Economic Monitor Weekly Commentary
by Scott J. Brown, Ph.D.
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.
Consumer stumble or just a pause?
April 3 – 7, 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 rate in 1Q17. Does this spell trouble for the consumer? Or is this merely the pause that refreshes?
The 3rd estimate of 4Q16 GDP growth showed a stronger gain in consumer spending (a 3.5% annual rate). A year ago, spending was soft, but rebounded into 2Q16. Monthly figures through February suggest that inflation-adjusted spending is tracking at below a 1% annual rate. That’s a sharp slowing, but doesn’t look too terrible following a strong fourth quarter.
The Conference Board’s Consumer Confidence Index surprised to the upside last week, rising to its highest level since December 2000. Other attitude measures have been mixed. Interestingly, the report on UM Consumer Sentiment continues to show a sharp division on political persuasion. Democrats are depressed. Republicans are downright giddy (which remains a positive factor for the stock market). Getting a representative sample is a key issue for consumer surveys. A shift one way or the other in the composition can skew results.
Consumers don’t spend confidence. Income is the key driver (wealth and the ability to borrow are also factors). While nominal (current dollar) average hourly earnings growth has been trending higher, real (inflation-adjusted) earnings are little changed relative to a year ago. Inflation-adjusted disposable income per capita has been trending about flat in recent months. That suggests limited firepower for consumer spending growth in the near term. This slowdown is likely to be temporary. Gasoline prices, up over the last year, have begun to stabilize in recent weeks (so y/y inflation is unlikely to be as high as it has been recently).
Other factors may have limited consumer spending growth recently. Delayed tax returns (relative to last year) have been widely reported. In addition, many households have health insurance plans with deductibles that reset once a year (often in January). This means more spending on prescriptions and doctor visits, and less money to spend on other things.
There were several tax aspects to the Affordable Care Act. Failure to repeal makes comprehensive tax reform unlikely, but we may see a reduction in tax rates in the months ahead. Still, tax cuts would be weighted toward the upper end of the income scale, and will provide little support for the typical worker.
As usual, the spring economic data will tell the tale. Keep a close eye on job and wage growth over the next couple of months. For the Fed, the focus is on the job market and the inflation outlook, but the outlook should remain consistent with a further normalization of monetary policy. Officials are likely to remain optimistic about growth despite the soft first quarter.
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