Download Sit Investment 29th Annual Client Workshop

Sit Investment 33rdAnnual Client Conference (Laguna Niguel, California; February 15, 2015)
Sidney L. Jones
ECONOMIC PROSPECTS and POLICIES
The U.S. economy finally gained real traction with robust GDP growth, moderate inflation,
and impressive employment gains – the “sweet spot” in the business cycle – during the last nine
months of 2014. More of the same is projected for 2015 despite intense uncertainty created by
familiar geopolitical and geoeconomic risks. Accelerating growth and net new job creation are
based on the solid revival of a “consumer economy” with surging sales of new cars and trucks,
consumer electronics, household appliances and furnishings, eating out, entertainment, recreation,
travel, health care, and government transfer payments and services supported by improving real
disposable personal income, modest personal saving, and private and public debt with unusually
low interest rates. A repetitive “virtuous circle” of more consumption/investment/ jobs -- which
enhances the ability and willingness of households, businesses, and governments to spend – has
created optimism about near-term prospects despite frustrating real and statistical surprises.
Dysfunctional fiscal policies have evolved into acceptable “pragmatic normalcy” allowing
governments to simply postpone difficult taxation and spending decisions despite potential risks
of the growing $18 trillion gross national debt, which will have to be financed with much higher
interest rates. Monetary policy officials have completed their unconventional quantitative easing
program used to create new money to reflate the economy – specifically financial asset and real
estate prices – and will rely instead on forward guidance to signal accommodative policies. The
traditional “go-and-stop” domestic economy will sustain its “go” phase throughout 2015.
The “slow, long, and erratic” recovery from the severe Great Recession, which officially
ended in June 2009, generated a moderate real GDP annual growth rate of only 2.4% during
the last 66 months despite very aggressive monetary and fiscal stimulus. But the U.S. economy
shifted gears last year, while inflation remained below the 2% target, and the unemployment rate
continued to decline from a cyclical peak of 10.1% in October 2009 to near the full employment
level of 5.6% by December 2014. My baseline forecast projects real GDP growth of 3% during
2015 (measured 4th to 4th quarters) – well above the current 2 1/4% trend target -- a 70% probability.
Faster growth is a 20% probability if low energy, food, and commodity prices ignite even more
household and business spending. Slower growth is a 10% probability if external shocks disrupt
economic activity. Headline CPI inflation is extremely uncertain – 1 1/4% estimate – depending
on future energy, food, and commodity prices and core CPI inflation (energy and food prices deleted)
should edge up to 2% as shelter costs rise and labor cost pressures develop. The unemployment
rate probably will decline slowly to an average of 5 ½% for the entire year (likely lower by yearend)
depending on the worker participation rate. Strong domestic demand for imports will maintain the
current account deficit of 2 ¼%. Pragmatic fiscal policies will create a FY 2015 federal budget
deficit in the $500 billion zone after additional contingent military operations and disaster relief
payments are added to the original estimate. The Federal Reserve will use forward guidance to
signal a moderate and gradual increase in its fed funds interest rate target after mid-2015.
Household spending will continue to be the driving force; business investment will gain traction;
residential construction will remain above the 1-million start level to match pent-up demand; and
net exports will be the only negative sector, as moderate global growth and appreciation of the
value of the U.S. dollar restrain exports while domestic demand increases imports. Major risks
are: the slowdown of global growth; recurring private and public debt crises; volatile financial
markets; energy, food, and commodity price and supply shocks as the “super cycle” ends;
chronic current account imbalances; disinflation/deflation pressures; monetary and fiscal
policy errors; and political, social, and economic stress caused by pervasive hot and cold wars,
insidious terrorism, civil unrest, and unstable, incompetent, and corrupt governments. My
baseline forecast will be vulnerable to all of these disruptive exogenous factors.
Despite this positive forecast for 2015 there are medium-term risks. The Great Expansion,
with robust growth and moderate inflation and unemployment, which prevailed from December
1982 until December 2007, has ended. This new era will have lower average and more volatile
GDP growth, higher inflation and unemployment rates, lower current account deficits, budget
stress at every level of government, and an accommodative monetary policy tilt. The dominating
“demographic twist” will require payment of retirement income and health care benefits to the
unique “baby boom” generation for a very long time period. Geopolitical disputes will continue.
Geoeconomic competition for trade and investment markets and transition of economic power
from the West to the East will intensify. Technology is portable enabling competing nations to
become more productive and competitive. Concerns about access to production resources and
the physical environment will escalate. Disparate income and wealth results will disrupt social
and political stability. The future integrated and realigned global economy will require policies
that encourage investments in human capital, technology, real resources, and the infrastructure.
CRITIQUE OF THE 2014 FORECAST
My baseline forecast was that the disappointing “slow, long, and erratic” recovery of the U.S.
economy finally would accelerate to a robust 3% growth rate, with moderate inflation and
gradually declining unemployment and underemployment rates, stabilization of dysfunctional
fiscal policies and easing of federal budget restraint, and sustained monetary accommodation
using forward guidance about the future policy interest rate as the quantitative easing program
gradually phased out – creating a “sweet spot” in the business cycle when output and job growth
improve before new inflation pressures develop and the next familiar boom/bust sequence begins.
After six years of severe recession and a tepid recovery, the U.S. economy entered 2014 with
positive momentum, prospects, and policies despite serious geopolitical and geoeconomic risks.
My baseline forecast projects real GDP growth of 3% during 2014 (measured 4th to 4th
quarters) slightly above the medium-term target of 2 ½% -- a 65% probability. Faster
growth is a 25% probability if business investment and inventory spending exceed
current expectations. Slower growth is a 10% probability if consumers become more
cautious or external shocks disrupt economic activity. Moderate energy, food, and
commodity prices should keep the headline and core inflation figures close to 2% targets.
The unemployment rate probably will continue to decline slowly and average 6 ½% for
the entire year depending upon changes in the participation rate. Strong domestic demand
for imports will likely delay further improvement in the persistent current account
deficit. Continued revenue gains and mandated spending restraint should reduce the FY
2014 federal budget deficit to about $600 billion. The Fed will complete the gradual
phasing out of quantitative easing purchases of bonds and use forward guidance to
continue its pledge to continue the existing “zero boundary” policy interest rate target
until at least mid-2015. (Economic Prospects and Policies, February 16, 2014, pp.1-2)
My baseline forecast of robust 3% growth was quickly distorted by a sharp negative swing in
inventory spending, net exports balance, personal consumption, residential construction, business
investment, and pessimism about global economic prospects. However, when the harsh weather
conditions improved, and the pace of payroll jobs creation finally accelerated after five years
of modest gains, consumer spending for durable goods and services revived (particularly surging new
car and truck sales) and business spending responded. Government spending, both federal and state
and local, swung from a negative to positive force and residential construction outlays stabilized.
The slowdown of economic activity in Europe, Japan, and Emerging Market economies, and the
rapid appreciation of the dollar’s forex value, did not erode exports as much as expected.
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Advance GDP estimates now indicate that during 2014 the real output of goods and services
increased 2.5% (4th to 4th quarters). CPI measures of inflation were below 2% (December to December).
The average unemployment rate steadily declined to 6.2%, as job creation accelerated and the
participation rate (civilian labor force as a percent of the civilian noninstitutional population) fell to the lowest
level since 1977. The Fed validated its accommodative policy interest rate target and quantitative
easing gradually was phased out. Federal budget “fiscal drag” declined as current spending and
tax policies stabilized. After a surprising negative first quarter, partially due to severe weather,
private consumption and investment regained momentum and government spending at all levels
contributed to GDP growth as improving tax revenues steadily reduced cyclical budget stress.
Comparison of Baseline 2014 Forecast Summary and Advance GDP Estimates
(Percent Change; Fourth to Fourth Quarters; Real Chained [2009] Dollar Basis)
Sector
Gross Domestic Product
Personal Consumption Expenditures
Business Fixed Investment
Residential Construction Investment
Federal Government Outlays
State & Local Government Outlays
Inventories (contribution to GDP; pp)
Net Exports (contribution to GDP; pp)
Unemployment Rate (average)
Headline CPI (December/December)
Core CPI (December/December)
FY 2012 Federal Budget Deficit
Federal Funds Rate Target
2014 Forecast
2014 Results*
3
2.5
2 1/2
2.8
7 1/2
5.5
12 1/2
2.6
-1
0.2
2
1.1
- 0.1
0.26
0.0
- 0.56
6 1/2
6.2
2
0.8
2
1.6
$600 billion
$483 billion
Zero Boundary & QE3 Zero Boundary & QE3
• First estimate of GDP figures released January 30, 2015; figures will be revised in February, March, and July.
Personal consumption expenditures increased 2.8% and contributed 1.92 percentage point
to GDP growth. Consumer durable goods spending increased 8.4% as sales of new cars and light
trucks surged to 16.5 million vehicles (easy credit and falling gasoline prices) compared with only 10.4
million units in 2009. Nondurable goods consumption rose 2.3% and services 2.1% as consumer
confidence rose to the highest level since 2007 after employment and income prospects improved.
