Calculating economic successes in 2018

It’s been a good run, but how long will it last?

(Editor’s Note: Daniel Island resident Steve Slifer, a noted national economics expert, served as keynote speaker at the 2018 Economic Outlook Conference at the Daniel Island Club on Dec. 6. Below is a synopsis, prepared by Steve, of his presentation.)

It is impossible to overstate the importance of the corporate tax cuts that are on the verge of enactment. Over the next few years they should:

• Raise the economic speed limit from 1.8 percent to 2.8 percent.

• Boost growth in wages from 1.4 percent to 3.5 percent.

• Accelerate growth in our standard of living.

• Boost the inflation rate slightly to 2.3 percent.

• Keep the Fed on track to raise rates slowly to the 3.0 percent mark but no higher.

• Propel the stock market to a record high level.

• Extend the expansion to 2022 or beyond.

The pessimists are wrong

In the 1990s, the economy grew at a 3.5 percent rate. As a result, in the good times we now expect the U.S. economy to grow at a similar pace. But in the current expansion growth has struggled to reach the 2.0 percent mark. Economists endlessly point out how the current pace of expansion falls far short of growth registered for comparable periods of other business cycles. The often-cited culprits are Republicans, Democrats, Obama, gridlock in Congress, or the Federal Reserve. Because growth is so anemic the naysayers note that it would not take much of a shock to push the economy into recession. They fear that the next downturn is right around the corner. But the pessimists are wrong. The economy is alive and doing well, it is gathering momentum, and will continue to expand for many years to come. We are in the midst of the longest expansion on record.

Examining GDP growth

To understand why growth has been so slow relative to other business cycles we need look only at what economists call “potential GDP growth” which is the economy’s speed limit. We can make a reasonable guesstimate by adding two numbers – growth in the labor force and growth in productivity. If we know how many people are working and how efficient they are, we can estimate how many goods and services they can produce – which is what GDP measures.

In the 1990s, labor force growth was 1.5 percent, productivity growth was 2.0 percent. Add them up and the economy’s speed limit was 3.5 percent. The economy grew that quickly for a decade. Thus, we now expect 3.5 percent growth in the good times.

But the economy today simply cannot grow that quickly. Labor force growth has slowed to 0.8 percent because the baby boomers are retiring. Productivity growth has slowed to 1.0 percent. The internet came into existence in 1995 followed by the cloud and apps in the early 2000s. These technological advancements completely revolutionized the way that we communicate with each other. As a result, productivity growth surged to 2.0 percent. But nothing earth shattering has occurred in recent years and that indicator has slipped to 1.0 percent. With labor force growth of 0.8 percent and productivity growth of 1.0 percent, the economic speed limit today is 1.8 percent. Today’s economy can expand at only one half the pace of the 1990s. Surely, we can do better than that!

Boosting the economic speed limit

To boost our economic speed limit, we have two choices – achieve faster growth in the labor force, or find some way to boost productivity. Because the baby boomers will continue to retire for another decade, we probably will not have much luck boosting growth in the labor force. If we are going to raise the speed limit we must stimulate productivity.

Productivity growth is closely tied to the pace of investment. Investment spending collapsed in 2014 and did not grow for two years. Part of the drop-off was tied to oil prices. When oil prices plunged from $104 per barrel to $25, drillers could no longer profitably operate many wells and shut them down. Investment spending in the oil sector collapsed. More broadly, business leaders were frustrated by the political gridlock in Washington. Why should they invest when they have no idea what the economy might look like in five years? Investment ceased to grow for two years. But oil prices are no longer $25, they are at $57. Drillers can profitably operate many of the previously-closed wells. Investment in the oil sector is rebounding.

The Trump effect

In November 2016, Donald Trump was elected president. He pledged to create jobs and boost investment. He wanted to cut the corporate tax rate from 35 percent to 20 percent, allow companies to repatriate earnings at a favorable 5.25 percent tax rate rather than 35 percent, and eliminate a wide range of confusing, overlapping, and unnecessary regulations.

Investment spending immediately began to rise. It has grown steadily in every quarter this year. Coincidence? We doubt it. Investment should continue to climb at a 6.0 percent pace in 2018.

