Outpacing the Rest
Ten years into the expansion, the U.S. economy continues to accelerate just as other major economies are seemingly running out of steam. After reporting modest growth in the first quarter at 2.2%, second quarter GDP is on track to grow at a rate of at least 4.0%. This would be the fastest rate of reported economic growth since the third quarter of 2014. Early data suggests that much of the rise in output was a result of a jump in exports in April and May. The second quarter GDP outlook also points to robust growth as the Institute for Supply Management’s manufacturing index rose to 60.2 in June up from 58.7 in May. Any reading above 50 indicates growth.
According to St. Louis Fed President James Bullard, the rise in growth may only be “temporary” as it is outpacing the economy’s long term growth rate of 2.8%. While factory activity has continued to accelerate during the second quarter, much of the rise was a result of manufacturers ramping up their activity before the steel and aluminum tariffs went into effect. The report also signaled shortages in the availability of raw materials and labor capacity, which might drag on future readings. Orders for nondefense capital goods excluding aircrafts, a leading economic indicator, have not increased in two consecutive months since last fall, which raises the question as to whether or not this growth is sustainable.
Supply chain issues in the housing market have also recently weighed on the economy. Builders have been facing rising input costs and a shortage of workers. Sales in both new and existing homes continue to slide due to constricted inventory and new building permit growth. As a result, supply has been unable to keep up with strong demand. While construction has started to rise, marked by an increase in housing starts and building permits, affordability has faltered, especially as mortgage rates continue to rise.
Consumer spending, which accounts for more than two-thirds of growth, rose 0.5% in April and 0.2% in May suggesting solid consumer spending growth for the quarter. Consumer spending has been supported by a number of factors including continued levels of low unemployment, tax cuts, strong consumer confidence, and generally low levels of inflation.
Wage growth has a positive impact on consumer spending, yet, gains in wages, while consistent, have been modest at best. Since the recession ended in 2009, wages have yet to grow above 3%. In June, the Department of Labor reported an increase of 2.7% in average hourly earnings from a year earlier. More importantly, real wage growth seems to be stagnant as inflation is increasing. Tepid wage growth continues to remain one of the biggest puzzles of this expansion, particularly as the unemployment rate has continued to decline.
One factor contributing to below average wage growth is the decline in productivity. Worker productivity, which gauges hourly output per worker, has been historically weak. In the first quarter of this year, productivity increased modestly at a 0.7% annualized rate. Fourth quarter productivity was revised up to 0.3% from 0% indicating that there is perhaps some improvement underway. It is unlikely that we’ll see a significant pick-up in wages until productivity firms.
There are certain pockets in the economy where wage growth is materializing. According to the National Federation of Independent Business (NIFB) approximately 36% of small businesses are unable to fill open positions. Anecdotal reports have found some companies under pressure to fill jobs are beginning to re-examine existing policies such as hiring ex-convicts of non-violent crimes and adopting a more laissez-faire attitude towards certain drugs, like marijuana. The labor market without a doubt continues to be one of the focal points of the U.S economy. Payrolls have increased consistently over the past 93 months - the longest streak in history. Most recently the Department of Labor reported that employers added 213,000 jobs to the economy in June. The continued availability of jobs has encouraged more individuals, approximately 601,000 people, to rejoin the labor force last month. The surge in re-entrants into the labor force is what caused the jobless rate to tick up to 4.0% from its 18-year low of 3.8% in May. Only those actively seeking work are considered to be unemployed.
Since the crisis, the Fed has kept shortterm rates near zero in order to boost the economy. However, as the economy firmed the Fed has raised rates to minimize the risks of inflation taking hold. With two rate hikes behind them, June’s meeting has marked a beginning of a new phase of economic policy as the Fed has upgraded the economy from “moderate” to “strong”, raising its Fed funds target range to 1.75%- 2.00%. Recently, the Federal Reserve has downplayed concerns about the economy overheating, but the June employment report provides support for the Fed to continue gradually raising interest rates. The Fed is poised to raise rates twice more this year and three times in 2019.
It is unlikely that the Fed will deviate from its path unless inflation approaches 2.50%. Inflationary pressures have been mounting recently as headline PCE just hit 2.00% in April. In May, the headline personal consumption-expenditures price index rose to 2.3% from a year earlier as a result of rising energy prices. The Fed’s preferred measure of inflation, core PCE, which removes volatile food and energy prices, rose to 2.00%. While inflation hit its highest level in six years, the Fed will want to see it sustained as structural factors like the “Amazon effect” of consumers buying goods cheaply online have been known to depress prices.
Going into the third quarter, one of the greatest upside risks to inflation is the impact of tariffs. Tariffs impose a tax on imported goods, costs that are largely transferred to the consumer. As such, we may begin seeing higher import prices filter into consumer inflation. The Trump Administration has already imposed tariffs on multiple consumer goods including washing machines and cars. In the immediate term, the impact of tariffs is likely to be very small on consumer prices but may end up eroding real wages.
Perhaps the biggest casualty to the economy will be the tariffs’ impact on business sentiment and ultimately business investment; a concern that the Fed emphasized at its June meeting. Already some business have been scaling back plans for capital spending or postponing investment, while other firms are moving production overseas to avoid retaliatory tariffs. Not only will this mean less business investment, but it also means fewer jobs, which equals less growth. These decisions are unlikely to have an impact in the immediate future, but may eventually trickle into future economic readings
While there are a few clouds on the horizon, multiple near-term indicators, including consumer spending and investment, suggest continued growth in the economy. Yet, the savings rate continues to be dragged down by rising personal interest expenses. As inflation continues to show signs of accelerating, wage growth is needed to continue to fuel consumer spending. Currently, BBVA Compass Research is anticipating growth near 3% in 2018.
Domestically, risks to the economy include the Fed raising rates too aggressively in order to prevent the economy from overheating. On a global scale, continued uncertainty around trade wars will constrict sentiment and investment, and political turmoil in the Eurozone could produce some unexpected volatility.
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