- Mortgage Debt Overshadows U.S. Wealth Gains
- U.S. Income Growth Remains Tepid
- Fiscal Space Stabilizes in the Euro Zone
- U.S. Spending Accelerated in October
- U.S. Chartbook: A Strong End to 2013
- Recession Thinned Non-College U.S. Workforce
- The Slow and Steady U.S. Labor Market
- U.S. Consumer Prices Flat Except for Rents
- U.S. Job Creation Gains Momentum
- A U.S. Jobs Report to be Thankful for
- What November Employment Could Mean for a Fed Taper
- U.S. Housing: If You Build It They Will Come
- Trade Could Be a Welcome Surprise In Q4
- The New, Improved ADP: An Assessment
- Global Outlook: Lurching Toward Recovery
- Aging Durables Signal Pent-Up U.S. Demand
- Slow Black Friday Doesn’t Foretell a Weak Season
- Construction Data Point to Stronger Q3, Weaker Q4
- Observations: The Truth About Income Inequality
- The Cost of Housing Reform
- U.S. Macro Outlook: First, Do No Harm
- A Budget Battle Postmortem
- The Path From Shutdown to Sustainability
- U.S. Macro Outlook: Back to the Brink
- Opening the Credit Box
- The Road to Housing Reform
- U.S. Macro Outlook: Failure to Launch
- U.S. Macro Outlook: Nearing the Threshold
- U.S. Macro Outlook: Hanging Tough
- How to Reform Housing Finance
U.S. Macro Outlook 2014: A Breakout Year?
View the Moody's Analytics U.S. Macro Forecast.
Preconditions are in place for much stronger economic growth in 2014. The path won’t be straight up, and significant hurdles remain, including Congress’ budget battles and the winding down of the Fed’s bond-buying program. But the U.S. economy’s fundamentals are strong.
Evidence of this underlying strength is clearest in the job market. Payroll employment growth has accelerated to around 200,000 net new jobs per month, and the gains are increasingly broad-based across industries and pay levels. The unemployment rate is steadily declining even as labor force participation stabilizes. The economy is on track to reach full employment—estimated as a 5.75% jobless rate and 64% labor force participation—in three years.
The problems and imbalances that developed during the housing bubble nearly a decade ago have largely been corrected. Households have significantly reduced their debt burdens. The average share of after-tax income that households must devote to servicing debt is as low as it has been since at least 1980. Households are also locking in extraordinarily low interest rates: Only a fifth of liabilities are tied to rates that adjust from year to year.
The banking system is well-capitalized and highly liquid. Banks are holding high-quality tier-1 capital equal to more than 9% of their assets. This compares with an average capital-to-asset ratio of just over 7% since the FDIC was established in the 1930s. Since being required to stress-test their portfolios every year, the nation’s largest banks have prepared themselves to withstand the darkest economic scenarios imaginable. With sturdy balance sheets, banks are looking to make more loans.
Especially encouraging is the financial health of nonfinancial businesses. Corporate profit margins have never been wider, as businesses have significantly reduced their cost structures. Unit labor costs—compensation measured in relation to productivity—have barely budged since the recession. In manufacturing, costs are about where they were a quarter century ago. Businesses have also done a good job repairing their balance sheets, as debt service is low and they are awash in cash. Like households, firms have locked in record low interest rates.
Some problems remain. More than 2 million first mortgage loans are in or near foreclosure and a growing number of home equity loans are approaching payment resets. But given consistently rising house prices, these problems are manageable. Rapidly rising student loan debt is also a worry, but not on a scale that will threaten the broader recovery.
In the groove
The main missing ingredient for stronger growth is confidence. The nightmare of the Great Recession weighs heavily on the collective psyche, and political brinkmanship and policy uncertainty have been hard to bear. But sentiment has improved in the weeks since Congress agreed to reopen the government and increase the Treasury debt limit.
Investors are especially upbeat, as stock prices continue to hit record highs. Corporate credit spreads have tightened as well, meaning that bond investors are demanding less of a risk premium to buy businesses’ debt. The Fed’s long-term asset purchases have helped to buoy financial markets, but investors also appear to expect better economic times ahead.
Consumers aren’t nearly as cheerful, particularly those in lower-income households that don’t benefit from rising stock and house prices. Yet even here optimism is growing. Consumer sentiment falls each time federal lawmakers become embroiled in another budget battle. Encouragingly, however, confidence rebounded quickly after the latest standoff ended in October.
Businesses also appear to be getting their confidence back. The Moody’s Analytics weekly survey finds business confidence breaking out to the upside. In early December, positive responses to the survey’s questions outweighed negative responses by more than at any time since the housing bubble’s peak in early 2005. The economy is bubble-free today.
