Forecast for the Economy

Incoming fresh economic data point to continued GDP expansion at a near 3 percent growth rate and about 2.5 million net new jobs over the next 12 months. Inflation remains tame – so far. But upward pressure will build with rent growth pushing up the overall CPI. The Fed will have no choice but to raise the fed funds rates by the spring of next year. Mortgage rates will move up even before the official Fed policy change since the longer-date bonds will rise in anticipation. Homes will become less affordable for those taking out a mortgage. However, when all is said and done, home sales will have notched up 5 to 10 percent in 2015. Real estate brokerage revenue will rise by even more (10 to 15 percent) because of the added boost from rising home values.

Let’s review each of the economic data separately:

  • GDP = C + I + G + NX. The equation is always a good starting point to see where economic growth will come from. Consumer spending (C) has been growing roughly at 2 percent for the past three years. A better figure of 2.5 percent was recorded in the most recent quarter. This component will continue to expand for the simple reason that consumers have more income. Americans simply do not chuck away a large portion for savings and the total personal income has been growing at 2.5 percent after inflation on a year-over-year basis. Not only that but the composition of personal income has turned for the better. Non-farm entrepreneurial income is up 5 percent on nominal terms from a year ago while income from unemployment benefits is down 43 percent. Rental income is up 7 percent. Bulk wages and salaries are up 5 percent, the result of job creation. On top of this, the stock market continues to make gains. The market capitalization of S&P 500 companies rose by more than $3 trillion. Such euphoria always leads to greater consumer spending, not less.
  • Investment spending (I) can be divided into two parts: business and housing. Business spending on factories, equipment, software and the like rose solidly by 8 percent in the second quarter, though after no gain in the prior quarter. This component tends to be volatile because some of the purchases are bulky and big growth in one quarter can be followed by soft growth in the next. Over the past 3 years, the growth rate averaged a decent 6 percent. Given massive corporate profits, there are plenty of financial resources to be spent by businesses. Aside from corporations, the optimism expressed by small business owners reached the highest since 2007, according to the National Federation of Independent Business. On the housing side, the recovery has been subdued, but the potential for a future ramp-up is strong. Existing home sales are modestly lower from one year ago and housing starts are trying to breakout cleanly above the one million mark. In July, housing starts hit 1.1 million. Given that the normal figure should be closer to 1.5 million, there is ample room for further growth. In other words, investment spending will be solidly positive going forward.
  • Government spending (G) will have hardly grown and will likely remain at the zero growth line for awhile. State and local governments have started to boost spending as tax revenues have come in nicely, but the federal government, particularly in regards to national defense, will still have to deal with further cuts. In the most recent quarter federal spending was down 1 percent while state and local government spending was up 3 percent. This component will neither add nor subtract to economic growth in any measurable sense.
  • Net exports (NX), like government spending, will be neutral. Whatever growth in exports will be negated by the growth in imports. In the second quarter exports grew by 10 percent while imports grew by 11 percent. Given the generally weaker conditions in European economies, export growth may get shaved somewhat compared to the recent path. The mighty German economy is also slowing to a no growth zone. Meanwhile, the Ukraine has no money to buy. Russia is sanctioned and cannot buy. The overall net export was $463 billion in the red in the second quarter (with imports exceeding exports by that amount). Figures in the upcoming quarters will be roughly the same. That means, the net export picture is neither improving nor deteriorating in any measurable way.

Adding up each of the components implies GDP growing at around 3 percent. That is enough to generate 2.5 million net new jobs. More jobs mean more income. More income means more consumer spending. Businesses then will ramp up their spending to produce more. That, in turn, means more GDP and jobs. The economy appears to be entering a steady-state virtuous cycle in the immediate future.

One external shock to the system is a sudden and fast rise in interest rates. Consumers and businesses could pull back as a result and put GDP growth at risk. But the expected rise in interest rates will be very manageable. The fed funds rate will go from currently zero to 1 percent by the end of 2015. That is still low given that the 20-year average fed funds rate is 2.9 percent, which includes the past 6 years of a zero interest rate policy.

The one variable that deserves careful monitoring is CPI inflation. As long as inflation is contained or not busting out then interest rate increases can be modest. Through the middle of 2014, inflation was showing at 2 percent. But one component of inflation that is not yet contained is rent growth. Rents have been rising and rising and are higher by 3.3 percent in July, the highest in 6 years. Falling apartment vacancy rates imply continued rent gains. Because rent and homeowner equivalency rent (which follows the apartment rent trend) comprise the largest weight to the overall CPI, the growth in rents will inevitably force up CPI. There has been a nice recovery in multifamily housing starts, averaging 360,000 year-to-date and 437,000 in July on an annualized rate – the rise in rental population has quickly soaked up any new supply. Moreover, there appears to be a greater number of single-family homes that are now rentals. So the increased supply may tame rent growth. On the other hand, the overall supply of new homes has been well below the historic norm of 1.5 million for eight straight years, signaling housing shortage conditions that will persist for a while. Rents could then approach a 4 percent growth rate. CPI inflation could get out of hand. The Fed may then be forced to sharply raise interest rates. An unlikely scenario, but it is a scenario worth a close watch.

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