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Copyright BieResearch.com 2017 1
United States
Tax cuts lift short-term growth outlook
20 December, 2017
Ulrik Harald Bie, Independent Economist, [email protected]
www.bieresearch.com
• 2018 outlook raised further by 0.3 percentage points to 3.0%
• The adjustment is mainly a reflection of increased consumption growth
• Net export contribution turning negative and trade deficit to increase further
• Increased labor participation should keep unemployment around 4%
• No major effect on wages and inflation, but Federal Reserve to hike rates four times in 2018
Adding fuel to the fire
As Republicans push their proposal for tax reform
across the finish line, the US economy is growing
strongly, fueling fears of overheating. The November
job report showed another 228,000 new jobs, with
2.1 million jobs created during the last year. My as-
sessment is that the US labor market has more slack
than indicated by the unemployment rate of 4.1%, but
also that wage dynamics have changed compared to
the pre-crisis period leading to lower wage growth.
This is also why I am less concerned than most US-
based analysts about higher inflation.
The final tax cuts of USD1,500 billion over ten years
are somewhat larger than I envisioned in October,
and I have added 0.3 percentage points (pp) to the
2018 GDP-growth outlook. It now stands at 3.0%.
That adds USD56 billion to actual (real) GDP; not a
whole lot, but my October forecast was already signif-
icantly above consensus. Federal Reserve/FOMC’s
2018 forecast from September was 2.1%. Using that
growth rate as a benchmark, my new forecast entails
USD164 billion in additional activity in 2018. I expect
growth to lose a little steam in 2019 settling at 2.5%,
primarily due to slower consumption growth. FOMC
expects 2.1% GDP-growth in 2019.
No major effect on corporate investments
The tax cuts are due to take effect in 1Q/2018. Larger
US corporations have enjoyed a period of strong
profit growth and are able to finance the investment
plans they want to undertake. I included a significant
bump to the investment outlook in my October up-
date, partly reflecting anticipated tax cuts and dereg-
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
2013 2014 2015 2016 2017 2018 2019
Current forecast
Change y/y (%)
US GDP growth outlook
October forecast
Source: Macrobond, BieResearch.com
Copyright BieResearch.com 2017 2
ulation, but also the increased underlying wage pres-
sure, which should lead to more purchases of ma-
chinery and technology to improve productivity.
Hence, for larger corporations the tax cuts should
flow almost exclusively to shareholders through in-
creased dividends and/or share buybacks. The stock
market is clearly expecting a quick, tangible return –
not an uncertain future payoff from increased pro-
duction capacity. Smaller businesses could allocate a
larger share to investments, and hiring intentions
have increased. Overall, I do not expect a major addi-
tional effect on business investments (up 7% in 2018
and 5% in 2019) from the final tax legislation com-
pared to my initial assessment.
Labor productivity should increase by 1.5% for the
2015-2019 period. Employment growth peaked at
2.3% in 2015, but has decreased in 2017 to an esti-
mated 1.4% and I expect a further decline to 1% next
year – or a monthly average of 125.000. It is unusual
that employment growth weakens at this stage of the
cycle; normally it is full speed until a recession hits.
However, this is in many ways an unusual recovery.
More tailwind to consumers
The individual tax cuts, a much stronger perception
of the economy and increased dividend payments
(showing up in the savings rate currently at 3.2%) are
likely to lift consumption more than I expected in Oc-
tober. As the cuts are not permanent (expires in
2026), and the tax reform massively increases public
debt, a Richardian-equivalence approach would see
the increased after-tax income move to higher sav-
ings. I doubt US households have this foresight, and
I have increased my forecast for private consumption
growth in 2018 by 0.4 percentage points to 2.8% -
and expect further 2.4% growth in 2019. While
households are increasingly willing to finance con-
sumption through higher debt, I still expect slower
real income growth to become visible.
As the tax reform does nothing to discourage the im-
portation of goods, the higher domestic growth trans-
lates into an even larger trade deficit – and negative
contributions from net exports. This also increases
the risk of adverse trade measures from President
Trump. However, some analysts expect the lower cor-
porate tax rate to reduce the use of transfer pricing
within multinationals, which could deliver a signifi-
cant technical one-off boost to exports and lower the
trade deficit. This would also benefit productivity
growth by lifting overall GDP, while employment stay
the same as actual activity is not affected.
Copyright BieResearch.com 2017 3
Higher potential growth
The level of potential growth is mainly an academic
issue, but has important policy implications. Higher
potential growth improves the (theoretical) ability to
absorb a period of high growth without generating in-
flation. That allows the Federal Reserve to be more
patient – and improves the CBO budget outlook.
The US economy is currently growing at around 3%.
The Congressional Budget Office (CBO) estimate po-
tential growth to be 1.88% in the longer run and the
Federal Reserve’s FOMC kept its projection at 1.8% at
the December meeting - completely dismissing dy-
namic effects from tax cuts and deregulation.
However, I think the current potential-growth esti-
mates will be revised up during 2018. Estimates of
potential growth are basically sophisticated moving
averages of growth in previous years. Hence, after a
period of subdued actual growth, potential growth
declines – without any assessment of why growth was
lower or whether structural changes have moved the
economy towards a more (or less) efficient state.