The outlook hinges importantly on how Congress handles the current round of budget negotiations. While a misstep is possible, lawmakers appear on track to reach a deal that will keep the government open and avoid another showdown over the debt limit. The tentative deal will also replace the budget cuts imposed earlier this year under budget sequestration, making up for smaller spending reductions with increased fees on air travel and an increase in pension contributions by some federal employees.
The economic drag from fiscal policy will thus fade, from close to 1.5 percentage points of GDP in 2013 to 0.4 percentage point or less in 2104. The drag in 2015 and 2016 will be minimal. The principal weight on growth next year will be the expiration of the emergency unemployment insurance program, which will also slow GDP growth by 0.15 percentage point.
Lawmakers still need to raise the Treasury debt limit again, as the government's borrowing authority will run out again early next year. The Moody’s Analytics’ baseline outlook assumes that policymakers will do this in a reasonably graceful way. Not doing so would create substantial economic and political fallout. Given Congress' past behavior, it is conceivable that there will be another round of brinkmanship, which would hurt the recovery.
Managing long-term rates
Stronger growth next year also depends on the Federal Reserve’s ability to gracefully manage long-term interest rates as the job market improves. Under the Moody’s Analytics baseline, the 10-year Treasury yield is expected to rise by about 100 basis points to 3.75% as the unemployment rate falls to 6.6%.
The Fed must accomplish this while winding down its bond-buying program. This could be tricky; an undesirable surge in long-term rates last summer was triggered when Fed officials began merely to talk about slowing the pace of asset purchases. Investors seemed to assume that tapering meant the Fed would begin raising short-term rates soon after QE ended. The jump in fixed mortgage rates hurt housing, which is vital to the broader recovery.
Policymakers have since worked to convince investors there are no plans to raise short-term rates soon. This appears to have worked, at least for now, as long-term rates are ending the year where policymakers want them. If rates again start to rise too quickly for comfort, policymakers can respond using a range of tools. One option would be to adopt a lower threshold for core consumer expenditure inflation, pledging not to raise short-term rates unless inflation is greater than, say, 1.5%. Core inflation has recently slowed near 1%. An even more aggressive step would be to reduce the 6.5% unemployment threshold for raising short-term rates.
A worry regarding the economy’s near-term prospects is the possibility that the Great Recession damaged its longer-term potential. Before the recession, it appeared that the economy could sustain real GDP growth as high as 3% per year without lowering the unemployment rate or increasing the capacity utilization rate—signs that output is heating up. Since the downturn, however, this potential rate has clearly fallen, as despite only 2% growth, the unemployment rate has fallen and the utilization rate increased.
This suggests the economy could have been weakened in ways that will last over the longer term. The growth of both productivity and the labor force, two key components of potential, has recently come to a virtual standstill. Unless this changes soon, the economy may reach full employment more quickly, but living standards will rise more slowly, exacerbating inequality in income and wealth and creating major fiscal problems down the road.
However, it is premature to conclude that the recession permanently undermined the economy’s potential. An important test will occur over the next several years as unemployment falls and labor compensation growth, which has been stuck around the inflation rate, accelerates. Businesses probably could pay even less, but are reluctant to undermine morale and productivity with wages that don’t keep up with inflation. As unemployment declines, however, businesses will eventually need to pay more. This should prompt potential workers who have left the labor force to return, and encourage businesses to ramp up investment, accelerating productivity gains.
Moody’s Analytics estimates the economy’s potential growth rate at 2.5% per year. The rate has slowed since the recession, but mainly because of the retirement of baby boomers, a demographic trend that has long been part of our baseline outlook.
Forecasting with a ruler
Economists have a tendency to forecast with a ruler, assuming the economy’s recent performance will continue into the future. Many such forecasts were issued in the last decade, assuming the so-called great moderation meant the good times would never end.
Similarly, straight-edge adherents now conclude that the difficult times since the recession are here to stay. This view holds that it will take years to return to full employment and that growth will be much slower than we want for the foreseeable future—that the economy is trapped in a "new normal.”
Forecasting with a ruler is inevitably wrong, however, and this will become evident again in 2014. Though the coming year could see another false start, the greater likelihood is that the U.S. recovery will finally evolve into a full-blown, self-sustaining expansion. The fundamentals are as good as they have been for decades, and it is increasingly difficult to envisage shocks that could undermine them. Worries exist, including Europe’s ongoing travails, political tensions in Asia, and the possibility of botched fiscal and monetary policy in Washington. But these threats don’t feel as existential as those the economy has been grappling with since the recession.
The U.S. should experience a breakout year in 2014. It is certainly due for one.
"Fifteen minutes with Dismal Scientist
saves you three hours..." Pete Gioia, CBIA
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"Fifteen minutes with Dismal Scientist
saves you three hours..." Pete Gioia, CBIA