United States Forecast Summary
The past month produced mostly good news about the U.S. economy. Second quarter GDP was better than expected and data revisions also enhanced the picture for the past year. Monthly data for June and July was generally upbeat, as well. This was basically in line with our expectations, and as a result our belief that the recovery will accelerate moderately in the second half of this year is unchanged.
The first report on second quarter National Income and Product Account data came in a little above our May forecast, with advance estimate growth of just below 4.0% versus our estimate of 3.5%. The data show consumption growth of 2.5%, with purchases of goods very strong and of services very weak. In the investment categories both equipment and housing had strong bounce-back from negative first quarter results. A rebound was also evident in both sides of the trade account.
From a longer perspective two comments are in order. First, our model is performing quite well. Our forecast a year ago looking out through the year ending in the second quarter estimated that output growth would be 2.3%. The actual data say 2.4%. Our expectations for components were also quite close with two exceptions: business spending on structures was much stronger than we foresaw, and residential investment the opposite. We were also too pessimistic about the drop in unemployment, although our forecast of employment growth was quite accurate. Second, the BEA has revised its estimates for the past three years. Three changes stand out: (1) Growth in 2011 and 2012 is lowered in the revised data. (2) Growth for 2013 is raised. (3) Estimates of business investment during the past year were increased.
The upshot of both the new data and the revisions is that the economy has been performing relatively close to our expectations. The first quarter now clearly looks like an aberration. While some of the second quarter strength was make-up, our basic view that the economy is gaining momentum seems reasonable.
Recent Monthly Data
This conclusion is reinforced by monthly data, which have been mostly positive. Household sector sentiment continues to improve. Both consumer confidence and expectations rose above 90 in July, their best levels since before the Great Recession. This reflects improvement in the labor market (discussed below) and increasing incomes. During the first six months of this year after tax real income has been rising at a 4.3% annual rate.
Business spending has been cautious, but that may be changing. New orders for capital goods were excellent in June, and both ISM indices rose strongly in July. The manufacturing index is at its highest since the stimulus induced boomlet in early 2011; the non-manufacturing measure is at the highest level since its inception in 2009.
Housing data for June were disappointing, but the weakness was concentrated in Southern states where weather (rain) was a problem.
Finally, the July data from the labor market were a little disappointing, but only relative to the previous three months. During that period payroll increase averaged 277 thousand per month and the unemployment rate dropped from 6.7% to 6.1%. In July by contrast employment rose “just” 209 thousand and unemployment ticked up to 6.2%. But this still gives six months in a row above 200k. And the rise in the unemployment rate was due in part to a significant increase in the labor force, which could indicate that workers who have been on the sidelines are now willing to reenter the game.
Overall both the second quarter GDP results and the recent monthly data are in line with our expectation that 2014 will see the economy transition from its subpar performance of the past three years to something like or even a little above its long-run potential.
Our current forecast is slightly less optimistic about the next year and a half than our May outlook. For the rest of 2014 our model puts output growth at 2.9% compared with 3.2% in May. The difference is due to a weaker trade balance and slightly less growth in consumption, partly off set by a little more strength in business investment and in housing.
Out forecast, both for the rest of this year and for 2015, basically represents a marginal improvement to the pattern of the past four quarters. It has increased contributions from housing and government spending, and a small increase from consumption (mostly of services). The trade balance is a negative this year and then shifts to a positive. Inventory accumulation, which added to growth during the past year shifts to nearly neutral.
The U.S. economic recovery is into its sixth year. The first two years of this period were dominated by the stimulus package, which had some positive effects that proved to be totally transitory. During the next two years the economy was stuck in neutral – north of recession, but well south of acceptable performance. Over the past year there has been some upward progress, but not a lot. Our current forecast has the economy continuing over the next year on this slow upward path.
There is potential upside relative to our baseline. The real economy (as opposed to the financial economy) currently has no significant imbalances. Our forecast does not contain any real exuberance. Indeed, our expectations for business investment, consumption, and perhaps the trade balance could easily prove to be conservative. If that turns out to be the case, growth in the mid 3% range could be within reach.
On the other hand, an outcome significantly below our projection will probably require some sort of negative shock. Two candidates are apparent: the international economy and the financial sector.
Recent developments in the former are clearly of concern. Europe – both its economy and especially its geopolitics – seems to be deteriorating. The Far East is at best holding steady. The Middle East and North Africa is a disaster from virtually any perspective. There is definite downside risk in all this.
However, we think the financial situation is a more immediate risk. We expect that the Federal Reserve will begin a move toward a more normal interest rate environment during the second quarter of next year. In our model, the gradual rise in rates that we assume has only a muted negative effect, but after seven years with short-term rates nearly at zero we are in uncharted territory. Our model does not include possible financial side effects – for instance, a significant correction in the stock market. The adjustment will be very risky business.