A 6-year moving average (6Y MA) captures the move-
ment in CBO’s forecast of potential growth well. Us-
ing my own growth forecast, the 6Y MA reaches 2.5%
in 2019. I think that is above the long-term potential,
but in my view the potential for growth in the US has
not declined compared to the pre-recession period
and remains 2.0-2.25%. I expect CBO budget reports
in 2018 to reflect this. President Trump will take full
credit for the better long-term outlook, although it is
mostly a reflection of past performance.
Labor market is key
While I expect productivity to increase substantially
in the coming years, the available supply of labor re-
mains a key issue. The actual level of slack in the labor
market confounds economists; even the Federal Re-
serve is in the dark – as stated repeatedly by Chair
Yellen this autumn.
The unemployment rate points to a very tight labor
market, however the relationship between unemploy-
ment and wage growth has changed substantially
since the recession. A regression using data from
1997-2007 generates an estimated wage growth of
4.1% with a 4%-unemployment rate, while the same
model generates 2.5% wage growth using data from
2012. The two models have comparable explanatory
power. Using a wider definition of unemployment
(U6) does not materially alter the result.
That also implies that a significant decline in the un-
employment rate to 3.5% only generates an estimated
Copyright BieResearch.com 2017 4
wage growth of 2.6% - well within my expectation of
2.5-3.0% wage growth in 2018, and in line with the
expectations priced into the equity market of no ad-
ditional allocation of revenue to labor. The diver-
gence in the wage growth for skilled and unskilled la-
bor is likely to increase as technology substitution are
more of a threat to low-skilled labor.
Looking at the GDP/unemployment relationship
since 1970 (including six recessions and recoveries),
GDP-growth of 3.0% should generate a quarterly de-
cline in the unemployment rate of 0.1 percentage
points. During the current recovery, the implied de-
cline has been even larger, but as productivity invest-
ments do their trick, I expect the relationship to move
closer to the historic average. Using my growth fore-
cast, unemployment should be bottoming out at 3.9%
by mid-2018 (with a model-wage growth of 2.6%).
While population growth is held back by a low
birthrate and a large decline in illegal migration, the
participation rate points to additional available labor
within the active age groups. The participation rate
(63%) remains lower than the one in 2010 (65%) for
all but the oldest cohorts. However, since 2015 par-
ticipation has increased a lot more for men than for
women in the age group 40-59 years – and the picture
is even more pronounced compared to 2010. Hence,
an additional increase in female participation should
be possible and is included in my assessment of the
labor market. Moreover, the 17.5 million part-time
employed women could also increase workhours add-
ing to the labor supply.
Inflation caught in the middle
In October I expected CPI inflation to average 2.1%
this year and 2.0% in 2018. Since then, headline in-
flation has picked up as oil prices have increased
more than expected, while core CPI has remained at
1.7%, and core PCE inflation stands at 1.5%. The ad-
ditional demand created by the tax reform removes
some of the downside risks to inflation, but since I do
not expect a major passthrough to wages, my infla-
tion forecast is unchanged.
For CPI, smaller increases in rents and owners’
equivalent rent exert a downward pressure on overall
inflation due to the weight in the index (33%), while
subdued health inflation (currently 1.2%) should
keep PCE core inflation from moving up substan-
tially. If anything, the lower corporate tax rates allow
for some additional price war in the retail space. I also
expect oil prices to decline in 2018 as US production
increases.
Copyright BieResearch.com 2017 5
Four hikes from the Federal Reserve
The December forecasts from the FOMC can best be
described as “wait and see”. With a tax reform in the
pipeline and Chair Yellen’s last press conference to
consider, substantial changes to the outlook could
have caused unnecessary attention. However, the
higher growth/lower unemployment forecast should
lead to an adjustment of the dot-plot for 2018. Alt-
hough I do not expect an outbreak of inflation, I do
expect Federal Reserve to err on the side of caution
and speed up the interest rate cycle with four hikes in
2018. However, as the business cycle loses steam in
2019, the pace slows to two further hikes. This could
well be the end-point for this hike cycle.
Less recession risk, more financial
Governor Kashkari from Minneapolis Fed – the lead-
ing dove on the FOMC – has argued that the flatten-
ing of the US yield curve indicates increasing risk of a
recession. While a missed opportunity for genuine re-
form of the tax code, I think the tax cuts lowers the
risk of recession before 2020; there is just too much
cash flowing around for the party to stop. I see the
flatter US yield curve as an indirect consequence of
ECB’s and Bank of Japan’s QE-programs and an
above-normal demand for longer, safe bonds.
While US 2Y yields are responding to Fed normaliza-
tion, 10Y yields are affected by arbitrage; the spread
to German 10Y yields cannot exceed the exchange
rate-corrected alternative return. Since German
yields are suppressed by ECB’s QE, US 10Y yields are
too. When German yields begin to rise in 2018, so
should US yields. Normally the relationship is the
other way around, but with interventionist central
banks, normal does not apply.
However, the tax cuts (and too lenient monetary pol-
icy in Europe and Japan) increase the risk of a major
financial correction. With record-breaking prices on
risky assets, the market is priced for a perfection that
could be frustrated. Talks of a US infrastructure pack-
age is the latest market boaster, although I do not ex-
pect much to happen. Convincing Republicans to cut
taxes is one thing. Convincing them to increase public
spending something completely different. Whether
the economy can outrun financial turbulence is un-
certain.