In their last economics report of the year Goldman Sachs' Jan Hatzius and his team discuss what they believe are the most important questions for 2018.
- US growth has accelerated substantially since early 2016, largely because of a much more positive impulse from financial conditions. Although the acceleration is likely behind us, growth should remain well above trend in 2018. Current momentum is strong, financial conditions have eased further in recent months, and fiscal policy should provide support via tax cuts and hurricane-related spending.
- The labor market is moving beyond full employment, and we expect the unemployment rate to fall to 3½% by the end of 2018. If so, both wage growth and price inflation are likely to move higher, although we do not expect the core PCE to reach the 2% target until 2019.
- We expect the Federal Reserve to raise rates four times in 2018, continuing the steady once-per-quarter tightening campaign of the past year. If this happens in an environment of above-trend growth and gradually rising core inflation, the market’s estimate of the terminal rate is likely to climb. We do not expect the yield curve to invert.
- The easing in financial conditions is unlikely to continue in 2019. With the economy moving past full employment, easier fiscal policy, and some concerns about financial imbalances, Fed officials will likely aim for somewhat tighter conditions. And ultimately, they are likely to succeed in this quest.
10 Questions for 2018...
1. Will growth remain above the 2.2% average of the recovery so far?
Yes. We expect real GDP growth to average 2.6% through 2018, slightly faster than in 2017. There are three main reasons to expect continued healthy growth: 1) strong current momentum, 2) an ongoing positive impulse from financial conditions, and 3) a moderate boost from fiscal policy.
Exhibit 1 illustrates the economy’s current momentum. Although real GDP growth is tracking a bit softer in Q4 than in the prior six months, there are few signs of significantly slower growth in the broader data. In fact, our current activity indicator (CAI) has been running at rates around 4%. Our 2018 forecast builds in some degree of convergence between the disparate signals from the GDP and CAI data.
Exhibit 2 shows the primary reason for the acceleration over the past two years, namely the sharp swing in the FCI impulse from a drag of 1pp in late 2015 to a boost of almost 1pp now. Going forward, we expect the contribution from financial conditions to diminish—partly because the FOMC will want it to diminish, as discussed below—but it should stay meaningfully positive at least for the next few quarters.
As the FCI boost diminishes, we think that underlying growth will slow somewhat. But one reason to expect this slowdown to be gradual is the turn to fiscal expansion next year. If we combine the boost from the tax package and the partly hurricane-related increase in government spending, we expect fiscal policy to contribute a little more than ½pp to real GDP growth in 2018, as shown in Exhibit 3.
2. Will unemployment fall below the April 2000 trough of 3.8%?
Yes. Despite our generally upbeat views on aggregate demand, we do expect a gradual slowdown over the next year. One reason is that we think further cyclical expansion will push the economy beyond its long-term capacity to produce. The most visible sign is likely to be a further sizable drop in the unemployment rate to about 3½% by the end of 2018, levels unseen since the late 1960s.
Even this estimate assumes some improvement in the economy’s potential growth rate. Based on a calculation that uses the long-term relationship between real GDP growth and changes in the unemployment rate (known as Okun's law) but allows the potential growth rate to vary over time, we estimate that realized potential growth since 2011 has only averaged about 1%. If this does not change, our GDP growth forecast of 2.6% would imply a drop in the unemployment rate of 0.8pp. Thus, our actual forecast of a 0.6pp drop already builds in some rebound in short-term potential growth toward our long-term estimate of 1¾%.
3. Will (single-family) housing starts rise further despite adverse tax changes?
Yes. Admittedly, there are a number of challenges for the housing sector in 2018. First, tax policy will turn more adverse. The increase in the standard deduction will persuade more households to stop itemizing their deductions, which increases the marginal cost of servicing a mortgage; even for those who do itemize, the deductibility of mortgage and home equity interest will decline from a principal amount of $1.1 million to $750,000 and there will be a $10,000 cap on the deductibility of property and income taxes.
Second, we expect both 10-year Treasury yields and longer-term mortgage rates to increase by around 50bp in 2018. Our conviction that Fed policy will tighten more than currently priced in the markets is high, and the term premium also looks likely to rebound somewhat from its current apparently negative level. Higher interest rates are likely to weigh somewhat on home demand in coming years.
Third, household formation has been relatively weak recently. Exhibit 4 summarizes the different series that provide information on this key metric of housing demand. While each is quite noisy, overall the numbers seem to have stagnated at around 1 million over the past few years, somewhat below our expectations.