The ability to spend increased as disposable personal income rose 4.2% and inflation remained
moderate because of declining energy, food, and commodity prices. Employee compensation,
proprietors’ income, rental income, personal financial asset income, and personal government
transfer payments all reported gains. Positive “wealth effects” created by rising stock market and
real estate values supported more consumer spending. The willingness to spend also increased as
income and job prospects improved, the personal saving rate declined from 4.9% in 2013 to
4.8%, and consumer debt rose to a new record of $3.298 trillion by November: nonrevolving
credit (automobiles, mobile homes, education, boats, trailers, and vacations) totaled $2.416 trillion and credit
card debt was $882 billion. As economic activity rebounded, following the harsh winter weather,
consumers reversed six yeas of recession and slow cyclical recovery by replacing their old cars
and increasing nondurable goods and services spending. Consumers also appear to have ignored
disruptive geopolitical events around the world. Personal consumption is again the driving force
in the accelerating pace of domestic economic activity. A significant part of this turnaround is the
very rapid drop in gasoline prices (down 37% from $3.64 in June to $2.30 per gallon by the end of December) ,
which has bolstered consumer spending and created new confidence about sustaining growth.
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Business capital investment increased 5.5% and contributed 0.68 percentage point to the total
GDP. Business equipment spending increased 4.7%, intellectual property products 6.5%, and
investment in structures (plants, office buildings, shopping centers, and utilities) 5.6%. Confidence rapidly
improved after the cautious first quarter based on solid sales and profits; cash reserves; access to
credit at low interest rates; competitive pressures to add new technologies; explosive growth of
investment to develop domestic energy resources; and the steady erosion of unused production
assets. The capacity utilization rate for production facilities increased to 79.2% by December,
compared with a 2009 recession low of 66.9%, and a 1972-2013 average of 80.1%.
Fluctuating quarterly inventory spending contributed a solid 0.26 percentage point to the GDP
growth rate. Inventory spending is a small part of the GDP but it often has a very large marginal
impact on quarterly growth rates. New durable goods orders, shipments, and other measures of
activity reported positive momentum after the first quarter. The Purchasing Managers’ Indexes
(PMIs) for manufacturing and services recorded solid improvement reflecting the cyclical gains.
Residential construction investment increased only 2.6% and contributed 0.08 percentage
point to GDP growth. New housing starts rose to 1,005,800 units, from a low of 554,000 units in
2009, but were far below the previous cyclical peak of 2,068,300 units in 2005. Single-unit starts
rose 4.9% and multi-unit starts were up 17.1%. The continued slow pace of new starts, sales of
new and existing houses, and steady deceleration of house price gains were caused by continued
employment and income concerns and a previous surge of prices (S&P/Case-Shiller Home Price Index,
20-city composite, rose 13.4% in 2013) , which discouraged buyers burdened by uncertain job prospects
and heavy personal debt (particularly student loans). Severe weather also limited activity during the
first quarter. Positive factors finally pushed new starts above the benchmark one-million annual
rate during the last six months: employment and income prospects improved; the “affordability
index” (ratio of median house prices to median family income) was still relatively favorable (4.3% rise in the
S&P/Case-Shiller index from November/November); historically low mortgage interest rates; sustained
builder optimism; the inventory of new and existing houses for sale remained historically low;
progress was made in reducing mortgage foreclosures and distressed sales (houses with “negative
equity” values declined from 25% of outstanding mortgages at the end of 2011 to 18.8%); many governments and
private financial institutions provided buyer assistance programs; and the Fed maintained its
accommodative “zero boundary” policy interest rate target to stimulate residential construction,
sales of new and existing houses, and related household durable goods spending.
Net exports of goods and services subtracted 0.56 percentage point from GDP growth. Real
exports increased 2.0% to $2.118 trillion and imports rose 5.3% to $2.590 trillion (4th/4th quarters).
Exports reported solid growth despite the global economic slowdown – particularly among U.S.
trading partners – based on enhanced competitiveness from low energy costs and stable unit labor
costs. However, stronger U.S. economic growth increased imports and rapid forex appreciation
of the U.S. dollar to its highest level in nine years restrained exports. Development of domestic
oil and gas resources and falling world energy prices increased U.S. petroleum product exports
and reduced its petroleum imports. The basic current account deficit declined to 2.3% of GDP
slightly below the 2 1/2% estimate in my 2014 baseline forecast and down from 6.2% in 2005.
Federal government spending for goods, services, and investment increased 0.2% and added
0.018 percentage point to GDP growth following an extended period of fiscal austerity. National
defense outlays reported a small decline of 0.4%, which subtracted 0.015 percentage point, and
nondefense spending edged up 1.2% and contributed 0.03 percentage point to GDP. Phasing out
previous cyclical stimulus, legislated “sequester” budget cuts, and declining outlays for foreign
military operations continued to create “fiscal drag” but those pressures eased and new political
budget disputes were postponed until after the crucial November 2014 congressional elections.
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State and local government consumption and investment rose 1.1% and contributed 0.13
percentage point to GDP growth after several years of austerity. Lower income and property tax
revenues and restrained federal assistance to help pay for Medicaid, education, and infrastructure
programs forced state and local officials to raise taxes, restrict spending, and tap special reserves
during the recession and slow recovery. Strong revenue gains and tight spending controls finally
have stabilized budgets and enabled officials to restore public services and begin new projects.
The average unemployment rate was 6.2% as monthly figures rapidly declined from 6.7%
to 5.6% (December to December). A broader measure, including underemployment (working part-time
for economic reasons and workers with marginal attachment to the labor force), declined from 13.1% to 11.2%.
The private sector added 2,861,000 new payroll jobs and governments added 91,000 workers -- a
remarkable increase of 2,952,000 jobs -- an average of 246,000 per month. The participation rate
(civilian employment as a percent of civilian noninstitutional population ) averaged 62.9% (62.7% in December) –
the lowest level since 1977 and down from 67.1% in 2000. December figures for states: North
Dakota (2.8%); Nebraska (2.9%); South Dakota (3.3); Utah (3.5%); Mississippi (7.2%); Georgia (6.9%);
California (7.0%; and Rhode Island (6.8%). The surge of job creation and declining participation
rate slashed the headline unemployment rate to near the “full employment” level (5 ½%) and was
the driving force behind improving consumer spending and confidence during 2014, even though
average hourly earnings rose only 1.7%. Nevertheless, there are chronic labor force problems
involving age, race, gender, education, training, obsolete skills, geographical demand and supply
of labor gaps, immigration, and persistent long-term unemployment (32% of unemployed workers have
been out of work for more than 27 weeks). Sustained economic and social progress will require more
effective solutions to be competitive in an integrated global economy dominated by technology.
Employment conditions and prospects will continue to be the major economic policy issue.
Inflation remained moderate (December to December) as the headline CPI rate plunged to only
0.8%. The food index rose 3.4% (14.1% index weight) but energy commodities declined 20.5% (4.7%
index weight). The core CPI (energy and food prices deleted) rose 1.6% as shelter costs (rental and owners’
equivalent rent of residences) increased 2.9% (32.5% index weight). Selected indexes for 2014 included:
apparel ( - 2.0%); new vehicles (0.5%); medical commodities (4.8%); medical care services (2.4%);
transportation services (1.7%); recreation (1.5%); tuition, school fees, and childcare (3.2%); personal
computers and peripheral equipment ( -10.5%). The collapse of oil prices (weak demand/excess supply),
modest labor cost pressures, a negative commodity-price index (The Economist: - 6.7%); rapid forex
appreciation of the dollar; and global competition for markets combined to restrain inflation.
The FY 2014 federal budget deficit of $483.3 billion (2.8% of GDP) fell far below the FY 2013
deficit of $680 billion (4.1% of GDP) and my baseline prediction of $600 billion. Revenues rose
9% to $3.021 trillion – 17.5% of GDP (17.4% average over last 50 years) because of stronger economic
activity, increased tax rates, and very large Federal Reserve System transfer ($99.2 billion). Outlays
rose 1% to $3.504 trillion – 20.3% of GDP (20.1% over last 50 years). The Social Security, Medicare,
Medicaid, and student loan program outlays increased, but mandated spending limits restricted
discretionary spending, including defense-military outlays, which declined from $607.8 billion to
$578.0 billion. Offsetting Fannie Mae/ Freddie Mac dividends to Treasury declined $25.6 billion.
The Gross National Debt rose $691.9 billion to $18.044 trillion during calendar year 2014.
Monetary policy was accommodative conforming to the Fed’s forward guidance that the
“zero boundary” policy interest rate target would be continued and quantitative easing (QE3)
regular purchases of $85 billion of bonds per month would be phased out gradually by October.
Officials emphasized that the timing, pace, and process of normalizing procedures to gradually
increase the policy interest rate target, will depend upon future employment, inflation, and growth
results rather than specific economic statistics (unemployment rate) or predetermined time schedules.
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2015 FORECAST
The Organization for Economic Cooperation and Development (OECD; 3.7%) and International
Monetary Fund (IMF; 3.8%) predict global GDP growth rate will rebound to trend in 2015 (3.75%;
1992-2007), from 3.3% in 2014, led by strong U.S. expansion, but key risks are tilted to downside.
Foreign trade is projected to increase only 4 1/2% given moderate growth and delayed reforms.
