the next year, and the additional workers likely to be hired won’t complain about getting jobs or (with any luck) pay raises.
Even the rosiest scenarios suggest that the US fiscal deficit will rise quite a bit over the next couple of years.3 Over the past decade—since the financial crisis—the US government has been able to sell securities easily and cheaply because the supply of other safe assets was small. As the global recovery picks up, other assets will become more attractive, and demand for US Treasuries is likely to fall. The combination of growing supply and falling demand creates a risk—a risk that the market could move quickly in the wrong direction.
The large stimulus also creates a challenge for the Fed. If signs of inflation begin to appear, the pressure will be on for more aggressive monetary policy. The impact of higher interest rates, however, will be felt only after some time. And by 2020, the spending from the budget agreement will likely be falling, creating a drag on the economy. The Fed may have to make a difficult choice between risking higher inflation and risking seeing interest rates slow the economy just as the stimulus comes off. Wrong choices have created recessions before, and this type of dilemma might just lead to such a result.
Given this, we have increased our subjective probability that a recession will occur in the next few years to 15 percent. Our scenario reflects one possible way that could occur—a financial crisis in 2018 that overwhelms the government stimulus feeding into the economy. But a Fed mistake could also create a recession, particularly if interest rates are rising while this year’s fiscal stimulus is reversed in 2020. We do not show this story explicitly. But it is an important reason why we’ve raised the overall probability that a recession might occur.
We still regard the chances of a recession to be relatively remote. There are no immediate signs that the economy could stall out. And the most likely path for the economy remains strong growth in the next two years, followed by a period of substandard growth as the economy adjusts to full employment.
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. A pickup in foreign growth helps to tamp down the dollar and increase demand for US exports, adding to demand. Fiscal stimulus from the tax reform bill and the budget agreement pushes growth up to close to 3.0 percent in 2018 and above 2.5 percent in 2019. With the economy near full employment, the faster GDP growth creates inflationary pressures. The Fed responds with an aggressive interest rate policy, and long-term rates rise quickly as alternative assets (abroad) become more appealing. A small increase in trade restrictions adds to business costs in the medium term, but this is offset by lower regulatory costs. As the impact of stimulus fades and the economy feels the effect of higher interest rates, growth slows below potential in 2020 and 2021.
Recession (15 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 fourth quarter of 2018 and first two quarters of 2019, and then recovers.
Slower growth (20 percent): Business tax cuts do not induce much investment spending, while households save their tax cuts. 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. The higher spending authorization from the budget bill translates only slowly into additional federal outlays, reducing the budget bill’s impact on the economy. GDP growth falls to less than 1.5 percent over the forecast period, and the unemployment rate rises to about 6 percent.
Productivity bonanza (10 percent): Technological advances in manufacturing begin to lower corporate costs, as efficient deregulation improves business confidence. Improved infrastructure boosts demand in the short run, and capacity and the productivity of private capital in the long run. The economy grows 3.5 percent in 2018 and 2019, and growth remains above 2.0 percent between 2020 and 2022, while inflation remains subdued.
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 unsurprising, 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 increase their spending. The continued steady (if modest) growth in house prices has helped, too, since houses are most households’ main form of wealth.
When it comes to spending decisions, political noise is just that—in the background—to consumers who are focused on their own situations. As long as job growth holds up and house prices keep rising, consumer spending will remain strong. And the tax cut, while modest for many consumers, will likely help to keep consumers confident that they can spend. More important, the fiscal stimulus from the tax bill will likely tighten the job market even further. If wages begin to rise, consumer spending is likely to get a further boost.
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 savings4). That may constrain spending and require higher savings in the future. That could be a shock, since a key feature of the current consumer boom is a decline in the savings rate (from an average of 6.1 percent in 2015 to just 2.4 percent at the end of 2017).5
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?,6 Deloitte’s most recent examination of the issue.
Real consumer spending growth picked up at the end of 2012 to 0.5 percent in November and 0.3 percent in December. Confidence has remained at remarkably high levels, likely reflecting the state of the labor market. Real disposable personal income is growing more slowly (about 0.1 percent per month), and so consumers continue to draw down savings. At 2.4 percent, the savings rate is quite low.
Headline retail sales were very strong until December, then went flat. Sales at auto dealers fell in the November–January period, although this may have been a drop-off after sales boomed to replace cars destroyed in the late summer hurricanes. Although it’s early to see a trend, slow sales growth in December and January may reflect the need for consumers to replenish savings depleted by earlier spending.
