The U.S. economy is performing excessively well. It exited 2017 with solid momentum and the expansion will be reinforced, somewhat needlessly, by the new tax bill approved late last year. The incremental growth will exacerbate scarcity in a labor market that is already tight, adding to upward pressure on inflation. The Fed appears to be increasingly wracked with disagreements over how slowly they can ratchet up interest rates while they wait for inflation to approach the 2% target. In the meantime, corporate earnings should be very solid in 2018, aided by the tax cuts, which augers positively for equities. Fixed income prices should remain under intermittent downward pressure, especially when signs of higher inflation emerge.
Economic growth was quite good in 2017. The unemployment rate fell to 4.1%, a cycle low and below what most economists consider full employment. The private sector created more than 2 million jobs, even as government employment declined. Job openings exceeded 6 million at year’s end, ensuring that job growth will remain solid in the new year. Inflation dipped in the middle of 2017, but seems to be rebounding once again. And financial markets have been very well behaved with stocks climbing nearly 20%, while bond returns remained positive, despite three rate hikes by the Fed.
Projections of economic growth for 2018 have increased in response to the just-passed tax bill that is expected to boost capital and household spending. Several provisions of that bill reduce the cost of capital to firms, which should encourage investment and improve productivity growth. These may be the best parts of the bill. Living standards are driven far more by gains in productivity than gains in GDP. This may not be obvious to the public at large or to the media and it is certainly unlikely to become visible in the near term.
The more immediate obstacle to growth is the scarcity of labor that already exists. (There’s a front page article on this in today’s WSJ.) Job growth has been decelerating for a few years now, which is precisely what should be expected when the unemployment rate declines to low levels. Hiring will become incrementally tougher from here, so any sizable or sustainable increase in economic growth is simply infeasible, political rhetoric notwithstanding. Still, don’t be surprised if the unemployment rate falls to 3.5% by the end of the year, making the fiscal stimulus more likely to increase inflation than real living standards.
Economic expansion in the U.S. is also reinforced by recoveries overseas. After years of lousy economic performance, solid expansions are now underway in Europe and Japan. This creates a mutually reinforcing economic expansion around the globe and provides considerable momentum for all these economies to maintain economic growth. Growth should continue until some of these economies run out of underutilized resources, notably labor. And with unemployment already quite low in the U.S., we are the economy most likely to hit the wall first, which will become manifest by a rise in the rate of inflation.
Most Fed policymakers understand the underlying economic dynamics and they favor normalizing interest rates to modulate the pace of growth to extend its duration. Growth needs to be moderated to give the expansion a longer lifespan. But some senior Fed officials would prefer to keep interest rates artificially low for as long as inflation remains below the Fed’s 2% target. By keeping interest rates low, monetary policy would remain highly accommodative at the same time that fiscal policy has turned expansionary. Such mutually reinforcing pro-growth policies will reinforce inflation pressures when labor is already scarce. Moreover, once inflation rises to 2%, there’s no economic reason for it to remain at that level. Instead, it is more likely to continue higher, which means policymakers will soon find themselves trying to stuff the inflation genie back into the bottle after they’ve permitted it to escape.
It appears that a comfortable majority at the Fed favors continuing to hike policy interest rates at the measured pace they have projected in the “dot” plot. But the turnover in personnel at the highest levels of the Fed, including some people who haven’t even been appointed as yet to fill critical vacant seats, makes this more uncertain. The Fed’s projections currently call for three 25 basis point rate hikes in 2018 (roughly twice as much as the market expects). Four rate hikes seems to be a more likely outcome, since whoever is at the Fed is going to have to respond to incoming data.
The performance of the economy should be favorable to corporate profits, which will also benefit considerably from the cut in corporate tax rates. So we expect the stock market to rally somewhat further in 2018. As long as inflation appears to be under control and interest rates are still low, stocks remain attractive investments. The tax cut also significantly improves valuations by providing a one-time, permanent boost to profitability. Stocks are especially compelling when compared to the meager returns available in the bond market. This calculus will change when inflation heats up, which will also force up interest rates. But the outlook becomes cloudier and less positive further out in the future. If inflation starts to rise meaningfully in 2018, as seems entirely possible, perhaps even likely, we enter a new chapter in the economic saga.
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