The Road Back, and Ahead

The U.S. economy data are likely to be mixed in the near term, but there is little doubt that we are gathering steam. The plunge in gasoline prices is an enormous tailwind. However, this isn’t just an energy story. The fundamentals are getting better.

This wasn’t your father’s recession we went through in 2008-2009. It was your grandfather’s depression. Policymakers made all the wrong choices in the Great Depression, but this time they got it mostly right. That doesn’t mean that everything turned out okay. Rather, policy efforts minimized the downside. The recovery process was bound to take a long time. That is what happens following a major financial crisis.

The Chicago Fed’s National Activity Index is a composite of 85 economic indicators, which can be divided into four broad categories. One of these categories, personal consumption and housing, has lagged in the recovery process. That reflects the aftermath of the housing bubble collapse. Importantly, housing has become much less of a drag on the overall economy.

The recession can also be characterized as a deleveraging of the financial system. Outside of the financial sector, levels of business debt, often a magnifying factor in economic downturns, were relatively mild. Cash flows were strong ahead of the recession and debt burdens were easily manageable. Most of the leverage was in the financial sector. As the financial crisis expanded, financial deleveraging fed through adversely to the real economy. Note that financial sector deleveraging was largely offset by an increase in government borrowing. As the federal budget deficit rose to 10% of GDP, national borrowing actually declined a bit. The Fed’s Flow of Funds data now suggests that credit conditions have improved – and with moderate loan growth, you get moderate economic growth.

One of the most disturbing developments in the fall of 2008 was banks cutting lines of credit to small businesses – not just reducing credit lines, cutting them completely! During the financial crisis, large firms were soon able to borrow from the big banks or raise money in the bond market. Not so for smaller firms. Bank credit to consumers and small businesses is still relatively tight, but it is gradually getting easier. That’s important, as small and medium-size firms account for much of the job growth in an economic expansion.

Yet, small firms with good credit have been reluctant to expand in recent years. These firms are unlikely to hire more workers or add to capital until they see evidence of a sustained increase in the demand for the goods and services they produce. We may have now reached that phase. In 2014, nonfarm payrolls posted the largest gain in this century. Hiring at smaller firms appears to have been a big part of that.

The drop in gasoline prices is expected to provide important support for consumers and small businesses in 2015. It’s estimated that the typical household will save an average of about $750 this year on gasoline expenditures. For the middle class, this extra cash is very likely to be spent, and that spending is someone else’s income (in other words, there will be a significant multiplier effect). Businesses will save on lower transportation costs and lower commodity prices.

So how long can a strengthening U.S. economy go on? Measuring the precise amount of slack is difficult. However, despite the strong job growth in 2014, many labor market measures suggest that there is still a large amount remaining. That means that the economy can grow above trend (which may be seen as somewhere between 2.0 to 2.5%, reflecting about 1% labor growth plus 1.0% to 1.5% productivity growth). We could easily grow at 3% per year for two or three years without generating much upward pressure on wages and prices. The Fed can still be expected to begin raising rates later this year, but only to begin a long, gradual trudge toward normal, not to take away the punchbowl as the party gets going.

© Raymond James

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