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 that 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 7.4 percent above their year-ago level in January. Single-family permits are up 7.4 percent during the year, while multifamily permits are down 7.3 percent. The share of single-family permits has been growing for some months. At about 1.4 million, total permits are likely 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 last March. That’s despite the Fed raising short-term rates and starting to let its holdings of housing securities begin to run down, and is a good sign that lenders are willing to make mortgages even without the Fed backstopping a large share of the market.
House prices continue to rise: In August, the Case-Shiller national index was 6.2 percent above the previous year’s level.
The key question for business investment in the next year or so is the impact of the tax reform bill. The bill contained four main components that could affect business investment at the aggregate level.
The impact of the tax reform may be less than suggested by past experience, however. Taxes affect investment decisions through the cost of capital, which also depends on interest rates and the depreciation rate. The cost of capital has been at historic lows over the past decade. Yet many businesses have been reluctant to take advantage of cheap capital to raise investment. So it appears likely that cutting the cost of capital further will have at best a modest impact. The forecast assumes that additional investment spending adds several tenths of a percentage point to growth in 2018 and 2019.
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 may want to postpone easily delayed investments in these networks until the administration’s trade policy becomes clearer.
Business investment news
Real business fixed investment rose 6.8 percent in the third quarter (according to the first GDP release). That’s the sector’s third consecutive month of good news. Investment in structures rose a weak 1.4 percent after falling 7 percent in Q3. Equipment investment was up 11.4 percent, the third very strong quarter in a row. Investment in intellectual-property products rose 4.5 percent.
Nondefense capital goods shipments—an effective high-frequency indicator of equipment spending—fell in December after rising in November. The trend appears to be softening. Less aircraft, capital goods shipments have risen every month since February, an unusually long streak for this volatile series, though recently growth has been decelerating.
Private nonresidential construction activity rose 1.1 percent in December after growing slowly in the previous months. Office construction grew 4.2 percent in November and December, and commercial construction posted a 1.6 percent gain. But manufacturing construction fell in December for the second month in a row.
Yields on corporate bonds have started to rise. Stock prices continued to rise until late January, when the market took a tumble. However, stock prices remain at high levels. Corporate profits before taxes rose 4.3 percent in the third quarter and were up 5.4 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.8
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, 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—could potentially reduce the value of capital investment put in place to take advantage of global goods flows. Essentially, the global capital stock could depreciate more quickly than our normal measures would suggest. In practical terms, some US plants and equipment could likely 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 likely 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.9 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.
Foreign trade news
US exports rose over 3.0 percent in each of the last two months of 2017; imports climbed at a similar rate. Since the value of imports is greater than the value of exports, the trade balance—the difference between them—rose. In December, it hit $72 billion.
The dollar depreciated in December and January. The Canadian dollar is now 1.27 per US dollar, with the euro up to USD 1.23. The Mexican peso continues to fluctuate depending on news from the NAFTA renegotiations; it’s 18.72 per US dollar at this writing. The dollar’s depreciation relative to the euro almost certainly reflects continued positive news about economic growth in Europe.
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.10 The country’s future remains a large question mark for the global economy.
Europe is showing substantial signs of growth. Euro-area GDP has grown at a strong 0.6 percent or more in each of the last five quarters. However, negotiations over the continuation of aid to Greece remain a potential source of uncertainty for the eurozone.
The three months since the last forecast have seen a remarkable turnaround in US government policy. First, Congress passed a comprehensive tax reform package, including a substantial tax cut. Second, Congress agreed to a budget proposal for the next two years, removing uncertainty about funding the government through FY 2019 (which ends in September 2019) and the debt ceiling (which was raised until March 1, 2019). These acts substantially reduce the near-term risk of a financial crisis related to a US government shutdown or inability to borrow to meet current financing needs.
The Deloitte forecast assumes that the two bills together will provide substantial short-term stimulus to the US economy, raising growth in 2018 and ’19 but causing growth to slow afterward as the stimulus is removed. The impact on the economy’s capacity in the long run remains a matter of debate, with estimates ranging from no real change after a decade (Tax Policy Center) to 2.8 percent, or almost 0.3 percentage points annually (Tax Foundation).11
Prospects for an infrastructure spending package remain uncertain. The success of the previous legislation suggests that—should congressional leadership prioritize infrastructure—a bill may yet be passed. The administration’s infrastructure proposal suggests that cost-sharing would be a key part of any infrastructure bill.12 That may reduce the impact, especially if state and local governments, already experiencing budget constraints, are expected to contribute a substantial portion of the spending.
