Economy watchers are getting nervous. By next summer, the current expansion will be the longest on record, which leads some to worry about it dying of old age (that doesn’t happen, by the way; Australia’s current expansion is in its 27th year). The housing sector is slowing, courtesy of higher interest rates, yet the Federal Reserve plans to keep raising. The economic corollary of the swamp monster — the inverted yield curve — has a lot of people freaked out. And let’s not forget the manic stock market.
All of which makes this a good time to try to dispassionately sort things out, macroeconomically speaking. One way to perhaps shine some light on the current situation is to consider the four horsemen of the gross domestic product: consumer spending (C), private investment (I), government spending (G) and net exports (NX, a.k.a. the trade balance). As readers of this column know, I do not fetishize GDP; to the contrary, I’ve long amplified its limitations, especially regarding environmental degradation. But in this simple context of positive vs. negative growth, it’s a useful organizing frame.
One way to characterize the 12 to 18 months (the “near term”) is C vs. I+G+NX. But before I go there, see the figure below on the relative shares of each of these components. C is the largest by far, and in fact, it makes up a much larger share of GDP here than in Europe (55 percent) or China (40 percent). It is also firmly supported by one of the strongest attributes of the current U.S. economy: the job market.
Let’s take each component in turn, evaluating its headwind vs. tailwind status. Then we’ll turn to risks to the outlook.
Consumer spending (68 percent of GDP): This is the big tailwind to the current economy. To be clear, wage growth took too long to get going in the expansion and has been subpar for many workers. But I expect continued job growth, a low unemployment rate and real wage gains to remain a strong plus for near-term growth. Low oil prices are in the mix here, as is historically high net worth relative to income and elevated savings rates (meaning consumers have room to spend out of savings and wealth).
Private investment (18 percent): It’s neutral now, but I’ve got it penciled in as a potential near-term headwind. It may turn out to be a mild one, but don’t let that minority share of 18 percent fool you. Many recessions, including deep ones, have been a function of collapsing investment, often after a bubble, with the late 2000s housing bubble as exhibit A. In fact, residential investment has been weak in recent quarters as the central bank’s rate-hike campaign has “fed” into higher mortgage rates. In this case, low oil prices flip from a positive to a negative, as they act to discourage investment in price-sensitive subsectors of the extraction industry (think fracking). Note also that private investment has yet to get the memo that the tax cuts that were supposed to be a such a boon to capital spending by businesses.
Government spending (17 percent): It’s a tailwind that’s about to turn into a headwind. See “fiscal fade” below.
Net exports (-3 percent): The trade deficit has long been a growth tailwind, as we’ve been running such imbalances since the mid-1970s. That’s not always a problem, however, as in strong economies when the other components are firing on all cylinders, the trade deficit simply means we’re consuming more than we’re producing, and, given strong capital flows at low interest rates, other countries are willing to lend us the money at favorable rates to do so. But President Trump’s trade war, the Fed’s rate increases and the recent slower growth of our trading partners have contributed to a stronger (read “less competitive”) dollar that’s pushing up the trade deficit.
That’s one big tailwind vs. three headwinds. To be clear, that doesn’t mean recession, but it does imply slower growth (which, for the record, is how I read the flattening yield curve). Let’s now take a closer look at a few risk factors affecting C, I, G and NX.
Cheap oil: As noted, it’s a plus for C (e.g., through higher real wages) and a negative for I. By putting downward pressure on prices, cheap oil could dampen price growth, perhaps allowing the Fed to pause its rate-hike campaign (true, the Fed tends to downweigh the effect of oil prices, as they’re clearly formed on global markets, but this dynamic could still boost the cause for the pause).
Fiscal fade: I’d tag this as the biggest single headwind to near-term growth. The deficit-financed tax cut and 2018 spending bill boosted G by enough to add close to one percentage point of GDP growth in 2018-19. But, barring new rounds of significant deficit spending (politically unlikely), the economy is widely expected to come off this sugar high by late next year. Economist Mark Zandi is projecting a GDP growth rate of about 1 percent in 2020, a big drop from this year’s likely 3 percent.
Fed hikes: Based on their theory that an unemployment rate this low must at some point trigger faster inflation, the Fed is steadily tapping the growth brakes with small, quarterly rate increases. The effect of higher rates is most evident in the housing and auto sectors (less I), and in the stronger dollar, which worsens NX.
Stock market: When equity values tank, C takes a hit through a negative wealth effect, estimated to be 2 cents for every dollar of lost wealth. So, paper losses of $1 trillion last week could shave $20 billion (0.1 percent of GDP) off consumer spending.
Anyway, you get the picture. Strong consumption fueled by the tightest labor market in decades vs. fading fiscal stimulus, cheaper oil (good for C; bad for I), the irony of Trump-induced larger trade deficits, volatile markets, all against a backdrop of slow but steady Fed tightening. My bottom line is C keeps the economy more than afloat for the near-term, but after that … well, stay tuned.