Viewpoint
December 13, 2024 | 15:54
December 13, 2024
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Economics
The Glass Half-Full Economy |
| The economy has a lot going for it right now. Its rapid GDP, consumer spending, and employment growth since the pandemic ended has been the envy of the world. How good do you ask? Real GDP growth has averaged around 3.6% a year over the past four years through 2024. Over the prior ten years from 2010 to 2019, GDP growth averaged just 2.4% a year. Real consumer spending has averaged an even stronger 4.3% a year compared to 2.3% from 2010 to 2019. Employment growth has averaged 2.8% a year from 2021 to 2024 compared to 1.4%. Professional macroeconomic forecasters, including the Federal Reserve, have been consistently underestimating the economy’s potential growth since this pandemic began. |
| While the outlook for 2025 is cloudier than most years, given the huge uncertainties around changes in taxes, tariffs, regulation, and immigration policies, the macroeconomic backdrop remains more favorable than I have seen in most years of my career—a restrictive monetary policy or not. The Republican sweep and impending change in leadership in Washington have already bolstered consumer and business confidence, and goosed U.S. stock prices to new heights. Small business owners and investors appear to be viewing all the potential changes in policy with a glass half-full mentality, while heavily discounting the potential for a damaging trade war. Granted we are still in the honeymoon phase and haven’t yet seen the downside of tariffs or mass deportations, but the positive initial reactions have allowed us to modestly bump-up our forecast for GDP and consumer spending growth for 2025. Our baseline forecast is for only the gentlest of slowdowns. Real GDP growth is expected to slow to 2.3% in 2025 from 2.7% this year (Chart 1). The economy should continue to grow at a pace slightly higher than its long-term potential of 1.9% next year. Real consumer spending is expected to ease from a 2.7% year/year growth rate in 2024 to 2.6% in 2025. A still restrictive monetary policy and a normalizing labor market are expected to be the primary drivers of this slowdown. We expect the unemployment to rise to around 4.3% and stay there for much of the next year, while nonfarm payroll growth slows to 1.1% in 2025 from 1.6% in 2024. Some households continue to struggle with rapidly rising prices and high levels of credit card and auto loan debt, but overall U.S. household balance sheets have rarely looked this good in aggregate. With U.S. equity prices holding near record highs, the increase in household net worth since the Great Recession is staggering (Chart 2). Household net worth has increased by 110 trillion dollars or 185% from the Great Recession low, gaining another $4.8 trillion in the third quarter. These positive wealth effects will continue to pay dividends for consumers’ willingness and ability to spend, despite the headwinds from a still restrictive monetary policy. The November surge in vehicle sales is a great example of this resilience. Bottom line, a gradual moderation in consumer spending appears to be the most likely path ahead rather than full-scale retrenchment. Business investment growth is also expected to slow, but not stall. Nonresidential fixed investment is expected to downshift to around 2.5% in 2025 from 3.9% this year. Strong corporate profit growth, spending and incentives from the CHIPS and Science Act, Inflation Reduction Act, and Infrastructure Investment and Jobs Acts, combined with the scaling up of Artificial Intelligence will drive further gains in business spending next year. |
The Fed has put inflation on a probable path toward 2.0%, but we don’t think inflation will actually get close to that destination until 2026 (Chart 3). We expect CPI inflation to slow to 2.5% year/year in 2025 from 2.9% this year, while core CPI inflation moderates to 2.7% from 3.4%. So, what could go wrong to this glass half-full economic outlook? In a word- plenty. Aggressive new tariffs have the potential to delay and undo the progress the Fed has made on inflation and interest rates even as they push down exports, employment, and GDP growth. The growth risks to our major trading partners could be even worse. Lower net in-migration and mass deportations reduce potential GDP, aggregate demand, and labor supply, adding to downward pressures on GDP growth, while adding to wage and inflation pressures. I also worry that stretched asset valuations in equity, bond, and housing markets, currently priced for perfection, could quickly magnify any unexpected negative shock to the economy or profits. |
Rates Outlook: Wider Confidence Intervals |
| After three straight rate cuts worth 100 bps in the final four months of 2024 (see Key for Next Week for our thoughts on an expected 25 bp reduction), we look for the same amount of total easing in 2025 but spread across all twelve months. The downshift reflects more Fed prudence after having adequately recalibrated policy. During the May-August period, just before the Fed began easing, real policy rates were peaking around 2.7%. This was three times the FOMC’s neutral level and the highest since just before the Great Recession. The 100 bps of easing to end 2024 lowers the nominal policy rate to 4.4% with a real rate tucked under 1.4%, given current stubborn core inflation readings near 3.0%. Real policy rates are now within the neutral realm (0.5%-to-1.5%) to begin 2025. Consequently, further easing can await further disinflation, which we reckon is going to be grinding… hence the downshift. And, from a risk