Weekly Economic Commentary by Scott J. Brown, Ph.D.
The pause in capital spending
April 27 – May 1
The Bureau of Economic Analysis will report its initial estimate of first quarter growth on April 29. There’s always a lot of uncertainty in the advance estimate, but that’s especially true for 1Q15. Of the key components of GDP, consumer spending is expected to have slowed to a more moderate pace – nothing terrible. However, business fixed investment should be soft. For business investment, as with manufacturing activity in general, it’s often difficult to distinguish a short-term slowdown from the beginning of a more significant downturn.
Orders for core capital goods (nondefense and excluding aircraft) have fallen for seven months in a row. This decline could be a “correction” from unusual strength in 2Q14 and 3Q14. More likely, it’s a reflection of the stronger dollar. The dollar has had a negative impact on corporate profits, which are a key driver of capital investment. The dollar has stabilized in recent weeks. If that continues, the currency impact on earnings should fade over time. There’s nothing to suggest a sharp decline in business investment similar to recent recessions.
There’s a reason that it’s called “the business cycle.” Business fixed investment accounts for about 13% of GDP, but it swings sharply in recessions and recoveries. Business fixed investment includes structures, equipment, and (since 2013) intellectual property products. Structures and equipment are the more cyclical components. In recent quarters, energy exploration and extraction accounted for about 6.8% of business fixed investment (some equipment, but mostly structures) or about 0.9% of Gross Domestic Product.
Durable goods orders and shipments provide some insights into the manufacturing sector, but some gauges will tend to lead (although not always). Unfilled orders, a favorite of former Fed Chair Alan Greenspan, are an early indicator of trouble when falling. The inventory-to-shipments ratio can be used to gauge imbalances. However, the increased use of computers and scanners in inventory management and the off-shoring of inventories make the U.S. economy less susceptible to inventory cycles (compared to a few decades ago). These gauges are not yet at “danger” levels, but they bear watching.
April 20 – 24
We live in an uncertain world. Policymakers have to sift through a wide range of data, much of which is subject to statistical error and measurement difficulties. Financial market participants deal with much of the same data, but also have to account for the uncertainty in how policymakers will interpret the data and respond. There are longer-term questions, which won’t be resolved anytime soon. So where do we stand now?
On April 29, Federal Reserve officials will meet again to set monetary policy. That morning, the Bureau of Economic Analysis will release its initial estimate of 1Q15 GDP growth. There’s always a lot of uncertainty in the advance GDP estimate. The BEA does not have a complete picture of the component data – and as we’ve seen over the last several quarters, subsequent revisions can be very large. Rather than focus on the headline GDP figure, investors would do better to consider the key details. Consumer spending accounts for 70% of GDP. Job growth has been supportive, but wage growth has been relatively lackluster over the last several quarters. The drop in gasoline prices has pushed consumer price inflation close to zero (the CPI fell 0.1% over the 12 months ending in March), resulting in a sharp rise in real wages. That should help drive consumer spending in the near term. Spending was soft in December, January, and February. Inflation-adjusted spending appears to be on track for about a 2.0% annual rate in 1Q15, down from a 4.4% pace in 4Q14 (reflecting unusual strength in October and November). Spending in 2Q15 should pick up.
The sharp drop in energy prices has led to a significant contraction in oil and gas exploration. While locally severe, the loss of jobs should be small on a national level. The bigger impact on GDP will come through the drop in business structures. That decline will be magnified in the GDP calculation. Growth is reported at an annual rate. So a sharp decline in a single quarter will appear much larger. It’s hard to put a precise number on it, but the decline in business structures is likely to help push the headline GDP figure close to zero (or a bit negative) in the first quarter. Note that while energy exploration has contracted, energy extraction is still going strong, helping to keep energy prices low.
The negative impact of lower energy prices should be more front-loaded, while the benefits (to the consumer) are likely to build over time. In the advance GDP estimate, there is also the usual uncertainty surrounding inventories and net exports.
