Since the election, objective data have been generally positive, but not dramatically so. Subjective measures (consumer and business sentiment) have risen strongly. Equity markets have surged. President Trump has been a tornado of activity, but mostly of the symbolic variety. So far there is little of real substance in terms of actual policy. As a result, our forecast is little changed as yet by the election surprise.
At first glance the advance data for fourth quarter GDP appear to be disappointing. Growth in total output was put at just 1.9%, barely half the 3.5% in the third quarter. For final sales (leaving out the impact of inventory accumulation) the difference is even more dramatic – 0.9% compared to 3.0%. However, this result was not a huge surprise. Our forecast three months ago was for fourth quarter growth of 2.0%, very close to the actual outcome. The biggest item behind the decline in the quarterly numbers was a huge swing in the trade balance from a 0.9% addition to GDP in the third quarter to a 1.9% reduction in the fourth. A lot of this came from the disappearance of a large sale of soybeans to China (which we anticipated), but it was compounded by a surge in imports of goods (which we did foresee). Our November forecasts for consumer spending was a little too optimistic due to weak purchase of services. For business investment our November forecasts were qualitatively correct (improvement in equipment and slowing in structures), but quantitatively too small. Overall business investment grew at twice the 1.2% rate we expected. The same was true for housing: we anticipated improvement from a large drop in Q3, but not to the extent seen in the actual data. Finally, our forecast for government purchases was quite close to the actual number.
Adding all this up, the second half of last year was at best a slight improvement on the first half. Top line GDP growth was much higher (2.7% vs. 1.1%, but this was entirely due to a shift from inventory decumulation to accumulation. Final sales were 1.9% in both halves. The slight improvement is two-fold. First, the first half inventory drop was needed and now is past. Second, the pattern of demand got better as the year progressed. Reliance on consumer spending declined a little, with the slack picked up by stronger spending on investment (both business and housing) and by government.
Recent monthly data are mostly consistent with our cautious positive evaluation of the fourth quarter data.
The labor market produced a strong January report. Payroll employment rose by 227 thousand, which was a little stronger than we expected. In the household survey unemployment rose a tick to 4.8%, but this was entirely due to an increase in the labor force. The participation rate rose to 62.9%, matching its highest level since early 2014.
Housing starts and industrial production both bounced back in December from quite weak November numbers. Consumer sentiment and auto sales both decreased a little in January, but from very strong December readings.
Finally, Institute for Supply Management (ISM) measure for manufacturing registered a fifth consecutive increase to a 56.0 level. Their non-manufacturing index was virtually unchanged at 56.5. Both values indicate strong growth.
As can be seen in the chart, our new forecast is little changed from three months ago. The current quarter has growth at 2.5%, the same as our November estimate. Growth remains at 2.5% in the second quarter (a little above November), and then slows slightly in the second half of this year. For all of 2017 GDP growth (4th Q to 4th Q) is 2.3%, also equal to our November forecast.
At the disaggregate level our forecast for this year differs from the past year mainly in a more optimistic prospect both for business investment and for housing. This strength is partly offset by somewhat lower consumption growth and by larger deterioration in the trade balance. It should be noted that all of these patterns were present in Q4 2016 relative to the earlier part of last year.
The most problematic of these shifts is the swing in business investment. Several comments on this: (1) The increase in investment is coming from the model, not from ad hoc adjustments. (2) Some improvement should be produced simply via an end to contraction in the energy sector. (3) The forecast investment growth rate (4.3%) is impressive only relative to the recent past. Over the period 2010-2014, investment growth averaged 6.4%. (4) Some of the shift may be due indirectly to the recent increases in consumer confidence and the stock market.
A few additional aspects of our forecast scenario warrant mention:
- We have U.S. crude oil prices averaging $49 per barrel through early 2018. This is a little below the current level, which reflects our skepticism about the ability of OPEC to achieve its output reduction targets.
- Inflation is a little higher later in the current forecast than in our November outlook. In both forecasts the personal consumption expenditures price index reaches the Federal Reserve’s target of 2% inflation during 2017. In the current forecast it reaches 2.5% in 2018, which is about 0.2% higher than in our November forecast.
- As we expected the Federal Reserve increased its target for the Federal funds rate by 25 basis points in December. In our forecast we assume the Fed will implement two additional raises per year through the forecast period. This is less than their recent rhetoric suggests, but in line with their past pattern of advertising more than they produce when it comes to higher rates.
Our forecast is not very exciting in several regards. For one thing, it is nearly identical to our forecasts going back to early last year. For another, it represents a continuation of the new normal status quo – a status quo that has now been in place with minor variations for the past five years. But most important, we have not yet attempted to incorporate policy changes that will surely be forthcoming from the Trump administration. As yet, there is almost no concrete information on what they will propose. And what they propose will almost certainly be different from what is actually enacted. There is thematic information to be sure (It will be HUGE!!) and some semi-concrete ideas from the Congressional side. But we don’t see enough to form the basis of numerical assumptions for our model.
This means that the probable error bands around our current forecast are larger than usual. Qualitatively, this risk cuts in every direction.
In an optimistic scenario Trump et. al. implement a “successful” set of policies – reasonable tax reform, more cost efficient regulation, long-term infrastructure improvement, no trade war. This implies growth faster than our forecast, although not until next year and beyond. But it is not at all clear the economy has the capacity to accommodate significantly faster growth unless labor force participation rises significantly. If not higher inflation could put the Fed in a real bind.
A pessimistic possibility is the policy actions stall in Congress and the administration falls back on executive actions, some of which backfire (e.g. on the trade front). Chinese and European debt problems roil financial markets. With central banks mostly out of ammunition this could get very scary.
Or perhaps somewhere in between, producing a continuation of something like the new normal for a while longer.