2018: Fed predicts stronger U.S. economy
At its Dec. 13 meeting, the Federal Reserve raised the benchmark fed funds rate by 0.25 percent, to a target rate of 1.25-1.50 percent. The fed funds rate is what short-term debt is often based upon. The rate hike was expected, completing the Fed’s 2017 agenda of three rate hikes on its mandate to promote economic health and stability.
The surprise, however, was the Fed’s upward revisions on the strength of the American economy.
The annual rate of projected economic growth in 2018 was raised from 2.1 percent to 2.5 percent. In 2019, the growth rate was increased from 2.0 percent to 2.1percent, and in 2020, from 1.8 percent to 2.0 percent. So, what is causing the Fed’s suddenly improved outlook on the U.S. economy?
First, the U.S. labor market should continue to strengthen. The national unemployment rate is currently 4.1 percent, near a 17-year low. Employers have been adding, on average, 174,000 jobs each month, just below 2016’s pace of 186,000 per month. In 2018 and 2019, the unemployment rate is expected to further decline to 3.9 percent.
Also, the U.S. economy, led by the American consumer, has finally been growing at a solid rate. Consumer spending, the purchase of durable and non-durable goods and services, accounts for more than two-thirds of all economic growth. In the second and third quarter, the economy grew at an average rate of 3.15 percent, well above the historical 9-year average of 2.1 percent. Initial data for the final three months of the year, including the all-important holiday retail shopping season, have been strong and above expectations.
Finally, the Fed raised its economic forecast on expectations the corporate and personal tax cuts bill would be passed. Named the Tax Cuts and Jobs Act, it is the largest restructuring of the U.S. tax code in more than 30 years. It was signed into law by President Trump on December 22, with most of the changes going into effect on January 1.
Despite the upward revisions, the Fed is still wrestling with low inflation and tepid wage growth. Rising wages fuel economic growth, and inflation is a key indicator of a strong consumer demand for goods and services. As demand rises, typically, so does inflation. But inflation remains stubbornly low at 1.5 percent and the Fed’s 2.0 percent target rate of inflation hasn’t been reached since April 2012. Annual wage growth this year has averaged just 2.57 percent, well below the 3.0-4.0 percent growth rate typically seen in times of economic expansion.
The offshoot to faster economic growth, of course, is higher interest rates, which the Fed uses to gently tap the brakes on the economy to prevent it from overheating. The Fed’s agenda calls for three more hikes in 2018 and two each in 2019 and 2020. The odds calculated by the financial markets reflect a 62 percent chance the next 0.25 percent rate hike will occur at the Fed’s meeting in March.
Having just capped off its fifth hike since December 2015, the Fed is maneuvering through territory not seen in over 10 years – the previous series of rate hikes ended in June 2006. Since then, and in response to the subprime mortgage crisis in 2007, the Fed had lowered the fed funds rate to near zero percent, where it remained for seven years before its 0.25 percent hike in December 2015.
But much has changed since 2006. Technological advancements, an aging population and the dynamics of an ever-changing economy have challenged the relevance of the Fed’s predictive models used to gauge and forecast economic outcomes. The Fed readily admits many of its benchmark hypotheses simply aren’t holding up in today’s world.
As we enter 2018, the Fed will oversee a level of economic growth not seen in years. But with this growth comes rate hikes, and more importantly, the impact they have on consumer spending. Yes, expectations are high as we start the New Year. Let’s hope the Fed can help deliver.
And to you, the readers, I wish you all a very happy, and prosperous, New Year.
Mark M. Grywacheski, Investment Advisor
Opinions expressed herein are subject to change without notice. Any prices or quotations contained herein are indicative only and do not constitute an offer to buy or sell any securities at any given price. Information has been obtained from sources considered reliable, but we do not guarantee that the material presented is accurate or that it provides a complete description of the securities, markets, or developments mentioned.
Quad Cities Investment Group, LLC is a registered investment advisor with the U.S. Securities Exchange Commission.
