2018 Economic Outlook

MCCOY: Welcome. And thank you, everyone, for joining us for this CFR Corporate Program conference call.

We are pleased to have Ira Kalish, chief global economist at Deloitte; and Michael McDonough, chief economist at Bloomberg.

I would like to remind the audience that this call is on the record and, in addition to CFR members, invited members of the press may be present.

We’re speaking today about economic outlook. And while we know that financial markets don’t represent underlying economic conditions, given movements in tradeable assets since last Friday, we agreed to start by briefly addressing capital markets, especially in the context of what has been an integrated global expansion.

Mike, can you comment about market moves in relationship to how risks have been either priced in or perhaps not fully considered by investors? I’ll ask you to share your view on the number of rate rises you expect from the Fed this year as well.

MCDONOUGH: Sure, great. Thanks for having me on the call.

So I think what we saw in the past couple days in the market is some proving of the fact that there’s not really much risk priced into the market at all. And I would say that the biggest risk that we’re facing this year is the unintended consequences of rising interest rates, which really was a direct cause of the big sell-off we saw.

And, you know, we have for a while—actually, always—been expecting two interest rate hikes in 2018, which is definitely below consensus. I think the Fed is at three. You have a lot of economists right now calling for four. And we think that, you know, there’s a bit more slack in the economy than meets the eye. And we do think, you know, with QT as the Fed is shrinking the balance sheet, you are going to have these unintended consequences on financial conditions, and yesterday was a bit of a proof of that idea at least.

I’ll leave it at that for now to keep it short.

MCCOY: Great. And moving from markets to the broader economy, in this case the U.S. economy, recent data show economic growth acceleration after a sustained period of slower-than-expected growth. Ira, what are your thoughts about this dynamic? And also please include your view on Fed rate rises.

KALISH: OK. Thank you, Debbie.

Well, despite what’s been going on in the financial markets, the U.S. economy is actually in pretty good shape. It did accelerate modestly in 2017. We saw relatively steady growth of consumer spending; a rebound in business investment; and export strengthening, largely due to the strength of the global economy as well as the relative weakness of the dollar. And I think we’re going to see even somewhat stronger growth in 2018 because the global economy continues to accelerate—that will help exports—and the tax cut will certainly help to boost at least consumer spending to some extent.

So, when you look at a strong economy with low inflation and low borrowing costs, you have to ask: What could possibly go wrong? And, unfortunately, there are a number of things that could go wrong. For one thing, consumer spending has been growing for the past half-year considerably faster than consumer income, and that has entailed a big drop in the personal savings rate and a fairly substantial increase in consumer borrowing, to the point where subprime lenders are starting to set aside unusually large loan-loss reserves. So, while this situation can be sustained for a while, it can’t be sustained forever. And that suggests the possibility of a slowdown in consumer spending going forward.

Plus, although the tax cut will stimulate the economy in the short run, it’s had a big impact on expectations of inflation and the expectations, therefore, of what the Fed will do. And I think that in part explains the financial volatility that we’ve seen. The suggestion that wage increases were stronger last month than investors expected was what led to this short-term panic.

Now, I think the bigger issue is the long-term growth of the economy. Over the past decade, we’ve seen slower growth in the U.S. and other major developed markets than we’ve seen in the past during recoveries. And although we’re seeing a little bit of acceleration right now, it suggests the possibility that we may be growing faster than is sustainable.

And in the long term, economies grow for two reasons: either you get more workers or you get more out of each worker, which is productivity. And we’re not getting that many more workers. The working-age population has been growing more slowly, and participation is down. And although we’ve seen a little bit of an uptick lately, over the past decade productivity growth has been modest. And, of course, productivity comes from innovation and technology. And there have been huge innovations lately but they’re not showing up in the productivity numbers and they may not for quite a while.

So, structurally, we’re looking at relatively slow growth. But we’re stimulating an economy that’s already at full employment and maybe forcing it to grow faster than it can. That is leading to the expectations of higher inflation and tighter monetary policy. So my view is that the Fed will at least raise rates three times this year, and maybe four, depending on what the data shows and depending on what expectations of inflation emerge from the mix of policies that we’re currently seeing.

MCCOY: Mike, do you have anything to add on this same topic?

MCDONOUGH: Yeah. You know, I agree with that, but I guess we have a slightly more optimistic outlook for productivity in the near term. And I think really, when you look at the economic cycle, you know, over the past decade or so, especially more recently, it’s primarily being driven by consumption right now, as was pointed out. You haven’t seen a lot of investment. You haven’t seen that—the technological advancements really applied yet by businesses.

But we do think we’re at a turning point, right? The economy’s been growing a bit faster than it should, you’ve seen capacity shrinking, and at the same time you’re starting to see labor get a little bit more expensive.

