Last month, the U.S. Federal Reserve (Fed) decided to raise interest rates in a closely watched event for the state of the U.S. economy. This was just the second time in a decade—since the 2008 global financial crisis—and reflected the Fed’s assessment that the world’s largest economy was recovering on track.[1][2] The Fed’s action was not a surprise: the markets had awaited this for weeks. Nevertheless, the dollar rose further on the Fed’s move. Both are related developments of global significance.
State of the economy
First, the U.S. economy is doing fine.
- It continues its expansion, with 2016 third quarter growth revised up 3.5%, with personal consumption and non-residential fixed investment beating expectations.
- U.S. consumer sentiment rose in December to its highest level since 2004.[3]
- Seven years of continuous expansion, with temporary setbacks, has led to higher savings and household net worth is back to pre-crisis peaks.
- The labour market looks strong. Employers have been adding roughly 180,000 jobs per month during 2016—and the overall unemployment rate at 4.6% is approaching full employment.
- Corporate profits are high, rising relatively rapidly in the third quarter of 2016, despite energy sector weakness that has halved oil investment in recent years.
- Housing is doing well. Housing starts reached a nine-year high in October 2016, and real estate prices are back to pre-crisis peaks.
- Financial conditions remain supportive, with still historically relatively low consumer lending rates. In particular, banks appear resilient, with high capital buffers and low risks on the asset side of the balance sheet. NPL levels are lower and profitability much higher than European and Japanese banks.
Can the recovery be sustained and what should be the agenda of the incoming Trump administration to deliver it?
U.S. growth challenges
There are several challenges facing the U.S. economy that need to be addressed to ensure strong, sustained growth over the medium term. The main challenge is that potential growth, or the long term trend growth of output, has fallen from about 3% in the early 2000s to 2% now. This means the U.S. economy could soon be hitting capacity constraints, sparking inflationary pressures, leading the Federal Reserve to raise the policy rate more assertively. In anticipation, there are already sharp upward moves in longer-term U.S. interest rates, and the dollar, partly reflecting the expansionary fiscal agenda of the incoming Trump administration.
Why has potential growth fallen? It is a global phenomenon–and the U.S. economy shares many of the global factors affecting the components of growth.
- Basic infrastructure in the U.S. is aging, business investment is weak, and the capital contribution to growth has declined. The American Society of Civil Engineers (ASCE) estimates infrastructure needs at 5-8% of GDP over 10 years.[4]
- As a result, labour productivity (or output per hour) growth has fallen significantly from over 3% to only 0.5% a year. Wage gains are anaemic despite the fall in the unemployment rate, and symptomatic of the need to build educational outcomes and address the skills divide.
- Even more worrying is that total factor productivity (TFP) growth has stalled in recent years. TFP reflects that part of productivity not explained by capital investment or labour quality, and is mainly a function of slowing technological innovation.
Why has TFP productivity growth stalled? A marked decline in business and labour market dynamism across various sectors has slowed innovation.[5] This has resulted in fewer firm start-ups and a growing polarisation of skills, with low-skilled workers facing greater difficulties in getting full time jobs. Regulatory and legal hurdles have interacted to hinder the entry and exit of firms and the reallocation of workers from less productive employment. The number of federal workers employed in regulatory activities has increased from about 180,000 in 2006 to well over 230,000, significantly offsetting the decline observed in the 1980s.[6] Barriers to entry of new firms could also result from rising firm concentration, reflected in the higher share of employment in mature firms.
The headwinds from these factors are accentuated by a number of secular trends, such as those emerging from the demographics of an aging population that will limit the labour force and quickly add to medium term fiscal challenges. Besides, there is an ongoing decline in the labour share of income from shifts in GDP towards services and an off-shoring of more labour intensive tasks. Together these trends are hollowing out the middle class, polarising income distribution, affecting domestic consumption, and dragging down potential growth.
What Trump can do
The election of Donald Trump as president, coupled with Republican control of Congress, has ended six years of a divided U.S. government, and raises the stake for taking overdue budget tax, and regulatory reforms to address these challenges and restore higher potential growth.[7] What are the possible implications for the future, and the spillovers outside the United States?
