United States Forecast Summary
The U.S. economy seems finally to be breaking out of the sub-par pattern that characterized the first four years of the “recovery.” The third quarter was the fourth of the past five in which GDP growth exceeded 3%. Monthly data has shown definite improvement as well. Although there are potential problems that could arise, we think this upward trend will continue during the next year.
The first report on third quarter National Income and Product Account data was stronger than we expected, with estimated output growth of 3.5% versus our August forecast of 2.9%. There were three surprises in the third quarter data. First, consumption was weaker than we expected, both for goods and for services. Second, there was a very large increase in government expenditures on defense. Third, the trade deficit had a large decrease (a positive for GDP) rather than the small increase we had forecast. This reflected both strong growth in exports and a decrease in imports. The latter was mostly due to falling imports of petroleum.
As is often the case the movement in imports was matched by a parallel change in inventory accumulation. The decrease in the latter means that final demand growth (at 4.2%) was significantly above both GDP growth and our forecast.
From a longer-term perspective our model is performing quite well. Our forecast a year ago looking out through the year ending in the third quarter estimated that output growth would be 2.4%. The actual data say 2.3%. Our expectations for components were also quite close with two exceptions: business investment spending was 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.
Our takeaway from the new data is that, except for the surge in defense spending (which is unlikely to be sustained) the economy remained in the third quarter on a trajectory that is relatively close to our expectations.
Recent Monthly Data
This conclusion is reinforced by monthly data, which have been mostly positive.
Most important are the data from the labor market, where there is clear evidence of steady improvement over the past year. After an extended period during which employment growth averaged a little below 200 thousand per month, the average has moved in recent months to about 240 thousand. In October the increase was just 214 thousand, but the previous two months were revised upward by 31 thousand.
The household survey also had positive news. The unemployment rate dropped another tick to 5.8%, even in the face of strong growth in the labor force. Over the past twelve months unemployment has fallen by 1.4%, and unlike earlier in the recovery, the past year has seen labor force growth in line with the underlying working age population. The labor force participation rate, which decreased by over 3 percentage points during the recession and the first four years of the recovery, has been stable over the past year.
Other data have also been positive. Real income is showing steady growth and consumer sentiment improved in October implying that the dip in third quarter consumption should be temporary. Both housing permits and starts were above a million annual rate in September. This raises at least some hope for the one sector that has been disappointing over the past year. Industrial production jumped in September and is up solidly over the past year. Finally, both ISM indices remain at high levels, with manufacturing up strongly in October.
Overall both the third 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 previous four years to something like or even a little above its long-run potential.
With the exception of the current quarter our new forecast is a little more optimistic than our August outlook. The deceleration in fourth quarter growth comes from two sources. First, we expect exports to slow their growth from the third quarter and imports to grow rather than decline. This still leads to improvement in the trade deficit, but much less than in the third quarter. Second, we anticipate that some of the defense spending increase in Q3 was transitory, with a return to normal this quarter. This produces a small decline in overall government spending (versus 4.6% growth in Q3).
In comparing our outlook for the next two quarters in our current forecast with our August forecast, several things stand out. First, we expect slower growth in consumption spending than in August, although stronger than last quarter. Second we continue to think that business investment and housing will improve on their recent results, the former slightly, the latter more substantially. Third, we are more optimistic about the trade balance, with most of the improvement coming on the import side of the equation. Finally we see less growth from government, but this is really an artifact of the strong third quarter growth.
Farther out in 2015 and beyond, our model shows growth averaging slightly below 3% and slightly more than our August outlook. Compared with the pre-2014 “new normal” of 2% +/- growth, the improvement comes pretty much across the board, but without any area of really exuberant performance.
The U.S. economic recovery is well into its sixth year. The first two years of this period were dominated by the stimulus package, which had zero lasting positive effects. During the next three years the economy was stuck in a mediocre rut – better than going back into the ditch, but far from satisfactory. Over the past year, however, there has been definite upward progress. Our current forecast has the economy continuing over the next year on this 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 would be within reach.
An outcome below our projection is also certainly a possibility, but will probably require some sort of negative shock. We see three “usual suspects” in this regard: the international economy, the financial sector, and the domestic political situation.
While the United States economy has been showing improvement, nearly all of the rest of the world has been doing the opposite. Europe, China, and much of Latin America all face serious fundamental problems, requiring significant reorientation of economic policy. Nowhere is there any real progress. The result is that Europe and several countries in South America are on the verge of recession, while in China growth continues to decelerate. Add to this an epidemic of geopolitical instability in the Middle East and North Africa, and an actual epidemic in West Africa and you have an ugly picture. In the face of all this it is a testament to our fundamental strength that the U.S. is doing as well as it is.
On the financial front the Federal Reserve has completed its quantitative easing program and now faces the need to return interest rates to something closer to normal. We think this process will begin in mid-2015. It is a source of significant uncertainty.
The same is true of the domestic political situation. The election rearranged the power balance in Washington, but whether that portends any real change in outcomes remains to be seen. There has been a lot of lamentation about the deadlock in Washington during the past several years, but over the past year there has been some backhanded improvement. While nothing positive has been accomplished, at least the two sides have managed to stop shooting the economy in the head. On one side the GOP has been able to stop or at least slow the counterproductive tendencies of the Obama administration. On the other hand they have also avoided their own death-wish proclivities – e.g. government shutdown. Looking ahead, there is talk of compromise in several areas. This could be quite positive. At the same time, there are also signs that stupidity will remain the order of the day.