Economy ready to let the good times roll in 2018

Economy ready to let the good times roll in 2018
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The economy grew 2.6 percent last quarter, less than consensus expectations of a 3-percent gain. However, this is a highly preliminary number.

There will be another revision to fourth-quarter 2017 gross domestic product (GDP) next month, a second revision in March and then another revision in July when the Commerce Department conducts its annual benchmark.

It is not uncommon for past economic performance to be substantially different than what was initially reported. And during periods of economic growth, real GDP tends to be revised upward, not downward.

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So, we may very well have a much stronger 2017 GDP performance when more comprehensive data are available to government statisticians. Nevertheless, what we have seen thus far is encouraging.

 

Underlying private domestic demand, especially capital expenditures, was particularly strong last quarter. This is important, because in the past, strong demand has typically been associated with real GDP growth well in excess of 3 percent.

In other words, the initial 2.6-percent annualized increase in Q4 2017 belies an underlying boom in activity. At a minimum, the strength in demand should lead to positive growth momentum for the current quarter. How do we measure demand?

Economists should focus on final sales to private domestic purchases. This series is defined as real GDP less inventories, less net exports, less government spending and is the best proxy for underlying non-public aggregate demand.

The latter grew a massive 4.6 percent last quarter and 3.3 percent over the last year, much faster than real GDP growth, which was up 2.5 percent in Q4 2017 compared to its year-earlier level.

The strength in demand was evident in consumer spending (3.8 percent) and equipment outlays (11.4 percent) or what is commonly referred to as capex. The drags on output came from net exports and inventories, which together subtracted nearly two full percentage points off of Q4 output.

This negative impact should prove temporary: Either growth will be revised higher or the economy will be much stronger this quarter. According to our calculations, the underlying strength in private domestic demand was consistent with real GDP gains well in excess of 3 percent.

Anecdotally, this is also supported by what so far appears to be a strong quarter for stock market earnings and revenue.

Going forward, the surge in capex is likely to intensify given record-high business confidence, which is largely the result of recently passed corporate tax reform. A lower statutory tax rate combined with a substantially reduced tax on repatriated capital as well as full expensing of capital outlays should produce big gains in investment spending.

This should be the case at least for this year anyway. Spending on nondefense capital goods excluding aircraft, a key measure of business investment, grew nearly 9 percent last year. This was the largest increase since 2011 (12.1 percent).

But, these data barely captured the impact of the tax reform measure — its passage was uncertain as of the second half of December. Thus, an acceleration in capex should be expected.

In light of all of this, last quarter’s initial GDP results should be cast in a positive light. The economy has a lot of underlying momentum, so this year’s economic performance should build upon last year’s, which itself, will probably turn out to be better than what we first thought.

Joseph LaVorgna is the chief economist of the Americas for Natixis, a French corporate and investment bank. LaVorgna was ranked as the No. 2 most influential economist in 2013 by The Wall Street Journal. He is a long-time contributor on CNBC.