Next week, government statisticians will release the first estimate for third quarter real GDP growth.  In spite of hurricanes, and continued negativity by conventional wisdom, we expect 2.8% growth. 

If we're right about the third quarter, real GDP will be up 2.2% from a year ago, which is exactly equal to the growth rate since the beginning of this recovery back in 2009.  Looking at these four-quarter or eight-year growth rates, many people argue that the economy is still stuck in the mud.

But, we think looking in the rearview mirror misses positive developments.  The economy hasn't turned into a thoroughbred, but the plowing is easier.  Regulations are being reduced, federal employment growth has slowed (even declined) and monetary policy remains extremely loose with some evidence that a more friendly business environment is lifting monetary velocity.

Early signs suggest solid near 3% growth in the fourth quarter as well.  Put it all together and we may be seeing an acceleration toward the 2.5 – 3.0% range for underlying trend economic growth.  Less government interference frees up entrepreneurship and productivity growth powered by new technology.  Yes, the Fed is starting to normalize policy and, yes, Congress can't seem to legislate itself out of a paper bag, but fiscal and monetary policy together are still pointing toward a good environment for growth.  

Here's how we get to 2.8% for Q3.

Consumption:  Automakers reported car and light truck sales rose at a 7.6% annual rate in Q3.  "Real" (inflation-adjusted) retail sales outside the auto sector grew at a 2% rate, and growth in services was moderate.  Our models suggest  real personal consumption of goods and services, combined, grew at a 2.3% annual rate in Q3, contributing 1.6 points to the real GDP growth rate (2.3 times the consumption share of GDP, which is 69%, equals 1.6).

Business Investment:  Looks like another quarter of growth in overall business investment in Q3, with investment in equipment growing at about a 9% annual rate, investment in intellectual property growing at a trend rate of 5%, but with commercial constriction declining for the first time this year.  Combined, it looks like they grew at a 4.9% rate, which should add 0.6 points to the real GDP growth.  (4.9 times the 13% business investment share of GDP equals 0.6).

Home Building:  Home building was likely hurt by the major storms in Q3 and should bounce back in the fourth quarter and remain on an upward trend for at least the next couple of years.  In the meantime, we anticipate a drop at a 2.6% annual rate in Q3, which would subtract from the real GDP growth rate.  (-2.6 times the home building share of GDP, which is 4%, equals -0.1).

Government:  Military spending was up in Q3 but public construction projects were soft for the quarter.  On net, we're estimating that real government purchases were down at a 1.2% annual rate in Q3, which would subtract 0.2 points from the real GDP growth rate.  (1.2 times the government purchase share of GDP, which is 17%, equals -0.2).

Trade:  At this point, we only have trade data through August.  Based on what we've seen so far, it looks like net exports should subtract 0.2 points from the real GDP growth rate in Q3.  

Inventories:  We have even less information on inventories than we do on trade, but what we have so far suggests companies are stocking shelves and showrooms at a much faster pace in Q3 than they were in Q2, which should add 1.1 points to the real GDP growth rate.

More data this week – on industrial production, durable goods, trade deficits, and inventories – could change our forecast.  But, for now, we get an estimate of 2.8%.  Not bad at all. 

Brian S. Wesbury - Chief Economist
Robert Stein, CFA – Deputy Chief Economist  

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Source: St. Louis Federal Reserve FRED Database