But we still expect the housing recovery to continue, at least in the core single-family owner-occupied sector. The biggest positive factor is the continued tightening in the supply-demand balance. As shown in Exhibit 5, the homeowner vacancy rate has fallen significantly further over the past year and now stands at the lowest level since 2001.
One key reason for this tightening is the rebound in the homeownership rate, which has more than offset the weakness in household formation. We recently estimated that demographic and cyclical factors are likely to raise homeownership by an average of 0.4pp per year in coming years. This equates to a demand shift toward owner-occupation worth roughly 500,000 units per year, and we think it could boost the level of single-family housing starts by 150-250k. Although the adverse tax changes pose a partly offsetting downside risk, we therefore expect further increases in single-family housing starts from their 2017 level of around 850,000 and continued increases in house prices, albeit at only about half the recent 6% pace.
We are less optimistic on the multifamily sector, where the pickup in homeownership following years of strong housing completions has pushed up the rental vacancy rate sharply over the past year. Although starts have already come down in response to this softening, further declines are probably necessary to restore pricing power to landlords in coming years.
4. Will wage growth resume its acceleration?
Yes. Wage growth disappointed somewhat in the last year, as our wage tracker—a weighted average of five key series—basically stagnated at 2.6%. However, we think that 2018 will see a renewed acceleration, for three reasons.
First, the wage Phillips curve generally fits the data quite well, the recent surprise notwithstanding. As shown in Exhibit 6, the behavior of our wage tracker is still quite well explained by the unemployment rate and the productivity trend. With unemployment falling sharply and at least some hints that productivity growth is rebounding, our model still projects a gradual increase in wage growth in 2018-2019.
Second, it seems that compensation per hour (CPH) in the nonfarm business sector—one of the five components of our wage tracker—was held down by statistical distortions. For one thing, the quarterly census of employment and wages (QCEW)—the underlying series to which CPH is eventually benchmarked—has been running ahead of the CPH numbers for a while now. Moreover, there is some evidence that upper-income households have been trying to defer income in the hope of lower tax rates, which could have further held down the reported CPH and QCEW numbers.
5. Will core PCE inflation pick up from the current 1.5%?
Yes. Admittedly, there are still some drags on the inflation data that could persist in 2018. The risks to rent inflation, while smaller, are probably still on the downside, and the outlook for healthcare service price inflation is murky. Markets still seem quite focused on these downside risks, and we think the consensus view among investors is probably a sideways move around the current 1.5% core PCE inflation rate.
But we see three reasons to expect core inflation to move higher over the next year. First, the price Phillips curve—while generally flat—might be steepening. Exhibit 7 plots core CPI inflation against the unemployment rate at a city level, using quarterly data over 20 years for the 13 US cities in the regional BLS database. There is not only a negative relationship between the two variables, but it also seems that the slope of the relationship steepens as unemployment falls below 4%.
Second, our analysis shows that the lags between import prices and core inflation can be long. Statistically, we find that even import price inflation two years earlier has a significant impact on core inflation—i.e., the sharp declines of 2015 have probably been weighing on the core PCE numbers in 2017. Over the next year, however, this drag should gradually turn into a (small) boost.
Third, base effects will push core inflation higher in the spring. Partly because of a shift in the measurement of cell phone service price inflation, March 2017 featured a 0.15% drop in the core PCE index—the weakest reading on record except for a drop in September 2001 that was immediately reversed the following month. Once this reading drops out of the year-to-year calculation, core PCE inflation should rise by 0.2-0.3pp.
6. Will the Fed hike more than the two hikes discounted in current market pricing?
Yes. The Fed’s own forecast remains at three hikes, one more than priced in the markets. But even this forecast strikes us as conservative, partly because we think the unemployment rate will fall by significantly more than the 0.2pp projected by the median FOMC participant. It would be surprising to see such a small decline in the 2.5% growth environment that the FOMC is projecting for 2018.
Our forecast is four hikes, i.e. a continuation of the once-per-quarter tightening regime that has been in place since late 2016. Although core inflation is likely to remain slightly below the Fed’s target, the unemployment rate is already ½pp below the committee’s estimate of the sustainable rate and will likely fall another ½-¾pp over the next year. Unless financial conditions tighten sharply, we think this is not the kind of environment in which the committee would be comfortable actually taking the 6-month break from rate increases that is suggested by its own baseline of three hikes in 2018, let alone the longer or repeated breaks that are implied in market pricing.
7. Will the Fed adjust its balance sheet normalization plan?
No. Currently, the Fed is allowing monthly runoff of up to $10bn from its portfolio of Treasuries and mortgage-backed securities. This number is scheduled to climb by $10bn every three months until it reaches $50bn in October 2018.