The continuing “GDP gap” (unused labor and production resources), declining energy and commodity
prices, and modest labor cost pressures will restrain global inflation (disinflation risks continue) and
high unemployment and underemployment will persist in many countries. Fiscal consolidation
will continue, to reduce budget deficits and control the rapid increase in gross-national-debt-toGDP ratios, but growing pressures to accelerate growth will prevent additional austerity actions.
Monetary policies will remain aggressively accommodative to promote growth and ease private
and public sector liquidity and solvency stress (but U.S./U.K. policy interest rates gradually will be raised).
Chronic current account imbalances will adjust to divergent national prospects and policies and
the impact of declining energy and commodity prices. Concern about private and public debt and
volatile financial markets, following the “deep, long, and diffused” global recession, continue
to frustrate the global recovery and create a legacy of huge debts, government intervention, and
“fine-tuning” macro policies that will dominate economic decisions for the foreseeable future.
The global economy probably will report modest growth in 2015, with persistent disinflation and
employment problems, disruptive current account imbalances, cautious fiscal consolidation, and
monetary accommodation. But there are many ominous risks: economic activity has decelerated
in Emerging Market Economies (EMEs) -- planned (China); cyclical (Brazil); catastrophic (Russia);
failure to achieve growth and inflation targets in Europe and Japan through macro policies and
structural reforms; anxiety about global financial conditions as monetary policies diverge – the
European Central Bank (ECB) and Bank of Japan (BoJ) are trying to stimulate growth and inflation
but the Fed has terminated quantitative easing and is preparing to increase its policy interest rate;
declining world energy and commodity prices will increase consumption in importing nations
but sharply reduce exports and revenues of supplier countries; falling energy and commodity
prices will reduce incentives for vital capital investments in developing resources; interest rates
in the United States will affect capital flows, particularly to Emerging Market Economies and
developing countries, shift relative forex currency rates, and realign current account balances,
thereby creating uncertainty and possible financial market volatility; a “normalization” of U.S.
monetary policy, combined with moderate inflation, will raise “real” interest rates, which will
make it more difficult to service existing private and public debt and threaten portfolio losses for
investors in dollar-denominated assets, particularly those with external debts and chronic current
account deficits; large government budget deficits continue in many countries, despite mandated
and voluntary consolidation programs; structural and regulatory barriers to growth still require
reforms to improve productivity and competitiveness; dysfunctional governments continue to
erode basic confidence; global trade and investment are limited by economic nationalism; little
progress has been made in most countries in adjusting retirement income and health care benefits
to match the reality of rapidly aging populations; and recurring crises caused by cold and hot
wars, terrorism, and natural disasters continue to disrupt economic activity. In the evolving
competitive, integrated, and rapidly realigning global economy these issues require focus on
long-term priorities beyond the next political election. Economic prospects for selected nations
are summarized below with real GDP growth rate forecasts for 2015 (year-over-year) prepared by
The Economist Intelligence Unit (“The World in 2015,” The Economist, November 2014, pp. 111-19).
Canada anticipates continued growth (2.3%)/ energy and commodity exports and business fixed
investment are key factors/ solid consumer spending projected to continue despite high household
debt and slowing residential construction boom/ inflation is rising steadily so the accommodative
monetary policy will begin to tighten/ fiscal consolidation is planned to reduce small government
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budget deficit/ unemployment is declining slowly/ current account deficits continue/ the positive
growth trend depends on energy and commodity exports, particularly to the United States/ sharp
decline of world oil prices could disrupt anticipated growth. Mexico projects faster growth (4.0%)
following disappointing 2014 results/ accelerating exports to the U.S. economy, strong domestic
consumption and investment, improved confidence based on government reforms in energy and
telecommunications sectors, broad fiscal stimulus, and accommodative monetary policies support
positive expectations/ inflation (3 ½%) and unemployment (5%) are relatively low and stable/ major
reforms have been legislated but implementation will be challenging/ government must focus on
difficult social and economic issues, particularly providing public safety and creating good jobs
for a growing labor force/ encouraging new technology and capital investment in the nationalized
petroleum industry (1938) is crucial/ Pemex now provides one-third of government revenues but
output has declined and sharp drop in oil prices threatens company cash flows and government
tax revenues/ foreign capital and technology continue to help diversify the economy and planned
structural changes will enhance productivity and increase domestic and foreign investment.
China (7.0%) is managing a planned transition from rapid growth rate (10.1% 1980 to 2009) to a more
sustainable 7% to 8% pace/ Chinese leaders now claim markets will play a “decisive” role and
have set 7 ½% GDP target to maintain domestic political and social stability and extend national
power/ China has become the world’s largest economy (purchasing power parity) but ranks 93rd on a
per capita basis/ gradual deceleration of growth throughout 2014 caused by reduced investment in
residential construction (high vacancy rates) and heavy industry (excess manufacturing capacity)/ OECD
projects sustained 7% GDP growth/ inflation rate is about 2% and unemployment rate (4%) will be
stable as surplus of workers is eliminated/ current account surplus (2.8% of GDP down from 10.1% in
2007) reflects strong exports and gradual appreciation of renminbi valuation/ surging demand for
imports of consumer and capital goods has increased/ China is aggressively promoting its “Silk
Road” strategy to increase exports throughout Asia and Europe by building new roads, railways,
and ports/ fiscal policies are conservative (budget deficit of only 1.3% of GDP) with emphasis on social
housing, infrastructure, and security projects/ accommodative monetary policies remain focused
on liquidity and solvency of public and private companies, thereby creating an implicit guarantee
of government bail-outs/ slowdown of growth in 2014 caused officials to lower the central bank
policy interest rate and increase liquidity assistance to targeted public and private borrowers but
there was no repetition of the massive monetary stimulus during the global crisis of 2008/ there is
flexibility to add fiscal and monetary stimulus if the economy falters/ China holds $4 trillion of
official foreign exchange reserves, about two thirds in dollar-denominated assets, despite official
program to diversify into other currency assets and accelerating efforts to make the renminbi an
international currency for trade, investment, and official reserves and to serve geopolitical goals/
China’s rapid economic transformation was based on a development model that emphasized huge
trade surpluses and capital inflows, a controlled/undervalued national currency, and public and
private investment in housing, manufacturing facilities, and infrastructure rather than public and
private consumption/ it is now realigning goals and policies to emphasize personal consumption
and caring for large and aging population by improving education, health care, and environmental
conditions, public pensions, and welfare services/ current challenges: serious imbalance between
consumption and investment (excess capacity and supply in basic industries and residential construction); jobs
for migrants moving from rural to metropolitan areas; transition from state to private companies
subject to market competition; “mercantilist” foreign trade and investment policies; shortages of
skilled labor; ominous demographic trends; unbalanced geographic economic development; risks
created by the surge of personal, company, and public debt from 156% of GDP at yearend 2007
to 250% by 2014; quantity and quality of risky loans extended by local governments and the huge
“shadow banking” system used to evade banking rules; structural and deregulation reforms; debt
“fatigue” of servicing huge private and public loans; transition of renminbi into global financial
markets; and creating cooperative and stable regional and global economic and security relations.
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Japan (1.8%) continues to experience volatile performance/ from 1950 to 1973 Japan reported
annual growth near 10% based on exports of innovative products, high productivity, and hard
work/ growth decelerated following the global oil shock of 1973 and its financial asset “bubble”
collapsed in 1991 (73% decline of equity prices)/ followed by two decades of erratic growth (about 1%
annually), large fiscal deficits and a huge public debt, destructive deflation, erosion of competitive
status, and a declining population/ 2014 reported two quarters of negative GDP results following
the April increase in the consumption tax (5% to 8%) and deterioration of slow progress toward 2%
inflation goal by yearend (excluding tax effects)/ the OECD forecast now projects modest growth of
0.8% in 2015 and 1% in 2016 based on improving household income, domestic consumption and
investment, and exports following devaluation of forex value of the yen (trade-weighted value down
25% since late-2012)/ controversial second consumption tax increase (2%) now postponed until 2017/
in 2013 Prime Minister Abe announced “three arrows” policies to reverse debilitating deflation
and accelerate growth/ monetary arrow pledged “zero boundary” interest rate target plus massive
quantitative and qualitative easing by purchasing more sovereign bonds to create 2% inflation and
raise expectations to encourage domestic consumption and investment and raise nominal GDP to
help correct chronic fiscal stress/ QE program sharply increased last October to restore progress
on inflation target after gradual rise in headline inflation appeared to regress in the second half of
2014/ OECD now predicts the headline CPI will be 1.8% in 2015 and 1.6% in 2016/ but decline
in world oil prices may limit progress/ decline in size of labor force and trend to “irregular” jobs
(short-term employment contracts) have reduced unemployment rate to 3 ½%/ second “Abeconomics”
arrow was a round of fiscal stimulus provided by tax relief and budget outlays for infrastructure
and rehabilitation of devastated areas hit by the tragic earthquake and tsunami/ additional fiscal
stimulus was added in 2014 to offset consumption tax increase/ the OECD projects another large
general government fiscal deficit of 7.3% of GDP in 2015/ chronic government budget deficits
have created a huge gross-public-debt-to-GDP ratio of 230% in 2014 – by far the highest figure
of any OECD country (net public-debt-to GDP is 143%)/ Japan has been able to finance its large fiscal
deficits with domestic savings at very low interest rates/ medium-term fiscal consolidation needed
to achieve official goal of eliminating its primary budget deficit by 2020 (excludes interest payments)/
third arrow of crucial structural adjustments has been frustrated by political timidity/ Japan needs
to restore fiscal stability, act on major structural reforms, adjust to a declining and rapidly aging
population, and resolve dangerous regional and bilateral (China/North Korea) geopolitical problems.
