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Key Questions for the U.S. Economy in 2020

The U.S. economy weakened in 2019 and there were plenty of fears of a recession, but they didn’t come to fruition. Now, how several key economic questions for the new year are eventually answered could see the economy deviate, for better or worse, from our expectation. Here are those questions. We also provide our confidence level in our projections.


Will a Phase Two trade deal be signed between the U.S. and China?


Projection: No


Confidence: High


A signing ceremony for the Phase One trade deal is being organized for mid-January. Therefore, the odds are high that it will be put to bed. The Phase One deal appears to resolve some of the easier rifts between the U.S. and China, but it doesn’t resolve the main issues behind the trade tensions, including China’s intellectual property theft, forced technology transfers, and China's industrial subsidies. 

The Phase Two deal would likely attempt to tackle some of these main issues, and it will be more difficult to strike a deal in 2020. If the U.S. economy and stock market continue to hold up, President Trump may not have a strong incentive to reach an agreement. China could be more willing if its economy continues to weaken, but Beijing may also want to see how the U.S. presidential election shakes out.


Will the U.S. effective tariff rate increase noticeably?


Projection: No


Confidence: Medium


The U.S. effective tariff rate has likely peaked. The Office of the U.S. Trade Representative recently released a two-page fact sheet around the unsigned Phase One trade deal. In return for China purchasing more U.S. agricultural products, the U.S. will reduce the tariff rate on $120 billion of goods put in place in September from 15% to 7.5% and will maintain the 25% tariff rate on approximately $250 billion rather than raise it to 30%. With progress toward a final agreement, the U.S. also postponed the tariffs that were scheduled to go into effect on December 15. It seems less likely that the U.S. will impose additional tariffs on China, but they could be threatened throughout the Phase Two process.


The Trump administration has proposed imposing tariffs on other countries, including Brazil and Argentina, though Trump later backed off on his Brazil threat. Even if they are implemented it wouldn’t cause a noticeable rise in the effective tariff rate. Also, it doesn’t appear likely that the U.S. will impose tariffs on imported autos.


Will U.S. GDP growth be above the economy’s potential growth rate?


Projection: No


Confidence: Low


We forecast real GDP to increase 1.8% in 2020, a touch below our estimate of the economy’s potential growth rate of 2%. The risks to the forecast are weighted to the upside and center around the potential boost to growth from past easing in financial market conditions.


The economy has become more sensitive to developments in financial markets. To assess the economy’s sensitivity to changes in financial market conditions, we used a vector autoregression model to examine the relationship between the St. Louis Fed Financial Stress Index and four economic variables: nonfarm employment, the personal consumption expenditures deflator excluding food and energy, the shadow fed funds rate, and the Chicago Fed National Activity Index.

This approach allows us to examine the impulse response of a sudden deterioration in financial market conditions on measures of economic activity. A positive or negative shock to financial market conditions is assumed to have no effect on the economic variables in the first month but rather with a lag.


To determine whether the economy has become more or less sensitive to changes in financial market conditions, we split the data into two subsamples. The first subsample is from 1994 to 2006 and the second is from 2007 to 2019. The selection of these subsamples is arbitrary because of the limitations in the data. The first historical datapoint for the St. Louis Fed Financial Stress Index is December 1993.


The estimated responses of employment and the Chicago Fed National Activity Index to changes in financial market conditions have been larger since 2007. Similarly, the impact is both larger and more persistent in the second subset than in the first, evidence that the economy is more sensitive to financial market conditions.


Possible explanations are the increased size of the financial sector, financial innovation that expanded the channels entrepreneurs and firms use to raise external capital, increases in leverage, and the enhanced global linkages in financial markets.


Given the improvement in financial market conditions and the lagged impact on the economy, GDP growth could be stronger than some anticipate in 2020. Assuming financial market conditions remain as supportive as they are today, 0.5 percentage point could be added to GDP growth in 2020.


Will the labor force participation rate continue to increase?


