IN THIS ISSUE:
- Fed still appears on track for a December rate hike
- Labor market conditions remain healthy
- Price pressures continue working their way toward the Fed's target level
- Recent fundamental events point to healthy gains in consumption
While coverage of Donald Trump’s surprise victory has been every bit as dramatic as the victory itself, U.S. economic fundamentals remain positive, and we are cautiously optimistic about the potential of new policies to modestly boost growth. Still, less than a month after the election, there is considerable uncertainty surrounding exactly what economic priorities a Trump administration will pursue. With Republicans controlling both chambers of Congress, the president-elect should be able to achieve much of what he wants. The key questions are: Which version of Trump will we see—pro-growth or anti-free trade? And will fiscal responsibility be observed?
So far, U.S. equity markets have rallied to record highs, driven by the prospects of a major fiscal stimulus next year, a rollback of regulations that could increase investment, and a much softer stance on trade than what Trump’s inflammatory campaign rhetoric suggested. Such enthusiasm over near-term economic growth prospects may be warranted. The U.S. economy would certainly benefit from tax reform, as well as from policies designed to lift its productivity and potential growth rate.
But investors should also be realistic. While some slack remains in the job market, the current slowdown in labor force growth will continue to be a restraining factor for the economy. This is simply a reflection of the nation’s changing demographics, including an aging population and reduced immigration. Moreover, the timing of a massive fiscal stimulus—seven-plus years into the expansion—would limit its power. In an economy approaching full employment, such an expansionary policy is likely to fuel inflation and raise long-term interest rates, which could undercut potential gains.
Longer term, we remain concerned about where the money to pay for all this will come from. The nonpartisan Tax Policy Center estimates that Trump’s proposed tax cuts alone would add $7.2 trillion to the nation’s debt over the next ten years. At $20 trillion and counting, our national debt is already on an unsustainable path. Additional potential infrastructure spending on top of increasing expenditures for Social Security and Medicare will require the federal government to borrow even more. All of these factors raise the risk of a fiscal crisis down the road.
Under current law, federal debt is projected to climb to 141% of GDP by 2046 (Figure 1) and in the process reduce the size of the overall economy by nearly 5% through slower growth. There would be other negative long-term consequences as well, with rising interest rate payments squeezing out other priorities such as infrastructure, education, and national security. Neither federal debt nor entitlement reform was a major focus during the presidential campaign, but both must be addressed if we are to create lasting health for the American economy.
The other big concern around Trump’s potential policies is a possible turn away from globalization. Increased global trade has created tremendous benefits over the past couple of decades, including economic growth, disinflation, and lower borrowing rates. However, the adjustment process has been poorly managed. Gains have not been equitably distributed, and low-skilled workers in the developed world face chronically poor job prospects, which has fueled social unrest and political pressure to forcefully curtail global trade. But adopting protectionist policies would be a mistake. Protecting uncompetitive domestic industries comes at a hefty cost to taxpayers, consumers, and businesses through higher prices and taxes. Meanwhile, retaliation from trading partners would hurt corporate profits in competitive domestic industries, likely causing more job losses than those salvaged by anti-trade policies. Government policy would be better off focusing on building domestic comparative advantages by improving the education and skill level of its workforce. If such steps were taken, then globalization would not be something to fear, but rather embrace.
For all the apocalyptical talk this campaign, we continue to be confident in America’s future. But our country is facing real challenges, and the results of the presidential election made it clear that the American people will no longer accept business as usual in Washington. The difficulty is that voters seem to want several incompatible things at once. Lower taxes and expensive entitlement programs, but also a balanced budget. The benefits of global trade (such as cheaper prices) without the accompanying job losses in uncompetitive industries. Under these circumstances, no matter who won the presidency, the economic way forward was not going to be easy.