Markets widely expect the fiscal agenda of the incoming Trump administration to be expansionary. Congressional Republicans have long advocated lower personal and corporate tax rates. Trump campaigned for substantial tax cuts, especially to bring down the corporate tax from its current 35% to 15%, as also increases in government spending, notably in defense and infrastructure.
It’s still too early to know how dramatic a shift in the fiscal stance will result. But fiscal stimulus by itself is not the answer. International experiences with fiscal stimulus packages raise doubts about their efficacy and effects on growth. Higher infrastructure spending needs to be carefully designed to boost potential output, while tax reform needs to be broad-based to encourage investment, labour supply, and inclusion.
An expansionary fiscal agenda has several implications. In the short run, real output will likely rise with a consequent widening of the external current account deficit. Given that there is little remaining slack in the U.S. economy, inflation pressures could rise quickly. Broader structural reforms will be needed to fund all this within a smaller deficit envelope, raise labour force participation, and convince markets that the agenda will sustainably boost productivity and potential growth over the medium term. Indeed, the future path of interest rates has already steepened, with the Federal Open Market Committee, which determines monetary direction, anticipating three interest rate hikes in 2017, with the likelihood of further dollar appreciation.
If that happens, there will be mixed implications for the U.S. economy, potentially severe for manufacturing output and employment. A marked strengthening of the U.S. dollar will hurt U.S. exports and help domestic consumers, raising the external current account deficit. It will work against domestic manufacturing, increasing the relative incentive to move factories overseas. The Trump agenda hopes to counter this with tax and other incentives to push U.S. corporations to bring back the past profits that they held abroad.
Spillovers outside the United States will be felt especially strongly in emerging market economies whose currencies depreciate against the dollar. While higher U.S. demand and more competitive currencies will help, many emerging markets will need to balance their weaker currencies with their debt vulnerabilities, and protectionist pressures may become a risk.
Certainly, protectionism around the world has already been rising in recent years, and this was a key plank of the Trump campaign. The danger is that new trade barriers will run counter to the growth agenda. Instead, the global priority needs to be to liberalise trade in services, and develop multilateral rules on investment, competition policy, intellectual property rights, and regulations.[8] Regulatory barriers that impede adoption and diffusion of technology are already affecting investment and growth in a number of countries. This will especially benefit the U.S. economy that is already a global leader in the fast growing area of tradeable services, and help reverse the decline in its factor productivity growth. It will also directly help India that has taken the lead among emerging markets in building its potential in the export of modern services.
There is a lot at stake for the global economy in how the Trump growth agenda develops.
Anoop Singh is Distinguished Fellow, Geoeconomics Studies at Gateway House: Indian Council on Global Relations.
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References
[1] Board of Governors of the Federal Reserve System, Government of the United States of America, Press Release, 14 December 2016, <https://www.federalreserve.gov/newsevents/press/monetary/20161214a.htm> (Accessed on 3 January 2017)
[2] Federal Open Market Committee, Government of the United States of America, Transcript of Chair Yellen’s Press Conference, 14 December 2016, <https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20161214.pdf> (Accessed on 3 January 2017)
[3] Surveys of Consumption, University of Michigan, Final Results for December 2016, <http://www.sca.isr.umich.edu/> (Accessed on 3 January 2017)
[4] American Society of Civil Engineers, Failure to Act Report and Infrastructure Policy Report, <http://www.asce.org/grand-challenge/> (Accessed on 3 January 2017)
[5] There are analysts who believe that this slowdown is only a passing phase and that the age of robots and machine learning will transform the economy in coming decades. Others argue that productivity and output are likely being underestimated because of the difficulties in measuring modern services and other internet related activities.
[6] This excludes TSA employees.
[7] Taylor, John B., First Principles: Five Keys to Restoring America’s Prosperity, (New York: W. M. Norton, 2012)
[8] Global Economic Governance, International Centre for Trade and Sustainable Development, G20 Hangzhou Summit 2016: Proposals for Trade, Investment, and Sustainable Development Outcomes, July 2016, <http://www.ictsd.org/sites/default/files/research/G20%20Hangzhou%20Summit%20Proposals%20for%20Trade%2C%20Investment%2C%20and%20Sustainable%20Development%20Outcomes_0.pdf> (Accessed on 3 January 2017)