The US economy, as we know, has been on a bit of tear recently—confirmed last week by the announcement that it expanded by a little over 4 per cent at an annualised rate in the second quarter, the fastest pace in four years. President Trump and his supporters were quick to cheer and take credit thanks to the government’s tax cuts. Allowing for a fall in inventories, demand (or, technically, real final sales) grew by just over 5 per cent per annum.
Yet, we can also consider this achievement in a calmer and more reasoned way. Faster growth is good news—but it won’t last long, and interest rates are still going to go up.
Remember first that 4 per cent growth is rare but not impossible in a modern, sophisticated economy. It happened 4 times during the Obama administration, once as the economy snapped back after the recession following the financial crisis, then again at the end of 2012, and in the middle quarters of 2015.
Second, the annual, or year-over-year growth rate, also rose but from 2.5 per cent in the first quarter to 2.8 per cent. This a more reliable view about how the economy is growing.
Third, note that 4 per cent annualised growth cannot last unless the economy’s potential growth rate is, itself, higher. It’s a bit like driving your car. The distance capacity (or potential) is set by the car’s physics and petrol tank size. The only way you can change it is to lower it by driving too fast or badly.
Similarly, the US economy’s 1.8-2 per cent growth potential is set by productivity and labour input. It can speed up for a while by using economic capacity more intensively, but unless capacity itself is expanded, it won’t be able to sustain faster growth.
How the acceleration happened
How and why did the US economy accelerate recently? Consumer spending picked up strongly, growing by 4 per cent at an annualised rate, after a paltry 0.5 per cent early in 2018. Averaging the two quarters probably tells you all you need to know about underlying consumption.The Bureau of Economic Analysis did revise up the savings rate quite considerably for the period since 2016, but this was largely a revision of small business owners’ and partners’ incomes, not household thrift. So-called “proprietors” tend to comprise people at the upper end of the income spectrum who tend to save more, and so higher savings do not necessarily mean that a consumer spending surge is waiting in the wings. That said, the savings rate in the second quarter did fall from an upwardly revised 7.2 to 6.8 per cent of disposable income.
Business investment slowed down from 11.5 per cent annualised growth to 7.3 per cent, but this is still a robust capital spending expansion. It looks likely to settle down coming quarters, given the trend of capital goods orders, which has been steady bit not remarkable.
Exports made a big contribution to second quarter economic activity, which looks odd given the rising value of the US dollar and Trump’s trade war. And it is odd—because what happened was that foreign economies stockpiled US goods in anticipation of the implementation of higher tariffs that have just come into force.
Soybeans were a case in point, with additional strong shipments generating half the 1 per cent contribution of net trade to GDP growth. China has just retaliated against US tariffs, including by imposing a 25 per cent tariff on US soybean imports.
What happens next?
As always, GDP numbers look backwards, and for reasons mentioned, economic growth doesn’t seem likely to remain in the 4 per cent atmosphere for very long. Over the last 3-4 weeks alone, more companies have warned that their earnings and operating conditions were likely to deteriorate. These include car companies such as GM and BMW, industrial companies such as General Electric and Alcoa, Airlines such as Delta and United, and most recently home appliance manufacturer Whirlpool.Further, monetary conditions are set to get tighter. The Federal Reserve meeting this week is not expected to raise interest rates but a third 1/4 per cent increase to 2.25 per cent is expected in September, and a fourth rise to 2.5 per cent is very much in play for the December meeting. As of the last Fed meeting, governors expected interest rates would rise three more times in 2019.
The Fed’s principal but not only lodestone disinflation as measured by the core personal consumption expenditure deflator (broader than just consumer price index), which is now running at its target level of around 2 per cent.
As things stand then, and given the perceived tightness of labour market conditions, and the state of demand in the economy, interest rates are still headed up, and with them, the US dollar. These developments will, of course, start to pull the economy back, but perhaps not for the time being.
Last but not least, Trump’s trade war itself can be expected to have a negative effect on the economy as higher tariffs raise costs for companies and individuals—surely offsetting more modest and often small positive consequences for say, steel companies and other supposed beneficiaries of protectionism.
Over-selling the benefits
The problem with the high growth achievement, boasted by the White House, is that the benefits of deregulation, tax cuts, higher capital spending write-offs for 5 years, and tougher trade policies have been over-sold.This is not to say that they have not helped to heat up an already warm economy. Yet, there isn't any evidence—at least yet—that these factors are showing up in significantly and durably more vigorous investment outside the oil and gas sector, which has enjoyed rising prices this year.
The adverse consequences for the economy from trade protectionism have to yet to come through. And monetary policy, as things stand, looks primed to become more restrictive for the foreseeable future.
For an economic expansion that is already 110 months old—pretty advanced when judged against the record 120 month expansion in the 1990s—these headwinds are likely to become increasingly stronger as we move into 2019.
