The peak season for economic forecasting is here and the consensus outlook has been pretty upbeat. To judge from forecasts coming out of the financial sector, the consensus is for about 2.5 percent real GDP growth during 2014, compared with an average of 2 percent over the past three years. Three to 3.5 percent growth is an optimistic forecast at this point, and 4 percent is the outer fringe. So what would it take to reach these outcomes?
Somewhat faster growth should be expected just from the improved policy environment. A year ago the political stalemate in Washington threatened a severe and abrupt tightening of fiscal policy. A last-minute compromise avoided the worst case scenario, but fiscal policy still tightened sharply in the winter months and the expansion slowed. Today the budget stalemate has been moved to the back burner. The recent agreement to undo some of last year’s sequestration is itself a plus for the economy. And it also makes it less likely that the debt ceiling will be used to create a new fiscal crisis any time soon. These fiscal changes alone should be enough to achieve 2.5 percent growth during 2014.
Auto sales and homebuilding, two traditionally cyclical sectors of the economy, have been leading the expansion in recent quarters and will continue rising in 2014. So will the ongoing development of the domestic energy industry which has added jobs and output rapidly throughout the current expansion. It is likely the growth in these areas will continue, but not accelerate further. So, to get noticeably faster, GDP growth will require a speed-up of demand from other sources. Our foreign trading partners are unlikely to provide it. And although business conditions and utilization rates are improving a bit, we are not on the verge of a broad capital spending boom. If we were, corporations would not be on a binge of buying back their own stock.
Because consumer spending accounts for about two-thirds of total aggregate demand, the most optimistic forecasts—those that expect GDP to grow by 3.5 percent or more next year—base that optimism on a strong rise in overall consumer spending. Candidates for predicting spending by consumers include household wealth, disposable incomes, interest rates and “animal spirits.” Let’s briefly look at each.
Over the past year, household wealth has surged as a result of stock market gains and increases in home values. But though wealth as a determinant of consumer spending has a long pedigree in economic theory, its usefulness in short-term forecasting is suspect. Stock ownership is highly skewed towards the wealthy. Their spending is no doubt higher as a result of rising markets, but the impact on GDP is relatively small. Retirement plans give many middle class families a meaningful stake in the market, but their price fluctuations should have only an indirect and very small effect on current consumption. Home values raise different issues. Homeownership extends much more broadly across income groups, but the impact of home price changes on consumption is questionable. As Alan Greenspan once observed, rising home values allow one to live in a finer neighborhood without having to move. Apart from that, they raise the homeowner’s property taxes.
Compared with wealth effects, the effect of income on consumption is far more direct and pervasive. However the stagnation of real wages and the very slow growth of earned income has been one of the hallmarks of the current expansion, and it has continued during 2013. The Federal Reserve can be counted on to keep interest rates low. But there is no scope for policy to become more expansionary than it already is, and little sign of a resurgence in consumer borrowing for consumption. That leaves improving animal spirits as the main hope for a substantially stronger consumer sector in 2014. Optimism can be a powerful force in the economy, but it is hard to forecast when it might improve.
Though the most optimistic forecasts for 2014 thus appear to be a stretch, the expansion will certainly continue for a fifth year and growth is more likely to be at a 3 percent rate than at the 2 percent rate now expected for 2013. It is reasonable to hope that Congress will not create another fiscal crisis. And monetary policy will be led by the extremely able and well-prepared Janet Yellen. That promises competence and continuity. We can hope for improving animal spirits as well.