Sunday, 30 of April of 2017

Economics. Explained.  

The Tax Plan is a Good Thing – But Not Revenue Neutral

April 28, 2017

The long-awaited Trump tax plan is still sketchy on details but, on balance, it is a good thing.  It will stimulate investment spending which will, in turn, boost productivity growth. Faster productivity growth will lift the economic speed limit for the U.S. economy from 1.8% currently to perhaps 3.0% by the end of the decade.  Unfortunately, that is not the 3.5-4.0% growth rate that President Trump envisions. To the extent that actual growth falls short of that mark his package will not be “revenue neutral”, which means that the budget deficit and debt outstanding will increase.   The deficit is already on a path to hit $1.4 trillion annually by 2026.  Any further increase is undesirable.  However, stimulating GDP growth to a 3.0% pace will create jobs, raise wages, and increase the growth rate in our standard of living.  It seems to us that the positive impact of these proposed tax cuts on the economy far outweigh the negative impact on the deficit which, as described below, may be far smaller than the Congressional Budget Office estimates.

How fast can the economy grow?  The economy’s speed limit is the sum of two numbers:  the growth rate of the labor force plus the growth rate of productivity.  Back in the 1990’s the labor force climbed by 1.5%, productivity was growing by 2.0%, which means that the economy’s speed limit (or potential growth rate) was 3.5%.  Today, however, the labor force is climbing by 0.8%, productivity is growing by 1.0%, so the speed limit has dropped to 1.8%.  The slow labor force growth largely reflects the impact of retiring baby boomers which will continue for another decade.  To boost the speed limit policy makers must boost the growth rate of productivity.  That growth rate, in turn, is determined largely by the pace of investment spending.

That takes us to the Trump tax policy.  It is focused largely on the business community.  He proposes to cut the corporate tax from 35% to 15%.  The lower rate applies to businesses of all types – corporations, partnerships, and small businesses of all sizes.  He plans to impost a one-time tax on an estimated $2.6 trillion of corporate earnings that are currently parked overseas.  And he proposes to end taxation on offshore income by adopting what is known as a “territorial” tax system which means that U.S. companies will pay no U.S. tax on income earned overseas (rather than the 35% rate they would pay under the current system).

At the same time he plans to simplify the individual tax code from seven tax brackets currently to three – 10%, 20%, and 35%.  He would end the alternative minimum tax and eliminate the estate tax.  He would simultaneously eliminate all itemized deductions except for home mortgage interest and charitable giving.

Tax cuts of this magnitude will reduce tax revenues and boost the budget deficit.  That scares people who are legitimately concerned about budget/federal debt issues in the years ahead.  But what if the proposed tax cuts boost GDP growth from 1.8% today to something higher like 3.0%?   The additional income generated by faster GDP growth will enhance tax revenues and, at least partially, offset the impact of the tax cuts.

Trump has said he expects the tax cuts to boost GDP growth to 3.5-4.0%.  His tax plan documents do not specific his specific growth assumptions, but he has talked about numbers in that ballpark in the past.  That is a reach.  Go back to the potential growth rate equation.  Labor force growth is probably going to be stuck at about 0.8% for another decade as the boomers continue to retire.  For Trump to reach his goal he needs productivity to accelerate to 2.7-3.2%.  Therein lies the problem.  Looking back over the past 40 years there is only one period when productivity climbed at a 3.0% pace for any protracted period of time.  That was the late 1990’s and early 2000’s which reflected the introduction of the internet in the mid-1990’s followed by the cloud and apps in the early 2000’s.  That was an unprecedented period of development.  It is unreasonable to expect productivity growth of that magnitude as the result of tax cuts.  However, to believe that productivity growth could be 2.0-2.5% is not unrealistic.  That would boost potential GDP from 1.8% today to 2.8-3.3% (0.8% growth in the labor force plus 2.0-2.5% growth in productivity).  If he is successful in boosting potential GDP to roughly the 3.0% mark that makes his tax reforms and tax cuts a desirable package.

But 3.0% GDP growth is not 3.5-4.0%, and tax revenues would fall short of the White House’s projections. Given that the budget deficit is already projected to climb from about $500 billion currently to $1.4 trillion within a decade that is not a desirable outcome.  However, if GDP growth jumps to 3.0% and Trump anticipates growth or 3.5-4.0%, the shortfall should be relatively small.

