The economy has come a long way since the recovery began eight years ago, and all things considered, we think the expansion is looking pretty good for its age. At a point where all but two prior post-war expansions had already succumbed to recessionary downturns, U.S. economic fundamentals remain solid (see Figure 1). More Americans are working today than ever before, consumer balance sheets are healthy again, housing continues to steadily improve, and asset prices have appreciated to record highs. Indeed, businesses and households are more optimistic about the future than they have been for years.
Of course, no expansion lasts forever, and our sense is that we are now in the later stages of this one. Pent-up demand is becoming less of a driver of spending while rising interest rates should temper some of the past enthusiasm for big-ticket purchases. As a result, hiring and consumer spending are likely headed for a more mature pace of growth in the quarters ahead. Still, it is important to remember that expansions don't die of old age. Rather, they are typically ended by a combination of rising imbalances and significant central bank tightening.
Presently, none of the usual warning signals are flashing: no overinvestment, no overconsumption, and no overaggressive policy action. Now, none of this means the horizon is risk-free. To sustain business and household confidence at current levels, for example, the Trump administration will likely need to begin delivering on some of its promised policy reforms. But even in the absence of fiscal stimulus, the economic outlook rests on a sturdy foundation. The natural tendency for economies is to grow, and barring some sort of shock, we think this expansion, while aging, still has room to run.
The challenge then is how to get the economy to grow faster in an environment where both labor force growth and productivity gains remain so low. Since the financial crisis, GDP growth has averaged little more than 2%. Yet even that lackluster pace has been enough to close the output gap and reduce the unemployment rate from a peak of 10% to less than 4.5%. In fact, with productivity and labor force growth each averaging only 0.6% per year over the past five years, potential economic growth may be even lower than 2%. Fed officials believe that long-term rate is only 1.8%.
So what could turn things around? The scope for a pickup in labor force growth appears to be limited. The decline in the overall participation rate, which peaked as far back as 2000, is mainly a structural decline linked to the aging of the population. That downward pressure will become even greater over the next decade. In terms of productivity, boosting investment holds some potential. According to the Bureau of Labor Statistics, the contribution to productivity growth from capital intensity fell from an average of 1.0% between 2000 and 2007 to 0.5% between 2007 and 2016.
But increasing capital investment back to even pre-crisis levels still wouldn't be enough alone to lift potential GDP growth all the way up to 3%. The bigger problem has been the drop-off in the contribution from multifactor productivity, which reflects a return to normality after the IT-revolution at the turn of the century. Other technological advances could generate a rebound in multi-factor productivity growth in the future, but exactly if and when is anyone's guess.
Putting all of this in perspective leaves us a bit less jaded than other market commentators, who remain frustrated at the inability of the economy to achieve “escape velocity.” The bad news is that until productivity begins to recover, the economy is likely operating close to its potential, and prospects for a meaningful acceleration even with potential fiscal stimulus remain low. The good news is the modest growth we've experienced over this expansion continues to help prevent the excesses that could sow the seeds of the next downturn.
The minutes from the May FOMC meeting strongly suggest that a federal funds rate hike will occur at the next meeting, which will be held on June 14. The markets have priced in a 100% chance of a 25-basis-point hike occurring then (see Figure 2). This would mark the second of three forecasted rate hikes this year. The market currently has a 93% probability of another hike later this year.
In addition to managing the level of short-term interest rates, the Fed has a second monetary tool, which is balance sheet management. The Fed has a $4.5 trillion balance sheet amassed from the securities purchases during various stages of quantitative easing (QE) and is working on developing a detailed strategy to reduce these holdings. It is expected to initiate this program sometime in the second half of the year. Allowing these securities to mature and not reinvesting them would put some upward pressure on short- and intermediate-term interest rates, as there would be one less buyer in the market.
The April employment report showed a healthy bounce-back in hiring following the surprising weakness in the March report. Nonfarm payrolls jumped by 211,000—a significantly stronger gain than March's 79,000. Although the monthly change has been relatively erratic, the trend has been on a consistently upward trajectory. The unemployment rate fell to just 4.4%, a level not seen in about a decade (see Figure 3).
A broader measurement, called the underemployment rate, measures the unemployed plus those who have had their work hours cut back due to weak economic conditions and those who have given up on finding a job. This metric has fallen to 8.6%, another cycle low. It is now near the low levels last seen in the previous expansion, which is a remarkable drop from the high level of 17.1% back in 2009. This is one of the signals the Fed uses to show that the once-feared excess labor slack of the past few years appears to be gone.
The outlook for labor looks just as strong. The number of job openings is near record highs, and the number of workers quitting a job for the ability to get a better job is near cycle highs.
Price pressures have stabilized this spring following five months of acceleration. The yearly change in the consumer price index (CPI), which hit a cycle peak of 2.8% back in February, has since fallen back to 2.2%. This causes the Fed some concern since the relatively steep upward trajectory of inflation from September to January helped give it confidence in its decision to raise the federal funds rate this year, with 25 basis points at each hike. However, it is not enough to alter the market's expectation of a 25-basis-point hike at the Fed's upcoming mid-June meeting, the reason being that the drop appears to be transitory rather than the start of a downward trend.
While the CPI has not moved in the past three months, most of the components have moved upward. Those advances have been offset by an unusual decrease in the cost of mobile phone services (see Figure 4). This is the result of price wars among some carriers, which have reintroduced unlimited data plans without much change in price. Under CPI accounting practices, this is called a “hedonic quality adjustment.” Since consumers will be getting more services for the same price, they calculate it as a drop in prices. Additionally, since this pricing is not expected to continue much into the future, the Fed is looking beyond the recent weakness and expecting the yearly change in inflation to stabilize.
New home sales have been on an upward trajectory since 2011. This trajectory is much shallower because the absolute number of homes involved is far below what we have seen during past economic expansions. The main reasons for this have been tighter lending standards from Dodd-Frank regulations and the demographic shift resulting from younger adults who want to rent instead of own (partly because many witnessed their parents losing substantial wealth in the recent housing crisis).
Despite those facts, we are seeing some stronger demand this year (see Figure 5). New home sales are up 11.3% compared to the same period last year. A recent survey of homebuilders also shows optimism; it has been increasing since 2009. This upsurge in demand is important, especially since many builders had to shrink their businesses during the housing crisis. It is important to note that homebuilders have had a hard time keeping up with demand due to a shortage of skilled labor, as many in the profession left during the housing crisis and are unwilling to come back to the frustration of the cyclical nature of the industry.
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.
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