Implications: Retail sales boomed in September as Hurricanes Harvey and Irma roiled consumer spending.  Everyone already knew auto sales rebounded sharply in response to vehicles destroyed by Harvey, so there should not be much surprise at the 1.6% gain in overall September sales.  However, sales were also revised higher for prior months and there was considerable strength for "core" sales, which grew 0.4% in September, a solid number, and are up 3.1% from a year ago.  We're at least a couple of months away from being able to see sales data that reflect the underlying trend and expect sales to continue to remain above trend in the coming months, both due to temporary pent-up demand from the hurricanes plus the purchase of replacements for what was destroyed.  For example, due to the hurricanes, carmakers reported sales at a 16.1 million annual rate in August, the slowest pace for any month since 2014.  But sales surged to 18.6 million annualized pace in September as vehicles totaled in the storm got replaced.  Gas station sales also rose substantially in September as gas prices rose due to Harvey and Irma.  Expect them to drop in the coming months as refineries get back to full speed and pump prices decline.  When all is said and done and the effects of the hurricanes are fully behind us, we expect the data to show continued Plow Horse growth in consumer spending.  Jobs and wages are still moving up, consumers' financial obligations are an unusually small part of their incomes, and serious debt delinquencies are down substantially from seven years ago.

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Implications:  Prices surged 0.5% in September as Hurricanes Harvey and Irma caused a 13.1% jump in gasoline prices.  While it will take another month or two to get a clean reading on consumer prices outside the storm impacts, a look at "core" prices – which excludes food and energy – shows the usual suspects continue to push prices higher.  Housing costs rose 0.2% in September and are up 2.8% in the past year, while auto insurance prices rose 0.5% in September and are up 8.2% in the past year.  In the last twelve months, consumer prices are up 2.2%.  This was boosted by the September storm impacts, but "core" prices, which are less impacted by the temporary factors, are up 1.7% in the past year.  That is only slightly below the Federal Reserve's 2% target, but, as yesterday's report on producer prices shows, a continued pickup in prices is in the pipeline.  And the trend in prices has been in place for a while now. For the twelve months ending September of 2015, overall consumer prices were unchanged, while the twelve months ended September of last year showed a 1.5% rise.  Taking this into consideration shows why the Fed has reason for confidence that the inflation picture is finally firming around their target and provides further justification for a December rate hike. Markets are currently pricing in a roughly 75% chance for a hike in December, with just one to two hikes priced in for 2018.  It is yet to be seen who will take over the Fed Chair position from Janet Yellen, but the two leading candidates at the moment – Jerome Powell and Kevin Warsh - are both likely to continue a slow but steady rate hike cycle, with three to four hikes likely if economic data continue to show modest but healthy growth in the year ahead. The most disappointing news in today's report is that real average hourly earnings declined 0.1% in September.  However, these earnings are up 0.7% over the past year and data from the Bureau of Labor Statistics employment report show overall worker earnings (which takes into account both wage gains and increased hours worked) are rising at around a 4% annual rate. Along with healthy household balance sheets, consumers have room to increase spending.

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Implications:  The impact of Hurricane's Harvey and Irma can be felt throughout today's report on producer prices.  The most significant impact from the storms was on supply chains, where increased demand for machine and equipment parts, paired with a limited supply, pushed up margins to wholesalers.  Meanwhile storm-related refinery shutdowns along the Gulf Coast led energy prices 3.4% higher in September, including a 10.9% jump in gasoline prices.  Food prices, however, showed little impact, unchanged in September and down at a 0.5% annual rate in the past six months.  Looking beyond food and energy, "core" prices rose 0.4% in September.  In addition to higher wholesaler margins, most major categories of goods and services also rose in September.  In the past year, producer prices have increased 2.6%, the largest twelve month rise since early 2012.  This is certainly elevated in September by the hurricanes, but producer prices have been at or above 2% on a year-to-year basis in seven of the last eight months.  And a look further down the pipeline shows the trend higher should continue in the months to come.  Intermediate processed goods rose 0.5% in September and are up 4.3% from a year ago, while unprocessed goods declined 0.4% in September but remain up 7.0% in the past year.  In other words, the "data dependent" Fed has clear evidence that inflation has met or exceeded their 2% target. In employment news this morning, new claims for unemployment benefits declined 15,000 last week to 243,000, while continuing claims fell 32,000 to 1.89 million, the lowest level since 1973. The temporary storm-related dip in employment looks to have passed, and we expect a very strong rebound in payrolls in October.