India’s growth rate is projected to accelerate (6.5%) but remain below its rapid 2003-08 pace and
8 1/2% target/ Narenda Modi became Prime Minister last May and promised active administrative
competence, significant economic reform, and support for dormant private and public investment
projects/ optimism created by preliminary actions/ chronic inflation has decelerated to pace below
the target of 7% and effective monetary policies and declining oil import prices suggest continued
progress/ chronic government budget deficits persist (6% to 7% of GDP) because of ineffective tax
policies, expensive subsidies, and wasteful public spending/ large current account deficit slashed
by limiting imports and a large devaluation of the rupee has increased exports/ despite turnaround
in economic results and underlying optimism there are many familiar problems: inadequate public
and private investment; widespread public and private corruption and bribes; pervasive regulatory
and structural barriers; inadequate global competitiveness that restricts exports; and inability to
attract crucial direct foreign capital investment/ Reserve Bank of India has aggressively targeted
inflation but there are pressures on monetary and fiscal officials to adopt more accommodative
policies/ previous growth has made India the fourth largest economy in the world (purchasing power
parity), and it has the “demographic dividend” of having a large group of young workers entering
its labor force (10 million per year during the next decade) when most countries have a slow or negative
population change, but increased public and private investment and fundamental regulatory and
structural changes are required to improve productivity and global competitiveness to accelerate
growth, eliminate chronic inflation, and reduce high unemployment and underemployment rates.
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The ASEAN-5 anticipates continued growth despite political tensions in several members:
Indonesia (5.9%); Thailand (4.5%); Malaysia (5.4%); Philippines (6.3%); and, Vietnam (6.6%)/
Thailand is expected to resume growth following intense political turmoil that created a military
government/ Indonesia recently elected a new president, who has promised economic reforms/
slower global economic growth, particularly in China, has restrained exports causing reduced
current account surpluses, or even deficits/ domestic consumption and investment remain strong
enough to sustain solid growth results throughout this region/ uncertainty persists about the
potential impact of monetary tightening in the United States on regional capital inflows and
outflows/ fiscal and monetary policies are accommodative/ structural reforms remain crucial.
The NIEs anticipate moderate GDP growth: Korea (3.7%); Taiwan (3.3%); Hong Kong (2.6%);
Singapore (3.8%)/ export-dependent economies have solid domestic demand, very low inflation
and unemployment rates, accommodative fiscal and monetary policies, and large current account
surpluses/ global and regional trade prospects (China slowdown), currency forex rates, and financial
stability as America tightens monetary policy will be crucial variables/ OECD forecast for Korea
(4.0% zone 2015-16) projects strong domestic demand and accelerating exports despite appreciation
of the national currency/ continued fiscal and monetary accommodation/ need to prepare for an
aging population and the contingent risks of any emergency in North Korea/ structural reforms
needed to sustain rising income levels and leading position in global innovation and technology.
Australia (2.5%) projects moderate growth/ lower commodity export demand and prices/ reduced
mining investment/ domestic consumption and investment are solid/ declining forex rate sustains
other exports but chronic current account deficits persist/ inflation remains moderate (2% zone) but
the unemployment rate has increased steadily (6%)/ fiscal and monetary policies remain basically
accommodative/ New Zealand (2.8%) anticipates sustained growth/ reconstruction following two
severe earthquakes supports consumption, housing, and business investment/ inflation remains
low (under 2%) and unemployment rate continues to decline (5.6%)/ current account deficit caused
by weaker commodity export demand and strong currency/ cautious fiscal and monetary policies.
Latin America projects a slow recovery from sharp slowdown caused by reversal of commodity
super cycle following boom (2003-13)/ Argentina (1.9%); Bolivia (4.0%); Brazil (1.8%); Chile (3.6%);
Columbia (4.4%); Ecuador (4.9%); Paraguay (4.1%); Peru (4.9%); Uruguay (3.3%); and Venezuela
(- 0.5%)/ the IMF predicts continued growth in Central America (3.9%) and the Caribbean (3.3%)/
lower prices and subdued global demand for oil and commodities, and sustained import demand,
restricted growth and increased current account deficits except for the energy exporters/ domestic
private consumption, investment, and public infrastructure projects decelerated/ fiscal restraint is
needed to limit public deficits and debt/ monetary restraint is focused on inflation, which is above
official targets (rapid inflation in Argentina and Venezuela)/ major problems include income and wealth
inequality; high unemployment; and inadequate spending on the infrastructure, health, education,
welfare, and public services/ private investments are required to diversify economies to reduce
reliance on oil and commodity exports/ several governments have created political, social, and
economic tensions that discourage investment/ Latin America has great potential: population of
more than 500 million people (not including Mexico), abundant land, extraordinary natural resources,
and established trade and investment relationships with North America, Europe, Asia, and Africa
but it must overcome a long history of political, social, and economic instability/ progress has
occurred in recent years but barriers to open and competitive markets continue to restrict growth/
Brazil (40% of regional economic output) experienced a brief recession during first six months of 2014
because of weak global demand for its exports, restraint of public spending to cut budget deficits,
previous appreciation of national currency, and anti-inflation monetary policies/ moderate GDP
growth is projected but structural reforms are required to control government spending, deficits,
and debt, improve the infrastructure and public services, and increase productivity investments.
9
Europe’s weak and fragile growth is projected to remain in 1% zone/ disappointing pace in euro
area but solid gains in Poland, Turkey, and United Kingdom/ weak domestic consumption and
investment/ extremely low inflation and pessimistic expectations (deflation in some countries)/ very
high unemployment rates (Germany low)/ small current account surpluses (large in Germany)/ erosion
of regional trade and exports to Emerging Market economies and Russia/ forex value of euro has
declined/ sustained budget deficit reductions from mandated fiscal rules (delays in France and Italy)/
continued accommodative monetary policies as the European Central Bank (ECB) has set minimal
policy interest rate target, provided liquidity aid, and now plans key quantitative easing by buying
sovereign debt/ sovereign debt problems have stabilized but bank liquidity and solvency issues
need bank reforms and coordinated regulation/ fiscal consolidation in troubled nations has eased
as modest growth has been restored/ political adjustments made to alleviate growing economic
and social risks of “austerity fatigue”/ but medium-term fiscal consolidation will be required to
reduce large public debt-to-GDP ratios/ need basic structural and regulatory reforms to enhance
productivity/ large interest-rate spreads between core (Germany) and peripheral countries continue
but sovereign debt and banking crises of recent years appear to be under control/ declining world
oil prices should increase consumption but exacerbate deflation risks/ Russian military adventures
create geopolitical problems / Economist Intelligence Unit 2015 estimates for selected nations
include: Austria (1.6%); Belgium (1.2%); Bulgaria (2.5%); Croatia (0.8%); Czech Republic (2.7%);
Denmark (1.3%); Estonia (3.0%); Finland (1.2%); France (0.8%); Germany (1.6%); Greece (2.3%);
Hungary (2.4%); Ireland (3.0%); Italy (0.3%); Netherlands (1.0%); Norway (2.5%); Poland (3.5%);
Portugal (0.8%); Romania (3.0%) Slovakia (2.5%); Slovenia (1.0); Spain (1.4%); Sweden (2.4%);
Switzerland (2.5%); Turkey (4.0%); Ukraine (1.2); and the United Kingdom (2.5%).
Russia (1.0%) rapid deterioration into “stagflation”/ declining domestic consumption/investment
and rising inflation/ crisis factors: sharp decline of global demand/price for oil causing exports to
plummet (oil accounts for 70% of export earnings); fiscal stress linked to erosion of oil exports; massive
devaluation of the forex ruble rate; misallocation of capital to crony military/industrial complex;
weak exports to Western Europe; lagged “bite” of geopolitical sanctions in response to military
seizure of Crimea and invasion of Ukraine; potential stress in servicing external corporate debt
payments (current foreign currency reserves adequate for about two years); severe tightening of monetary
policy to relieve intense forex pressures and comply with “inflation targeting” rules; accelerating
capital flight given “oil/ruble” crises; and autocratic and corrupt domestic business environment.
International Monetary Fund (IMF) predicts strong 5.8% GDP growth in Sub-Saharan Africa:
oil exporters (7.0%); middle-income nations (3.6%); and low-income nations (6.6%)/ during previous
decade region reported robust real growth, decelerating inflation, improved fiscal and monetary
policies, declining external debts, and growing domestic consumption and investment/ increased
demand and high prices for energy and commodity exports/ but slow global growth now threatens
exports/ current surge of personal, corporate and public debt/ extreme political, economic, and
social differences in the region but the impressive record indicates responsible political and social
policies can sustain economic progress/ positive factors include: solid domestic consumption and
investment supported by a growing middle class; a “demographic dividend” of rapid labor force
growth; and relative stability when civil and regional wars are avoided and real elections are held/
but serious problems persist: extreme poverty in many countries; income and wealth inequality;
inadequate health, education, security, and infrastructure services; corruption; civil unrest; border
wars; extreme dependence on energy and commodity exports; volatile capital and credit inflows;
recent surge of external private and public debt; and chronic political instability/ Nigeria (7.3%)
and Angola (5.9%) are major oil exporters/ the middle-income group includes South Africa (2.3),
Ghana (4.7%), Cameroon (5.2%), Zambia (7.2%), Senegal (4.6%)/ the low-income group includes
Ethiopia (8.5%), Kenya (6.2%), Tanzania 7.0%), Uganda (6.3%), and Madagascar (4.0%).