The corporate tax cuts are going to boost growth in productivity, accelerate GDP growth, keep inflation in check, prevent the Fed from raising rates too sharply, propel the stock market to record levels, and lengthen the current expansion by several more years.

In the past three years productivity has grown 0.7 percent. As investment spending surged in 2017, productivity growth quickened to 1.5 percent. Within a couple of years productivity growth will reach the 2.0 percent mark.

Labor force impacts

Let’s re-calculate the economic speed limit. Labor force growth of 0.8 percent combined with 2.0 percent growth in productivity raises the economy’s speed limit from 1.8 percent today to 2.8 percent. While short of the 3.5 percent growth rate in the 1990s, it is a significant improvement.

Faster growth in the economy accelerates growth in our standard of living. Economists typically measure that by looking at real, after-tax, income per capita. Take our income, subtract what we pay in taxes, adjust for inflation, and see what is left. Today this measure of income is rising 0.9 percent. If the economy grows 1.0 percent more quickly, that number will jump to 1.9 percent.

Faster growth in productivity will alleviate upward pressure on inflation. At 4.1 percent, the unemployment rate is below anybody’s estimate of full-employment. Wages have begun to rise. But inflation may not accelerate too much because of renewed growth in productivity. Consider the following: If your employer pays you 5.0 percent higher wages and you are no more productive, its wage costs have climbed by 5.0 percent and it might be tempted to raise prices. But what if it pays you 5.0 percent higher wages because you are 5.0 percent more productive? It does not care. It is getting 5.0 percent more output. We are supposed to watch wage pressures adjusted for productivity.

In the past year, compensation has risen 1.4 percent, productivity has risen 1.5 percent. The increase in wages has been countered by a commensurate increase in productivity.

In 2018, we expect compensation to rise 3.5 percent and productivity to climb to 2.0 percent. Thus, labor costs adjusted for productivity will rise 1.5 percent. But the Fed has a 2.0 percent inflation target so an increase in adjusted wages of 1.5 percent is not a problem.

The bottom line is that we expect the core CPI to increase 2.3 percent in 2018 versus 1.8 percent this year. While that is a bit above the 2.0 percent target it should not alarm Fed officials.

Putting all this together, we expect GDP growth to pick up to 2.8 percent during the next couple of years. Our standard of living will rise more quickly. Our paychecks will get somewhat fatter. Productivity will accelerate. Inflation should continue at a 2.3 percent pace, which is roughly in line with the Fed’s target.

If that is the scenario that unfolds, the Fed should continue to tighten until the funds rate reaches a neutral rate of 3.0 percent by mid-2020. At that point, it is neither stimulating the economy nor trying to slow it down.

Growing pains?

So, when might this expansion end? Historically the U.S. economy has never, ever, fallen into recession until the Fed has pushed the funds rate above that so-called neutral rate. At the end of the most recent expansion in December 2007, the funds rate reached the 5.0 percent mark.

When might the Fed raise the funds rate to 5.0 percent? No time soon. By mid-2020 the funds rate should reach a neutral rate of 3.0 percent. If the economy is expanding at its potential pace of 2.8 percent it is not overheating. The inflation rate should be 2.3 percent, which is just a shade above its 2.0 percent target. The Fed has no reason to raise rates further. The funds rate should remain at the 3.0 percent mark.

How long will the expansion last? What we should be looking for are signs that the economy is overheating, and that inflation is moving substantially above the Fed’s 2.0 percent target. Those two pieces are nowhere in sight. The expansion could last another five years.

This expansion is going in the history books as the longest expansion on record. The current record-holder is the decade of the 1990s, which lasted exactly 10 years. The current expansion will reach that milestone in June 2019. We are suggesting 2022 as a possible end date. If the Federal Reserve can produce an expansion that lasts 13 years or longer, it certainly deserves high praise.

All is well. Enjoy the coming year. Rock on!

Steve Slifer has been an economist for almost 40 years. He began his career by spending a decade at the Federal Reserve in Washington D.C., followed by more than 20 years as the Chief U.S. Economist at Lehman Brothers. Today, he is owner and chief economist at NumberNomics, a firm that provides economic analysis to a wide variety of clients including fund managers, financial firms, investors, and corporations. For more information, visit www.numbernomics.com.

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