Source: Euromonitor International Macro Model
General Outlook: strong private sector demand growth, constrained by low productivity growth
The US economy has improved in the last two quarters, with year-on-year GDP growth of 2.3% in Q3. As a result, we have slightly increased the annual growth forecasts to 2.2% in 2017 and 2.3% in 2018%. Business investment has accelerated, with growth likely to exceed 4% in 2017, and consumption is growing at a significantly above-trend 2.7% annual rate. This is supported by strong private sector confidence and an ongoing stock market rally. On a more negative note, labour productivity and worker compensation growth remain weak and are likely to remain so over a 5-year horizon. This limits the ability of the economy and consumption to grow faster than 2% annually after 2018.
Tax Cuts and Fiscal Stimulus: reconciling two bills and conflicting goals complicate the picture
The Republicans in the House of Representatives and the Senate passed their tax cuts bills by early December. However, they still have to reconcile the two versions of the bill before it becomes law. Our current estimate is the mainly corporate tax cuts in the bill will provide marginal fiscal stimulus, raising GDP growth by 0.1-0.3 percentage points in 2018.
Both bills provide modest income tax cuts for most households. But the centrepiece of the legislation remains a corporate tax cut from 35% to 20%, coupled with a reduction of the top-tax rate on non-corporate business from 39.6% to 25-32%. In order to pass a bill without support from Democrats, the TCJA cannot raise government debt by more than 1.5 trillion USD over the next 10 years, and it cannot increase budget deficits after 10 years. Satisfying these requirements has forced Republicans to offset their tax cuts with the elimination of various tax deductions (mainly the deduction for state and local income taxes, and some of the mortgage payments exemption).
The House has already passed its bill, but this version cannot be passed in the Senate, which has stricter rules on long-term budget deficits. Relative to the House bill, the Senate bill would cut annual healthcare spending by around 30 billion USD, delay the corporate tax cut to 2019 and let all non-corporate and individual income tax cuts expire after 10 years. There are several Republican factions opposed to key elements of the current bill. Some Senators are opposed to large increases in deficits, while others are opposed to the phasing out of certain tax cuts after 10 years. Moderates are against cuts to healthcare spending. With Republicans holding a thin four Senators majority, passage of the bill in the Senate is still highly uncertain.
Analysing the economic impact of these tax cuts is complicated by the political uncertainty about the final form of the legislation. However we can make some preliminary estimates, with the House version of the bill providing an upper bound on the impact. The house bill reduces annual business and individual income taxes by 130 billion USD in 2018-2027, representing almost 0.7% of US GDP in 2017. Using a baseline tax multiplier of 0.5, this implies an increase in GDP in 2018 of around 0.3% in 2018 due to higher investment and consumer spending. However, passing a bill through the Senate is likely to require significantly smaller tax cuts, or more offsetting spending cuts. The current Senate bill would also delay most of the impact on output into 2019, when the corporate tax cuts would enter into effect. As a result, our baseline forecast assumes marginal fiscal stimulus effects in 2018-2019, raising annual GDP growth by around 0.1 percentage points.
Estimates of the long-term impact of the tax cuts range from 0.3% to 4% higher GDP by 2027. The main factors affecting these estimates are the size of the decline in the tax rate on new investment (which differs from the headline business tax rates due to various exemptions), and the sensitivity of international capital inflows to lower business taxes. The lower range of GDP impacts is based on an estimated 5-8 percentage points decline in the tax rate on new investment, and limited international capital mobility (TPC, 2017, PWBM, 2017). The higher range of GDP impacts reflects a 16 percentage points decline in the tax rate on new investment, combined with large capital inflows into the US in response to lower business taxes (Benzell et al, 2017).
A stock market correction and a reversal of the current private sector optimism are the key risks to the US outlook. In our most likely downside scenario, a 10-20% decline in stock market prices in combination with falling business and consumer confidence lead to a slowdown. Annual GDP growth is 1.3% in 2018-2019. We assign this scenario a 15-20% probability in 2018.
On the upside, significantly bigger than expected tax cuts and a larger than expected responsiveness of investment and consumer spending to taxes could raise GDP growth to 2.9% in 2018 and 2.8% in 2019. We assign this scenario a 10-20% probability in 2018.
Further strengthening of advisors supporting more conventional Republican policies in the White House and greater evidence of the willingness of Republicans in Congress to oppose more extreme elements of President Trump’s campaign promises have lowered the risks of a general trade war with Asian countries or Mexico. We have lowered the 2-year probability of our Trade War scenario to 10-20%.
