Optimism is not enough: Realization of pro-growth policies will shape U.S. economic outlook

Since the U.S. presidential election last November, there has been a noticeable surge in many of the "soft" economic indicators—those that point to Americans' beliefs about the health or direction of the economy—such as the Conference Board's Consumer Confidence Index, the University of Michigan Consumer Sentiment Index, the National Federation of Independent Business (NFIB) Small Business Optimism Index, and various U.S. stock market indices. (See Figure 1.)

The surge in business confidence has a lot to do with the expectation that President Trump and the Republican-led Congress will cut corporate taxes, reduce personal income taxes, remove regulations, and introduce more pro-growth policies. These measures, it is assumed, would lead to stronger economic growth, increased profits, and expanded capital spending, which, in turn, could help boost productivity growth—turning the "soft" data into more objectively quantifiable economic reality.

Article Figures

[Figure 1] Consumer and business optimism rise together Enlarge this image

[Figure 2] Income and consumption to surge with fiscal stimulus in 2018 Enlarge this image

The "wealth effect" and "animal spirits"
Consumers have been doing most of the heavy lifting in the U.S. economy over the past several years. Now, rising stock prices coupled with a stronger housing market are pushing up household wealth, further stimulating consumer spending through the phenomenon known as the "wealth effect." The idea is that when households' stock market portfolios and home values rise, consumers feel more financially secure, which causes them to increase their spending even if their income is unchanged. The wealth effect is one example of a real impact of "soft" consumer attitudes; economists estimate that it may boost consumer spending by about 3 cents on the dollar. However, "hard" economic factors like improved job prospects, lower income tax rates, and rising real wages have a significantly stronger impact on consumer spending.

For the most part, the surge in "soft" indicators has been unaccompanied by equivalently strong "hard" economic data. Although it was mostly a function of one-off factors and seasonal effects, the first quarter's real gross domestic product (GDP) growth rate, measured at 1.2 percent (annualized) as of this writing, was the weakest since Q1 of 2016. Additionally, the average monthly payroll increase in March, April, and May was 121,000, compared with 201,000 in the prior three months.

Yet the U.S. economy is strengthening. The unemployment rate currently stands at 4.3 percent, the lowest since 2001, and there is ample evidence that the economy is chugging along at a 2.0–2.5 percent growth rate. The growth in final sales to domestic purchasers, which excludes inventories and exports (and therefore is a better gauge of the economy's underlying growth rate), was 2.0 percent in the first quarter. In light of this strength, the U. S. Federal Reserve is likely to continue its gradual pace of rate increases, such as its recent decision to raise the target range for the federal funds rate by 25 basis points, to 1.00–1.25 percent.

But the size of the disconnect between the "soft" and "hard" data (for example, income, profits, and interest rates) suggests that the surge in business and consumer confidence is a manifestation of "animal spirits." This term, first used by John Maynard Keynes to explain investment behavior, is now used to describe consumer and business dynamics, which can be better understood by considering the interactions and contrasts between "soft" and "hard" indicators.

Expecting a wave of pro-growth policies, markets reacted to the November election with exuberance. However, consumer sentiment could change if there is a sufficient shock. In particular, concern is growing that amid the political turmoil in Washington the Trump administration's and Republican majority's reform agenda could come up short. Already, progress on health-care and tax reform has slowed considerably. The American Health Care Act, passed by a razor-thin margin by the House, is unpopular with the public. The corresponding Senate version of the bill has yet to be finalized or its contents released to public scrutiny. On the tax front, House Republicans' plan for a border adjustment tax (BAT) has been opposed by some members of both the House and the Senate, and the president's position is unclear at this writing. Meanwhile, the White House's public tax plan still only consists of a one-page outline. Given these obstacles, it is unlikely that legislation will be passed on either of these priorities by the end of the year. Still, some progress has been made in other areas; in June the Trump administration rolled out its infrastructure initiative, and through its executive powers the White House has slowed or reversed the expansion of regulatory controls on business.

Robust growth depends on economic agenda
In spite of these concerns, we continue to believe that, on balance, a modest pro-growth agenda is likely to be implemented next year. Our assumptions for these changes include:

• A reduction in the statutory corporate income tax rate from 35 percent to 25 percent, partially offset by fewer tax breaks, starting in January 2018;
• Repatriation of US $800 billion of foreign profits at a reduced tax rate of 10 percent in 2018;
• Personal income tax reforms that lower the average effective federal tax rate from 20.3 percent to 19.6 percent in January 2018; and,
• Additional public infrastructure investments totaling US $250 billion over 10 years, starting in Q1 of 2018.

At the same time, several of Trump's priorities are unlikely to gain traction, such as the border adjustment tax mentioned earlier, significant capital expenditures, major changes in health care, or major changes to international trade policies.

IHS Markit predicts robust economic growth in the next two years, but this outlook is predicated on the passage of a pro-growth agenda of roughly the shape described. We expect that real GDP growth will be 2.3 percent this year, and that it will accelerate to 2.7 percent in 2018—but only if fiscal stimulus is enacted. Consumer spending will remain an engine of U.S. economic growth, supported by rising employment, disposable incomes, and household wealth. Income tax cuts in 2018 will likely accelerate a hike in spending growth and the personal saving rate. Real consumption is projected to grow 2.6 percent this year and 3.2 percent in 2018, then ease to 2.9 percent in 2019 as the stimulus wears off. (See Figure 2.)

In this outlook, business fixed investment will benefit from strengthening global markets, firmer commodity prices, an easing of regulations, and tax cuts in 2018. With oil and natural gas prices likely to climb higher, growth in mining structures should remain solid during 2017 and 2018. Consistent with this story line, we expect Federal Reserve policy rate increases of 75 basis points in each year through 2019 and a cautious reduction in the Fed's asset holdings. Brisk sales, low inventories of homes for sale, and rising prices will encourage more homebuilding, even as interest rates rise.

Measures of consumer confidence remain very close to their post-election highs, and as of early June, stock indices were hitting all-time records. But an economy cannot run on animal spirits alone, and the growth rate during the next few years will depend on the policies that the Trump administration and the Republican majority are able to enact.