More of the same?
12 December 2017
Looking ahead to 2018, we have five major macro calls. The first is that the pace of GDP growth will remain well above potential (see Chart 2), dragging the unemployment rate below 4% and generating a positive output gap for the first time since 2007. The second is that private non-residential fixed business investment will be the fastest growing expenditure component of GDP, helping to keep labour productivity growth elevated compared with its sluggish post-crisis average. The third is that wage growth will respond only weakly to the elimination of spare capacity, allowing underlying inflation to edge up only gradually and corporate profit margins to stay high. The fourth is that the tax cut package will have little impact on the supply side of the economy, mostly pulling forward future growth into 2018 and 2019. The fifth is that the Federal Reserve (Fed) will lift its policy rate another three times and continue with its plan to ratchet up the speed of its balance sheet runoff, causing the Treasury yield curve to flatten further (see Chart 3).
Like any set of forecasts, our calls rest on a number of critical judgements and assumptions. One is that the scarring from the financial crisis has faded significantly and the economy and financial system are both largely free of systemic imbalances. That in turn implies that firms and consumers should be prepared to stretch their spending horizons, with less concern that demand or incomes will fall short of expectations. It also means that there is less to fear from the additional withdrawal of monetary policy support than was the case earlier in the recovery. Another is that the structural forces that have been constraining wage growth and firms’ pricing power will endure even as the labour market tightens further. That will support corporate earnings growth and allow the Fed to avoid the rapid policy tightening that would threaten the longevity of the expansion.
A third assumption is that the impact of tax cuts on growth will be modest and temporary rather than large and persistent. We have repeatedly argued that demand-side fiscal stimulus in an economy rapidly approaching full capacity is unwise. But as long as the economy responds only moderately to the changes, the offsetting monetary tightening should be limited as well. Conversely, if we are underestimating the long-term benefits of corporate tax changes the terminal real policy rates could increase significantly, causing a repricing of the entire Treasury curve. A more technical assumption is that the real effective exchange rate will broadly be unchanged over our forecast horizon. In most open economy macro models, the economy and asset prices adjust to fiscal easing in part through currency appreciation. But if the dollar were to increase too rapidly the resultant tightening in global liquidity conditions could upend the virtuous cycle that the global economy has benefited from over the past year. Finally, we are assuming that the Trump administration does not take any foreign or trade policy actions that severely disrupt domestic or global growth. Although we are confident in our forecasts, any or all of the judgements we have made could be wrong. In the first briefing after we return from our Christmas break, we will explore the consequences of a much more adverse scenario in which our errors are not offsetting but instead reinforce each other.