Economy: U.S. Outlook Mixed

This month, I broaden my column beyond the state’s borders and offer a look at the United States economic outlook for 2019. Overall, absent a major shock or big policy mistake, I expect the nine-year-old U.S. economic expansion will continue, though at a slower rate. The rate of U.S. Gross Domestic Product (GDP) growth – 2.4 percent – will be below 2018’s 3 percent and the 2.9 percent average of the last 50 years.

The main reasons I think GDP growth will slow are: (1) higher interest rates, (2) smaller – or negative – wealth effects and (3) lower levels of confidence. Despite faster income growth, consumer spending should grow more slowly.

In addition, with the economy operating beyond full employment, below-trend levels of foreign immigration will limit GDP growth. Multi-family homebuilding starts will trend lower due to delivery of new units already in the pipeline, tighter credit for new apartment development and the rising proportion of households opting for home ownership.

Sub-par productivity growth will also hold down GDP and personal income growth. Sub-par productivity growth reflects several factors, including the aging of the U.S. population, low levels of business investment, less foreign immigration, regulations at every level of government, the repercussions of many years of mediocre gains in educational achievement and new restrictions on foreign trade. In fact, trade tensions, a stronger dollar and slower foreign economic growth also mean exports will grow more slowly than in recent years.

While GDP growth will be slower, several things will contribute to a rise next year, including consumer spending, gross private domestic investment, government spending and industrial production. Indeed, investment spending by businesses is likely to grow faster than in 2018.

Corporate balance sheets are not as strong as a few years ago but should be manageable as long as interest rates do not increase very quickly. Nonetheless, I am concerned that many corporations have taken on considerable debt and are vulnerable to interest rate shock. Small businesses’ finances are in comparatively good shape. Small business lending should expand, with credit growing steadily through at least the third quarter of 2019.

The Federal Reserve’s monetary policy stance will be restrictive as it raises short-term policy interest rates above the rate of inflation. I expect the federal funds rate to reach 3.5 percent in December 2019, while inflation will be 2.5 percent. An inversion of the yield curve, which is when long-term debt instruments have a lower yield than short-term debt instruments of the same credit quality, is very likely. An inverted yield curve often leads a recession by 6 months to 24 months.

The U.S. economy is operating at the late stage of the current economic cycle. Excesses have developed in both the financial and labor markets, which make the overall economy more vulnerable to an unexpected shock or major policy blunder than was true earlier in the economic expansion. In addition, federal tax reform is providing modest late-cycle fiscal stimulus, which raises the risk that the Federal Reserve will increase interest rates too aggressively, ending the current economic expansion sometime in 2020.

Indeed, the expansion may be particularly vulnerable to even moderately higher interest rates because many years of artificially low interest rates encouraged investors to pile into risky assets. It also encouraged businesses to take on a lot of debt, which is manageable at low interest rates, but will be a vulnerability should rates rise substantially. Rate hikes therefore may lead to a sharp correction in the prices of risky assets (e.g., equities and bonds) and financial difficulties for businesses and their creditors, which could swiftly push the U.S. economy into recession.

The main risks to U.S. economic growth are (1) a full-blown trade war, (2) financial panics and/or massive shifts in asset prices and (3) restrictive U.S. monetary policy. I expect the yield curve to invert in 2019, raising the probability of recession in the second half of 2019 and continuing to a more than 50 percent chance in 2020.

As always, energy prices are a wild card. I expect oil prices to fall below their 2018 peak levels to about $65 dollars per barrel, but the political situation in several oil-producing regions is tenuous.

Finally, informal executive branch communications and/or policy changes with the potential to destabilize markets are impossible to handicap with any degree of confidence, but add to the overall riskiness of the economic environment.