Pace of Economic Growth Expected to Accelerate in 2018
Buoyed by spending, the U.S. economy expanded at a 2.9% annualized rate in the fourth quarter of 2017. The current consensus is for growth to remain firm, supported by domestic momentum and fiscal stimulus, though there are some potential downside risks attributable to trade tariffs. BBVA Research anticipates real GDP is on track to rise around 2% in the first quarter. However, it is important to note that the initial GDP reading almost always disappoints, often reflecting seasonal deficiencies that have yet to be adjusted properly. For the year, BBVA Research anticipates the economy growing at 2.8%.
Optimism in the economy was a key focus at the Federal Reserve’s meeting in March. The Fed’s current outlook anticipates stronger growth in the first quarter and expects the economy could grow faster than its sustainable rate for the next few years. Moreover, all voting members of the FOMC are anticipating that inflation will rise to their 2% target this year. While the Fed is expecting inflation to increase, it did not shift its target inflation rate as members continue to believe 2% inflation is an appropriate rate that is consistent with the sustained rate of growth.
Still, this marks a significant shift from the Fed’s outlook last year when slow inflation caused debate about the need for continued rate increases. Now, the Fed is warning that rates may need to be lifted to deliberately restrain growth. The central bank raised the federal funds rate 0.25% in March, lifting the current range to between 1.5% and 1.75%. Officials are expecting two more 0.25% increases this year and three more 0.25% increases in 2019. If the recent tax cuts and new federal spending, coupled with low unemployment, cause inflationary pressures to accelerate faster than expected, the Fed could act more aggressively and raise rates an additional time this year for a total of 4 rate hikes in 2018.
In March, the U.S. Labor Department reported an increase in payrolls of 103,000 – far less than the estimated 185,000 gain and the smallest advance in six months. It is also a sharp drop from February’s gain of 326,000 jobs. In the first quarter, the U.S. economy added an average of 202,000 jobs per month, which are some of the strongest gains in a year. Unemployment remains near an 18-year low, holding at a seasonally adjusted rate of 4.1% for the sixth straight month. Currently, there are more jobs available than there are individuals seeking employment, making it harder for employers to fill their positions.
Weekly unemployment claims remain near the lowest level since 1973. The participation rate, or share of working age people in the labor force, slipped to 62.9 in March after rising to 63 percent in February. The participation rate, still near the lowest level since the 1970s, will continue to decline as older workers retire. This should be offset, however, by improving job prospects, which are helping to pull many people into the labor force from the sidelines.
Wage growth, or the lack of it, continues to be a key factor in the ongoing discussion on the health of the U.S. economy. In general, it is assumed that if the economy continues to grow at the current pace and unemployment continues to decline, there would be some upward pressure on wages, although that has not proven true for many years. In January, average hourly earnings rose 2.9%, alarming investors because it suggested that consumer inflation may rise higher than expected, but the growth in January was marred by low productivity growth. Payroll reports for February and March showed a more tempered rate of wage growth.
The seemingly paradoxical case of wage growth can largely be attributed to not only the advancement in technology, but the composition of the workforce and the type of wage growth accruing to those employed full time.1 Wage growth continues to remain restrained due to the rising number of highly paid baby boomers retiring who are ultimately replaced by lower paid, younger workers. Moreover, the recent rise in wages has mainly been attributable to workers who leave their job for a higher paid opportunity elsewhere. The number of people who quit their jobs jumped to a 17-year high of 13.1 percent in March. Rising confidence levels about job prospects and more job openings may push wages higher in the future.
After struggling to gain traction last year, inflation has finally begun to accelerate and move closer to the Federal Reserve’s 2.00% target. The Federal Reserve’s preferred inflation measure, Core Personal Consumption Expenditures (PCE), has not surpassed the target level in five years, but recent consensus suggests that it may begin picking up in the near future. Core PCE remained flat for four months at 1.5% before increasing slightly at 1.6% in February. Other measures of inflation have also been trending higher in recent months. Core consumer prices, which exclude volatile food and energy items, rose 2.1% in March from a year earlier – the highest reading since February 2017.
The Puzzling Case of the U.S. Housing Market
While demand for homes continues to climb higher, potential buyers are having a harder time than seen in recent years finding a home. In March, existing home sales increased 3.0% on a monthly basis and 1.1% compared to the prior year. Existing home sales are struggling to move higher as inventory remains stretched, leaving buyers with few choices and higher prices. Similarly, a decade after the U.S. housing glut, home construction per household remains at its lowest level in over 60 years, which helped reduce the inventory of new homes. At the same time, building across the U.S. has become more difficult as the availability of land and labor is declining, while materials are becoming more expensive.
It’s too early to see the full impact that recent tax cuts may be having on the economy. Withholding rates for individuals have been reduced and corporate stock buybacks have accelerated, but the extent to which the tax cuts may filter into GDP numbers is still unknown.
Immediately, the recent tax cuts should help strengthen discretionary spending. However, retail sales increased only moderately in March, gaining 0.6% after three months of continuous declines. The so-called core retail sales, which correspond most closely with the consumer spending component of gross domestic product, rose 0.3% for the month. Consumer spending is the main driver of the U.S. economy, accounting for over two-thirds of GDP.
It is also unclear how $150 billion in proposed tariffs by the Trump administration on Chinese steel and aluminum imports and other goods imported from China may affect economic growth and the extent to which tariffs could offset the positive impact of the tax cuts. In their March meeting, Federal Reserve officials noted that the prospect of retaliatory actions by others poses a risk to U.S. growth. The Chinese government has already outlined potential plans for a 25 percent tariff on 106 U.S. products, including soybeans, aircraft, cars, and chemicals. These tariffs sum to $50 billion.
Among other U.S. exports that China intends to target are corn, cotton, beef, whiskey, tobacco, and various lubricants and plastic products. Worries about the impact of trade policies on the U.S. economy caused consumer sentiment to slip in April.
Barring any major surprises, growth prospects in the U.S. for the remainder of the year are increasing on the back of low unemployment, tax cuts, and fiscal stimulus. The Federal Reserve is anticipating that not only will growth pick up, but so will inflation, which has been weak for the past few years. As inflation begins to gear up and the unemployment rate remains low, the Federal Reserve will continue to raise rates. Based on the current outlook, BBVA Research anticipates four total interest rate hikes in 2018. It is unlikely the Fed will raise rates before its June meeting.
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