Economic Outlook: Stop Watching the Fed, Start Following the Consumer
While the world frets about oil and the Fed, all eyes should be on the consumer and demographics.
While our overall economic forecast for 2014 and 2015 GDP are little changed from our third-quarter update, some of the pieces have changed quite dramatically. Overall GDP growth is likely to remain in the 2.0%-2.5% range in 2015, as it has for the past three years. We stuck with our GDP forecast for the entire year and avoided the up-and-down adjustments that a lot of other forecasters have made. Most forecasters were a lot more bullish on 2014 and then overreacted to weather-related issues early in the year. Though some year-end data, especially from the United States, looks stronger going into 2015, a weak world economy is likely to act as a brake on overall U.S. results.
Due to a year-end dive in gasoline prices, our December-to-December inflation forecast will come in wide of the mark for 2014, with inflation likely to be 1% or less compared with our previous forecast of 1.8%-2.0%. We are, however, sticking to that forecast for 2015, as gasoline prices are likely to be considerably higher a year from now.
Our interest rate forecast of 3.5% for the 10-year Treasury Bond for 2014 was particularly embarrassing, as Fed tightening and a stronger U.S. economy were offset by actions of other central banks loosening monetary policy. Money, being the ultimate fungible commodity, found its way into the U.S. with a truly depressing effect on U.S. interest rates. We still think rates at some point will have a quick bounceback to 3.5% and then stabilize without much further change for a potentially long period of time. Fed tightening, combined with our inflation expectations and normal spreads over inflation, suggest this higher rate. The slower long-term growth rates around the world and low inflation suggest that rates are not going massively higher over the near and intermediate term.
Though not visible in our summary forecasts, housing was also a disappointment that was offset by stronger-than-expected consumption data and auto sales. Housing was hurt by higher prices, student loan levels, and continued tight lending conditions. We were more pessimistic than most housing forecasters for 2014, but even our conservative forecast proved to be too aggressive. Next year should prove a little better for housing with the labor market looking up and interest rates remaining relatively low, though slightly higher by year-end 2015. Though again, I am more cautious than most on the housing industry because of demographics, changing tastes, and affordability issues. We did manage to get our home price estimate just about right.
As we close out the year, investors seem obsessed with falling oil prices and actions of the Federal Reserve. I don't think that anyone should fixate on either of these issues. With energy supply and demand in relatively close balance, recent price declines aren't likely to last all that long. In the short run, prices can move a lot because of energy placed in storage. But as we burn through those excess supplies, cost of production and longer-term supply and demand issues come into focus. Therefore, while cheap prices sound good now, they aren't sustainable for long. Either producers will cut back or users will pick up the pace. And what is produced in a day isn't very far off what is used in a day. No one knows how long oil will stay cheap, but I wouldn't be changing a lot of forecasts assuming cheap oil forever. Likewise, I think most oil-producing countries have at least some staying power and I wouldn't expect cheap oil to wreck our whole financial system.
In terms of the Fed, you'd think everyone would have learned their lesson in 2014. In general, forecasters were nearly perfect in their predictions of Fed actions for 2014 (start tapering and end new bond purchases, talk more hawkishly about rate increases based on a stronger economy). The only problem was that even knowing that in advance, interest forecasts were exactly wrong. Instead of increasing more than a point, interest rates, at least on the 10-year bond, fell more than a point. Rates depend more on economic activity and central bank actions, not just in the United States, but also around the world. Given open markets, the Fed often doesn't control rates. During much of the past half century the Fed was always behind the curve, fighting the last battle and raising or lowering rates well after markets had already moved rates based on economic activity and supply and demand.
Given that the consumer represents about 70% of the U.S. GDP, economists' time is better spent analyzing what the consumer is doing versus navel-gazing about when the Fed will make its next move or worrying about which oil producer is going broke next. In this report, we take a closer look at what the consumer has been doing lately and what the outlook might be. The quick answer is that the hourly wage rate is likely to go up, but the demographics of an aging population will limit employment growth, keeping consumption below its long-term trend of 3.6% but above the 1.9% rate of the past 10 years. Another hint, long-term demographics are going to be more important than temporarily cheap oil prices, which have turned everyone into consumer bulls. Cheap oil prices come and go quickly; demographic realities, not so much.
Consumers Poking Their Heads Out After 10 Years of Hibernation
To the outside observer, it feels like the consumer is stuck in neutral, showing little real growth. That observer would appear to be right--examining 10-year blocks of data looking back as far as the 1950s. Inflation-adjusted consumption data shows that for the 10 years ended in October 2014, inflation-adjusted consumption is running at about half its usual rate, 1.9% instead of 3.6%. As consumption represents as much as 70% of GDP, slow growth in consumption has really hurt the economy. The good news is that consumption has begun to grow faster again over the past several years, though it is still operating below par. Consumption growth over the past three or four years is finally looking a little better, and the prognosis for more improvement is good.
Consumption Growth Slowed Because Income Growth Was Lethargic
Consumption is generally driven by income growth. Consumers generally spend what income they have and then some. In the 1984 to 1994 period and in the 1994 to 2004 period, consumers outspent their incomes. That was because consumers leveraged up their meager income gains with additional loans. That let consumption growth exceed inflation-adjusted, aftertax income growth. More borrowing and inflation masked the fact that the consumer was already beginning to struggle.
Total Wage Dollars Even Weaker Than Overall Income Data
However, looking at just incomes and not wages probably makes the situation look better than it is. Direct wages comprise about 50% of real disposable income, but it is the portion of income that is the most likely to get spent. Interest and dividend receipts, rent collection, and small-business profits are far less likely to be spent than wage income. Part of that is because some of the other categories of income are invested back into the market/business and are not spent. And part of the reason the cash from the nonwage categories isn't spend is that it accrues to high-earning households that may spend less than half of what they earn compared with the very poorest quintiles, who spend every dime that they make and then some. Looking at the wage growth data, the levering-up effect becomes a little more visible.
Both Hourly Wage Rates and Employment Growth Have Been Weak in the Latest Decade
We continually get questions about how can the economy grow if hourly wage rates aren't getting better. It's very interesting to see that growth in the hourly wage rate has never been very high. In fact, the average wage rate was almost non-existent for a stretch of time from 1974 to 1994. (Note the change in hours worked is relatively negligible.) However, at least part of the sluggish growth in hourly wage rates was offset by more people working. In the last decade, both wage growth and employment growth were subpar. Currently, the number of workers on the job has begun to improve but the average hourly wage hasn't really budged. Given the aging population and a shrinking working age population, I suspect that the hourly wage growth will tick up over the next several years, perhaps by a lot.
Population Growth Will Eventually Weigh on Employment Growth
Population growth is often very closely correlated with overall economic activity and employment growth. Without growth in the population, it is very hard to grow GDP and especially consumption. Immediately after World War II, population growth surged, boosting employment and consumption. However, as population growth slowed, so did a lot of other measures of economic activity.
Unfortunately, population growth continues to fall, which may limit the growth in employment levels. It will be very interesting to see if growth in hourly wages due to potential labor shortages can offset the weaker growth in employment stemming from slumping population growth. Of course, that won't be the best of news for businesses with a lot of labor content.
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