The outlook for 2017 is now shaping up as a battle of ideas, though few seem to be realizing it yet. The stock market has risen since the election. Consumers, small businesses owners, homebuilders, and manufacturers are all more optimistic. Many expect that a rollback in regulation, increased infrastructure spending, and lower taxes will spur growth. Yet, most economists, including those at the Fed, have raised their GDP forecasts for 2017 and 2018 only slightly at best. At the center of the discussion are differing views of how much stimulus we may get, how much slack remains in the labor market, and whether increased optimism can be self-fulfilling.
In the Fed’s revised Summary of Economic Projections, the median forecast for 2017 edged slightly higher, to 2.1% (from 2.0%), while the median forecast for 2018 GDP growth remained at 2.0%. In her post-FOMC press conference, Fed Chair Janet Yellen emphasized that the economic outlook is “highly uncertain.” Some, but not all, of the Fed governors and district bank presidents adjusted their forecasts for possible changes in fiscal policy (government spending and taxation) and other policies (deregulation) that might affect growth. Surveys of private-sector economists also showed only a mild increase in GDP growth expectations since the election.
Changes to the regulatory outlook are often difficult to gauge as a new administration takes charge. Laws may remain on the books, but they may be ignored. Just about everybody agrees that the country needs infrastructure investment, but it will likely be difficult to achieve through deficit spending. The House of Representatives no longer has earmarks (specific allocations in spending bills). Without the ability to do any “horse trading” for votes, it will be hard to reach a broad spending agreement. Funding infrastructure through the private sector would mean privatization. That may make some sense for airports, ports, or major bridges, but most Americans would bristle at the thought of having to pay simply to drive down the road. Privatization would also be unlikely to funnel infrastructure investment to where it is most needed.
Tax cuts should be easily achievable. It’s what Republicans do. However, it’s unclear how much of a reduction we’ll see. Reducing deductions could offset the impact of lower rates, but nobody is going to want to give up their current tax breaks.
The bigger question for economists is what happens when fiscal stimulus faces constraints in the job market. As the job market tightens, wages ought to rise more rapidly. Can firms pass the added labor costs along? If not, they will eat into corporate profits. Higher wages could lead to increased labor force participation and to reallocations of labor, putting workers into positions where they are more productive, and creating more room for more inexperienced workers to move up. This could certainly be accomplished through increased (labor-saving) capital investment. However, none of that is quick and easy. In her press conference, Chair Yellen said that fiscal policy could be effective if concentrated on efforts to boost productivity, but this takes time. Over the next year or two, GDP growth is likely to be constrained by a tight job market.
The effectiveness of fiscal stimulus may also be constrained by market reactions to it. That is, higher long-term interest rates would likely restrain the improvement in the housing market and limit business borrowing. A strong dollar would make U.S. exports more expense for the rest of the world (and also make foreign goods and services cheaper here). Indeed, we ought to see somewhat better growth in underlying domestic demand next year, but a wider trade deficit will likely keep GDP growth from picking up significantly. In an open economy, some fiscal stimulus leaks away to other countries (which is why it important to have coordinated fiscal stimulus in a global recession). One might expect restrictions on global trade to reduce that leakage, but trade disruptions could destabilize supply chains in a number of industries.
Might the increased optimism about growth be self-fulfilling? In the short term, perhaps. Firms have faced low borrowing costs and are generally flush with cash, but are unlikely to expand unless they expect increased demand for the goods and services that they produce. This has been the “chicken or egg” question for much of the recovery. However, if demand fails to materialize, there would be a clear downside to follow.
To be sure, the stock market’s recent rise is consistent with the renewed sense of optimism we’re seeing in many areas of the economy. However, there ought to be more uncertainty in the outlook for the next few years. There are many moving parts here, including Fed policy, long-term interest rates, and exchange rates, and they may not mesh all that well in 2017.
© Raymond James
© Raymond James
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