10
Middle East and North Africa outlook determined by price and volume of commodity and oil
exports and chronic political and security crises created by pervasive instability/ oil exporters:
Saudi Arabia (4.4%); Iran (2.0%); Algeria (3.3%); Libya (5.4%); and Iraq (6.8%)/ oil importers:
Egypt (3.3%); Morocco (4.3%); Jordan (4.3%); Lebanon (2.6%); and Israel (3.6%)/ area economy
disrupted by wars, civil unrest, terrorism; repressive governments; inflation and unemployment;
socioeconomic inequality; falling tourism; limited economic diversification; volatile oil price and
demand; large current account surpluses and deficits; restrained foreign direct investment/ despite
decade of high world oil prices there are budget deficits in many countries/ require more spending
on education, social services, and infrastructure/ structural reform needed to diversify economies.
My United States baseline forecast projects solid GDP growth of 3% (4th to 4th quarters) -- a 70%
probability – well above the current 2 1/4% medium-term target, (determined by estimating changes in
the size of the labor force, productivity, hours worked, and unemployment rate). Even faster growth is a 20%
probability if net consumer and business spending accelerates because of the sharp drop in energy
and commodity prices. Slower growth is a 10% probability if external shocks disrupt confidence.
General baseline forecast assumptions are summarized below but actual results may vary widely
depending upon global energy, food, and commodity demand and prices and major external risks.
BASELINE ECONOMIC FORECAST FOR 2015
(Fourth to Fourth Quarters; Real Chained [2009] Dollar Basis)
Sector
Change
Personal Consumption
Business Fixed Investment
Inventories (contribution to GDP)
Residential Construction
Net Exports (contribution to GDP)
Federal Government
State & Local Government
X
Share of GDP = Contribution to GDP
3%
6%
67%
12%
8%
3%
1%
2%
7%
11%
2.01
0.72
0.00
0.24
- 0.30
0.07
0.22
100 %
2.96
Total
The U.S economy now enters 2015 with cumulative momentum despite pessimism about
geoeconomic and geopolitical prospects. Positive contributions to domestic GDP growth are
projected from every sector except the net exports balance. Previous “headwinds” have become
new “tailwinds” – rapid payroll job gains, improving personal incomes, energy and commodity
prices, evolving residential construction and sales, stable business capital investment, restoration
of consumer and business optimism, and gradual easing of “fiscal drag” created by government
budget austerity. The shocks of severe weather, Ebola health crisis, Russia’s military aggression,
China’s complex transition to more balanced and sustainable growth, Europe’s “stagflation” and
sovereign debt problems, chaos throughout the Middle East, and the new challenge to Africa and
Latin America of adjusting to the end of the commodity “super cycle” have been controlled. The
convergence of improving employment and income prospects, unusually low inflation, recovery
of household net worth , and stable monetary and fiscal policy support has created a foundation
for robust near-term GDP growth. Previous legislative deals have stabilized the federal budget
and delayed the next firestorm. The preliminary political struggles leading up to the pivotal 2016
national elections will not disrupt the economy. Monetary officials have repeatedly emphasized
that they will be “patient” – code for moderate and gradual – during the “normalization” of
accommodative policies beginning after the mid-year. This will be the best economy since 2007.
11
Personal consumption expenditures are expected to increase 3% – close to the 3½% pace
during the Great Expansion (1982 to 2007). This sector accounts for about two-thirds of total GDP.
The University of Michigan Consumer Sentiment Index surged to a reading of 98.1 in January
2015, its highest level since 2004 (average of 89.0 during five years prior to the recession and 64.2 during that
18-month downturn), as household employment and income prospects improved and gasoline prices
plummeted. The strong demand for new cars and trucks, to replace aging vehicles, is expected to
continue (over 17-million units) and household durable goods spending also should rise as residential
construction and sales steadily increase. Spending for nondurable goods and services is projected
to grow at solid trend rates. Personal consumption optimism is the crucial forecast variable.
The ability of households to spend will be increased by positive disposable income gains and
modest inflation. Wages and salaries finally are expected to accelerate, after a disappointing flat
trend during the recovery, as more and higher-paying jobs are created – over 200,000 per month
compared with the natural labor force growth of about 150,000 per month. Proprietors’ income,
rental income, personal dividend and interest income, and government transfer payments also are
projected to rise steadily and no new personal income tax increases are scheduled. Household
spending will be enhanced by the positive real and psychological “wealth effects” of booming
stock market indexes and real estate price gains. Household net worth increased to a record high
of $81.35 trillion by the third quarter of 2014 compared with a pre-crisis level of $68.1 trillion
in the third quarter of 2007. Consumer purchasing power also is significantly improved by the
exceptionally low inflation rate (the core PCE measure of inflation rose only 1.4% 2013.4 to 2014.4). Falling
oil prices are a major factor and Citigroup analysts recently predicted that the decline in energy
prices will increase annual disposable personal income by about $1,400 per household. The
enhanced ability to spend is reflected in the Gallup U.S. Standard of Living Index, which rose
to +50 last December from a recession low of +14 in November 2008. This daily national survey
reported that 81% of those polled were “satisfied with your standard of living, all things that you
can buy and do” (up from 69% in November 2008) and that 61% felt their current status “is getting
better” while only 23% believe it “is getting worse.”
The willingness of households to spend ultimately depends upon employment and income
prospects but personal debt and saving decisions are important factors. Households appear to be
satisfied that their “deleveraging” efforts are adequate and have resumed their typical spending
and saving habits. Total consumer credit increased rapidly in 2014 to a record $3.298 trillion.
Revolving credit (credit cards) has been restrained since the recession but automobile and student
loans have exploded as interest rates have been extremely low and lending terms have been eased.
Surveys of lending institutions confirm that accommodative credit guidelines will continue as
loans to subprime and low-credit-score borrowers have increased rapidly despite the extensive
problems in the mortgage markets when the “housing bubble” collapsed. The anticipated increase
in short-term interest rates after mid-year, when the Fed begins to “normalize” monetary policies,
should not disrupt consumer spending this year as the process is likely to be moderate and gradual
and automobile and student loan credit demand is determined by other decision factors. Personal
saving as a percentage of disposable income is likely to remain at relatively low levels – it fell to
4.8% in 2014 -- below the 40-year average of 9.6% reported from 1960 trough 1999. The positive
psychological benefits of rising financial asset and real estate prices also will encourage robust
consumer spending. The probable ability and willingness of households to spend should increase
personal consumption by 3% during 2015, despite many ominous geoeonomic and geopolitical
risks, thereby supporting a broad cyclical expansion.
Residential construction investment is projected to rise 8% continuing its moderate growth
pace after several years of depressed activity. This gradual rebound reflects pent-up demand for
housing created by new households and a low supply of houses for sale. An average 1.4 million
12
new households were formed each year from 1958 through 2007 but that figure plummeted to an
average of 500 thousand from 2008 through 2011 during the Great Recession and disappointing
recovery. The Wells Fargo Economics Group now estimates 1.2 million households were created
in 2014, and predicts another 1.5 million in 2015, as improving job and income prospects will
enhance the ability and willingness of potential buyers. The pace of new household formations
and destruction of existing houses will create an underlying demand for over 1½ million new
units for several years. Strong GDP growth during 2015, with steady employment and household
income prospects, will sustain moderate gains in housing starts, sales, and prices. The Housing
Affordability Index (median house price to median household income ratio) is a positive factor as prices
decelerated to a 4.3% gain last year (November to November). Mortgage interest rates are relatively
low by historical standards (conventional rate is below 4%) and private and government programs
provide financial and mortgage debt-restructuring assistance. Builders are cautiously optimistic
as national income and employment prospects improve. Higher house prices now provide equity
to help owners to “trade up” and the number of mortgages outstanding with “negative equity”
has declined steadily (debt exceeds the market value of the house). Rising rental costs also will encourage
new residential construction investment. The probable ”normalization” of monetary policy after
mid-year will raise short-term interest rates but the moderate and gradual adjustment should not
disrupt long-term mortgage borrowing during 2015. Moderate house price increases and the
previous “wealth effect” of rising stock market and real estate values also will encourage buyers.
Residential construction investment currently represents only about 3% of total GDP but it has a
crucial impact on household spending for appliances and furnishings and the baseline economic
outlook. The recovery of this vital sector has been cautious because of the severe losses caused
by the cyclical collapse of the “housing bubble”, and related financial market meltdown, but a
positive expansion trend appears to be established. Multifamily unit construction probably will
level off, after the recent surge of building, but single-unit activity should expand. Government
budget controls probably will prohibit any new mortgage-assistance programs or tax credits
for homebuyers but personal income tax deductions for mortgage interest payments are safe and
monetary accommodation will continue to have a favorable impact on the cost and availability
of credit for builders and buyers. The housing sector did not fulfill its traditional role of leading
the recovery but it will be an important factor in sustaining a strong expansion during 2015.
