The Post-Election U.S. Economy with an Anticipated Mix of Real and Psychological Impacts

Abstract

Board = Conference Board, New York, New York; Fannie Mae = Fannie Mae, Washington, D.C.; iHS = iHS Global insight, Eddystone, Pennsylvania; GSU - EFC = Georgia State University, Economic Forecasting Center, Atlanta, Georgia; Moody's Economy = Moody's Economy, com, Westchester, Pennsylvania; Mortgage = Mortgage Bankers Association, Washington, D.C.; NAM = National Association of Manufacturers, Washington, D.C.; Northern Tr = Northern Trust Company, Chicago, illinois; Perryman Gp = The Perryman Group, Waco, Texas; Royal Bank of Canada, Toronto, Ontario, Canada; S&P = Standard & Poor's, New York, New York; US Bank = U.S. Bank, Minneapolis, Minnesota; US Chamber = U.S. Chamber of Commerce, Washington, D.C.; Wells Fargo = Wells Fargo Bank, San Francisco, California. [...]growing income inequality continues to present a problem in managing aggregate demand, since much of equity market gains are concentrated at the top of the income and wealth population with a considerably lower marginal propensity to consume relative to wage earners.

PARTICIPANTS I Conf. Board = Conference Board, New York, New York; Fannie Mae = Fannie Mae, Washington, D.C.; iHS = iHS Global insight, Eddystone, Pennsylvania; GSU - EFC = Georgia State University, Economic Forecasting Center, Atlanta, Georgia; Moody's Economy = Moody's Economy, com, Westchester, Pennsylvania; Mortgage = Mortgage Bankers Association, Washington, D.C.; NAM = National Association of Manufacturers, Washington, D.C.; Northern Tr = Northern Trust Company, Chicago, illinois; Perryman Gp = The Perryman Group, Waco, Texas; Royal Bank of Canada, Toronto, Ontario, Canada; S&P = Standard & Poor's, New York, New York; US Bank = U.S. Bank, Minneapolis, Minnesota; US Chamber = U.S. Chamber of Commerce, Washington, D.C.; Wells Fargo = Wells Fargo Bank, San Francisco, California.

The U.S. presidential election finally ended and the Fed finally raised the rate, albeit very modestly, giving way to the phase of speculation and "what if" policy analyses on a host of topics, ranging from fiscal and monetary policies to trade, immigration, energy, and environment. Equity markets have responded positively and strongly to the election's outcome and seem unfazed by the Fed's decision to increase the key interest rate in 2016 with a hint of additional hikes in 2017. Anticipation of improving profit margins due to the promise of deregulation, corporate tax reduction, domestic energy production, and further reduction in slack unemployment to boost aggregate demand are contributing to the euphoria. However, for an 18-trillion-dollar economy, it will take time for even drastic policy shifts to impact the growth of real output. The President-elect has hinted strongly about fiscal spending on infrastructure and defense in addition to restrictive trade and immigration policies. The question remains whether the Fed will adopt accommodating policy to mitigate the cost of borrowing, the national debt, and the value of dollar. The long-term cost of borrowing, for example the 30-year fixed mortgage rate, has already nudged upward, reflecting anticipated additional rate hikes by the Fed in 2017 to combat inflation. Inflated equity markets will have a complex set of impacts on household savings, wealth effect on consumption spending, and consumer confidence.

Consensus puts expected growth of the nominal GDP at a modest 1.6 percent by the end of 2017, signaling that it will take time for either fiscal stimulus on infrastructure or supply-side tax and deregulation policies to produce a higher growth rate of the GDP. Rajeev Dhawan of Georgia State University expects the GDP growth will have to wait until 2018 before reaching close to 2-percent rate. John Silva of Wells Fargo is more optimistic and puts growth in real GDP at 2 percent for 2017 and 2018.

CONSUMERS

Consensus expects personal disposable income to grow by 3.41 percent by the end of 2017. This is slightly better than the 3.33 percent reported in last issue of the Journal, reflecting continued improvement in employment and income. Personal consumption expenditure is expected to grow at 3.53 percent, in contrast with the 3.63 percent reported in last issue. This outcome is expected, given that the higher employment level will reduce transfer payments that tend to have a higher marginal propensity to consume relative to wage income. The Consumer Confidence Index finally entered into positive territory in October and up sharply again in November to 107.1, at par with the pre-recession level according to the Conference Board Survey.

The Philips curve that captures the relationship between inflation and unemployment is reemerging more convincingly as low unemployment finally is pushing the rate of growth of wages from the stubbornly below 2.0 percent to 2.8 percent with anticipated price inflation to follow. Higher household income will finally make it possible for firms to pass some of the rising labor cost to consumers. Consensus expected a slightly above 1-percent decline in total light vehicle sales between the first and last quarters of 2017 at 17 million units as auto manufacturers scale back buyers' incentives. The Consumer Price Index is expected to rise by 1.70 percent by the last quarter of 2017, which will miss the Fed's desired target of 2 percent. The Chained Price Index is expected to rise slightly less than the CPI at 1.61 percent. This difference is expected as households replace more expensive goods with substitutes that have risen in price less than other goods in order to maintain their standard of living. The substitution bias in consumer expenditure has brought about plummeting grocery prices as large chain grocery stores are forced to lower prices to compete with discount grocers. A similar phenomenon is affecting anchor retail department stores. Macy's has announced 100 store closings in 2017 while online and discount chains like Marshalls are growing in sales. Consensus expects the unemployment rate to decline to 4.68 percent by the fourth quarter of 2017, which should result in higher consumer spending and aggregate demand that is crucial for continued GDP growth. It is unclear when higher consumer spending will have a spillover effect to spur investment in capital equipment, which has been flat in 2016. Equity markets have performed well, particularly in the post-election weeks, which is expected to boost consumer demand by way of the wealth effect. However, growing income inequality continues to present a problem in managing aggregate demand, since much of equity market gains are concentrated at the top of the income and wealth population with a considerably lower marginal propensity to consume relative to wage earners.