If, in addition to his proposed tax cuts, Trump is willing to consider cuts in so-called entitlement expenditures such as Social Security, Medicare, and Medicaid he could achieve faster GDP growth and no long-term increase in the budget deficit.  Such a combo would be deemed as “revenue neutral”.  That would be the best of all possible worlds.

Republicans and Democrats agree that tax reform is long overdue.  Hopefully, they can agree on a “revenue neutral” package of tax cuts and reduced spending similar to what was just described.  The bipartisan Erskine-Bowles Commission agreed on such a package back in 2010.  If seven years ago a bipartisan group of Republicans and Democrats could reach an agreement on what needs to be done, they can do it again.

The issue of revenue-neutrality is more than just an academic issue.  To boost the deficit outside a 10-year window requires a two-thirds majority in the Senate, i.e., it would need support from some Democrats.  A simple majority can pass the bill, but it would expire at the end of 10 years.  A major tax overhaul should clearly be a permanent change not a temporary one.

Hopefully, some agreement can be reached to make these proposed changes revenue neutral and thereby permanent.  But if that is unattainable, temporary changes in the tax code that produce faster GDP growth, more jobs, higher wages and faster growth in our standard of living are a desirable alternative.

Stephen Slifer

NumberNomics

Charleston, S.C.


GDP Forecasts

April 28, 2017

First quarter GDP growth was softer than expected as growth came in at just 0.7% versus an expected increase of about 1.5.  However, this figure will get revised twice in coming months so this is not the final word.  A lot of the weakness came in inventories which rose by just $10.3 billion in the first quarter compared to $49.6 billion in the first quarter.  Thus, the inventory component subtracted 1.0% from GDP growth in the first quarter.

We continue to expect a pickup in growth in the quarters ahead.  Likely cuts in both individual and corporate income tax rates along with simplification of the tax codes, combined with repatriation of corporate earnings currently locked overseas and huge investments in spending on infrastructure  should help. Given that the economy is at full employment that faster pace of growth will probably boost both the CPI  and the core CPI to 2.4%.  Higher inflation will push long-term interest rates higher with the 10-year hitting 2.7% by the end of 2017 and mortgage rates climbing to 4.3%.

With GDP expanding at a pace at roughly its potential and inflation only slightly above its target, the Fed will not feel compelled to rush into any further tightening.  It needs to do so to get itself into position to lower rates when the time comes, but it appears to have the luxury of taking its time.  We expect two more rate hikes in 2017 which would put the funds rate at 1.25% by the end of this year.

Stephen Slifer

NumberNomics

Charleston, SC

 


Employment Cost Index

April 28, 2017

The employment cost index for civilian workers rose at a 3.1% annual rate in the first quarter after having risen 1.9%rate in fourth quarter.  Over the course of the past year it has risen 2.4%.  Thus, the labor market is slowly beginning to get tighter, and to attract the workers that they want employers are having to work employees longer hours, and offer higher wages and/or more attractive benefits packages.

With the unemployment rate at 4.5% and full employment also presumably at 5.0%, it is not surprising that we are beginning to see a hint of upward pressure on compensation.

Wages climbed at a 3.2% rate in the first quarter versus 1.9% pace in  fourth quarter.  Over the course of the past year wages have been rising  at a 2.4% pace.  Wage pressures are beginning to accelerate gradually.

Benefits climbed at a 2.7% pace in the first quarter versus 1.8%  in the fourth quarter.   As a result, the yearly increase in benefits is now 2.2%.

What happens to labor costs is important, but what we really want to know is how those labor costs compare to the gains in productivity.  If I pay you 5.0% more money but you are 5.0% more productive, I really don’t care.  In that case, unit labor costs were unchanged.

Currently, unit labor costs  have risen 2.0% in the past year as compensation rose 3.0% while productivity increased by 1.0%.   Such an increase in ULC’s is consistent with an inflation rate somewhat higher than the Fed’s desired target rate of 2.0%.    If that is the case, something is clearly different.  Productivity gains are no longer offsetting the increase in labor costs. The Fed should continue to raise interest rates.

