Economic Monitor – Weekly Commentary
by Scott J. Brown, Ph.D.

“Soft” vs. “Hard” Data and 1Q17 GDP Growth

April 24, 2017

Consumer spending accounts for 69% of Gross Domestic Product. Last week, the data on the household sector were mixed. The Conference Board’s Consumer Confidence Index surged to a 16-year high. Meanwhile, inflation-adjusted consumer spending has been tracking at below a 1% annual

The Bureau of Economic Analysis reports its advance estimate of first quarter economic growth on Friday. In recent years, the National Income and Product Accounts have exhibited what’s called “residual seasonality” in 1Q growth. That is, first quarter growth has tended to be below that of the rest of the year. Investors may be willing to dismiss a soft first quarter. There are other reasons to be skeptical of soft 1Q data, but the ongoing difference between various sentiment survey results and the hard economic data add to the view that labor market constraints will limit the pace of growth in the quarters ahead.

There are regular seasonal patterns in the economy. The holiday shopping season, the school year, and the summer travel season are the most notable examples. Most economic data are seasonally adjusted. Since the Great Recession, on average, 1Q GDP growth (+1.1%) has been less than half of the 2Q-4Q pace (+2.5%). It’s possible that the severity of the recession generated a permanent change in the seasonal pattern, but if so, the government’s seasonal adjustment will adapt over time – and we may find that this residual seasonality disappears in future revisions to the national accounts.

The advance estimate of 1Q17 GDP growth is expected to be held down by a sluggish pace of consumer spending growth. Consumer spending accounts for 69% of GDP. Interestingly, there is no evidence of residual seasonality in first quarter consumer spending growth (although fourth quarter figures have tended to be above the average of the rest of the year).

Still, there are other reasons to take soft 1Q17 consumer spending numbers in stride. Notably, at a 3.5% annual rate, 4Q16 consumer spending growth was strong and it’s not unusual to see a strong quarter followed by a soft quarter. Job and wage growth should continue to provide support for consumer spending growth in the second quarter.

Consumer and business attitude surveys have improved sharply since the November election. By themselves, consumer confidence figures generally reflect the strength of the overall economy. They fall in recessions and rise in recoveries. However, consumers don’t spend confidence. Spending is largely a function of income growth, but it also depends partly on wealth and the ability to borrow. Inflation-adjusted income should pick up. Consumer credit has begun to tighten, not terribly, but that will bear watching in the months ahead.

In contrast to the household sector, business sentiment plays a significant part in capital spending. Orders and shipments of nondefense capital goods began to pick up last summer, partly reflecting a bottoming out in energy extraction and some improvement in the global economy – and they picked up further following the November election. However, business sentiment may fall back. Washington’s inability to advance the Trump agenda, especially on tax reform, may be a factor. However, to remain optimistic, firms must eventually see increased demand for the goods and services they produce.

For economists, the divergence we’re seeing between the soft and hard data isn’t unusual. The soft data are useful, but you wouldn’t want to bet the ranch on them. The hard data also have limitations (statistical noise, sampling uncertainty, difficulties in the seasonal adjustment), which is one reason to look to the anecdotal information. Note that you can tie yourself in knots relying on the word-of-mouth assessments. In practice, look at everything (especially if you’re a Fed official).

The hard data / soft data divide points back to the key underlying story. That is, there are limits in the labor market which will restrain economic growth in the quarters and years ahead. Unless we see a sharp rise in productivity growth, slower labor force growth means slower economic growth. That’s not necessarily bad, but you might want to curb your enthusiasm.

The federal budget outlook

April 17, 2017

It’s a long-standing adage in Washington that the federal debt is a problem only when the other party is in charge. Republicans label Democrats as the party of “tax and spend,” while Republicans are deemed the party of “borrow and spend.” In truth, the federal budget is about what kind of society we want and who pays for that. Periodically, over the years, the budget has sometimes been seen to be in a crisis. The real concern has always been the long run, which is getting a lot closer.

By now, the demographic story should be well-entrenched. Labor force growth has slowed in recent decades – and will continue to slow in the years ahead. In the last half of the 20th century, the baby-boom generation entered the workforce and female labor force participation rose. Those trends are far behind us now. Growth is simply labor force growth plus productivity growth. Job growth estimates simply reflect the demographics. Productivity growth, which is more uncertain, is seen largely as a function of previous business investment. A softer pace of capital spending following the Great Recession meant slower growth in output per worker over the last decade. Capital spending appears to be picking up now, and advances in artificial intelligence and robotics should lift productivity growth in the years ahead. That will help to offset some of the slowdown in labor force growth. However, it’s unlikely that the trend in real GDP growth will be much above 2%. Moreover, if productivity growth doesn’t pick up, potential GDP growth would be more likely to center around 1.5%.

The federal budget deficit ballooned to $1.4 trillion (10% of GDP) during the financial crisis, but that was temporary. The surge merely reflected the magnitude of the economic downturn. Revenues dried up. Recession-related spending (food stamps, unemployment insurance, etc.) rose sharply. The budget deficit was 2.4% of GDP in FY15, but is now rising again.

The long-term budget outlook is troublesome, and we’ve known that for a number of decades. During the 1980s, President Reagan’s National Commission on Social Security, led by Alan Greenspan (before he became Fed chair), made a number of recommendations. One was to build up a trust fund. Workers would pay more into Social Security (and also Medicare) than was coming out. The trust funds would build up. Then, as the baby-boom generation retired, those funds would be tapped, extending the life of these programs. The government has effectively borrowed against these funds. They still exist, as an account, earning interest, but the government cannot reduce them without increasing taxes or borrowing more from the private sector. Can’t the government spend less? There’s nothing to be done about interest payments. If you don’t touch Social Security or Medicare, and want to keep defense spending steady or higher (as a percentage of GDP), there isn’t a whole lot left to cut. Something will have to give.