FIRMS

Consensus puts expected capacity utilization at 75.5 percent, which is one percentage point below the 15-year trend and considerably below the historic average of 80-plus percent. This explains the lackluster capital investment expenditure that has affected the productive capacity of the United States. Recently, the Fed chair, Janet Yellen, has made the case that it might be necessary to let the economy to run "hot" for a while in order to spur investment in fixed capital that is vital to labor productivity. Since 2010, average growth in productivity per labor hour has been in negative territory partly due to the lack of investment in capital in addition to the impact of longterm unemployment of skilled laborers. Low labor productivity combined with rising real wages will put additional downward pressure on already weak corporate profit.

Consensus puts growth in non-residential fixed investment at 2.4 percent by the end of 2017. The near zero interest rate for the past decade has failed to spur fixed investment spending. Average deviation from the 2007 level business fixed investment has declined in excess of 15 percent. Investment in intellectual property products has been growing however. Intellectual property investment tends to contribute to efficiency innovations that, according to Clayton Christensen of Harvard Business School, lead to labor-saving technologies that put downward pressure on employment. The drive to create autonomous cars as well as the development of cognitive robotics are among examples of such innovations. Consensus expects starts in new private housing to reach 1.26 million units, a 6.25 percent growth between the first and fourth quarters of 2017. Higher employment and income should boost demand for new homes while rising mortgage rates can dampen the demand, particularly for first-time buyers. The Federal Fund Rate is expected to rise slightly above 1 percent by the last quarter of 2017 in anticipation of three additional rate hikes by the Fed in 2017, modestly pushing the cost of borrowing higher. The triple A corporate bond rate is expected to rise slightly between the first and fourth quarters of 2017 from 3.8 percent to 4.4 percent. Policies aimed at inducing repatriation of corporate profits held offshore is not expected to have significant impact on either aggregate demand or aggregate supply in an economy flushed with capital. One benefit of profit repatriation will be a higher tax revenue for government.

INTEREST, CREDIT, AND THE FED

On December 14, 2016, for the first time since December of 2015, the weighted average of negotiated overnight borrowing cost among financial institutions to meet their required reserve, otherwise known as the Federal Fund rate, was raised to an effective rate of 0.50 to 0.75 basis points. The snail pace rate increase by the Fed is in part due to the continued presence of slack in the labor market and the below-potential performance of the economy. Despite the below-5-percent unemployment rate, labor participation remains low relative to pre-recession, particularly among marginal and discouraged working age population. The Fed chair, Janet Yellen, remains concerned about the segment of the labor force that still needs to find meaningful employment in addition to 6 million part-time workers who would like to have full-time jobs. Ms. Yellen has hinted at the potential benefits of continued easy monetary policy concurrent with gradual rate increases to run the economy "hot" in order to boost aggregate demand sufficiently strong to trigger supply-side expansion that struggled greatly after the great recession of 2007-08. However, several members of the Open Market Committee are concerned that if interest rates are not increased gradually, the Fed might be forced to hike rates dramatically in the future with a more disruptive impact on household and firms' decisions. The Fed has been pushing for a 2-percent inflation target for quite some time. In light of global glut in energy and primary goods, in addition to sluggish European economies, a very tight labor market seems the only option for achieving the 2-percent target rate of inflation. Consensus expected M2 money supply to grow by 2.4 percent between the first and last quarters of 2017, almost a full percent point higher than the growth in GDP. For several years, excess growth of money supply relative to the GDP has not produced inflationary pressure. The Fed with Yellen at the helm is not likely to engage in tight monetary policy should the Trump administration launch large fiscal spending and tax cuts. However, the new administration has been pointing to restricting immigration and border tax adjustments. Restrictive immigration policy most certainly will lead to higher construction labor cost and home prices while the imposition of higher taxes on imports will impact the cost of particularly household goods and general inflation. If this scenario comes true, the Fed might be forced to engage in monetary contraction sooner than expected. Importing disinflation has been helping real wages and trade restrictions can reverse modest wage improvements.

In closing, there is still room for improvements in the labor market if the economy is to operate at its potential GDP. Expansionary monetary policy has done all it could to avert a deep recession, but aggregate demand remains weak, particularly in business fixed investment. An extremely slow recovery has adversely impacted labor skill and productivity, which will contribute to the rising cost of production as nominal wage climbs. Consumers seem to have fallen in love with online competitive pricing as well as discount retail and groceries and are not showing signs of returning to old spending habits. Population aging and the high divorce rate among baby boomers who make the second largest population segment is contributing to a higher rate of poverty, putting dampening pressure on consumption spending. A research study by the National Center for Family and Marriage indicates that the rate of poverty is 16 percent and 19 percent for couples who divorce before and after age 50, respectively. The poverty rate among married couples is only 3.4 percent. Loss of family assets due to divorce, combined with the higher cost of single living, is pushing many of the retirement age population back into the labor market, making it more difficult for younger workers to find jobs. The rising cost of medical care in the form of higher deductibles and co-insurance is eroding the purchasing power of an otherwise shrinking middle class that historically drove the largest component of the aggregate demand. The new administration will have a more psychological than a real impact on the reversal of income inequality and aggregate demand, at least in the short-run.

-Send Comments to: [email protected]