Projection: No


Confidence: Medium


The labor force participation rate is forecast to decline to 63% by the end of 2020, compared with 63.2% in November 2019 (latest data available) but better than its cyclical low of 62.4%. There is the potential for a larger decline than we expect because demographics remain unfavorable. The median person among baby boomers will turn 66 in 2020, and the youngest person will be in the 55-59 cohort, a cohort when labor force participation rates begin to drop. Therefore, the demographic drag on labor force participation won’t be lifting.


Away from the baby boomers, there is still room for improvement in the prime-age labor force participation rate, as it remains below its prerecession peak. The prime-age labor force participation rate has noticeably improved over the past couple of years, but it’s been mostly driven by an increase in female participation. The male prime-age labor force participation rate has lagged behind and is nearly a full percentage point below its prerecession peak.

Will the unemployment rate increase?


Projection: Yes


Confidence: Low


The unemployment rate is forecast to average 3.8% in the fourth quarter of 2020, compared with 3.4% in November 2019. Risks favor a lower unemployment rate than what is penciled into our forecast. A key factor is the number of new jobs needed to keep the unemployment rate stable. This estimate is the function of the size of the civilian population, the labor force participation rate, the employment-to-labor force ratio, and the ratio of payroll to household employment. The break-even rate of job growth isn’t constant, and the key determinant will be the labor force participation rate. We estimate that the break-even level should drop below 100,000 per month next year.


Can single-family starts and new-home sales continue to build off their recent improvement?


Projection: Yes


Confidence: Low


Single-family housing starts are forecast increase from 2019 to 2020, but mortgage rates will need to remain low and months supply can’t break 6.5 months. We look for only a modest gain in single-family starts in 2020, and it won’t be surprising if the year gets off to a slow start. Single-family permits continue to run below starts. Mortgage rates are also key to new-home sales and we expect further improvement in sales in 2020. The mix of construction has been shifting toward more affordable new homes.

Will less trade policy uncertainty cause business investment to rebound meaningfully?


Projection: No


Confidence: High


Weak business investment in 2019 had more to do with fundamentals than with a spillover cost of the trade tensions between the U.S. and some of its major trading partners. To highlight this, we built a simple model in which real equipment spending is a function of after-tax corporate profits as a share of nominal GDP, the Baa-Aaa credit spread as a proxy for credit conditions, trend growth in the labor force, depreciation, and a dummy variable for recessions. All variables were statistically significant and had the correct signs.


The results were not overly surprising. There is a strong relationship between after-tax profits and equipment spending. Since 1950, larger after-tax corporate profits have coincided with capital expenditures contributing more to GDP growth. Given that profits struggled in 2019, this could continue to weigh on capital spending. Though policy uncertainty may not boost investment, better financial market conditions and an increase in corporate profits’ share of nominal GDP should. Therefore, business investment should improve in 2020, but it won’t be booming.


Will inflation exceed 2% by the end of the year?


Projection: Yes


Confidence: Low


Some of the transitory drags on the core PCE deflator should lift in 2020, primarily the weight from financial services prices. Still, it wouldn’t be surprising if core inflation ends 2020 a hair below 2%. Monthly growth in the core PCE deflator will need to average 0.17% in 2020 to put year-over-year growth in December 2020 at 2%. For perspective, the core PCE deflator rose an average of 0.1% in 2019 (through November).

Will there be a significant acceleration in nominal wage growth?


Projection: No


Confidence: Medium


A traditional wage Phillips curve that uses the unemployment rate as the basis for measuring labor market slack would suggest that wage growth should be much stronger than it is currently. However, a broader measure of labor market slack may be necessary to correctly interpret current conditions. Creating a Phillips curve using the prime-age nonemployment rate as opposed to the unemployment rate has fit the data rather well over the last 25 years and would suggest wage growth accelerating further beyond 3%.