And why this is meaningful is if, you know, you put yourself in the shoes of somebody running a business and you wanted to expand, you know, over the past five years you may have been cautiously optimistic about the future, but not blindly optimistic about the future. If they had a choice, hire 100 people who you could fire later if things didn’t really pan out the way you were expecting it to or make a million-dollar investment in some robotic system that did something extraordinarily well, companies were choosing to hire. That dynamic’s changing a bit now. So companies are now making the decision to hire—continue hiring, maybe not as much, but to start buying that robotic system.

So I think that’s going to have a pretty positive impact on productivity as we go forward, and it should also have a positive impact on wages. You know, one of the interesting anecdotes of this was last year—at the start of last year you had several states meaningfully increase minimum wage. And in—there’s not a lot of sectors exposed to minimum wage, but fast food is one of them. And almost overnight in those states you saw places like McDonald’s, Panera, et cetera implement where, instead of ordering from a person, you’re now going in and ordering from a kiosk. And I think that’s kind of the tip of the iceberg of what is about to come as we start seeing less capacity and higher wages.

MCCOY: Mike, in this case, broadening beyond our relatively U.S.-focused conversation so far, can you comment on China and what we can expect—(inaudible)—there?

MCDONOUGH: Sure. Sure. So, you know, I’ve spent—I’ve actually spent a lot of time in China. I used to live in Hong Kong covering China. You know, from a, you know, outward perspective looking in, 2018 is going to be a kind of boring year, I think, for China. When you look at some of the risk that China has—the debt load, property sector, you know, risk of capital outflows—it doesn’t look like there’s a lot of probability that those will be triggered this year. There is some trade risk with trade policy, but put that aside.

I think, though, the biggest thing I want to dispel is that in 2017 growth in China looked a lot better than most economists were anticipating, and there was a belief that China had somehow almost overnight transitioned their economy to what they like to call a new normal—to services, consumption, et cetera—into this new, strong, sustainable growth model. The truth is that’s not really what happened. What really stabilized China’s growth were a lot of the old drivers, especially residential investment. The fact of the matter is we did some math and tried to figure out what China’s 2017 growth rate would have been without the fiscal stimulus. And officially it was close to 7 percent, but we think without the fiscal stimulus it would have actually been closer to 5 and a half percent, 5.7 percent to be precise.

So, you know, going forward in 2018, the growth rate’s going to continue to be a political choice. Do they want to push ahead with deleveraging, transforming the economy, and accept a growth rate closer to 6 percent? Or are they going—(audio break)—kind of put the reform agenda on the (backburner ?)? We think it will be a bit of a balance of the two. Growth will slow to about 6.3 percent. But if there’s one thing to remember about the Chinese government, they value stability above everything else. So they will implement whatever policy they think they need to to maintain stability within the economy.

And I’ll leave it at that on China, unless there’s more questions later.

MCCOY: Ira, what observations do you have about the eurozone in the year to come?

KALISH: Well, Mike said that China is going to be boring. I’d say Europe will be interesting.

Right now the eurozone economy, the 19 countries within the European Union that use the euro as their currency, is growing quite strongly. It grew faster than the U.S. in 2017, something that might be repeated in 2018. And when you take into account the fact that the eurozone population is not rising and the U.S. population is, on a per capita basis the eurozone is doing much better than the United States. And this reflects, in part, the very aggressive monetary policy of the ECB, which has suppressed the value of the euro until recently. And that helped export competitiveness. It created a little bit of inflation. It boosted asset prices and encouraged consumer and business spending. On top of that, we’ve seen relatively benign fiscal policy after a prolonged period of fiscal austerity. So the absence of that austerity has been helpful as well.

And strength in the global economy has also been very helpful. Even the stimulus of investment spending in China has certain been helpful to capital goods exports in Europe. So I think Europe looks pretty good. With unemployment still quite a high in a number of countries, that is helping to keep inflation low. So I’d expect the European central bank to maintain a relatively easy policy at least toward the end of the year, if some uncertainty as to what the ECB will do after that. And within Europe, I think we’re seeing considerable strength in Germany, in the Netherlands, in Ireland, in Spain, certainly. We’re seeing France, long beleaguered, starting to recover quite nicely, in part because of the reforms implemented by President Macron. And even longsuffering Italy is starting to see a pretty considerable rebound as well.

The one exception in Europe, which is not part of the eurozone but still very important, is, of course, the U.K., where growth is actually expected to continue decelerating. And this stems entirely from Brexit. After the referendum, the pound fell sharply. That led to a big rise in import prices and higher inflation, which was not offset by wage gains. So consumer purchasing power declined. Consumer spending growth decelerated. That led to deceleration in GDP growth. And we’ve seen a chilling effect on business investment because of the uncertainty as to what Brexit will entail. So companies that used to look to investment in the U.K. as a gateway to the rest of Europe are reluctant to engage in that type of investment.

