United States: An economy in transition Global Economic Outlook, Q1 2017

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The new US president is championing a wide range of policy proposals. However, since it is not known what the Trump administration will be able to achieve with Congress as to the specific form and timing of these policy objectives, there is substantial uncertainty in the near to mid-term.

Introduction

The election of a new US president, particularly one of a different political party than the predecessor, comes with the expectation of a shift in policies. Among the changes that President Donald Trump is advocating are lower corporate and personal taxes, increased federal infrastructure spending, a change in existing trade deals, increased immigration enforcement (including a wall on the southern border), the repeal or replacement of Obamacare, and a reduction in regulation. The fact that the president’s party controls both houses of Congress increases the odds that many of these proposals will indeed become reality in some form, although the details and timing are unclear at this point. Also unknown is how these changes will be paid for.

The current state of the economy

The incoming president is inheriting an economy that is in fairly good shape, with moderate growth and a labor market that continues to show strength. Last year got off to a slow start, with just 1.1 percent growth (annualized rate) in the first half. In the third quarter, growth picked up, with GDP growing 3.5 percent (annualized), the fastest pace of growth in two years. Over the first three quarters of the year, real consumer spending was strong, supported by low gasoline prices, cheaper imports due to the strong US dollar, and increasing employment. Business investment remained muted, as increased investment in intellectual property (primarily investment in research and development and software) was offset by declines in equipment investment over all three quarters. Exports grew at their fastest rate in nearly three years in the third quarter, driven by large increases in soybean and corn exports, as bad weather in Brazil and Argentina caused widespread crop damage. Otherwise, the contribution from exports was low but sufficient to offset the subtraction from imports. Residential investment contracted in both the second and third quarters, which was surprising given the rising home prices and low levels of inventories. Government spending (at all levels) made a very small but positive contribution over the three quarters in total.1

The incoming president is inheriting an economy that is in fairly good shape, with moderate growth and a labor market that continues to show strength.

During 2016, the US economy generated 2.2 million net new jobs (figure 1). Although the pace of job creation was slower than in 2014 (3.0 million) and 2015 (2.7 million), it was still a healthy rate of growth. While job creation was slow to gain steam early in the expansion (it took until 2014 for the level of employment to surpass its prior peak of 2007), the growth has now been sufficient to reduce the unemployment rate to 4.9 percent for 2016 as a whole, just above the 4.6 percent rate experienced before the recession (figure 2).

Change in employment

Unemployment rate

With the economy and, particularly, the labor market continuing to exhibit strength, the Federal Open Market Committee (FOMC) of the Federal Reserve Board raised the target for the federal funds rate a quarter of a point in December, one year after the last increase. The current target range is 0.50–0.75 percent.

Looking forward

While the formulation and timing remain uncertain, as noted above, some version of the following changes are likely to be debated this year and possibly enacted:

  • Corporate and personal income tax reform—While the top rates for both types of taxes will likely be lowered, the details will determine what the final impact on individual tax bills will be. The details will also ultimately determine how stimulative to the economy and costly to the Treasury the actual plan will be.
  • A federal infrastructure spending program—An increase in federal spending should spur economic growth over what it otherwise would have been.
  • Review of existing trade deals and a move toward bilateral enforcement—The United States currently has free-trade agreements (FTAs) with 20 countries, the first of which was with Israel (in 1985) and the most recent with Colombia and Korea (both in 2012). The North American Free Trade Agreement (NAFTA), with the United States’ largest trading partners, Canada and Mexico, was signed into law in 1994.2 In 2015 (the last full year available), the United States had a trade deficit of $500 billion, comprising a $763 billion deficit in goods trade partially offset by a $262 billion surplus in services trade. Any action by the United States to withdraw from or fail to abide by the terms of an FTA would invite retaliation, putting at risk some portion of the over $2 trillion in goods and services that the United States exports annually.3
  • Increased immigration enforcement and stronger border controls—Any policies that ex-President Barack Obama put in place, such as the 2012 directive that the US Citizenship and Immigration Services accept and process “requests for consideration of deferred action, which could enable people who arrived in this country as children to receive employment authorization for two years,” can—and most likely will—be rescinded.4 It is unclear what other steps to increase enforcement Trump plans to take, but he remains committed to building a wall on the US-Mexican border, with the Mexican government eventually covering the cost. According to the Pew Research Center, the number of unauthorized immigrants in the workforce has been stable at around 8 million since 2009.5
  • Repeal and replacement of Obamacare—Popular provisions of the 2010 Affordable Care Act (Obamacare), such as the ability to keep young adults on a parent’s health insurance plan until age 26 and guarantee of coverage for pre-existing conditions, will most likely remain in whatever new health insurance law is enacted.
  • Regulatory reform across agencies—One of the first actions in this area will likely involve substantial changes to the 2010 Dodd-Frank Wall Street Reform and the Consumer Protection Act.
Any action by the United States to withdraw from or fail to abide by the terms of an existing FTA could invite counter-measures, putting at risk some portion of the over $2 trillion in goods and services that the United States exports annually.

Following the election, the major US stock indices reached new heights on expectations of at least some of these actions actually being taken. But with the economy nearing full employment, there is also an increasing awareness that some of these actions, particularly the stimulating impact of tax decreases and infrastructure spending, along with new trade restrictions, may drive up prices. Indeed, in the three weeks following the election, the five-year inflation expectation rate rose sharply, reaching 2.0 percent for the first time since August 2015 (figure 3). Should actual inflation start accelerating at a rate that alarms the FOMC, interest rates would increase faster and possibly in larger increments than would otherwise be the case. This would negate some of the stimulus impact of lower taxes and increased government spending.

Five-year forward inflation expectation rate

One of the biggest unknowns is how the new administration and Congress will choose to pay for the tax cuts and infrastructure spending. Federal deficits will be significantly larger if Congress passes large tax cuts and infrastructure spending bills without taking steps to curtail spending. Even without these changes, the budget deficit was on track to rise because of projected rises in Social Security and Medicare spending, reflecting an aging population. Trump suggested during the campaign that he would not change Social Security and Medicare, although some of his advisors as well as the speaker of the house, Paul Ryan, are advocates of privatization. Although the new administration may cut other entitlement programs such as medical care for the poor (Medicaid), changing the long-run path of the budget without reforming Social Security and Medicare will be difficult.