All eyes and ears are on the bank’s leading policymakers as they prepare for their two-day meeting on December 13 and 14. Expectations are high for the Fed to raise the federal funds rate by 25 bps, which would lead them to trade at the new mid-point level of 0.625%. This would mark the only interest rate increase in 2016. Since the Great Recession, the Fed has only raised this rate once: in December 2015. As for the future, the Fed’s current plan is for two rate increases in 2017; neither is expected in the first part of next year (Figure 2).
In previous years, the Fed recommended increasing the fiscal stimulus to help generate a higher rate of economic growth. But on November 17th, Chair Janet Yellen, in her testimony before the Congressional Joint Economic Committee, warned that big government spending could fuel inflation and swell the national debt. This is not a flipflop; the world has changed since the earlier pronouncements. In the past few years, the unemployment rate has fallen significantly and is now in an area that economists view as full employment. An increase in demand for more workers increases the probability of higher wages, which would lead to higher inflation. The wider budget deficit will boost long-term interest rates.
The October employment report showed another month of solid gains, along with an acceleration in hourly wages. Nonfarm payrolls increased by 161,000, and revised figures from the previous two months amounted to a combined increase of 44,000 new workers. The three-month and six-month moving average gains are 176,000 and 179,000 respectively, revealing stable job growth. While these are strong numbers, the pace of growth has been slowing for over a year.
The unemployment rate, which has generally remained in the very narrow range of 4.9% to 5.0% over the past year, fell from 5.0% to 4.9%. More importantly, the underemployment rate fell from 9.7% to 9.5%, the lowest level since before the economic crisis (Figure 3). Average hourly earnings popped up 0.4%, putting the yearly change at 2.8%, the highest level since 2009. These higher wages appear to be drawing more workers into the labor force, which has increased by 2.6 million in the past 12 months.
Since the worst of the recession, the unemployment rate has fallen from 10.0% to 4.9% and payrolls have increased by a total of 15.2 million. This should give the Fed enough ammunition to raise the federal funds rate at its December meeting.
Price pressures continue their march towards the Fed’s target of 2.0%. The Consumer Price Index, which is presently at 1.6%, has been trending upward since its early 2015 nadir of -0.2%. This past month, inflation got a boost from a 3.5% leap in energy prices—their highest monthly gain in three and a half years. Normally, energy prices experience substantial declines in October as demand drops following the heavily traveled summer months. The yearly change in energy prices, which has been trending upward since January 2015 and now stands at 0.5%, has moved back into positive territory for the first time since February 2013 (Figure 4).
The Fed is concerned with core inflation, which separates out the volatile food and energy components. This figure has remained relatively stable in 2016, running between 2.1% and 2.3%.
Around this time of year, policymakers focus on consumers to get a read on how robust the ever-important holiday selling season may turn out. Recent fundamental events point to healthy gains in consumption. Retail sales have picked up recently (Figure 5), and the last two months marked the largest back-to-back monthly gain in more than two years. This comes on the heels of a relatively benign growth rate in the previous months (distraction due to negative campaigning during the election season is often cited as a reason for the lack of spending during the summer months). Consumers are in very good shape due to rising wages, increased confidence in current conditions, a low unemployment rate, and a balance sheet they have been deleveraging since the start of the Great Recession.
This year’s Black Friday results came in higher than last year. The term “Black Friday” came from the accounting tradition of recording profits in black ink and losses in red ink. The general belief is that on Black Friday, the day after Thanksgiving, retailers sell enough to turn a profit for the year; they go from operating at a loss for most of the year, being “in the red,” to being “in the black.”
The Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, including transportation, food, and medical care. The CPI is calculated by taking price changes for each item in the predetermined basket of goods and averaging them; the goods are weighted according to their importance. Changes in CPI are used to assess price changes associated with the cost of living.
The Core Personal Consumption Expenditures Price Index (Core PCE) measures the prices paid by consumers for goods and services without the volatility caused by movements in food and energy prices to reveal underlying inflation trends.
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