The Opposite of Pump Priming?

During an economic slowdown, the government often employs fiscal stimulus to “prime the pump.” In such cases a burst in aggregate demand boosts income, which adds to consumer spending, which adds to income, and so on. This process can work in reverse. A shock to aggregate demand hits income, which reduces consumer spending, further reducing income, and so on. The self-inflicted wounds of misguided trade policy and the impasse on the federal budget could lead to broader economic weakness, but it depends on how long they last.

The near-term economic outlook remains positive, based largely on robust expectations for consumer spending growth (which accounts for 68% of Gross Domestic Product). Strong job growth and a pickup in wage growth should have boosted personal income into the new year (we won’t get December personal income and spending data due to the government shutdown, but we can get a good idea from the December Employment Report). Lower gasoline prices have added to consumer purchasing power (inflation-adjusted wage growth has improved). Confidence should remain relatively high by historical standards, although below peak, reflecting the negative press on the economy and Washington.

Residential fixed investment accounts for a little less than 4% of GDP, but the housing sector is often seen as the canary in the coal mine, weakening as the economy enters a recession. However, the recent softening in home sales doesn’t appear to be due to weak demand for housing. Job growth and wage gains are supportive. The National Association of Realtors has noted a high degree of sensitivity to mortgage rates, which peaked in mid-November (Freddie Mac 30-year commitment rate at 4.94%). Rates have since decreased (4.45% more recently), which should help, although the bigger test for the housing market comes in the spring. The one missing element of the housing recovery has been a rebound at the low end. Higher construction costs have decreased incentives for firms to build starter homes and price increases have reduced affordability. There is a growing mismatch between demand at the low end and the supply of homes for sale at the high end.

Business fixed investment made up 13.6% of nominal GDP in 3Q18, but this accounts for most of the swing in the business cycle. Less than half of that (6.0% of GDP) is equipment. The rest is structures (including energy extraction) and intellectual property products. Much of the strength in business investment in the last two years has reflected the rebound in oil and gas well drilling. The tax cut doesn’t appear to have significantly boosted spending on equipment – most has gone to share buybacks and increases in dividends. Moreover, the global economic slowdown and trade policy uncertainty have been negative factors. The Conference Board’s CEO Confidence Index fell to 42 in 4Q18, down from 55 in 3Q18.