MCCOY: Well, we will now open the floor for questions. I want to remind all participants that this call is on the record. Operator, can you please give instructions for asking a question?

OPERATOR: Yes, ma’am. At this time, we will open the floor for questions.

(Gives queuing instructions.)

MCCOY: While participants are queuing, I’ll ask a question to both you, Mike, and Ira, which is about trade. What are the assumptions you’re making about trade in 2018?

MCDONOUGH: So, I mean, I think that the—every economist pretty much—the biggest risk to trade, first off, is potentially surprise protectionist policy, especially from the U.S. I think the problem is right now that every economist—you can’t speculate on what that could be. So everyone’s baseline is assuming there is no disruption. And I think that is correct. You know, President Trump has certainly come out pretty strongly in the past in favor of protectionist policies. We haven’t really seen much of that implemented. I think the two most extreme examples being removing the U.S. from NAFTA and also slapping large—I think it was a 30 percent tariff on Chinese imports to the U.S. 

You know, but when push comes to shove, and you look at who that harms, yes, it would harm the countries in NAFTA. Yes, it would harm China. But it would also harm the U.S. just as much, if not more in some cases, in parts of the U.S. Like, I think one of the interesting things I saw recently when President Trump was speaking at a farm conference, everyone was cheering and applauding everything he said. But when NAFTA came up, there was basically silence. So I think that there is a threat there, but it’s not actually going to amount to a lot of action.

There is one risk I see to that, which is if it looks like—this is not a base—this is no one’s baseline right now. But if it looks like U.S. growth is slowing, and there’s a rising risk of a recession in the U.S., the president has a lot of levers he could pull when it comes to trade policy. You could see him defensively implement some of those policies that he has threatened to in the past. But, again, I don’t think—you know, when you look at everyone’s growth projections, no one is expecting a big disruption to trade. So that could be a curveball that comes this year. But it does seem somewhat unlikely at this point.

KALISH: Well, my view is—I agree with Mike that the baseline is no disruption. But I’m not entirely confident that that will necessarily be the case. So far, there’s been a big disconnect between the talk about trade from the administration and actions. The only major action was the decision to withdraw from the TPP, which didn’t really have a big impact since TPP had not yet been implemented. It was more of a lost opportunity. But there are the two big issues of NAFTA, and the fact that the administration has launched multiple investigations of China with the possibility of imposing punitive tariffs on China. I don’t know what will actually happen. I think it’s clear that even within the administration there are sharp differences of opinion about this and it’s not clear what the president will want to do.

If there is a withdrawal from NAFTA, obviously it would have a big negative impact on both the Mexican and Canadian economies, and a more modest negative impact on the U.S. But it would have a sizable impact on the U.S. manufacturing industry. Many companies in the industry have highly integrated supply chains across North America. And without NAFTA or a substantially changed NAFTA, that would have to change. With respect to China, a number of investigations have been launched. And there’s been a lot of discussion lately about potentially seeing implementation of punitive measures as way to try to get China to change some of its practices on intellectual property and other issues. I think it’s clear that if that happened, the Chinese would ultimately retaliate in some way, whether through punitive tariffs of its own or possibly through large-scale sale of U.S. treasury securities. 

In any event, the end result would be an increase in prices, a reduction in consumer purchasing power in the U.S., a reduction in the growth of trade volume. And that would also have substantial spillover effects on other countries. Keep in mind that Chinese manufacturing is within a highly integrated supply chain system across East Asia. So countries like Taiwan, South Korea, Japan, and some of the countries of Southeast Asia would be negatively affected by a trade war between the U.S. and China. So I can’t predict what will happen, but I think it does represent a substantial risk.

MCDONOUGH: Can I—can I add one thing to that? I think that China is willing to accept and is expecting some certain very targeted measures—punitive, or tariff, or however you want to define it—measures against some trade. And I think they’re willing to accept a minimal amount. So we have to see what that actually is. I think where you could see a reaction is if it’s very widespread and specifically targeting China. I think that’s where the biggest risk lies. So I agree with that, that you could have some rebuttal from China on that. But I think that the trigger may be higher than just small, targeted measures.

MCCOY: Thank you. Operator, is anyone in queue to ask a question?

OPERATOR: Yes, ma’am.

(Gives queuing instructions.)

Our first question comes from Peter Coy with Bloomberg Businessweek.

Q: Hi. This is for Ira.

Back on your point about spending rising faster than income, and savings rate down, borrowing up, do you think there comes a point where that consumer spending just crashes into a wall, or is it just becomes harder and harder for consumption growth to continue at a current pace?

