Outlook and Market Review - Third Quarter 2017

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The U. S. economy grew 3.2 percent in the third quarter of 2017 following 3.1 percent growth in the second quarter, according to revisions by the Bureau of Economic Analysis. Fourth quarter growth is shaping up to also hit the 3 percent rate. It is too early to proclaim a breakout from the post-recession doldrums but the economy is now on a better footing. The unemployment rate fell to 4.1 percent in November and job growth remains healthy. Nevertheless, the labor force participation rate is stuck around 62.7 percent and wages have yet to show the kind of growth expected when the economy hits full employment. Inflation also remains tame with the personal consumption expenditure deflator increasing only 1.6 percent on a year-over-year basis and the core rate growing only 1.4 percent.

The Fed continues to follow easy money policies even with gradual increases in the fed funds rate into 2018. The Fed recently increased the fed fund rate target to 1.5 percent and plans on increasing the rate three more times in 2018. Even so, monetary policy remains accommodative. The Fed has a long run target of 2.75 percent for the fed fund rate, which would call for five more increases of 25 basis points each. Applications of the Taylor Rule in its various versions calls for a 4 percent fed fund rate when the economy is at full employment with target inflation. While the Fed continues to “look at everything” rather than follow guidelines like the Taylor Rule, current monetary conditions remain easy with fed funds rates well below 4 percent. Some economists believe the Fed should pause with rate hikes until the economy hits the 2 percent inflation target but the consensus is that tight labor markets justify tightening now. Analysts do not expect the new Fed chair, Jerome Powell, to rock the boat by changing course in 2018.

Wages have not yet fully responded to tight labor markets, partly due to the dismal record of low labor productivity. Productivity in the U.S. economy grew only .8 percent over the past five years. Much of the explanation for low productivity rests on labor market shifts to lower productivity service jobs along with a lack of private investment in productivity enhancing technology and capital equipment. To stay on a trend growth track above 3 percent, productivity growth needs to be on track to grow around 2.5 percent. While it is controversial, many analysts are now considering how the new tax plan might stimulate higher wages, higher quality manufacturing jobs, improved private investment in technology, and new incentives for work. These are many of the missing ingredients for higher productivity growth.

Low expected inflation continues to keep a lid on long-term rates, but the yield curve is slowly getting steeper as a weaker dollar and increased federal government deficits slowly put upward pressure on longer-term rates. Low interest rates, healthy after-tax earnings projections, and strong sentiment are all keeping equity values growing.