However more limited trade restrictions on specific industries such as steel or aluminium are much more likely. The risks of a breakdown in renegotiation of the North American Free Trade Agreement (NAFTA) are also growing. US negotiators have adopted a hard-line bargaining stance, including a sunset clause that would see the NAFTA expire in five years, without an explicit renewal agreement. Canada and Mexico have objected to this clause and other demands such as greater US content in imported cars. Ending NAFTA and reverting to WTO trade rules with Canada and Mexico could reduce US GDP by 0.1-1% over several years. The impact on specific sectors such as the automotive industry would be much larger.
Private Sector Confidence and the Stock Market: sentiment remains high and the stock market rally continues
Small business confidence has remained stable at quite high levels since the end of 2016, suggesting continuing expectations of lower business taxes and lighter regulation from a Republican administration. Consumer confidence increased in October to the highest level since 2004, despite low income growth. Confidence is supported by a rising employment rate, as well as expectations of accelerating wage growth. However, the high average confidence index hides a large gap between Democrat and Republican voters, with the former tending to be much more pessimistic. This dispersion lowers the impact of consumer confidence on overall spending.
The US stock market rally has continued since the summer, despite political tensions related to North Korea’s nuclear programme and repeated warnings by some analysts about excessive valuations. The stock market is likely only moderately overvalued after taking into account the long-term downward shift in interest rates. However, a moderate 10-20% correction is a significant risk. On its own, it would likely not reduce US GDP growth in 2018 by more than 0.3-0.6 percentage points. However, it could contribute to a more general decline in consumer and business confidence, leading to a more substantial slowdown or downturn in the US economy.
Aggregate Demand: business investment rebound continues, consumption growth remains above average
The US economy in the last two quarters has been sustained by accelerating business investment and robust consumer spending growth. Net exports have also increased on the back of a depreciating US Dollar and improving global demand conditions. In contrast, government spending growth has been slightly negative.
Consumption has been growing moderately faster than overall output at 2.7% year-on-year despite low wage growth, supported by ongoing improvements in labour markets and high consumer confidence. Overall growth for 2017 is expected to reach 2.5%, followed by 2.3% in 2018. However, much of this faster growth is due to durable goods that are more interest rate sensitive or for which rapid technological improvement is leading to lower prices. Consumption of nondurables and services has been growing at a rate that’s closer to overall output growth, slightly above 2% annually.
Business investment has picked up with year-on-year growth of 4.3%, reflecting more optimistic earnings expectations, low financing costs and large unused cash reserves of US corporations. The recovery has been especially strong in oil and gas sector structures and more generally in equipment spending. Business investment is expected to grow by 4.3% in 2017, followed by 3.9% growth in 2018.
Labour Markets and Income Growth: labour markets close to full employment, but wage growth remains disappointing
Private sector employment growth has continued at an annual pace of around 2%. The unemployment rate has moved around 4.1-4.4% in recent months and is expected to average 4.3% in 2018, suggesting full employment. The employment rate of 25-54 year olds (one of the best measures of the health of the labour market accounting for discouraged workers) has recovered around 80% of the decline during the great recession, reaching 78.8% in October. However disposable income growth has slipped, due to low wage growth. Overall worker compensation (including benefits) has actually declined over the past year after accounting for inflation, falling below the already low labour productivity growth. Real (inflation-adjusted) worker compensation per hour is barely 3% above its level in 2007.
Interest Rates and Inflation: inflation has increased, interest rates are set to rise but will remain low
Consumer price inflation (CPI) has increased since June, reaching 2% year-on-year in October. However, other measures such as inflation excluding food and energy or the personal consumption deflator inflation (the Fed’s preferred inflation measure) are still below target, at 1.6-1.8%. With limited expectations of fiscal stimulus, we forecast annual inflation to remain around 2% over 2017-2019.
The Fed appears to have discounted the weakness in some of the inflation data, emphasizing improving labour markets and GDP growth data in its decisions. It has kept interest rates unchanged in recent meetings, and has maintained approximately the same projection for the pace of monetary policy normalisation. It has also started reducing its financial asset holding accumulated under previous quantitative easing programmes. Another interest rate increase is expected in December. Short-term interest rates are forecast to reach 1.7-2.1% towards the end of 2018, and 2.4-2.6% by the end of 2019.
Despite rising interest rates, real (inflation adjusted) interest rates have actually declined since 2015 due to rising inflation, close to their level in 2013-2014. Real interest rates are expected to remain negative in 2018, gradually rising to a still historically low long-term rate of 1%.
In our latest report extract, we provide you with an update on our latest macroeconomic forecasts for key economies and what these mean for our predictions for the global economy. Download Global Economic Forecasts: Q4 2017 to stay ahead of risks and opportunities as they emerge on a macroeconomic basis.