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The labor market has tightened considerably to slightly below the level in 2007, and there is no sign of wage inflation yet, casting doubts on the robustness of the Philips curve, which established the relationship between unemployment rate and inflation. Rajeev Dhawan of the Georgia State University expects a small personal income tax cut for the middle-class with an anticipated boost in consumption and growth in 2018, leading the Fed to an interest rate hike in December. James Bullard, President of the Federal Reserve Bank of St. Louis, points to the empirical evidence that the Philips curve is flat, delinking the presumed relation between the unemployment rate and inflation as the policy guide for tightening monetary policy. Board = Conference Board, New York, New York; Fannie Mae = Fannie Mae, Washington, D.C.; IHS Markit = IHS Global Insight, Lexington, MA; 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.; 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. economy is on its longest cycle of post trough recovery and is continuing to grow both in employment and output. A recently released report by the U.S. Census Bureau shows a 5-percent boost in inflation-adjusted median income in 2016, following a 3.2-percent increase in 2015. The middle-class household income is approaching the 2007 pre-Great Recession level. The female head of households experienced the largest jump in income by 7 percent. The younger population has fared considerably better than the older population. This is all good news for the economy. Compared with the aging population, which is stretching its savings in retirement, the younger population is engaged in income-producing activities and consumption spending. The labor market has tightened considerably to slightly below the level in 2007, and there is no sign of wage inflation yet, casting doubts on the robustness of the Philips curve, which established the relationship between unemployment rate and inflation. However, a broader measure of the unemployment rate is one that includes discouraged workers who quit the market and part-time workers seeking a full-time job; it is currently at 8.6 percent. Some of these workers do not have the right skill or do not live in the right cities to fill the open positions. However, their joblessness contributes to the psychology of those who are employed, hesitating to demand wage raises. The real final sales measure of the GDP that excludes inventory fluctuations is positive, suggesting that the consumer spending is growing. The consensus puts growth in the GDP at 1.8 percent by the third quarter of 2018. The administration is taking credit for gains in the equity market. Keith Hembre of the Nuveen Asset Management does not expect the administration to impose a ceiling on the debt that can disrupt the equity market calm. The Fed's snail-pace monetary tightening has paid off. More than three decades of decline in labor participation has leveled off at close to 63 percent and has prevented wage inflation. More sideline workers have been pulled into the labor market, and more seniors are postponing plans to exit the labor market, all good news for both output and consumption spending.
CONSUMERS
Sustained growth in employment and income has produced the second highest consumer confidence since 2000, to 122.9 in August, up from 120 in July, reports the Conference Board. There are over 6 million job openings. We expect that, sooner or later, wages will rise faster than 2.5 percent. Consensus puts growth in the personal disposable income at 3.34 percent, almost twice the growth rate of the economy. Personal consumption expenditure is set to grow at 3.16 percent by the third quarter of 2018. The ratio of expenditure-to-income has nudged upward to 93 percent from the 91 percent we reported a year ago. Household debt has returned to the pre-recession peak. However, the debt as a percent of income has declined to an all-time low, in part due to mortgage refinancing. Households' improved debt-to-income ratio is boosting discretionary consumer spending. Consumer credit rating has been on the rise and there has been a decline in the more-than-90-day delinquencies. Sub-prime auto loans are of concern, but remain a fraction of total household debt. A bigger concern is the mounting student loan debt that has impacted the millennials in decisions about home ownership and savings for retirement. The majority of student loans are backed by the federal government and could hit the taxpayers at some point, but they are not expected to have a systemic effect on the economy. Rajeev Dhawan of the Georgia State University expects a small personal income tax cut for the middle-class with an anticipated boost in consumption and growth in 2018, leading the Fed to an interest rate hike in December. We agree with Dhawan that rhetoric by the administration is unconventional, but policies remain conventional and the market has figured it out. Dhawan correctly points out that spending on infrastructure will experience delays and when it does happen, it will take a while for the multiplier effect to kick in. Household nominal wealth has rebounded due to a rise in home values and a strong equity market with a likely wealth effect on consumer sentiments and growth in discretionary spending. Consensus expects the unemployment rate to drop slightly to 4.2 percent by the third quarter of 2018. Inflation, measured by the consumer price index, is projected to miss the 2 percent target set by the Fed, again at 1.56 percent for the four quarters. The chained consumer price index that captures the substitution effect of households switching to less expensive alternatives is expected to be 1.48 percent by the third quarter 2018. The difference between the CPI and the chained consumer price index is shrinking, reflecting the growing competition in groceries and online shopping for competitive prices.