We are asked quite frequently whether the Fed will adjust this plan in one direction or another. Some think that the committee might decide to suspend the runoff program in response to negative news about the economy. Others wonder whether a new committee with more Trump-appointed officials who have expressed anti-QE views in the past might accelerate the runoff or even turn to asset sales.
Both strike us as unlikely. On the one hand, the committee has made it clear that suspending the runoff would require a “material” deterioration in the economic outlook that warranted a “sizable” reduction in the funds rate—in other words, a recession or near-recession. We view the recovery as sufficiently robust to make such an outcome quite unlikely in 2018.
On the other hand, the current runoff schedule is actually quite aggressive once fully phased in. As shown in Exhibit 8, we estimate that it implies runoff of about $440bn in 2019, a number that lies only about $110bn below the amount that might result from a full “uncapping” of the runoff. The Fed’s balance sheet as a share of GDP would decline by 2.8pp per year under the current runoff schedule and by 3.3pp under a fully uncapped regime. We think this difference is sufficiently small—and the baseline for the adjustment of the balance sheet sufficiently rapid—to dissuade new officials from the uphill battle of trying to overturn existing committee decisions.
A turn to asset sales could result in a significantly faster normalization of the balance sheet. But we see a widespread consensus within the current committee that asset sales could tighten financial conditions too rapidly, and this consensus may well strengthen in an environment where rising budget deficits further stress the absorption capacity of the bond market. New committee members would likely have a difficult time overturning this consensus.
8. Will market pricing of the terminal funds rate rise?
Yes. In 2017, we were surprised that the terminal funds rate implied by a straight read of OIS or Eurodollar futures did not increase, despite strong growth and more actual Fed hikes than markets had priced at the start of the year. That said, it is a little unclear whether market expectations of future Fed policy were truly quite this inflexible, as the term premium model of our rates strategy team—which closely mirrors the ACM model developed at the New York Fed—implies that the stability of the forwards may have reflected a decline in the term premium further into negative territory that offset an increase in the market’s pure expectation of the future funds rate.
For 2018, we think our economic forecast strongly implies a rise in market pricing of the terminal funds rate, as measured by the 5-year/5-year forward OIS. If the Fed hikes the funds rate by more than currently priced and—importantly—if this additional tightening is viewed as appropriate given the economic backdrop, markets are likely to revise up their estimate of what funds rate is sustainable in the longer term. Additionally, the term premium is likely to rise somewhat from its very depressed current level. Both points suggest that the 5 year/5 year rate is likely to rise.
9. Will the yield curve invert?
No. Over the past year, the gap between the 10-year Treasury note yield and the federal funds rate has declined from 180bp to 100bp. Many investors have started to wonder about the likelihood and implications of an inverted curve, especially if the Fed continues to push up the funds rate at the current once-per-quarter pace.
Whether this happens is closely related to the previous question around pricing of the terminal funds rate. We can think of the 10s/funds spread as the sum of the expected change in the funds rate—or more precisely, the difference between the average funds rate over the next 10 years and its current level—and the 10-year term premium. This means that for the curve to invert, the market must think that the funds rate has overshot its sustainable level, or the term premium must be negative, or both. Conversely, if the pricing of the terminal funds rate increases, either because of higher funds rate expectations and/or a rising term premium, an inverted yield curve becomes much less likely.
10. Will financial conditions ease further?
No. Despite three Fed hikes and the start of balance sheet adjustment, our financial conditions index eased by more than 100bp in 2017 as stock prices rose, credit spreads tightened, the dollar weakened, and long-term interest rates stagnated. As shown in Exhibit 9, it now stands at the easiest level of the entire expansion and about 1.3 standard deviations below the long-term average.
But we this think this easing has now largely run its course because the Fed will increasingly resist it. This is mostly because of concerns about the impact of financial conditions on the real economy. The economy is already at or slightly beyond full employment, growth momentum is strong, and a further boost from fiscal policy is already in the offing. Adding more fuel to the fire via yet easier financial conditions looks undesirable.
Concerns about financial imbalances might also rise. Asset valuations in some areas - especially credit - have risen to high levels by historical standards. And while we have not seen the type of large credit expansions that would be most worrisome for Fed officials concerned about financial imbalances, there are now some signs of speculative behavior in financial markets, e.g. the cryptocurrency boom. Fed officials are therefore likely to view further easing of financial conditions as increasingly undesirable and an argument in its own right to normalize policy.