management perspective, it’s serendipitous that the downshift coincides with increasing inflation uncertainty arising from potential changes to fiscal and trade policy. The latter emphasizes that the net risk to our Fed call rests on the upside. Also, to start 2025, we get the annual rotation of voting regional Fed presidents. This will see Richmond’s Barkin, Atlanta’s Bostic, San Francisco’s Daly and Cleveland’s Hammack replaced by Boston’s Collins, Chicago’s Goolsbee, St. Louis’ Musalem and Kansas City’s Schmid. Based on recent comments, the incoming group appears to have a faint dovish bent compared to the hawkish tilt of the outgoing group. However, we judge the overall complexion of the Committee will still be slightly hawkish. And, by mid/late-2025, we expect the Fed will be adjusting its quantitative tightening (QT) program again. We judge that once bank reserves slip below $3.0 trillion (currently $3.2 trillion) the Fed will end the roll-off of Treasuries as a precautionary move with QT continuing via MBS roll-off. Meanwhile, 10-year Treasury yields have spent 15 of the past 17 months averaging at least 4.00%. Lately, it seems that the impact of Fed rate cuts is being countered by market concerns over bigger budget deficits and sticky inflation (perhaps made stickier by higher tariffs). Given the expected profile for Fed cuts and presuming some fiscal discipline emerges in Congress, we see yields modestly drifting down as 2025 unfolds, but staying above 4% for most of the year (and averaging no lower than 3.80%). Here again, the net risks are skewed to the upside. Finally, the market’s old U.S. dollar narrative was that it would carve a weakening trend once the FOMC started cutting policy rates. And, the dollar did depreciate during the July-to-September period—but, it has been appreciating since, despite additional Fed rate cuts. The turnaround reflects the market’s new narrative: that the incoming Administration’s proclivity for tariffs will result in offsetting dollar strength and more inflation (which could prevent the Fed from easing further). By March 2025, we see the trade-weighted unit hitting a new record high, surpassing the prior peak from October 2022. But when the Fed is still seen easing in March and, presumably, the market’s worst tariff fears aren’t being realized, we reckon the old narrative should gain some currency again. Amid these dueling narratives we see the dollar depreciating 2.5% from March’s probable peak and a net 0.6% from last month’s level. However, the net risk is that the greenback could be stronger than this. |
Inflation: Progress, But… |
| Despite the perky economy, inflation behaved largely as expected in 2024. A year ago, we thought annual CPI growth would ease to 2.8% this year and, with just a month to go, it should come close to the mark. The decline from 4.1% in 2023 reflects several factors, including moderating energy and food costs, a strengthening dollar, and sturdy productivity growth (2.2% y/y in Q3) which held unit labor costs to a moderate 2.2% pace. Importantly, labor markets loosened, with the unemployment rate rising half a percentage point in the past year to 4.2%, a level the Fed deems consistent with both low inflation and full employment, a.k.a., nirvana. Not that there haven’t been bumps on the road to price stability. The downward trend in core CPI inflation has stalled at around 3.3% y/y since early summer. Some of this reflects challenging base effects. But the real sticking point is the broad services sector, where inflation clocks in at 4.5%, a stark contrast with a mildly deflating goods sector. The positive news is that CPI rent increases, though still more than 4% y/y, have cooled and should continue to do so in a soft rental market. The bad news is that other services are running hotter due to robust demand. Adding to the sticky situation is the fact that inflation expectations remain stuck above pre-pandemic levels, with the University of Michigan’s five-year-ahead measure holding just above 3.0%, compared with 2.4% in 2019. Still, inflation should renew a downward trend in 2025, with the CPI averaging 2.5% and the Fed’s preferred measure (the PCE price index) easing to 2.3% by year-end before hitting the target in early 2026. Wage growth should moderate as the jobless rate moves slightly above current levels, reinforcing consumers’ sensitivity to price increases as cited in the Beige Book. Oil prices should hold steady near US$75 in 2025, with domestic production rising as more federal land is made available for drilling. The mighty dollar could stay aloft, even as Fed easing clips its wings a bit. A bumper harvest should tamp down food costs, though deportations might provide some offset. Tariffs are the main risk to our inflation call. A threatened 25% duty on goods from Canada and Mexico (and a 10% increase for China) could directly raise U.S. consumer prices by 1%, though the final impact will be diminished by an appreciating dollar and foreign producers trimming prices. Layering on a potential 10% tariff for all other countries and at least a 60% hike for China could easily double the hit to inflation. However, barring repeated rounds of tariffs, the upward pressure on inflation should prove transitory, as economic growth will also get dinged by tariffs, especially if other countries retaliate. Still, regardless of how long the inflation spike lasts, price levels would remain permanently higher, unless the tariff increases are revoked. Where goes inflation, so goes interest rates and growth. Barring a trade war, U.S. inflation should cool further, paving the way for lower rates and healthy growth. |
