The headline number for fourth quarter GDP came in short of our expectation. But the numbers underneath the top line were mostly quite encouraging and above our forecast. Other recent data generally support the latter view, and our new forecast is quite optimistic.
The advance data from the BEA on economic activity during the fourth quarter put growth in total output at just 2.6%, which was well below our November forecast value of 3.3%. But all of the difference (and then some) came from a weak value for inventories. We had expected that they would add $12 billion to GDP; instead they subtracted $29 billion.
The other negative feature of the fourth quarter report was a very dramatic surge in imports. Some of this was probably makeup from disruption during the hurricanes. The rest was driven by strong domestic demand, but not enough to keep up – hence the weakness in inventories. We think this implies that 2018 will receive some impetus from inventory rebuilding.
The rest of the fourth quarter picture was solid, both in absolute terms and relative to our expectations. Consumption led the way with growth at 3.8% concentrated in purchases of goods. Business investment was strong. Purchases of equipment rose at a double-digit rate for the second quarter in a row. Exports were also strong, although not enough to match imports, leading to a substantial increase in the trade deficit. For each of these three components (consumption, investment, exports) the strong growth represented improvement on good growth earlier in 2017. For the final two sectors – housing and government –growth was also solid, but this was a favorable switch from recent contraction.
There are some caveats. First, there is some distortion from the fall hurricanes. In Q4 his probably benefited consumption, both sides of the trade account, and housing. Second, some of the strength in investment is coming from oil production. As we learned in 2015-2016, surges in this sector can shift into reverse in short order. But even so the fourth quarter numbers, to us, are indicative of an economy that was firing on all cylinders, and this prior to the impact of the tax cut/reform bill.
Recent monthly data support this optimism.
Supported by a tightening labor market and a rising stock market, households are confident and willing to spend. Consumer senti-ment remains at a high level, up a little in January after a small decline in December. Monthly consumption data have been strong, rising at a 4.6% annual rate since September. Indeed, perhaps too strong. Over the same four months disposable income rose at only a 1.4% rate, implying a declining saving rate. January auto sales came in at a 17.1 million annual rate well down from the 17.9 million average for the previous four months. This suggsts hurricane damage replacement has run its course. December housing starts fell off after two very strong months, but building permits held up.
On the business side, sentiment remains positive. The ISM indexes for January were very solid with both registering readings above 59 (anything above 50 indicates expansion). The manufacturing index was essentially unchanged, while the non-manufacturing measure reversed two down months with a leap of nearly 4 points to 59.9.
The labor market continued in January to produce strong results. In the household survey the unemployment rate had a fourth straight month at 4.1%, while the participation rate had its third month at 62.7%. Payroll employment, from the establishment survey, rose for the month by 200 thousand. Most sectors showed gains. Establishment data on wages had an increase in average hourly earnings of 2.9% compared with a year ago. This represents a significant jump from the 2.5% +/- that characterized most of last year. More on this below.
Finally, the Federal Reserve Open Market Committtee held the federal funds rate stable (at 1.25-1.50%) in Janet Yellen’s final function as head of the Fed. Jerome Powell will be in charge when the Committee has its next meeting on March 20-21.
Our current forecast is stronger than three months ago due to the introduction last month of the tax cut package into our baseline scenario. In the chart on the next page we show the difference for final sales, which eliminates the impact of inventories from the picture. We expect growth in final sales over the next four quarters to average 2.9%. Inventory accumulation could add one or two tenths to that. Beyond that output slowly decelerates to growth just above 2.5%.
In our model the tax cuts have a fairly significant impact on growth over the intermediate term, but do not permanently elevate growth. Their labor market effect is more dramatic. Average monthly job creation this year comes in at 201 thousand, 30 thousand above our November outlook. In 2019 employment growth remains at nearly 200k, which is 75 thousand above the November forecast rate. Unemployment, too, is significantly improved, declining slowly over the next two years to 3.7%, compared to 4.0% in November.
At a disaggregate level our forecast for the current quarter shows some payback for the unsustainably strong consumer spending in the fourth quarter. Consumption growth falls from 3.8% in Q4 to just 2.3% in Q1, lowering its contribution to GDP by a full percent. At the same time, the growth surge in imports and government spending both recede. This implies a much smaller drag from the trade deficit, but also less boost from the public sector.
Later this year each of these effects reverses to some extent. For all of 2018 consumption grows 2.9%, the trade deficit increases and government spending picks up slightly. Investment is more stable, with the fourth quarter’s expansion continuing unimpeded through this year. For the full year growth in business investment comes in at 7.0% and housing at 8.8%.
A few additional aspects of our forecast scenario warrant mention. First, we now have crude oil prices a little above $60 per barrel in the first half of this year and then averaging $58 through the end of next year. In November we were at $52 this year rising to $54 in 2019. Second, as in November we have the Fed raising the federal funds rate three times in 2018. During the next two years, however, the funds rises more rapidly than in the November forecast. By the end of 2020 the rate reaches 3.3%, 0.5% above November. This extra tightening is driven by higher inflation and faster employment growth in the current forecast.
The economy ended 2017 with three strong quarters, with business and consumer confidence at very high levels, with the stock market making record highs almost weekly, and with a significant reduction and reform in taxes, especially on the business side, taking effect in 2018. In this setting it is not surprising that our model produces an optimistic outlook for the immediate future.
Our baseline forecast has GDP growth at around 3% for the next two years – a little above this year, a little below in 2019. The growth produces job creation of around 200 thousand per month. This employment expansion exceeds the increase in the labor force with the difference made up by a decline in the unemployment rate.
Growth is driven by strong investment spending both by business and in the housing sector. Exports and consumer spending continue to be solid, while government expenditures, while not strong are better than in most of the recent past. The strong domestic demand does lead to significant imports, which imply a continuing increase in the trade balance deficit.
This is a Goldilocks scenario – not too hot (inflation rises as does the federal budget deficit, but not enough to incite Fed or financial market reaction); not too cold (well above the mediocre growth during most of the recovery).
The danger is that it is too good to be true. The most likely alternative scenario, in our estimation, is that the tax changes, perhaps augmented by spending side stimulus prove to be too much of a good thing. The expansion exceeds our expectations and doesn’t produce the improvement in productivity that is in our forecast. Wage and price increases accelerate. The Fed raises interest rates precipitously. And the expansion ends.
The stock market in early February may be a preview of coming “attractions”. But well ahead of the actual release or perhaps for a film that will never make it to the screen. For now we are comfortable with our forecast, certainly for this year, and (with a few qualms) into 2019.