United States Forecast Summary
Just when it seems possible that the economy and the political system might finally have stumbled onto a more favorable roadway, reality produces a roadblock. Final output data for the third quarter and advance data for the fourth quarter suggested that the economy was approaching a configuration able to support sustained growth at or above a 3% rate. Through November labor market data was consistent with is hypothesis. After the government shutdown signs of selective political compromise were present. But labor market numbers for December and January raise some doubts. And hope for serious political progress has mostly evaporated. Even so, our current forecast is slightly more optimistic than three months ago, both for this year and the following two.
Revisions between the advance report of third quarter National Income and Product data, which was the basis for our November forecast, and the final report two months later changed the quarter from adequate to quite favorable.
In the first report total output was up 2.8%, but one-third of that came from inventory accumulation. Consumption and business investment were both unimpressive (with purchases of equipment down 3.7%). Government spending was flat as was the trade balance. Only housing showed real strength. The final numbers brightened the picture on most fronts. Consumption was stronger, as was business investment (with equipment now showing a slight increase). Government was slightly stronger. On the negative side, housing growth was less exuberant and trade was still flat.
The advance fourth quarter data confirm some of these improvements, but also contain some indications of possible concern. Consumption is stronger, with high spending on services. In spite of an unexpected decline in structures, business investment is encouraging, especially purchases of equipment (up 6.9%). The trade balance, driven by the energy sector has a large improvement. On the other hand, housing exhibits a large decrease as do government purchases. There is probably some weather component in the poor construction numbers, but perhaps also some impact of higher interest rates. There may be some budgetary shenanigans in the government decline, but perhaps also an indication that fiscal austerity has not yet run its course.
Monthly indicators have been a mixture of positives and negatives recently. In the former category household sentiment rose in both December and January. Industrial production registered a solid December increase, marking five straight up months. But the January ISM manufacturing index had an unexpectedly large decline. Consistent with the strong fourth quarter number for consumption of services, the ISM index for non-manufacturing rebounded in January after two months of decrease. Both ISM indices remain above 50, and both are close to their year ago levels. Housing starts, which feed into the NIPA rresidential investment number, declined in both November and December. Auto sales in January came in at an annual rate in the low 15 million range, close to their level in three of the previous four months. This is below the “new normal” which was declared last summer.
That brings us to the labor market, which continues to spew confounding data. In the household survey the employment numbers have been highly erratic, with three of the past four months showing changes in excess of 600 thousand (relative to an underlying average rate of about 100 thousand). The unemployment rate, on the other hand, has been declining in fairly steady fashion at a rate of about one percentage point per year. Ordinarily, this decline in unemployment would require employment to rise at close to double that actually recorded by the household survey. The gap is filled by a decline in the labor force rather than the increase a rising population should produce. Some of the decline is due to baby boomers aging out of the labor market, but a lot is due to other not understood factors. Physics has dark matter; economics has a dark hole in labor force participation. Relative to this confusion the establishment survey had seemed well behaved until December. Through November going back to late 2012, it had monthly employment increases fluctuating around about 190 thousand with perhaps a slight upward trend. But then December came in at just 75 thousand, followed by 113 thousand in January. I have no idea what to make of all this.
On top of this murky data are several layers of policy confusion. At the Federal Reserve the end of the Bernanke era saw a second move to reduce quantitative easing, now down to a mere $65 billion per month. Given the conflicting economic signals, Janet Yellen will certainly face pressures to delay this “taper.” In addition unemployment is now within a whisker of the 6.5% level the FOMC once declared would trigger a higher federal funds rates. Clearly that won’t occur leaving Ms. Yellen the hard task of deciding when and how the inevitable rise in rates will be accomplished.
Fiscal policy seems likely to remain on autopilot for the next year after a minimal bargain between the Republican House and the Democrat Senate. This agreement led to hope of progress in other areas where the two sides have at least some overlap of their individual self-interests. One such topic is immigration reform; another is trade liberalization. Progress in either could be a spur to economic growth. But in the past two weeks these hopes seemed to evaporate. First Harry Reid in the Senate torpedoed a trade deal. Then John Boehner in the House did the same to immigration reform. Very discouraging.
So what does all this imply for the future? The answer from our model is a slight shift toward optimism. For all of 2014 (fourth-quarter to fourth-quarter) we now estimate output growth to average 2.8% up 0.1% from November. In the current quarter growth is 2.5% compared to 2.2% in November. But in the current forecast inventories are a larger negative factor. Final sales this quarter are now put at 3.3% up from 2.5% in November. Farther out growth is right at 3% about 0.2% above our November estimates.
In some regards our model expects the economy to approximate the average of the past two quarters. This is true for consumption, both investment components and net exports. For government, however, we expect the picture to improve in part due to some make-up from the fourth quarter drop in federal spending.
Regarding the first quarter we are neutral about our model’s estimates for consumption and investment, but suspect there could be some misplaced optimism in our trade balance estimates and our assumptions about government spending. Farther out, our baseline forecast rests on a relatively benign view of the current economic environment: Fiscal policy turns slightly positive. Fed policy begins to tighten in mid-2015, but without causing major distress. The trade balance continues to steadily improve.
A skeptic could challenge each of these items. In the long-term there is a real need for fiscal restraint, especially with regard to entitlement spending. Fed tightening could produce some serious disruption in financial markets. The stock market so far this year may be trying to tell us something. In the international arena major elements of support are under pressure. The large injections of liquidity from the Fed and from China are being withdrawn. Emerging economies have a variety of problems. Europe is still at sea, perhaps in calm waters for now, but still far from solid ground.
Overall we think the risks to our forecast are about balance for the next several quarters, but perhaps tilted to the downside farther out.