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.
March employment report – fear vs. hope
April 6 – 10
The nonfarm payroll data for March were disappointing. Job growth was substantially less than expected and figures for the first two months of the year were revised lower. These data fit in with the general theme of other recent economic reports. Growth slowed in the first quarter, reflecting bad weather and the negative impacts of a stronger dollar and lower oil prices. Growth is still widely expected to pick up in the spring, but for investors, that may begin to feel more a matter of faith.
Payrolls advanced by 126,000 in the initial estimate for March, about half the expected gain. Simply looking at the payroll graph suggests that we may be seeing a statistical moderation. There’s a fair amount of statistical uncertainty in the payroll figures. The monthly estimate is reported accurate to ±105,000 (for those of you who stayed awake in your statistics class, that is a 90% confidence interval). It’s not unusual to see the payroll figures bunch a bit higher or lower than the underlying trend. In other words, a strong quarter of payroll growth is often followed by a softer quarter. That doesn’t mean that job growth has necessarily “slowed.”
The impact of the weather can seem a bit quirky in the payroll reports. The payroll survey covers the pay period that includes the 12th of the month. That can vary from firm to firm (depending on whether workers are paid weekly or semi-monthly). The BLS noted that the survey period dodged the bad weather in February, but was not so lucky in March. The household survey, which covers the week of the 12th, showed that 328,000 people could not get to work due to bad weather in February, compared to a 387,000 average over the 10 previous Februarys. In March, 182,000 could not get to work due to bad weather, versus a 150,000 average over the past 10 years). So we went from better-than-normal weather in February to worse-than-normal weather in March. That may explains some of the shortfall in payrolls for March. Note that these are unadjusted figures from a different survey and are not directly comparable to the nonfarm payroll data, but suggest that we may see a weather-related rebound in April payrolls.
The stronger dollar and the decline in oil prices have both positive and negative effects on the economy. It’s likely that the negative effects are showing up more quickly than the benefits. The decrease in energy exploration is seen in the drop in mining payrolls (-11,100 in March, -11,100 in February, -7,400 in January). While perhaps devastating to local economies (these are high-paying jobs that are being lost), it is tiny on a national scale (about 0.02% of total payrolls). Even accounting for multiplier effects, the impact on total payrolls is small. The bigger impact from the retreat in energy exploration will come in capital spending. Note that the stronger dollar has hit corporate profits. Corporate profits are a key driver of capital spending and new hiring. This will show more at larger firms. Unlike the official BLS data, the ADP estimate of private-sector payrolls provides a breakout by size of firm. The March report showed a sharp slowing in job gains at large firms, but continued strength in hiring for small and medium-sized firms.
Job growth has been strong over the last year (over 3.1 million, or 2.3%). Combined with the increase in purchasing power from lower gasoline prices, consumer spending should be picking up. Consumer spending accounts for 70% of Gross Domestic Product, so the benefits of lower gasoline prices should offset the negative effects of the stronger dollar.
The general theme of recent data reports should make Fed policymakers less inclined to raise short-term interest rates this summer. The Fed is still justified to plan for policy normalization and to return to “business as usual” in June (that is, considering whether to raise rates on a meeting-by-meeting basis). However, the monetary policy outlook will depend critically on the upcoming economic data and signs of a spring awakening.
March 30 – April 3
Recent economic data reports have painted a weaker picture of first quarter GDP growth, but that’s likely to mean a bigger rebound in the second quarter. Still, there’s a lot of uncertainty in the near-term outlook, which may hurt investor sentiment.
The estimate of 4Q14 GDP growth remained at a 2.2% annual rate in the government’s third estimate. The report also included corporate profit results. As expected, profits from the rest of the world fell sharply. However, profits of domestic nonfinancial corporations continued to improve.
Profits and cash flows are important drivers of capital spending. The Federal Reserve’s flow-of-funds data for 4Q14 showed a rise in the financing gap (the difference between capital investment and internal funds) in the second half of 2014. Orders for nondefense capital goods ex-aircraft (a rough proxy for business fixed investment) declined for the sixth consecutive month in February. Unfilled orders are falling and inventories are outpacing factory shipments. These are worrisome signs, but while they certainly bear watching going forward, they are not yet at levels that would be considered dangerous to the overall economic outlook.
Some of the softness in capital spending may reflect the impact of the stronger dollar. Some may reflect a return to the longer-term trend, following unusual strength in the second and third quarters of last year. The sharp drop in energy exploration will be an important factor in the 1Q15 GDP data.
Oil and gas drilling account for a tiny fraction of overall employment. However, it’s a significant portion (roughly 28% in 4Q14) of business structures (7% of overall business fixed investment or about 0.9% of GDP). Remember, GDP is quoted as an annual rate. A sharp drop in one quarter will have about four times the magnitude in the headline GDP figure.
There are two broad strategies in forecasting GDP growth over time. One is to make a forecast and stick with it, altering the projection only when the data overwhelmingly suggest a need to do so. This has the advantage of showing that the forecaster is less wishy-washy and stands by his or her convictions. The other is to adjust the forecast as information becomes available. That would seem to be a more natural process, but it can lead one to repeatedly revise the outlook. In practice, most forecasters are somewhere in the middle.
The Atlanta Fed has a model that updates the forecast of the current quarter GDP estimate on the fly, adjusting the figure as economic data are released. No surprise then, the forecast of 1Q15 GDP growth has fallen as disappointing economic data releases have rolled in in recent weeks. At this point, the Atlanta Fed’s model anticipates a sharp negative contribution from business structures. A wider trade deficit is expected to subtract a full percentage point from overall growth. Inventories and government are also expected to subtract.
There are a couple of points to make. One is that the Atlanta Fed’s forecast, which mirrors many private-sector forecasts, will shift as more data become available. This week, we’ll receive important data on consumer spending and foreign trade. Another point is that the Atlanta Fed model only produces forecasts for the current quarter (until the advance GDP estimate arrives). Many forecasters have lowered their GDP forecasts for 1Q14, but they’ve also lifted projections for 2Q15.
The recent string of disappointing economic data has led to a moderation in the growth outlook for this year and next. As we saw in the recent projections of senior Fed officials, this isn’t a huge change in the outlook, but it implies that the Fed will likely be less aggressive in raising short-term interest rates in the months ahead. For investors, it adds to the level of uncertainty about where the economy is headed in the near term.
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.
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