Year to date, global financial markets are on track to deliver some of the strongest cumulative returns on record. Similarly, broad-based U.S. equity indices are experiencing double digit returns above the 20th percentile as of writing. In the words of John C. Williams, president and chief executive officer of the Federal Reserve Bank of San Francisco, “The economy is in a good place.”
A significant aspect of the good news story is the synchronised growth currently underway in the global economy. Gross domestic product (GDP) projections from the Organization for Economic Cooperation and Development (OECD) are expected to top 3.6 percent this year and 3.7 percent for 2018, with all 45 of the world’s largest economies experiencing positive growth. The momentum in U.S. GDP growth in particular, was accompanied by strong consumer confidence numbers, low borrowing costs and solid gains in personal income as a result of low unemployment and record gains in equity markets. But does the full economic picture support this sanguine mood in markets? And what factors seem to be driving this optimism?
Despite the weak first quarter readings that have plagued the U.S. economy in the last two years, revised Q3 numbers lend strong support that growth will continue into the rest of the year. The long awaited lift in growth was supported by monetary policy stimulus, and now the sweeping tax bill is expected to provide even more boost to the economy in the coming year. But is this tax reform enough to support the 3 percent growth rate the president had hoped for? In dissecting the new bill, it is highly anticipated that most consumers will only see a one-off increase in disposable income. Most of benefits of the reform appears skewed towards higher income earners who forecasters believe will save versus spend the additional income.
Further, according to Capital Economics, there is little empirical evidence linking a cut in the corporate tax rate to significant and sustained boost in business equipment and spending. Although the headline corporate tax rate was 35 percent, most firms pay an effective rate closer to 25 percent. This implies that the actual reduction in the tax bill to a 21 percent corporate rate will be minimal. Making matters worse, previous tax cuts to individual income and small businesses are set to expire after almost a decade, forcing lawmakers to grapple with extending these cuts at a time when the U.S. debt is approaching 100 percent of GDP. To be fair, there are some bright sparks evident in the recent tax reform. Firms now have the ability to expense equipment investment and there are significant tax breaks to repatriating foreign earnings. The corollary of the tax reform, however, is that the benefits are at best likely to be temporary. This partially explains the unison in GDP forecasts by markets and policymakers alike for only a temporary boost in 2018, with growth decelerating into 2019 and beyond. It is also widely expected that the current tax reform could boost inflation more than it spurs growth, lessening its intended impact. It is therefore quite plausible that the optimism in markets as a result of the recent tax reforms is vastly over exaggerated.
Strength of the labor market
Despite the temporary setbacks from a very active hurricane season this year, U.S. unemployment is perhaps the best performance indicator on the Fed’s scorecard. Overshooting the maximum employment target within its dual policy mandate, the Federal Open Market Committee (FOMC) is firmly on track to add close to two million jobs in 2017. With non-farm payrolls averaging close to 178,000 over six months, the unemployment rate is expected to dive even further to less than 4 percent by Q3 next year. But with such stellar performance in employment, wage pressure, one of the greatest contributors to inflation, remains subdued. The lack of wage pressure could be explained by lags inherent in the impact of policy initiatives on the general economy. Another reason could be the presence of even more slack in the labor market than previously anticipated. This argument appears unlikely however given recent reports that the quality of labor available is one of the largest problems firms are facing, approaching pre-crisis levels.
Perhaps the most widely discussed economic factor since the start of the recovery is inflation. Equally as import as maximum employment to the Fed scorecard is maintaining price stability. In the last eight years, the Fed has undershot their medium range inflation target of 2 percent citing transient factors as the primary driver of inflation weakness. As the effects of transitory factors anchoring inflation dissipates, labor markets continue to improve and the temporary boost from the tax reform takes effect, the U.S. economy seems well poised to experience an increase in inflation over the coming quarters. Some strong concerns remain however that the lag from transitory factors may continue to drag on Personal Consumption Expenditures (PCE), wage pressure may fail to manifest in inflation and the global economic slack could widen as a result of a strong U.S. dollar.
Admittedly the U.S. economy is signaling a very clear path to strong growth in 2018. A significant and growing number of factors could however disrupt its path. The challenge for the FOMC will be to keep the expansion going whilst balancing growth, productivity levels and preserving improvements in the labor market. The tripartite effect of monetary policy normalization, a sweeping tax reform with the propensity to widen the budget deficit, all while inflation remains stubbornly anchored at 1.6 percent, presents significant headwinds for growth. As markets assess these threats, opportunities and the Fed’s ability to navigate uncharted territory, minus a Black Swan event, the challenges facing the U.S. economy are some very good ones to have.
Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information.