We'll Be Laughing All the Way to the Bank, Right? - OZY | A Modern Media Company

We'll Be Laughing All the Way to the Bank, Right?

We'll Be Laughing All the Way to the Bank, Right?

By Gregory Daco



Because not everyone is buying rosy economic predictions.

By Gregory Daco

Gregory Daco is chief U.S. economist at Oxford Economics.

With U.S. tax code changes pending, 2018 is supposed to ring in a year of renewed economic development, or so we’re told. So will the economy hit 3 percent growth in 2018? Maybe, but a 4 or 5 percent advance is out of reach. Here’s why …

Business investment and exports will be stronger engines of growth, but consumer spending trends are increasingly reflecting a maturing economy. Meanwhile, elevated stock market valuations pose a significant risk.

So, politically speaking, Trump will deliver on his fiscal stimulus promises, but his administration will also fall short on promises for growth. As a result, we may see a more pronounced lean toward protectionist policies throughout 2018, which would hurt trade and economic activity in the long run. On the Federal Reserve front, a more hawkish Federal Open Market Committee will deliver three rate hikes, despite core inflation remaining below the 2 percent objective, and further tightening could create an adverse surprise for markets.

The economy will continue to rotate away from consumer spending as the sole engine of growth, with business investment and exports becoming greater drivers. Strong global demand, along with increased policy and demand certainty, will allow business investment and exports, which jointly represent about a third of the economy, to contribute over 1 percentage point to real GDP growth for the first time in four years. Household outlays, which represent about 70 percent of the economy, should add close to 2 percentage points so that it won’t take much to reach the symbolic 3 percent growth mark.


Yet there is an important downside risk from the recent “savings dip.” Since early 2016, real consumer outlays have continually outpaced real income gains, leading to a significant decline in the personal savings rate — reaching a decade low of only 3 percent in September. The 3 percentage point drop from 6 percent at the start of 2016 can be explained by a combination of factors including still-modest wage growth, moderating credit growth and rising stock prices. And, while it is nearly impossible to distinguish the dominating factor, it appears that the massive 35 percent gain in stock prices since the start of 2016 has been an important driver leading to a $10 trillion increase in household net worth.

Why worry? Well, if income growth remains sluggish and total spending is increasingly supported by high-income earners and elevated stock market valuations, then a stock market correction could lead to a significant negative effect on consumer outlays, business activity and, in turn, the overall economy. Indeed, a negative wealth effect would mean reduced spending by high-income households, while a negative confidence effect would limit spending across all middle- and low-income families.

On the policy front, the administration has managed to deliver on its pro-growth initiatives, with passage of a $1.5 trillion fiscal stimulus package. Lower individual income tax rates across the seven tax brackets, a doubling of standard deductions and an increase in the child tax credit should lift disposable income growth in 2018 and support firmer consumer outlays. But note that tax reductions will be quite regressive, with about 50 percent of the household tax cuts going to the top 5 percent of income earners and 20 percent going to the top 1 percent of income earners in the first year. Since only a third of the tax cuts would go to the bottom four quintiles of income earners, the average fiscal multiplier on income tax cuts would be only 0.30 — in other words, for every tax cut dollar, the boost to the economy will be just 30 cents.

On the corporate side, the tax package assumes a reduction in the statutory tax rate from 35 to 21 percent, a repeal of the corporate alternative minimum tax and a five-year increase in expensing allowances for capital equipment (i.e., 100 percent bonus depreciation). These measures should lift business investment growth to its fastest pace in over four years, up to the 6 to 8 percent range.

A lot is changing at the Federal Reserve. Chair Janet Yellen will be replaced by Jerome Powell. Randal Quarles (nominated by Trump) and Lael Brainard (an Obama nominee) could be joined by Marvin Goodfriend, who was recently nominated by Trump, but this would still leave three empty seats on the Board of Governors. Further, the changing of the guard among voting regional Fed presidents will tilt the FOMC toward a moderately more hawkish stance with two hawks, two moderates and one dove in 2018.

With the economy currently close to potential and limited supply-side benefits to the tax cut package, expansionary fiscal policy will lead to modest inflationary pressures. Given the Fed has effectively lowered the inflation bar for future rate hikes, even a modest rise in inflation from 2017 is likely to lead to further rate hikes. And, since the Fed managed to raise rates three times in 2017 without any major market disruption, it is very likely that we will see at least another three rate increases in 2018. With markets only pricing in two rate hikes next year, however, three or more hikes could potentially prove disruptive for stock prices — another risk for the U.S. economy.

In short, while the $1.5 trillion Tax Cuts and Jobs Act will push the U.S. economy toward 3 percent growth in 2018, we should not discount the risks emanating from a potential stock price correction, a more hawkish Fed or more protectionist trade policies.

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