Business fixed investment is expected to increase 6% during 2015. Spending for equipment,
intellectual property products, and structures (plants, commercial buildings, shopping centers, utilities, health
care, education, religious, environmental) will continue given positive fundamentals: strong sales, cash
flows, and profits; easy access to credit and capital markets at very low interest rates; the capacity
utilization rate has returned to historical average; need to replace aging capital stock to increase
productivity and control costs; pressures to use cash reserves (estimated $1 ½ trillion) for productive
investments rather than “financial engineering” purposes; and business confidence in future GDP
growth. A major negative factor is the sharp decline of world oil prices, which may limit energy
development investments and affect support businesses, manufacturers of equipment, pipelines,
transportation firms, and related services. The “normalization” of monetary policy after midyear should not cancel many planned capital investments because it will be moderate and
gradual. After several years of cautious business capital investment plans this sector should
report impressive gains this year despite possible energy industry spending restraint.
Inventory investment is projected to have a neutral effect on the GDP by tracking real final
sales. The inventory-to-sales ratio has declined steadily for several decades as companies have
used information technology to increase efficiency and control operating costs. The I-S ratio has
moved in a narrow range of 1.25 to 1.30 since the cyclical recovery began in mid-2009. Robust
growth should sustain cautious inventory spending at the same pace and prevent the buildup of
unwanted stocks. Quarterly fluctuations in inventory spending have a major impact on the GDP.
13
The real net export balance is projected to subtract 0.3 percentage point from total GDP.
The OECD predicts U.S. exports of goods and services will increase 5.7% and imports will rise
4.4% this year. Exports of capital goods, automobiles, agricultural products, consumer goods,
industrial supplies and materials, maintenance and repair services, telecommunications, tourism,
transportation, financial, insurance, royalties, and government services are expected to gradually
increase despite the slowdown of GDP growth in many trading partners in Europe, Asia, and
Latin America and the 17% appreciation of the forex value of the U.S. dollar to its highest level
in nine years. The relative value of the dollar is expected to continue to rise because of the faster
growth rate in the U.S. economy and the potential “normalization” of its monetary policy, which
will increase interest rates, while Europe and Japan use “quantitative easing” to try to stimulate
growth and avoid deflation. New technologies, involving hydraulic “fracking” of shale rock and
innovative horizontal drilling procedures, have restored domestic output of oil and natural gas
and the benefits of lower energy costs and secure supply sources have spread throughout the
domestic economy. Exports of refined petroleum products (gasoline and diesel fuel), crude oil, and
natural gas have increased rapidly and imports of crude oil and fuels have declined steadily. The
demand for imports also will continue to rise as the U.S. economy accelerates and private and
public consumption and investment increases. Academic studies have demonstrated that imports
grow faster than exports when the momentum of the U.S. economy accelerates because of its
consumption orientation. Combining the chronic deficit on goods and services trade, net surplus
of receipts and payments on foreign direct and portfolio investments, and net government transfer
payments (includes military grant programs) will create a current account deficit in a 21/4% zone. The
United States is still the world’s largest debtor nation and its large current account deficit will
continue, but the potential of higher yields and safe-harbor safety of dollar-denominated assets
will sustain the strength of the U.S. dollar. Completion of bilateral trade agreements with Europe
and Asia to reverse the sluggish pace of global trade and persistent mercantile policies will be a
major goal this year. It may be possible for the Obama Administration and Congress to cooperate
on this policy issue, although complex environmental, regulatory, and labor rules will have to
be resolved. Restoring balanced global growth, trade, and investment will help the United States.
Federal government consumption expenditures (the value of goods and services provided but not
transfer payments such as Social Security, Medicare, Medicaid, benefits, grants, or interest) and gross investment
(equipment, software, and structures) are projected to rise 1% during 2015 after a surprising increase in
defense and nondefense spending last year. The temporary “fiscal drag” -- caused by phasing out
anti-recession programs and Iraq/Afghanistan outlays and enforcement of “caps” and “sequester”
rules set by the Budget Control Act of 2011 -- has been neutralized by legislative compromises
required to approve federal budgets responsive to the specific priorities of both political parties.
Serial omnibus spending packages have prevented another government shutdown debacle caused
by failure to provide appropriations for government operations. Additional spending pressures are
likely as budget deficits have temporarily declined and politicians focus on proposing new ideas
that will appeal to voters prior to the 2016 national election. Unexpected outlays for disaster relief
and contingency military actions in the Middle East also will increase actual federal spending.
State and local government spending is projected to increase 2% following several years of
fiscal austerity. Personal income, corporate, and sales tax revenues are rising and state officials
now project balanced budgets, or small surpluses, for FY 2015 even though spending for basic
public services and delayed infrastructure projects is increasing steadily. Local governments will
have more budget options as property tax revenues begin to recover as real estate values rise. The
turnaround of state and local government spending will make an important contribution to the
strong GDP growth rate projected for 2015 (this sector spends twice as much as the federal government on
direct goods and services included in the GDP and employs twice as many workers as the manufacturing sector).
14
The unemployment rate probably will continue to decline throughout the year and report an
average 5½% figure in 2015 (down to 51/4% by yearend) -- the lowest level since 2007 -- depending
upon potential changes in the size of the labor force. A broader measure (those working part-time for
economic reasons and workers with marginal attachment to the labor force) will report similar improvement to
about 10%. Net payroll jobs should continue to rise by more than 200,000 per month, which
will steadily push the unemployment rate below the “full employment” level – now estimated to
be 51/2%. Wage indexes have been stagnant despite declining unemployment but the rapid
reduction of slack in the labor market will create moderate pressure on the Employment Cost
Index (ECI). The broad quality of jobs has improved with gains in professional/business services,
health care, construction, and manufacturing positions. The unemployment rate will depend upon
the actual GDP growth rate and changes in the labor force composition. The participation rate
(civilian employment as a percent of civilian noninstitutional population) will have a major impact on results.
During a recession the labor force naturally contracts as job prospects deteriorate. When cyclical
recovery begins the participation rate then typically rises as workers become more optimistic
about searching for jobs and decide to return to the labor force. The positive inflow of new and
marginally attached workers creates pressure on the unemployment rate. However, during this
recovery the participation rate has declined from 65.7% in July 2009 to 62.7% by December
2014. Voluntary retirement of older workers in the “baby boom” generation explains part of the
erosion but some discouraged employees have dropped out of the labor force, stayed in school,
or chosen early retirement or disability benefits. Those suffering long-term unemployment may
also have left the labor force. It is difficult to predict how these diverse factors will influence job
gains and participation rate changes but my baseline forecast assumes faster economic growth
gradually will reduce the unemployment and underemployment rates. That progress will increase
household spending and residential construction leading to sustained business capital investment.
Robust economic growth will relieve fiscal tensions and provide flexibility and credibility for the
Federal Reserve to begin its necessary “normalization” of monetary policy after mid-year.
The inflation forecast is the most problematic part of the baseline estimate because of great
uncertainty about future business “pricing power” and energy, food, and commodity prices.
The core CPI probably will rise about 2% (December to December) as prices for shelter, health care,
and other services continue to increase and the Employment Cost Index gradually moves higher
as the unemployment rate falls below the benchmark 51/2% level. The projected headline CPI
figure of 11/4% is simply an average of a very wide range of possible results – 3/4% to 13/4%.
In 2014, the headline CPI tracked my 2% forecast during the first six months (up 2.1%, June over
June) but world oil prices then fell from $115 to less than $50 per barrel. The unexpected collapse
of energy prices helped to slash the headline CPI inflation rate to only 0.8% last year as energy
commodity prices fell 20.5%. Last December, the headline CPI declined 0.4% as gasoline prices
fell 9.4% that month. The rapid appreciation of the trade-weighted forex value of the U.S. dollar
to its highest level since 2003 also restrained domestic inflation by reducing import prices. The
actual headline CPI this year will depend upon the GDP growth rate, labor costs, the forex value
of the dollar, and near-term global energy, food, and commodity demand and prices. A probable
low rate of inflation will provide the Federal Reserve considerable flexibility in selecting the
timing and pace of the potential “normalizaton” of monetary policy. Monetary officials remain
more concerned about disinflation (decelerating rates of price increases), or even deflation (general price
decline), than any immediate threat of inflation above the “2% or a bit below” policy target. Most
analysts assume the benign inflation environment will extend through 2015, but inflation risks
should not be ignored as the U.S. economy moves from its “slow, long, and erratic” recovery
into the expansion phase of the business cycle. Inflation risks eventually will accelerate, because
of fundamental demand and supply conditions and external shocks, but the problems usually are
not recognized until after inflation gains considerable momentum, which forces macro policies
to suddenly react to unexpected events and shifting expectations.