Stephen Slifer

NumberNomics

Charleston, SC


GDP

April 28, 2017

The first estimate of first quarter GDP growth came in at 0.7% which was weaker than the 1.5% growth rate that had been expected.  That compares to a 2.1% pace in the fourth quarter.  This is the first look at first quarter growth.  This estimate will be revised twice more at the end of both May and June.

Final sales, which is GDP excluding the change in business inventories grew at a 1.6% pace in the first quarter compared to a 1.1% rate in the fourth quarter .   Over the past year final sales have risen 2.1%.  In the first quarter inventories as rose $10.3 billion compared to an increase of $49.6 billion in the fourth quarter.  Thus, inventories subtracted 1.0% from GDP growth in the first quarter.

Final sales to domestic purchasers excludes both the change in inventories and trade rose 1.5% in the first quarter versus an increase of 2.8% in the fourth quarter.  Over the past year this series has risen at a 2.2% pace.  The deficit for net exports narrowed by $2.3 billion which means that the trade component added 0.1% to GDP growth  in the first  quarter as exports rose 5.8% while imports climbed by 4.1%.

Consumption spending climbed by just 0.3% in the first quarter versus an increase of 3.5% in the fourth quarter.  Consumers took a breather in the first quarter but it is not expected to last.  We expect consumer spending to increase 2.2% pace in 2017.  Solid employment gains should boost  income.  The rising stock market will boost net worth.  Expected individual income tax cuts should further stimulate spending.  Everything related to the consumer seems quite solid despite the first quarter weakness.

Nonresidential investment jumped 9.4% in the first quarter after having climbed by 0.9% in the fourth quarter.  We expect nonresidential invest to  increase 4.5% in both 2017 and  2018 as business regains confidence in the wake of expected corporate tax cuts, relief from the currently onerous regulatory burden,  and some repatriation of earnings from overseas.

Residential investment jumped 13.7% in the first quarter after having climbed 9.6% in the fourth quarter.   While demand remains strong, builders are having an increasingly difficult time finding qualified workers which curtails growth in this category.   We expect residential investment to  increase 6.4% in 2017.

The foreign sector as measured by the deficit for real net exports narrowed by $2.3 billion in the first quarter after having widened by $82.8 billion in the fourth quarter.  Exports rose 5.8% while imports rose by 4.1%.  We expect the deficit for net exports to widen slightly this year and subtract 0.3% from GDP growth in 2017.

Federal government spending declined by 1.9% in the first quarter after having fallen 1.2% in the fourth quarter.  Government spending is expected to rise 0.7% in 2017 as President Trump increases defense spending while non-defense spending rises slightly.

We expect growth of  2.1% this year, and 2.7% in 2018 given expected individual and corporate tax cuts and some repatriation of earnings from overseas.

Stephen Slifer

NumberNomics

Charleston, SC


Final Sales

April 28, 2016

When the economy is slowing down, firms will accumulate unwanted inventories.   Those inventories still show up in GDP, but they are unsold.  Hence, GDP will be biased upwards.  Similarly, in good times businesses will reduce inventory levels to satisfy demand.  In this case, GDP growth will be understated.

To get a sense of the underlying pace of sales, economists will look at final sales which is GDP less the change  in business inventories.  In the first quarter final sales rose 1.6% after having risen 1.1% in the fourth quarter.  Given that GDP growth in the first quarter was 0.7%, the change in business inventories subtracted 0.9% from  GDP growth in the first quarter.

We believe that growth will expand at a moderate pace throughout 2017.  Consumers are confident.  The stock market is close to another record high level.  Job growth is increasing.  The unemployment rate continues to decline slowly. Oil prices remain low.  Inventories remain lean.  Corporations are making steady profits.  They have a ton of cash.  Interest rates are going to remain low for another year.  Plus, the economy should receive some stimulus from expected individual and corporate income taxes and from some repatriation of overseas earnings.

Given all of this the economy should expand at a moderate  pace of  2.1% in 2017 and 2.7% in 2018.

Stephen Slifer

NumberNomics

Charleston, SC


Final Sales to Domestic Purchasers

April 28, 2016

It is important to remember that final sales is a measure of how many domestically produced goods are sold each quarter.  But we also sell goods overseas — our exports.   And we purchase goods from other countries — our imports.

