Quarterly Review and Outlook, Fourth Quarter 2017
Optimism is pervasive regarding U.S. economic growth in 2018. Based on the solid 3%+ growth rate during the last three quarters of 2017, this optimism is well-founded. The acknowledgement of this economic health by the Federal Reserve (Fed) is evident: they have outlined a continued pattern of increasing the federal funds rate over the coming year. Further, the solid 2017 performance of the European Union and of Japan is forecast to continue in 2018. Finally, the recent enactment of a tax cut is expected to boost U.S. economic growth in the new year. Well-regarded economic research suggests a 2.5% - 3.5% real growth rate in 2018 with continuing stable inflation. In addition, most surveys suggest a modest interest rate increase across the entire maturity spectrum of the yield curve.
Our view of the economic environment is somewhat divergent from the consensus opinion. Our analysis of concurrent and leading economic variables, including consumers, taxes, monetary policy and the yield curve, suggest that disappointing growth, lower inflation and ultimately lower long-term interest rates will hallmark the new year.
Consumer spending, the economic heavy lifter of U.S. economic growth, has expanded by 2.7% over the past year (as measured by real personal consumption expenditures, or PCE, as of November 2017). This is similar to the past eight years of the expansion, with real PCE averaging 2.5%. What is interesting about the increase in spending is that incomes have failed to keep pace. Real disposable personal income rose by only 1.9% over the past year. It was only the ability to borrow that supported the spending increase. In economic terms, borrowing is a form of dissaving. The saving rate for consumers dropped from 3.7% a year ago to 2.9% in November, a 10-year low.
It is remarkable that as recently as October 2015 the consumer saving rate was 5.9%. Had that rate been sustained through November 2017, the cumulative spending increase over the past 25 months would have registered only a 3.2% advance (1.5% annual rate) or $496 billion. However, actual spending was $939 billion, a 7.5% cumulative gain (2.8% annual rate). An increase in consumer credit of $253 billion and an actual reduction in savings of $190 billion account for this difference. It is possible that the saving rate will continue to fall. A drop of the same magnitude in the next 25 months would mean the saving rate would be -0.1%, a possible yet unlikely scenario. The higher probability is that the saving rate begins to move up towards its historic average of 8.5%.
History suggests that the economy will register a slower rate of expansion following a low saving rate (Chart 1). This positive correlation between current saving and future consumption means a low saving rate should be followed by a lower level of consumption and vice versa. Therefore, considering that the only period in which the saving rate was lower than it is today was 1929–1931, it is more likely that spending in the future will be in line with, or lower than, real income growth, which is currently weak.