15
Monetary policy will be accommodative – to promote growth and jobs creation and push the
core PCE inflation rate towards the 2% goal after the Quantitative Easing (QE3) program ended
last October. The Fed is expected to begin the “normalization” process by gradually raising its
fed funds interest rate target from the low level of zero to ¼% in place since December 2008 to
help reflate the U. S. economy to fulfill its dual mandate to create stable prices and maximum
employment. Critics argue that it is premature to raise interest rates when inflation is far below
official targets – with falling energy, food, and commodity prices – and that a 3% GDP growth
forecast is too optimistic given the geoeconomic and geopolitical problems. But the consensus
analysis is that the Federal Open Market Committee (FOMC) probably will announce a new policy
sometime after mid-year to gradually increase its fed funds target by 25 basis point increments,
raising the rate close to 1.0% by the end of 2015 and continuing the process in 2016. Officials
already have signaled their forward guidance that the FOMC “can be patient in beginning to
normalize the stance of monetary policy.” They also emphasize that the actual timing and size
of tightening will be “data driven” so the transition may be delayed but it is unlikely to occur
prior to mid-year despite the rapid decline in the unemployment rate. The Fed assumes the almost
60% drop in oil prices is temporary but it is concerned about the risks of low core PCE inflation.
The process of raising the target will involve adjusting the interest rate paid on reserves held by
banks in excess of the legal requirements (that rate will become the fed funds “floor” because banks will not
provide credit at lower rates) and the Fed has conducted experiments using new Reverse Repurchase
Agreements with eligible financial institutions to manage its open-market transactions to achieve
future FOMC instructions. Continued reliance on forward guidance from the FOMC is feasible
because of the institutional credibility created by several decades of responsible monetary policy.
The crucial point is that the future increase in the fed funds rate will not begin immediately and
the pace will be gradual and limited to avoid disrupting domestic and global financial markets.
This “patient” approach reflects the risks and the pragmatic priorities of the central bank. The
dominant majority of the voting members of the FOMC continue to believe: that growth benefits
are more important than inflation risks for the foreseeable future; unconventional Fed tactics can
accelerate growth without igniting inflation; forward guidance can effectively influence the
behavior of financial markets and the term structure of interest rates; fostering more economic
growth is the best and fastest way to return to traditional Fed policy tools; and given the risks it
is preferable to error on the side of excessive accommodation rather than premature tightening.
Most political and economic officials strongly support that viewpoint and policies probably will
remain accommodative after traditional statistical benchmarks for policy changes are fulfilled.
After six years of “ zero boundary” policy interest rates and three rounds of quantitative easing
the projected gradual tightening of basic policies will have negative “announcement effects” on
money and capital markets around the world, and marginal restraint on private consumption and
investment, but there is a consensus that a “normalization” process will be required to restore a
more realistic allocation of resources and recognition of the risks of large private and public debts
accumulated during the global financial crisis and disappointing recovery. The challenge will be
to rationalize divergent monetary trends as the United States gradually tightens policies while
Europe and Japan rely on ultra-low interest rates and “quantitative easing” to reverse stagnation.
My baseline forecast assumes more easing of “fiscal drag” and another federal budget deficit
in the $500 billion zone in FY 2015 – 50th annual deficit in the last 55 years. The Congressional
Budget Office (CBO) projected a gap of $468 billion in its latest January 2015 analysis (if current
spending and tax laws are not changed). Deficits have declined steadily since the Great Recession crisis
(FY 2009, $1.413 trillion; FY 2010, $1.294 trillion; FY 2011, $1.300 trillion; FY 2012, $1.089 trillion; FY 2013, $680
billion; and FY 2014, $483 billion) from 9.8% of GDP in FY 2009 to 2.8% last year. The CBO analysis
assumed 2.9% real GDP growth and 1.5% headline CPI inflation rates (2014.4 to 2015.4). Revenue
gains are expected as faster growth generates more personal and corporate income and payroll tax
collections and other sources, such as remittances from the Federal Reserve, continue to expand.
16
Outlays are now projected to move higher as mandatory funding for Social Security, Medicare,
Medicaid, and the Children’s Health Insurance program steadily increases and subsidies paid for
health insurance purchased under the rules of the Affordable Care Act (ACA) accelerate rapidly.
Required interest payments on the national debt are projected to increase as the size of the debt
quickly increases and interest rates begin to rise. New unemployment compensation benefits will
decline as labor market conditions continue to improve. Discretionary spending for defense and
other programs requiring annual appropriations will still be restrained by the Budget Control Act
of 2011, which enforced caps and sequester rules, but those new guidelines were adjusted by the
Bipartisan Budget Act of December 2013, which created more flexible rules through FY 2015
(September 30, 2015). Actual budget outlays probably will exceed the current projections as political
pressures mount to increase spending and reduce taxes prior to pivotal national elections in 2016.
Increased funding for domestic and overseas contingency operations, involving military actions in
the Middle East and anti-terrorist responses to current attacks, probably will push the FY 2015
deficit above the recent $468 billion projection. A sharp decline from $1 to $11/2 trillion deficits
to 2.8% of the GDP in FY 2014 (slightly above the 50-year average of 2.7%) has dissipated the tenuous
commitment of most politicians and economists to supporting real medium-term fiscal reforms to
reduce potential budget deficits. The general public does not understand the significance of the
gross national debt of $18.044 trillion (December 30, 2014) or the anticipated $227 billion of net
interest payments in FY 2015 and most politicians and economists simply ignore the problems.
The CBO reports continue to emphasize that existing budget spending and revenue trends are
“unsustainable,” and delaying real priority decisions will increase the costs and complexity of
necessary changes, but there is no medium-term political plan. The fiscal outlook is: spending
for goods and services will rise rapidly; revenues will not increase enough to pay for spending;
large future deficits will add to the gross national debt; debt service burdens will expand quickly
when interest rates return to normal levels; foreign sources of funds will continue to finance a
large share of the incremental national debt; and the accelerating pace of retirement and health
care payments and known and unknown national security risks will make it extremely difficult to
change budget trends. This scenario will continue until a fiscal crisis compels priority decisions.
The CBO baseline 10-year projection (2016-2025 based on current legislation) assumes that deficits
will steadily increase creating a $7.641 trillion gap, averaging 3.3% of GDP (2.7% 50-year average).
Revenues are expected to average 18.2% and outlays 21.5% of GDP, slightly above the previous
50-year average levels. Revenues will rise because of stable economic growth, personal income
tax rules in the Affordable Care Act, “bracket creep” effects of inflation pushing taxpayers into
higher marginal tax brackets, and taxes on withdrawals from tax-deferred retirement programs as
baby boomers retire. Mandatory spending (set by eligibility and benefit rules) for Social Security and
government health care programs is projected to increase rapidly because of the aging of society
and medical costs. Discretionary spending (national security and nondefense outlays set by Congressional
appropriations) will be restrained by caps and automatic sequester cuts in the Budget Control Act
of 2011 as amended and will decline as a share of the total budget and GDP to below historical
average levels. Net interest payments will rise rapidly as the national debt increases and market
interest rates ratchet up to historical levels (from 2014 to 2017, 90-day Treasury bill rates are projected to rise
from 0.1% to 2.6% and 10-year Treasury notes from 2.5% to 3.9%). Mandatory outlays for Social Security,
major health care programs, and net interest payments will dominate future budget trends and
create large deficits in absolute terms and relative to the potential GDP. Projected budget deficits
would increase the potential Gross National Debt to $27.3 trillion by 2025 ($21.6 trillion held by
the public). The CBO continues to emphasize that the baseline budget trends are unsustainable,
because projected deficits and debt will reduce economic growth by raising basic interest rates,
“crowding out” private capital investments, and restricting the flexibility of monetary and fiscal
policies to respond to future business cycle stress and shocks, but there is very little concern and
no real plan to eliminate the acceptable “normal deficit gap” between revenues and spending.
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Long-term budget estimates always are uncertain, and these projections provide only general
guidelines, but compelling claims against the national output will exceed available resources.
During periods of robust growth there are few incentives to restrain spending or increase taxes
and when economic distress occurs more spending and tax cuts are used to respond to the crisis.
The inevitable result is a chronic deficit during good and bad times despite solemn promises
the gap will be closed. Officials offer persuasive arguments to prove that deficits are justified and
the Treasury has been able to sell its large supply of new debt to domestic and foreign investors.
The various proposals to control deficits have lacked political traction to control the behavior of
powerful appropriation and tax committees that respond to interest groups. Trillion dollar deficits
indicate that more effective guidelines are required rather than “doomsday” mechanical rules and
schedules that evade and postpone painful priority decisions. The Budget Reform Act of 1974 did
direct the Congress to prepare comprehensive annual spending and revenue plans, and created the
Congressional Budget Office to provide nonpartisan analysis, but those rules have been ignored.
The Budget Enforcement Act developed by the Congress and Bush Administration in 1990, and
later renewed in 1993 and 1997 during the Clinton Administration, did effectively enforce caps
on discretionary spending and pay/go rules to limit new mandatory entitlement programs and
tax cuts. Those guidelines created growing cumulative surpluses of $559 billion from FY 1998
to FY 2001, but the rules expired in 2001 and have not been replaced. That unique historical
example demonstrated that difficult budget decisions are possible, if a viable political framework
can be created, but the current dysfunctional system does not work. A “gradualism” strategy of
targeted spending and revenue fiscal priorities rather than “fine-tuning” cyclical stimulus and
restraint policies would create better budget controls and goals, but this approach would have to
overcome the dominant power of interest groups and political election schedules. The reality has
been deficits in 50 of the last 55 years and the current gross national debt of $18.044 trillion.
