Will the Road Runner economy turn into Wile E. Coyote in 2020?

Will the Road Runner economy turn into Wile E. Coyote in 2020?
© Getty Images

Get ready to pop the champagne on July 27 as the U.S. economy is on track to record its strongest growth rate in four years with real GDP growth expected to reach nearly 5.0 percent (annualized) in the second quarter!

As Federal Reserve Chairman Jay Powell described in the wake of the mid-June FOMC meeting, “The economy is in great shape,” and, “There is a lot to like about low unemployment.”

ADVERTISEMENT

The U.S. economy appears set to breach the symbolic 3-percent year-on-year (y/y) growth mark this summer for the first time since early 2015. Retail sales surpassed expectations in May, posting their strongest gain in two years (excluding the hurricane disruption last September) and indicative of strong consumer spending growth.

Even adjusting for higher consumer prices, May was a particularly strong month for automotive dealerships, building equipment stores, clothing outlets and department stores as well as restaurants and bars. A sign most consumers feel comfortable enough to indulge as the warmer days make their comeback.

Why now you ask? A combination of strong labor market fundamentals, elevated confidence and reduced tax burdens amid an environment of still-low interest rates and moderate inflation are the key drivers.

On the employment front, we are currently in the longest stretch ever of consecutive months of job growth, with the economy adding jobs for 92 consecutive months. In fact, the economy is on track to add more than two million jobs for the eighth-consecutive year in 2018.

This feat is even more remarkable when you consider that the unemployment rate is currently hovering at a 17-year low of 3.8 percent. What is more, wage growth is slowly firming, with average hourly earnings at 2.7 percent y/y in May and the employment cost index for wages and salaries reaching 2.9 percent in Q1 — its highest since 2008.

Combine these strong labor market fundamentals with a significant fiscal stimulus boost from the Tax Cuts and Jobs Act and you have the right ingredients for a more confident consumer that is more willing to spend.

On the business front meanwhile, we have a trifecta of drivers that are boosting investment: moderate global activity supporting exports, rising oil prices boosting investment in the shale sector and a fiscal package reducing tax obligations, increasing capital depreciation allowances and favoring some repatriation of foreign held profits.

Why then would former Fed Chair Ben Bernanke talk about an impending Wile E. Coyote moment in which the economy falls off a cliff? While the U.S. economy is currently very strong, some cracks are appearing in the pillars of growth, and 2020 could represent a delicate year in terms of economic activity.

Here are five reasons for this potential Wile E. Coyote moment:

1. Fiscal cliff

The $1.5 trillion Tax Cuts and Jobs Act (TCJA), signed by the president last December, and the $300 billion Bipartisan Budget Act (BBA), signed by the president in February, will provide a significant boost to the U.S. economy.

Oxford Economics estimates the fiscal stimulus will add 0.7 percentage points (ppt) to growth in 2018 and another 0.5 ppt in 2019. However, as we look into 2020, the marginal fiscal stimulus will likely be minuscule.

More importantly, the BBA is not a traditional one-time increase in government outlays. The law only provides for a two-year (2018 and 2019) increase in the spending caps from the 2011 Budget Control Act.

As such, unless Congress votes for another increase in the spending caps in 2020, then federal discretionary outlays would have to be cut by 6 percent in 2020 which would reduce real GDP growth by around 0.5 ppt.

2. Trade tensions

News on the trade front has been disappointing, with the administration implementing 25-percent steel and 10-percent aluminum tariffs on all trading partners, including Mexico, Canada and the EU on June 1.

Retaliation measures were swiftly announced, and there is a growing sentiment that global players are saying “enough is enough” to Trump’s trade tantrums.

Trade tensions between Beijing and Washington fluctuate daily with the administration to set to impose tariffs on $50 billion of U.S. imports from China. On the NAFTA front, news isn’t encouraging either, and the odds of 2018 deal are close to nil.

Oxford Economics estimates the implementation of U.S. tariffs on $50 billion of imports from China will lift the annual pace of core CPI by 0.1 ppt, and slow the pace of GDP growth by less than 0.1 ppt.

However, an escalation of tensions with the U.S. imposing tariffs on $150 billion of imports — 30 percent of total merchandise imports from China — would lead to a cumulative loss of GDP over 2018-2019 of over 0.3 percent.

3. Consumer savings

Half the growth in consumer spending over the past two years has been financed by a reduction in household savings with lower income families dipping more heavily into their savings and in some cases borrowing more — a worrying trend at this point in the business cycle.

This greater dissaving by lower-income individuals points to nascent cracks in the main pillar of the U.S. economy and along with that, greater exposure to external shocks.

For instance, a 10-percent fall in stock prices would likely reduce real GDP growth by 0.5 ppt via the wealth and confidence channels. Likewise, a strong rise in gasoline prices could significantly constrain household budgets.

Oxford Economics calculates that if crude oil prices stabilize at their current levels, then higher prices at the pump will offset nearly half of the fiscal stimulus boost to GDP in 2018 — a 0.3 ppt drag on growth.

4. Fed tightening

The Fed could also be a troublemaker in 2020. In its June update to the Summary of Economic Projections, the Fed’s median dot-plot estimate put the federal funds rate at 3.4 percent in 2020, which would be 50 basis points higher than the Fed’s estimated long-run neutral fed fund rate of 2.9 percent.

This would imply a restrictive monetary policy stance at a time when economic activity would be slowing. Further, the Fed hasn’t clarified how it reconciles its expectations of having an unemployment rate at 3.5 percent in 2020, but 1 ppt higher at 4.5 percent in the longer-run. The tighter monetary policy stance and unemployment rate forecast point to an important risk for the U.S. economy in 2020.

5. Growth exhaustion

If not for one of the specific factors noted above, the 2020 slowdown could come from “growth fatigue." The combination of reduced marginal fiscal stimulus, higher inflation stemming from supply constraints, tighter monetary policy and increased protectionism would represent a poisonous mix.

If these factors were to materialize, it could be that instead of a Wile E. Coyote moment, we experience a growth recession with the Road Runner experiencing a bad spell of food poisoning.

Gregory Daco is the chief U.S. economist for Oxford Economics, a firm that provides research on major economies, the emerging markets, commodities, industrial sectors, global economics, global industry, cities and regions.