By most measures, wages appeared to be making steady progress, reaching year-over-year growth of 3% or better by the end of 2018. The Employment Cost Index, the most reliable measure of wage growth for gauging the business cycle, reached a cyclical high in the fourth quarter of 2018. However, as of the third quarter of 2019, wage growth was essentially unchanged over the prior seven quarters, back to the beginning of 2018. This comes on the heels of a period from the beginning of 2016 through the first quarter of 2018 when wage growth accelerated briskly from 2% to 3%. This stalling of wage growth is consistent with employment growth over the last 12 months being more sluggish than initially reported. Therefore, some of the pressure on wages has decreased and they may improve only modestly in 2020.


Is the Fed going to cut interest rates in 2020?


Projection: No


Confidence: Medium


Most Fed officials believe monetary policy is in a “good place.” This implies a consensus around the idea that the midcycle adjustment has likely been sufficient to help sustain the expansion. Our December baseline forecast has a rate cut occurring next June but this very likely will be removed from the baseline soon.

Will the Fed alter its policy framework?


Projection: Yes


Confidence: Medium


A change is coming but the timing is a little fuzzy. It would make the most sense to announce a change in January, when the Fed normally alters or reaffirms its Statement on Longer-Run Goals and Monetary Policy Strategy, but we don’t think the Fed will be ready in a few weeks to make that change. Still, sometime in the second half of the year it won’t be surprising if it does make an announcement that it is adopting average inflation targeting.


Average inflation targeting should be fairly easy to communicate and prescribes that if inflation has been below target for a period, then the Fed will aim for a stretch of above-target inflation, so that inflation averages the target over the cycle. Though there has not been any formal change in the central bank’s inflation-targeting approach, it could be influencing some of the Fed officials’ views now; a number of policymakers have publicly voiced their support for allowing inflation to run above their 2% objective for a time. Given Fed rhetoric, it seems policymakers would aim for 2.25% inflation during expansions. If the Fed were to adopt this approach next year, it would move the goal posts and likely delay rate hikes even further out in our baseline, which has a hike occurring in the first half of 2021.

Will the U.S. enter recession?


Projection: No


Confidence: Medium


We looked at the catalysts of recessions and broke them down, highlighting several causes in the post-WWII
era:


• Inventory imbalances
• Oil supply shocks
• Overheating
• Monetary policy error
• Financial imbalances
• Fiscal tightening


None of these appear overly threatening now. Our probability of recession models have shown an increase in the probability of a recession in 2020 but they are nowhere near raising a red flag.


Is this the year productivity finally breaks out?


Projection: No


Confidence: Medium


Trend U.S. productivity growth has firmed recently but remains unimpressive. We don’t believe a tight labor market is sufficient to provide a big boost to productivity growth. In our past work, we used a vector autoregression model to examine the relationship between business investment and unit labor costs. This approach allows us to examine the impulse response of a sudden acceleration in labor costs, but the boost to business investment was around 0.5 percentage point. Therefore, stronger wage growth will likely boost business investment, but the impact is likely to be modest. This would suggest that a quick turn in productivity growth is unlikely. Stronger productivity is coming but it may not be in 2020. Business investment in intellectual property has been strong over the past couple of years, and this boosts productivity but with a fairly long lag

Will President Trump win re-election?


Projection: Yes


Confidence: Medium


Our Presidential Election Model currently has Trump easily winning re-election. The economic implication of the outcome of the election is for 2021 but our initial thoughts are if Trump is re-elected, he is likely to double down on his current economic policies. This means more deficit-financed tax cuts and government spending increases, renewed trade tensions with China and other nations, and tougher immigration policies. Also, he will likely not reappoint Fed Chairman Jerome Powell, replacing him with someone who shares Trump’s views on monetary policy.


However, if a Democrat is elected, economic policy will be flipped on its head. At a minimum, the Trump tax cuts for higher-income and wealthy households will expire as they are set to do under current law in the next presidential term. While a Democratic president will take a hard stance in trade negotiations with China, the tariff wars are unlikely to continue.

Courtesy of Moody's

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