The Fed generated some confusion by saying it would begin debating rate increases in June. That doesn’t mean that the Fed will begin to raise rates at that time. Rather, it’s simply a return to business as usual for the Fed (less reliance on the forward guidance). While officials have continued to indicate that conditions are likely to warrant a rate hike by the end of the year, they have also suggested that the pace of increases (after the first) will be much more important, and likely very gradual.
U.S. investors are not the only ones interested in the Fed policy outlook. We saw significant global reactions in the “taper tantrum” of 2013. The reaction in emerging market economies to the initial Fed rate hike could be just as severe or greater.
Greece has been a reoccurring worry for investors here and abroad. We’ve been through this a number of times, and it usually ends with the can kicked down the road. However, the length of these “kicks” has gotten shorter and the calls for a Greek exit from the euro have grown louder. Both sides have been reported to be preparing plans for a Grexit, but there will be enormous challenges for policymakers if that happens.
The financial markets appear to be searching for a direction. Stocks often climb a wall of worry, but a lot of good news (a 2Q15 rebound in GDP growth, a Federal Reserve not in any hurry to tighten policy) is already factored in.
The long-term outlook: secular stagnation or not?
April 13 – 17
The good news is that the output gap, the difference between real Gross Domestic Product and its potential, has narrowed. The bad news is that’s largely because potential GDP has declined. The big question now is whether the economy is on a permanently lower track. The answer is not so clear.
We like to say that the 2008-09 economic downturn was not your father’s recession. It was more like your grandfather’s depression. This was not the typical Fed-induced recession. This was a collapse of a housing bubble combined with a huge deleveraging within the financial system. More than eight years after the initial downturn and nearly six years into the economic recovery, the borrowing situation appears to be in better balance. That doesn’t mean that everything is okay, but we are on better footing and poised for improvement.
It’s an odd fact that GDP growth has averaged about 3% per year over the last several decades. Through that time, we’ve had variations in labor growth (increased female labor force participation in the 1960s, 70s, and 80s) and changes in productivity growth. This trend may go back well before the turn of the last century, as suggested by some historical analysis (GDP, as a concept, did not exist back then). GDP deviated from the trend during the Great Depression, but returned to it after World War II. There is no good theoretical reason to expect 3% GDP growth over a long period of time. Output is equal to labor times the productivity of that labor. Why would labor growth and productivity growth sum to 3% on average?
Potential GDP can be defined to be the level of economic activity consistent with steady inflation (2%) over time – not too hot, not too cold. There are some challenges in forecasting it. The standard approach is to project labor input (considering population growth and the removal of current slack) and apply that to an estimate of productivity growth. Estimating the amount of slack in the labor market isn’t terribly difficult, but there are uncertainties. Population growth is slowing, so the longer-term trend in labor input should be slowing accordingly. The estimate of productivity growth will depend on the pace of capital investment. The main reason that the Congressional Budget Office’s projection of potential GDP has come down in recent years is that business fixed investment has been subdued through most of the recovery.
The key question is whether the lower track in potential GDP is permanent or secular (persisting over an indefinitely long period). One can imagine a scenario where population growth slows further (Europe is turning Japanese and the U.S. may not be far behind). This is a very important issue. At 1% GDP growth, the economy will be 34% larger in 30 years. At 3%, it will be 143% larger. Even a 0.5% difference in long-term growth will matter a lot for the outlook for the standard of living and for funding government entitlement programs.
Secular stagnation is not simply a concern for the U.S. In the analytic chapters of its World Economic Outlook, the IMF reports that “potential output growth across advanced and emerging market economies has declined in recent years.” For the advanced economies, the slowdown in potential GDP began well before the financial crisis, but the pace should pick up “as some crisis-related effects wear off (yet will still remain below the pre-recession trend). For emerging economies, the slowdown happened after the crisis. However, the slowdown in potential GDP for emerging economies is likely to continue, as their populations age and productivity slows as they “catch up to the technology frontier.” China has had phenomenal growth over the last few decades, but may have a tough time meeting current (lower) growth targets.
Investors tend to focus on the short term, but they would be wise to pay attention to the debate about the long term.
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