The economy performed well during the third quarter even in the face of two strong hurricanes. Monthly data suggest that this momentum is at least continuing into the fourth quarter. The past two quarters give signs that the economy is finally breaking out of its “new normal” rut. Our new forecast is consistent with this optimism.
The advance data from the BEA on economic activity during the third quarter were encouraging. Growth was good and more broadly based than in 2016. It was also relatively close to our expectations.
Real output growth for the quarter came in at 3.0%, just 0.1% below our August forecast. As we expected inventory accumulation added to third quarter growth. Final sales grew at a 2.3% rate. On a year-over year basis total growth was 2.3%, which was 0.1% above our forecast a year ago.
We also did relatively well with the disaggregate details. Total consumption increased 2.4%, very close to our August forecast. Spending on goods was a little stronger than our expectation and on services the reverse. Business expenditures on equipment showed strong growth as we expected. Construction spending by business, on the other hand, was dismal, registering a 5.2% decline. We had forecast an increase of 4.6%. Residential investment was also significantly negative well beyond the small decrease in our August outlook. Exports exceeded our August estimate, while imports were well short. As a result the trade deficit improved by $18 billion rather than the slight deterioration we anticipated. Finally government expenditures declined for the third quarter in a row.
The NIPA data so far in 2017 suggest a modest break from the slow growth pattern of the past seven years, with some signs of a more significant improvement. In particular, growth this year has had better balance than during 2016. There has been less reliance on consumption and a significant improvement in business investment. Housing and government are still lagging, but housing should get a boost from post-hurricane rebuilding. Trade could also hold its own given the improvement in other economies across the globe.
Recent monthly data support this optimism.
The October report on the labor market situation was mostly positive. The payroll survey showed total employment up by 261 thousand, which pretty much made up the hurricane induced shortfall in September. The latter was revised upward by 51 thousand to +18 thousand. [This revision reestablished a record streak of monthly gains that goes back to early 2010.] In the household survey the unemployment rate dropped to 4.1%, a new recovery low. There was, however, a large decrease in the labor force, lowering the participation rate by 0.4%.
Other data have also been generally upbeat. Consumption spending was weak in September (hurricanes?), but household income was up solidly. Consumer sentiment jumped in October. September housing starts were held back by the hurricanes. Both ISM indexes are at very high levels. The manufacturing index was down a little, while non-manufacturing was essentially unchanged.
Finally, the Federal Reserve gave a very clear indication that it will again raise rates at its December meeting and then further next year. President Trump’s nomination of Jerome Powell to replace Janet Yellen as Fed Chair is unlikely to alter this plan.
As can be seen in the chart, our new forecast is stronger than three months ago. Growth in total output over the next three quarters now averages 3.0%, with a small push in Q4 from hurricane bounce-back. Beyond that output settles to growth at a 2.5% rate, about 0.2% above our August outlook.
The forecast has job creation averaging about 170 thousand during 2018. This is over 20 thousand above our August forecast. The unemployment rate ends next year at 4.0%, which matches our assumption about the long-run equilibrium rate.
At a disaggregate level our forecast for the next five quarters is broadly similar to the patterns over the past three. Consumption remains the primary support of growth, with business investment continuing to contribute solidly. Housing becomes a small positive, unlike the recent past. The same holds for government spending. These shifts offset a slowly increasing trade deficit.
A few additional aspects of our forecast scenario warrant mention. First, we now have crude oil prices averaging $52 per barrel through the end of next year. This is $5 higher than in August. Second, we have the Fed raising rates again in the fourth quarter and then three times in 2018. The federal funds rate stabilizes a little below 3% in 2020. Adjusting for inflation at about 2%, this leaves the real federal funds rate just slightly below 1%, which we view as an accommodative level.
The economy has been doing quite well so far in 2017. Overall growth has been above the recovery norm, particularly the past two quarters. Of the five components of aggregate demand the two most important (consumption and business investment) have been strong. The international sector has also been a positive, with the inflation adjusted net export deficit shrinking in each of the past three quarters. Only construction (both residential and business) and government purchases have disappointed.
For the immediate future our baseline forecast has a continuation of the current situation with some modest help from housing and the public sector. This produces growth in 2018 of 2.7% – a slight improvement on this year. This may seem optimistic, but we think there is definite upside potential in two regards. One is the current revival of growth in the international economy. Trade is a positive sum game.
The second is tax reform, which if successful could push growth to or above 3%. Of course success from the current Congress would be a clear break with precedent to date. Our guess is that the probability is less than 50-50, but higher than a month ago.
Partly the improved chance is because the cost of failure is likely to be high – both politically for the GOP and also for the economy. Rising household and business confidence, partly resting on the possibility of tax reform, have aided the economic resurgence in the past two quarters. If the reform falls apart that process could work in reverse. This could pull the 2018 economy back to the new normal or worse.
On the other hand, if the economy does take off during 2018 onto a flight path above our baseline, it raises the risk of overheating in 2019. There is no hint of that at present, but the labor market is already tight. The Federal Reserve is in a very gradual tightening mode (and soon under new management). Past experience is that when overheating develops the Fed reacts too slowly and then too much, tipping the economy into recession. But that is all speculation.
For now we are optimistic about the outlook for at least the next year.