My baseline forecast of “more of the same” -- robust 3% GDP growth, moderate inflation,
strong job creation, and declining unemployment rate depending on labor participation rates -- is
based on the convergence of positive trends and easing of negative factors. Consumer spending
for cars and trucks, household appliances and furniture, consumer electronics, recreation, tourism,
entertainment, and health care will sustain growth. Business capital investment will increase and
inventory restocking will track the growth of final sales. Residential construction gradually will
increase to meet cumulative demand. Exports will slowly expand, despite a large appreciation of
the U.S. dollar, but imports will rise even more as the U.S. economy grows more rapidly than the
global economy. Fiscal austerity will ease as revenues increase and spending rules are adjusted
enabling the federal, state, and local government sectors to make positive contributions to GDP
growth. The Fed will use forward guidance to signal the timing and process of “normalizing”
its policy interest rate target after mid-year. And crucial consumer and business confidence has
improved dramatically in recent months. This “rosy scenario” is the most probable outcome but
there are real risks: sovereign debt and banking tensions in Europe; the slowdown of economic
activity in several developing and Emerging Market Economies; geopolitical crises may disrupt
the balance of energy, food, and commodity demand and supply conditions; global capital flows
and financial markets may react negatively when the Fed begins to adjust its monetary policy;
natural disasters may disrupt activity; government leaders may create another fiscal debacle for
political purposes; disinflation/deflation pressures may escalate; incompetent governments may
collapse creating disruptive shocks; and a domestic terrorist attack might erode consumer and
business confidence. These risks are unpredictable and effective policy solutions are not easy
or obvious because they extend beyond economic variable to complex political and social issues.
Political leaders and technocrat advisers constantly refer to these serious risks and the urgency
of effective policy responses. But merely identifying problems does not mean they are solved.
Economic problems cannot be corrected until there is a political will to act. That will not occur
until voters require leaders to explain their strategies and tactics and then hold them accountable.
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CONCLUSION
The U.S. economy now is going through two concurrent transitions – from a “slow, long, and
erratic” cyclical recovery to more robust expansion and from a stable Great Expansion, which
continued from December 1982 through December 2007, to an uncertain medium-term outlook.
The convergence of positive domestic and global factors should push the GDP growth rate to 3%
this year with moderate inflation and gradual decline of unemployment and underemployment
depending on labor force participation rate changes. Fiscal drag created by federal spending and
tax policies should diminish and monetary officials are committed to sustained accommodation
through “forward guidance” as the quantitative easing program is phased out. Growth could be
even faster if business investment accelerates more rapidly than expected or the surprising gains
from inventory spending and exports continue. But there are several basic risks: households may
try to “deleverage” their debt balances or increase saving rates; business investment may continue
to be extremely cautious; contentious political debates about the gross national debt limit might
cause another debacle that would disrupt consumer and business sentiment and economic activity;
moderate growth forecasts for Europe and Japan may be too optimistic; the slowdown occurring
in Emerging Market Economies may quickly deteriorate; “taper panic,” caused by the Fed’s plan
to terminate its quantitative easing program, might prevent crucial global credit and capital flows;
problems of disinflation and deflation in Europe and Japan may intensify; current or unexpected
geopolitical crises might cause a breakdown of global trade and investment; and the balance of
demand and supply of energy, food, and commodities resources may be distorted by the recurring
crises. These are serious risks, which must be considered, but the momentum of current economic
activity at this stage of the business cycle should sustain solid real GDP growth in the 3% zone.
Success in solving medium-term structural and policy issues will be more difficult. After the
turbulent 1970s two economic forces converged: the average age of the “baby-boom” generation
was 25-to-35 years, the age when new households are formed; and the Fed, under the leadership
of Paul W. Volcker, attacked inflation when the March 1980 CPI reached 17% (seasonally adjusted
annual rate), Treasury 3-month bills yielded 15.5%, and banks charged “prime” borrowers 19 ½%
for loans. The high inflation and interest rates were slashed and real income gains were restored,
thereby creating strong consumer spending and new housing starts. Rising tax revenues supported
increased government spending. When the economy finally emerged from a serious recession in
December 1982 it began the Great Expansion that lasted until December 2007 based on private
and public spending financed by debt. During the entire 25 years there were only two brief and
mild recessions – July 1990 to March 1991 (Gulf War oil price effects) and March 2001 to November
2001 (inventory distortions caused by Y2K uncertainty) – 284/300 months of robust growth at the average
“targeted” pace, relatively low inflation and unemployment rates, chronic current account deficits
caused by large imports, moderate budget deficits in most fiscal years and four surpluses (FY 19982001) based on responsible fiscal policies initiated by President Bush and continued by President
Clinton, and stable monetary policies. The fundamental variables were favorable demographic
trends, new technologies, global trade and investment, immigration, effective fiscal and monetary
policies, ready access to energy, food, and commodity resources at low prices, deregulation of
many economic activities, new entrepreneurs, and deep and broad financial markets. That Great
Expansion has now ended leading to an era of volatile and lower average GDP growth, higher
rates of unemployment and underemployment, potential inflation, current account deficits, large
federal budget deficits and growing government debt, unconventional monetary policies, and the
proliferation of government regulations and administrative controls.
The beginning point for preparing for the medium-term transition is to fix the broken fiscal
policy so that monetary policies do not have to bear the entire burden of economic stabilization.
The first step in that process is to rationalize the potential outlays for Social Security, Medicare,
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Medicaid, and other programs for the elderly with other national priorities. Over one-third of the
federal budget now is allocated to older people -- 13.5% of the total population (2012) -- and their
share will accelerate rapidly. At our first Sit Investment Conference 32 years ago I discussed the
potential “demographic twist” -- a large “baby-boom” generation followed by a smaller “babydearth” group caused by declining fertility rates and increasing life expectancy leading to more
older and fewer younger people – and argued that this process would dominate the public policy
agenda by “squaring the population pyramid.” America’s pay-as-you-go system created in the
1930’s was based on the concept that a young and growing labor force always would be willing
and able to pay the benefit claims of older people at the top of the population pyramid by using
current taxes on active workers in exchange for an implied promise that they would be cared for
when they retired. That system was designed for a population distribution in which older people
lived for only a few years after retirement. A combination of historically low national birth rates
and extended life longevity has caused the “squaring of the population pyramid” as demographers
have predicted for over 60 years. The first “baby-boomer” opted for early retirement on October
15, 2007 and about 10,000 of them will become 65-years old every day during the next twenty
years. Those 79-million people expect to receive retirement income and health care benefits for
many years as average longevity continues to rise. There now are 57-million people receiving
Social Security Benefits and that number will rise rapidly. Total expenditures have exceeded noninterest revenues since 2010 (2010, $49 billion; 2011, $45 billion; and 2012, $55 billion), so Treasury must
transfer funds from General Revenues. Trustees also had to issue a “Medicare funding warning”
in the 2013 annual report -- for the seventh consecutive year -- because Medicare outlays were
projected to exceed revenues requiring General Revenues to cover more than 45% of the program
costs (Part B covering physicians fees and Part D prescription drug benefits are largely covered by appropriations).
Some analysts argue that the Social Security program is not an immediate issue because the trust
fund balance is expected to report a positive balance until 2035, but this view ignores the reality
of the cash flow effects on the Treasury and the obvious need to prepare for the future transition
as the number of retirees rapidly increases and they are projected to live for an average additional
19 years. In the 2013 Annual Report for Social Security and Medicare Trust Funds, the trustees
declared: “Neither Medicare nor Social Security can sustain projected long-run programs in full
under currently scheduled financing, and legislative changes are necessary to avoid disruptive
consequences for beneficiaries and taxpayers.” The mandatory entitlement programs are the most
obvious source of future federal budget stress but every outlay should be evaluated to determine
relative priorities. Officials did not plan to increase the Gross National Debt to $17,352 billion
by yearend 2013 but that was the inevitable result of specific line-item budget decisions that are
not subject to aggregate limits. Every good thing is not equally good – is the economic reality.
The Treasury has easily financed the deficits at historically low interest rates, so the established
budget rules and trillion dollar deficits have been ignored because compelling arguments can
be made to increase spending and cut taxes to support interest group priorities and provide fiscal
stimulus. Creating fiscal cliffs, debt ceilings, sequesters, budget constitutional amendments, caps,
sunset rules, and maximum spending and minimum revenue “targets” are not effective solutions.
They merely substitute mechanical rules and arbitrary schedules to avoid crucial consideration of
short- and long-term priorities in allocating scarce national resources to competing claims. Failure
to make necessary decisions matching claims and resources creates chronic budget deficits and a
growing national debt – the loss of policy agency. Economists emphasize competitive markets to
allocate resources and reward performance; technology and capital investment to foster growth;
risk to create incentives, and long-term goals. Politicians try to influence marketplace results and
control economic power; protect designated interest groups; rely on collective decisions; mitigate
competitive risks and structural adjustments; and focus on near-term plans and election schedules.
This tension will continue because democratic governments establish the “rules of the game” and
set the boundaries between public and private authority and responsibility. Current policies will
not change until global financial markets apply the discipline lacking in the current process.
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