In the never-ending process of analyzing the GDP data, there is yet another series called “final sales to domestic purchasers” which measures how much U.S. residents are actually spending.  It starts with final sales, but then subtracts exports (which represents how much foreigners are buying from the U.S.) and adds imports (which represents how much U.S. residents are spending on imports).  The end result is a measure of sales to domestic purchasers.

Final sales to domestic purchasers rose 1.5% in the first quarter after having climbed 2.8% in the fourth quarter.  The deficit for real net exports narrowed by $2.3 billion in the first quarter as exports rose 5.8% while imports climbed by 4.1% .  The widening of the trade gap means that the trade component added  0.1% to GDP growth in the first quarter.  However, the gradual widening of the trade gap should subtract about 0.3% from GDP growth this year.

Going forward the positive factors are that the stock market remains close to another record high level.  The consumer is confident.  Consumers have record net worth.  Interest rates remain low.  The economy is creating a reasonable number  of new jobs.  The unemployment rate continues to decline slowly,  oil prices remain low, the housing sector is expanding nicely, and income is rising.  Furthermore, corporations are making steady profits, have a ton of cash, and corporate interest rates remain low.  Finally, the economy should receive some  stimulus from expected individual and corporate income tax cuts plus some repatriation of overseas earnings.

The economy should expand at a moderate 2.1% in 2017 and 2.7% in 2018.

Stephen Slifer

NumberNomics

Charleston, SC


Gross Domestic Purchases Deflator

April 28, 2017

There are many different deflators that are available.  This one is for gross domestic purchases which measures prices paid by U.S. residents.  It is the one measure of inflation that the Commerce Department talks about when it releases the GDP report.   It is our broadest measure of inflation and contains more than 5,000 goods and services.

The gross domestic purchases deflator rose 2.6% in the first quarter after having risen 2.0% in the fourth quarter. Over the past year this index has risen 2.0%.

Excluding the volatile food and energy components this index rose 2.3% in the first quarter after having risen 1.6% in the fourth quarter.

Remember that these deflators are weighted measures of inflation.  That means that when a builder switches from using copper pipe to PVC to save money, it registers as a price decline in these particular inflation measures.  Or when a consumer switches from buying butter to less expensive margarine the result is the same.  Thus, the deflator represents a combination of price changes and changes in consumer and business behavior.

The CPI, however, is a fixed basket of goods and services.  So what it shows are price changes only which, to us, is what inflation is all about.   In 2017 we look for the overall CPI to increase 2.4% while the core rate also rises by 2.4%.  Oil prices should increase slightly, rents will continue to climb, medical costs will surge, and with the economy at full employment wages will begin to climb and lead to higher prices.

Stephen Slifer

NumberNomics

Charleston, SC


Pending Home Sales

April 27, 2017

Pending home sales retreated by 0.8% in March after having jumped 5.5% in February.  This series tends to be rather volatile on a  month-to-month basis.

Lawrence Yun, NAR chief economist said, “Sparse inventory levels caused a pullback in pending sales in March, but activity was still strong enough to be the third best in the past year. Home shoppers are coming out in droves this spring and competing with each other for the meager amount of listings in the affordable price range.  In most areas, the lower the price of a home for sale, the more competition there is for it. That’s the reason why first-time buyers have yet to make up a larger share of the market this year, despite there being more sales overall.”

Housing remains quite affordable for middle income buyers.  After peaking at 213.6 in January 2013 the housing affordability index has declined slowly and now stands at 160.6.  What that means is that potential buyers had 60.6% more income than was necessary to buy a median priced home (compared to 14% in 2007).   The  housing affordability index has declined slightly in response to the recent run-up in the 30-year mortgage rate to 4.1% following the election.  However, it has not fallen more sharply because consumer income continues to climb.  Looking forward the extreme shortage of available homes for sale has caused home prices to rise more quickly — and climb more rapidly than the increase in income.  This development seems to have occurred only in the past three months but what it suggests is that this series needs to be monitored closely in the months ahead.

This  series on pending home sales is collected by the National Association of Realtors and represents contracts signed, but not yet closed, on existing home sales.  Thus, it is both a leading indicator of existing home sales and housing market activity in general.   Not all these contracts go to completion.  The buyer may not qualify for a mortgage, the house may not appraise at a sufficiently high value, or the house may fail the buyer’s inspection.  But the series is clearly indicative of changes in housing market activity.