KALISH: That’s difficult to say. I think that if we see a rise in interest rates on the part of the Fed, and therefore more stress on the part of lenders, especially financial institutions that lend to lower-income consumers, we could see a tightening of credit conditions for those consumers, which could lead to a bit of a wall for consumers at the lower end of the income spectrum. And that’s where we’ve seen pretty good growth of spending. On the other hand, as Mike mentioned earlier, a number of states have increased minimum wages. We just had the tax cut, which while it skewed toward upper-income households will have some positive impact at the lower end. So I don’t think we’ll necessarily see a big problem this year. But the problem could emerge later on.

Q: OK. Thank you.

MCCOY: Operator, is anyone else in queue?

OPERATOR: No, ma’am. We have no further questions in the queue at this time.

MCCOY: I’ll pose a second question. The topic of labor participation in the U.S. came up earlier in the call. I wonder, either Mike or Ira, if you have comments around the drivers and implications of these decreasing participation rates.

MCDONOUGH: Ira just spoke; I’ll give him a break. You know, so I think that—you know, I think that when you look at the labor market in the U.S., it’s a very different story by industry. You know, and part of the argument is, over the participation rate, how much of that is cyclical versus how much of that is people actually retiring? I think at this point it’s been fairly obvious that economists have underestimated the amount of slack that actually has existed in the labor market. And how do we know that? Because you’ve been hearing the narrative of higher wages now for the last couple years, and we haven’t really see it. Admittedly, I do think in aggregate things have changed a bit at this point. So we are going to start seeing an uptrend there. 

But where—I’m going to tie this into policy a bit—where I think things are most interesting is the actual—is an existing mismatch of skills right now in the U.S. economy, right? I’m someone who—I have run a team of programmers, and I know how difficult it is to hire programmers in this country right now. And that sort of high-tech, highly skilled labor—be it manufacturing or be it in services. And, you know, what I find fascinating is the U.S. has this big comparative advantage in that space right now. And when you look at some of the policy that’s being discussed, at least, out of Washington, there’s ideas on, you know, limiting the amount of visas that are issued to companies to bring in this sort of labor. 

And, you know, speaking long-term, this is what I find most troubling because you could pretty quickly erode the U.S. comparative advantage in these spaces by doing this, right? If you are a tech company, two-thirds of your staff are there on H-1B visas. And suddenly you can’t get those visas. You need to make a decision what to do. You know, I think there’s an idea that you could just turn around and hire Americans to replace these workers. But, you know, in actuality where you look at the places where you would—at the broader labor market, you don’t—there are not people with those skillsets to take those jobs. So I think that these things need to be considered. And it’s something that concerns me.

So while, you know, you might have, you know, the participation rate or the labor market statistics looking quite bad in other areas, they’re red-hot in other areas. And we need to figure out how to address this more effectively to really bolster that long-term growth that Ira was talking about earlier. And I don’t know, Ira, you probably have a lot to add on that, given your specialty in demographics.

KALISH: Oh, well, yeah. I agree with what you said. And I think, you know, there are two issues. One is the overall participation rate has in large part declined for demographic reasons, because participation is defined as the 16 and over population. And a lot of that population has started to retire. But even as you look at the working age population, we’ve seen a drop in participation. I think among men it has a lot to do with the skills mismatch you talked about. So for example, if you look at the manufacturing industry we’ve seen a lot of automation, loss of jobs for high-school educated assembly line workers. Those people don’t have the skills needed for the kinds of jobs that are being created. 

We did a survey at Deloitte. And we found that the manufacturing industry has a fairly large number of unfilled jobs. They have a job shortage, but they’re not looking for those high-school educated assembly line workers. They’re looking for software engineers. And so that skills mismatch has driven a drop in participation, especially by less educated men. With women, it’s a slightly different story. It’s interesting that in the past decade there’s been a decline in female participation in the U.S., which has not been matched by the experience of other developed countries. In fact, we’re the only major developed county where that’s happened. Female participation has continued to rise in other major industrial economies. 

What’s the difference? The difference is that in the U.S. we don’t have a sizable system for providing childcare or paid family leave, as is the case in most other countries. And surveys done by the government asking people why are you not working, the answer among women overwhelmingly is because I’m taking care of someone at home, usually a child. So that has had a negative impact on female participation. Perhaps a change in policy there would make a difference. It’s still too early to tell.

MCCOY: Thank you. Operator, is anyone in queue to ask a question?

OPERATOR: No, ma’am. There’s no further questions in the queue.

MCCOY: In this case, I’d like to thank Ira and Mike, along with the participants, for being part of today’s call. All may disconnect. 

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