FIRMS
Nonresidential fixed investment or capital formation rebounded in the first quarter of 2017 at a brisk annualized rate of 7.1 percent, contributing to the faster real GDP growth. Consensus expects the nonresidential fixed investment to grow by 2.75 percent by the third quarter of 2018. The manufacturing sector has rebounded well and needs more capital equipment to extract more labor productivity that has struggled in recent years. Without capital deepening, the stagnant labor productivity will put downward pressure on profitability and wage growth. For a good while, firms sat on the sidelines regarding investment due to uncertainty about long-term consumer spending. To keep up with the anticipated rise in demand, the supply-side needs to respond quickly. The Institute for Supply Management's report shows the factory index grew to 57.8 in June from 54.9 from the prior month, the highest since August of 2014. Factories powered up in June at the fastest pace in nearly three years, with robust advances in production, orders, and employment, indicating a strengthening in the economy. Consensus expects the private housing starts to grow from 1.26 million units in the fourth quarter of 2017 to 1.34 million units by the third quarter of 2018. A mix of exhausted marketing schemes by the auto manufacturers and subprime auto loans is expected to produce a modest growth in total light vehicle sales of slightly below half a percent. Consensus puts sales of auto at 17 million units by the third quarter of 2018. The two massive hurricanes in Texas and Florida could lead to a one-time boost in auto sales to replace destroyed cars and pickup trucks. The industrial capacity utilization is expected to nudge upward to 76.65 percent by the third quarter of 2018, almost one full percent higher year-over-year from third quarter 2017. This is good news, for a more intense use of capital will reduce costs and increase profitability and labor productivity. Persistent unfilled job openings will push firms to more investment in automation with a positive effect on labor productivity.
INTEREST, CREDIT, AND THE FED
In 2017, the Fed has hiked the key interest two times, and one more is expected before the year is out. Meanwhile, the Fed is set to gradually reverse the quantitative easing that started in 2008 by reducing its balance sheet of maturing Treasury and mortgage securities. However, the Fed seems committed to evidence-based policy formulation. Consensus expects that the Federal Fund Rate to increase from 1.22 percent to 1.74 percent between the third quarter of 2017 and the third quarter of 2018. The triple-A corporate bond rate is expected to rise slightly from 4.13 percent in the third quarter of 2017 to 4.68 percent in the third quarter 2018. Firms are flush with cash and a modest rise in the cost of borrowing is not expected to have a significant effect on investment spending. The M2 money supply is projected to grow by 2.37 percent in the next four quarters. The money supply growth rate is expected to be slightly larger than the expected growth in GDP. In the past, even a significantly larger growth in money supply relative to the GDP has proven to be mute in creating inflationary pressure. James Bullard, President of the Federal Reserve Bank of St. Louis, points to the empirical evidence that the Philips curve is flat, delinking the presumed relation between the unemployment rate and inflation as the policy guide for tightening monetary policy. The view that monetary tightening in the absence of inflationary pressure is not warranted is shared by Neel Kashkari, president of the Minneapolis Fed. Janet Yellen has shown a willingness to let the economy run hot to pull the discouraged workers and marginally unemployed into the labor market. Much anticipated tax reform in the context of full employment economy is likely to encounter a nonaccommodating monetary policy by the Fed. Keith Hembre of the Nuveen Asset Management expects that the Fed is prepared to reverse course, should there be disruptions in the financial markets that would lead to market volatility. Historically low labor force participation suggests that the economy is operating considerably below its potential and can tolerate low-interest rates for some time to come.
CONCLUSION
The economy has rebounded from one of the deepest recessions since the 1930s. Americans have much to be hopeful about: increasing employment opportunities, rising incomes, and a rise in asset values. There are also some headwinds to be concerned with. Despite rising household incomes, the economic share of the middle-class is at a record low. Labor mobility across state borders has declined, contributing to low labor productivity and slow wage growth. The equity market has been the primary beneficiary of record high profit, buy-back, and dividends. The labor share of the economic pie continues to decline. A study published by Harvard's Institute of Politics in 2016 reported that 51 percent of 18- to 29-year-olds who took part in a national poll expressed anxiety about their future. This finding is consistent with the decline in teen labor participation. Teens have increased their participation in summer school courses, and a growing number are completing advanced courses in math, science, and English. This development is good news for the competitiveness of the economy in an interconnected flat world where competition is no longer local. It seems that teens have internalized the threat and are investing in their future. Rising medical costs and longer life expectancy will strain the aging population in retirement. Unless the economy manages to produce at or close to its full potential, government obligations for social security and Medicare and Medicaid will not be sustainable without raising taxes across the board. Another headwind is the rise of artificial intelligence and machine learning in labor-saving innovations that are accelerating in all sectors. Industry insiders have predicted that in five to ten years, 30 percent of banking jobs will be eliminated. It is possible that the three decades of steady decline in labor force participation is structural. Labor-saving innovations have steadily reduced manufacturing jobs and now are penetrating the services sector at an alarming rate. The economy is delivering goods and services people need and then some more without hiring everybody. One question remains is that whether the employed can be sufficiently productive to pull the weight of retirees and structurally unemployed population. This phenomenon has given rise to a debate on the merit of universal basic income for all citizens regardless of their employment status.
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Copyright Journal of Business Forecasting Fall 2017