Stephen Slifer

NumberNomics

Charleston, SC


Durable Goods Orders

April 27, 2017

Durable goods orders rose 0.7% in March after having risen 2.3% in February and 2.4% in January.   As always this is a very volatile series.  Over the course of the past year durables have risen 4.5% which is the largest year-over-year increase since mid-2014..

In most  months transportation orders are the biggest category contributing to that month’s change  — both to the upside and downside.  That was certainly the case in recent months.  Transportation orders rose 7.0% in January, 5.5% in February, and 2.4% in March. This means that non-transportation orders rose 0.3% in January, 0.7% in February but fell 0.2% in March.  Over the past year non-transportation orders have risen 4.2% and they seem to be quickening.  In the past six months they have been climbing at a 7.9% pace, and in the past three months at a 6.6% rate.

Economists are also interested in capital goods orders so we can get some sort of a handle on the investment spending portion of GDP.  But even capital goods orders can get blown around from one month to the next if there is a huge defense order or if there is a big airline order.  Orders will rise very sharply one month, only to decline almost as sharply in the subsequent month.  Thus, the focus is typically on non-defense capital goods orders ex air.  These orders rose 0.2% in March, 0.1% in February and 0.1% in January.  Over the course of the past year such orders have risen 3.0% which is the biggest yearly increase since mid-2014.  At long last they certainly seem to be on the rise.

The backlog of orders rose 0.2% in March and 0.1% in February.  If orders begin to climb consistently the backlog will climb as well which will eventually boost production.   We are not looking for a lot of strength from the manufacturing sector this year, but we do expect it to continue its gradual uptrend.

We think the worst is over for the manufacturing sector.   Home prices are rising.  Consumer net worth is at a record high level.  Corporations are making near record profits.  They have a ton of cash to invest.  Interest rates are near historic lows.  And the rate of capacity utilization in the manufacturing sector suggests a need fairly soon to either re-furbish the assembly line and/or invest in new technology.  And with both corporate and consumer tax cuts now in the works the factory sector should get a boost in 2017.  The  underpinnings of the economy remain firm.

We expect investment spending to climb  3.1% in 2017 and 4.8% in 2018.

Stephen Slifer

NumberNomics

Charleston, SC


Initial Unemployment Claims

April 27, 2017

Initial unemployment claims rose 14 thousand in the week ending April 22 to 257 thousand.  Because these weekly data can be volatile the focus should be on the 4-week moving average of claims (shown above), which is a less volatile measure.  It fell 1 thousand to 242 thousand.  The late February average of 234 thousand was the lowest level for this series since April 14, 1973 — 44 years ago!

Ordinarily, with initial unemployment claims (the red line on the chart below, using the inverted scale on the right) at 242 thousand  we would expect monthly  payroll employment gains to exceed 300 thousand.  However, employers today are having difficulty finding qualified workers.  As a result, job gains are significantly smaller than this long-term relationship suggests and are currently about 170 thousand.

Initial Unemployment Claims vs. Employment

With the economy essentially at full employment, employers will have steadily increasing difficulty getting the number of workers that they need.  As a result, they will be forced to offer some of their part time workers full time positions.  This series is still high relative to where it was going into the recession.

They will also have to think about hiring  some of our youth (ages 16-24 years) .  But the youth unemployment rate today is lower than where it was going into the recession so there may not be too many younger workers available for hire.

Finally, employers may also consider some workers who have been unemployed for an extended period of time.  But these workers do not seem to have the skills necessary for today’s work place.  Employers may have to offer some on-the-job training programs for  those whose skills may have gotten a bit rusty.

The number of people receiving unemployment benefits rose 10 thousand in the week ending April 15 to 1988 thousand.  The four week moving average fell 16 thousand to 2,007 thousand. This is the lowest level for this series since June 10, 2000.  The only way the unemployment rate can decline is if actual GDP growth exceeds potential.  Right now the economy is climbing by about 2.0%; potential growth is  projected to be about 1.8%.  Thus, going forward  the unemployment rate will decline quite slowly.

Stephen Slifer

NumberNomics

Charleston, SC