Tough choices lie ahead, but for Congress, the first rule should be to do no harm. Cutting taxes isn’t going to help the situation and raising them won’t close the budget gap over time. Voters will dislike cuts to Social Security and Medicare spending.

One partial solution would be to boost immigration. Immigrants, legal or otherwise, on average pay more in taxes than they receive in benefits. Instead, the near-term policy push is in the other direction. While labor force growth is slowing down, about 40% of the labor force increase over the next ten years is expected to be immigrants. Current policies may reduce that – further reducing trend GDP growth and adding more strain to the long-term budget outlook.

There is plenty of room for the two parties to reach agreement. The long-term budget situation does not need to be solved overnight. However, it would be helpful if the two sides simply recognized the problem and dropped the rhetoric.

March payrolls, the FOMC, and backcasting 1Q17

April 10, 2017

Nonfarm payrolls were reported to have risen by “just” 98,000 in March, while the unemployment rate fell to its lowest level (4.5%) since May 2007. The March 14-15 FOMC minutes “revealed” that officials plan to begin reducing the size of the Fed’s balance sheet later this year. Why this should be news to anybody is a mystery – it’s been well telegraphed for some time. Meanwhile, two regional Fed nowcasting models paint drastically different pictures of the 1Q17 economy. Let’s see if we can straighten this out…

Bad weather was not a significant factor in March payrolls. The BLS reported that 164,000 individuals were not able to show up to work (during the survey week) due to bad weather (vs. an average of 151,000 over the last 10 years for March). However, mild weather may have pulled forward seasonal job gains that would normally have occurred in March. The late Easter could also be a factor (figures are adjusted for floating holidays, but it’s hard to get it right). One should not put much weight on any one particular month, but the three-month average of private-sector job gains (+171,000) matched the average for all of last year (+170,000). The trend in payroll growth since 2015 is lower, but that reflects the fact that the job market is getting tighter. The monthly change in payrolls is reported accurate to ±120,000 (90% confidence interval), which means that we can be 90% certain that the true monthly change for March was between -22,000 and +218,000. On a side note, a 98,000 monthly gain in payrolls is roughly consistent with the pace of growth in the working-age population (that is, enough to keep the unemployment rate from rising).

If payroll growth was reported to have slowed in March, how can the unemployment rate be lower? These figures come from two different BLS surveys. The household survey uses a sample of just 60,000 households – not a lot (given the size of the overall population), but enough to get relatively accurate estimates of ratios, such as labor force participation and the unemployment rate. The unemployment rate is reported accurate to ±0.2%, which means the drop in March was not statistically significant. However, there are plenty of other signs that the job market is getting tighter.

Normally, a tight job market would lead to faster wage growth. Average hourly earnings rose 0.2% in March, up 2.7% from a year earlier. That’s not especially strong, but it’s higher than we were seeing a couple of years ago.

The Fed expanded its balance sheet during the financial crisis and well into the economic recovery. Some critics feared that this would lead to hyperinflation and a plunge in the dollar – nonsense! Currently, the Fed buys new securities to replace maturing Treasury securities and mortgage-backed securities (and agency debt). The Fed planned to unwind its asset purchases before it even started to buy. Ending the reinvestment policy will allow the size of the balance sheet to decay over time. During Ben Bernanke’s tenure as chair, the end of the reinvestment policy was expected to be the first step in policy normalization. Under Yellen’s leadership, the end of the reinvestment policy was deferred until after the federal funds target rate had been raised a few times. None of this is news. The Fed has well-telegraphed that this is coming – no big deal. Note that, in order to maintain a steady, appropriate mix of maturities in its portfolio, the Fed expects to both buy and sell securities as the balance sheet shrinks.

Nowcasting models are used to estimate GDP growth. One simply adds the contributions of the various GDP components. The models differ in how they forecast the components. Some are fancier than others. As one adds more variables to the equation, you get a better fit to historical data – however, you’re also likely to get poorer forecasts. Parsimony is key.

The Atlanta Fed’s GDP Now model estimates 1Q17 GDP growth at +0.6%. In contrast, the New York Fed’s model has it at +2.8%. A week ago, the monthly personal income and spending numbers through February suggested that inflation-adjusted consumer spending (69% of GDP) was tracking at below a 1% annual rate in 1Q17. Unit auto sales were reported to have fallen in March and retail payrolls fell by nearly 30,000, which is consistent with weak retail sales results. My 1Q17 GDP estimate (now at 1.0%) is closer to the Atlanta Fed’s figure.

One soft quarter is not the end of the world. Consumer spending growth (and GDP growth) should pick up in 2Q17. However, the trend in payrolls is consistent with the view that economic growth will be restrained by the job market. The Fed focus is not on GDP growth, but on the job market.

The opinions offered by Dr. Brown should be considered a part of your overall decision-making process. For more information about this report – to discuss how this outlook may affect your personal situation and/or to learn how this insight may be incorporated into your investment strategy – please contact your financial advisor or use the convenient Office Locator to find our office(s) nearest you today.

All expressions of opinion reflect the judgment of the Research Department of Raymond James & Associates (RJA) at this date and are subject to change. Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete. Other departments of RJA may have information which is not available to the Research Department about companies mentioned in this report. RJA or its affiliates may execute transactions in the securities mentioned in this report which may not be consistent with the report's conclusions. RJA may perform investment banking or other services for, or solicit investment banking business from, any company mentioned in this report. For institutional clients of the European Economic Area (EEA): This document (and any attachments or exhibits hereto) is intended only for EEA Institutional Clients or others to whom it may lawfully be submitted. There is no assurance that any of the trends mentioned will continue in the future. Past performance is not indicative of future results.