Scott Brown, Ph.D., Chief Economist, analyzes the current state of the U.S. economy and labor force as well as challenges facing the Federal Reserve.
To read the full article, see the full Investment Strategy Quarterly publication linked below.
The U.S. economy continued to expand at a moderate rate in the first half of 2018, although growth was a bit uneven across sectors. The underlying fundamentals of the economy remain sound.
Consumer spending has been supported by job growth, though higher gasoline prices limited purchasing power to some extent. Nominal wage growth has been moderate, yet inflation-adjusted wages rose only modestly year-over-year.
Residential homebuilding has been choppy, yet reflected year-over-year strength. Higher mortgage rates have been a minor drawback, but strong housing demand and supply constraints further boosted home prices, hurting affordability.
The expansion is now the second longest on record and there are no signs of a recession on the immediate horizon. However, there are some challenges for the second half of the year.
Gains in nonfarm payrolls were somewhat stronger in the first half of the year. Yet, the trend was not much different than that of the last couple of years. Job growth remains beyond a long-term sustainable pace. The unemployment rate has fallen further and measures of underemployment have decreased. That is okay in the short term, as slack continues to be reduced. However, the retirement of the baby boomers is reducing labor force growth, and demographic constraints will lead to a slower pace of job gains in the future.
Inflation ticked up in the first half of 2018, though not by a lot. Commodity price pressures generally moderated since the early part of the year, and the stronger dollar should help. However, tariffs raised the cost of steel and aluminum, and we have seen increases in oil, lumber, and cement prices as a result.
Since every firm employs workers, the labor market is the widest channel for inflation pressure. The tight job market led to worker shortages in a number of skilled labor positions. Wage growth for these jobs picked up, but overall wage gains remain relatively moderate. Firms responded to labor shortages by offering signing bonuses and increasing perks (such as time off).
Left unchecked, continued strength in the job market could lead to a reallocation of labor amid higher wages, boosting productivity growth, increasing in-house worker training, and further reducing underemployment. However, we could also see higher consumer price inflation if productivity does not increase and firms are able to pass higher costs along. The unemployment rate may fall further, leaving policymakers to move more aggressively down the line. This is the Federal Reserve’s dilemma.
While the U.S. central bank experienced a number of personnel changes this year, the underlying approach to monetary policy is the same as it was under Janet Yellen. Fed policymakers recognize that there will be more work to do later if they do not raise short-term interest rates soon enough. In a late-cycle economy, the risks of a monetary policy error naturally rise.
There are a number of uncertainties in the Fed’s economic outlook, including the impact of fiscal and trade policy, and we can expect policymakers to adjust their expectations as more information becomes available. Still, the most likely scenario is that we will get a 25-basis point increase in short-term interest rates each quarter until the economy shows more definitive signs of arriving at a more sustainable pace of growth, or if we get a major external shock (such as the three hurricanes experienced in the third quarter of 2017).
The likelihood of entering a recession does not depend on the length of the expansion. Economic expansions never die out on their own. Downturns are often associated with sharp increases in oil prices, but Fed policy is the usual catalyst. The Fed typically inverts the yield curve by raising short-term interest rates either too early or too late in the cycle. There is little risk of the U.S. economy entering a recession this year, though the odds are higher as we look to next year, reflecting the possibility of a monetary policy error.
The president’s decision to impose tariffs on imported steel and aluminum and letting the exemptions for our key allies lapse – including those for Canada, Mexico, and the European Union – increased trade tensions and engendered economic uncertainty. In an unprecedented move, G7 finance ministers and central bankers formally rebuked the U.S. for “undermining open trade and confidence in the global economy” in early June.
Financial market participants generally believe that this is all a negotiating tactic and the end result will be some minor tweaks to current trade agreements, which will avoid more substantial trade disruptions. However, there are downside risks. White House officials are divided. Some insist that this is simply a renegotiation among friendly countries, while others see tariffs as a tool to rebalance trade. Nobody really knows how the trade conflict will end. Investors reacted negatively to protectionist efforts, but positively to signs that they may be rolled back. We can expect this back and forth to continue, adding to financial market volatility.
These uncertainties will make the Fed’s task of achieving a soft landing even more difficult, and the risks of a policy error are rising. However, the near-term economic outlook remains optimistic.
All expressions of opinion reflect the judgment of Raymond James & Associates, Inc., and are subject to change. There is no assurance any of the trends mentioned will continue or that any of the forecasts mentioned will occur. Economic and market conditions are subject to change. Commodities are generally considered speculative because of the significant potential for investment loss. The yield curve is a graphic depiction of the relationship between the yield on bonds of the same credit quality but different maturities. Past performance may not be indicative of future results.