After years of belt-tightening, most state and local governments are no longer actively cutting spending. However, many state budgets remain constrained by the need to meet large unfunded pension obligations,13 so state and local spending growth will likely remain low over this forecast’s five-year horizon.
The federal deficit for the fiscal year through January was 11 percent larger than in FY 2017. Receipts are up 4.2 percent, but outlays are up 5.1 percent. Rising interest outlays, spending for military programs, and disaster relief costs were key drivers of the relatively fast rise in spending so far this fiscal year.
Government employment has held steady over the recent past. Federal employment rose slightly in January, offsetting a decline in December. State and local employment growth was flat for the three months ending 2018.
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 begun 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 are remaining in the labor force 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 trend growth below 2.0 percent by 2021—even with an optimistic view about productivity, we expect 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.14 Removal of all such workers would clearly have a significant impact on the labor force and on the economy—but such a dramatic, disruptive 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.15 But that would likely have little significant impact at the aggregate level.
Labor market news
Initial claims for unemployment insurance remained very low, especially considering that the US labor force and total employment continue to grow over time. Job openings fell from 6.1 million in September to 5.8 million in December, while voluntary quits increased to more than 3.2 million. The large number of quits suggests that labor demand remains strong.
Payroll employment was up 200,000 in January, above recent average levels. The underlying rate of job growth is over twice as much as would be required by the growth of the labor force, although slower than the rate recorded during 2014–15. The labor force participation rate was flat at 62.7 percent. The participation rate for people aged 25 to 54 has been rising since 2015, offsetting the impact of the growing population of older people who are less likely to be working or looking for work.
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.
The forecast sees both long- and short-term interest rates headed up—maybe not this week, or this month, but sometime in the future. Fed officials are clearly concerned about the possibility of the economy overheating: The January Federal Open Market Committee minutes noted that “participants . . . anticipated that the rate of economic growth in 2018 would exceed their estimates of its sustainable longer-run pace.” This was before Congress passed the large spending stimulus in February. Any signs of incipient acceleration in inflation will likely elicit a strong response by the Fed.
We expect the Fed to continue to hike short-term interest rates at every second FOMC meeting for the next two years, and to continue to let its inventory of short-term assets shrink at a slow rate.
As the economy approaches full employment and the possibility of higher inflation increases, long-term interest rates will follow the Fed funds rate up—and perhaps even rise faster. The improvement in foreign economic conditions will play an important role as well. The European recovery, in particular, will draw investors away from the United States and toward higher returns in Europe. That’s not a bad thing, as slow European growth has been a significant problem for the global economy, as well as for US exports. But it will help to hasten the return of long-term interest rates to a more “normal” rate of 4 percent or more (reflecting 2 percent inflation and a long-run risk-adjusted real rate of 2 percent).
Financial market news
The biggest news in the past few months was the interruption of the stock market’s good news in late January and early February. The stock market dropped by just over 10 percent in the first two weeks of February before beginning to recover. Although the excitement rapidly went away as the recovery started, the drop was a reminder that the stock market is volatile and not always a good indicator of the underlying state of the economy.
Long-term bond yields are starting to rise. This reflects the Fed’s continued interest rate hikes, growing perception that inflation could pick up, and the improved economic conditions abroad, which is attracting investors out of US markets. The AAA spread over Treasuries has fallen however, from 72 basis points in September to 53 basis points in January. The junk-bond spread fell from 200 basis points in August to 162 basis points in January.
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. Despite recent discussion about inflation, there are few signs that inflation is actually picking up.
Some observers believe that the economy is approaching full employment,16 although the Deloitte forecast suggests that the labor market still retains some slack. The combination of the tax cut and spending increase 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. Higher inflation rates are now a significant risk because of the size of the stimulus being applied to the economy this year.
The overall CPI was up 0.5 percent in January, sparking some worries about accelerating inflation. The year over year rate of increase was 2.1 percent, however, unchanged from the previous month. And core CPI was up 0.3 percent in the month and 1.8 percent in the quarter. These are not strong signs that inflation is a significant worry. The PPI rose 0.4 percent but is still up only 2.6 percent over the year, about the level that has been recorded for the past six months. Core CPI was up 1.8 percent.
The hourly wage rose just 0.1 percent in January and is up a modest 2.4 percent over the past 12 months. Some measures of pay, such as the employment cost index, are beginning to show signs of acceleration. If that continues, it may indicate that the economy is nearing full employment, and that policymakers may need to begin to lean against economic growth.