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Source: St. Louis Federal Reserve FRED Database

If the current economic expansion lasts another year and a half, it'll be the longest on record, even surpassing the expansion of the 1990s that ended in early 2001. 

Notice how we didn't say it'll be the "best" expansion of all-time, just the longest; it's not the best by a long shot.  From the recession bottom to the expansion peak, real GDP expanded 39% in the 1980s and 43% in the 1990s.  So far, eight years in, this one is only up 19%.  That's why we've been calling it the Plow Horse Economy. 

Still, the length of the current expansion is pretty remarkable given how doubtful most were that it would even get started back in 2009, as well as all the predictions since then that it would end in spectacular fashion during the past eight years.

And we think the odds of going at least another 18 months are very high.  Nowhere do we see the kinds of policy shifts or imbalances that could curtail economic growth enough to throw us back in recession.

In terms of policies, tight monetary policy, a major shift toward protectionism, or large tax hikes could all hurt growth. 

In the past, tight money has usually been the key factor behind recessions.  But, for now, short-term interest rates are about 125 basis points below the yield on the 10-year Treasury, roughly 200 basis points below the growth trend in nominal GDP (real GDP growth plus inflation), and the banking system remains stuffed with excess reserves.    

Yes, President Trump has talked tough on some trade issues, but has yet to follow through in any major way compared to previous presidents.  Meanwhile, geopolitical issues regarding North Korea may limit his ability to antagonize China with the sort of protectionist policies he suggested during the presidential campaign. 

As far as tax hikes go, recent tax proposals would cut key marginal tax rates, not raise them. 

In other words, public policy isn't going to be the source of recession anytime soon.

Meanwhile, home builders haven't overbuilt, consumer financial obligations are still hovering near the lowest share of income since the early 1980s, and bank capital ratios are substantially higher than before the financial crisis.  Moreover, market-to-market accounting rules were tamed so that there's less likely to be a sudden drop in monetary velocity.  

Will there be another recession?  Certainly!  It's just very unlikely to start any time before Spring 2019, which means the current expansion looks set to become the longest on record.  And if Congress and the President get their acts together and find a way to pass tax cuts or tax reform (or both!), that should postpone the next recession even further into the future.  

Just another reason why equity investors have good reason to remain bullish.

Brian S. Wesbury - Chief Economist
Robert Stein, CFA – Deputy Chief Economist  

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Implications: The trade deficit narrowed in August, coming in at $42.4 billion, a slightly smaller trade deficit than the consensus expected.  Exports rose $0.8 billion while imports declined $0.4 billion, but both imports and exports are up from a year ago: exports by 4.2%, imports by 4.0%.  We see expanded trade with the rest of the world as positive for the global economy, and total trade (imports plus exports) is up 4.1% in the past year.  Look for more of that in the year to come as economic growth accelerates in Europe and Japan.  France's new president Emmanuel Macron is pushing ahead with labor market reforms that should, in turn, make some other European countries follow suit.  Better growth in Europe will increase global trade and US exports as well.  In fact, exports to the EU grew 9% in August and are up 7% in the past year.  In the meantime, international trade is on track to be a very slight positive for real GDP growth in the fourth quarter, which looks like it will come in around a 3% annual pace in spite of the havoc wreaked by Hurricanes Harvey and Irma.  Trade is one of our four pillars to prosperity; freer trade leads to improved economic growth.  And while we have our qualms with some of the talk coming out of Washington related to paring back free trade, there has been significantly more hot air than substance.  We will watch trade policy as it develops, but don't see any reason yet to be sounding alarm bells.  In other news this morning, new claims for unemployment benefits declined 12,000 last week to 260,000, while continuing claims increased 2,000 to 1.94 million. These numbers do not affect our 65,000 forecast for tomorrow's official report for nonfarm payrolls in September.  Don't be concerned about the slower short-term pace of job growth; it's a temporary dip due to recent hurricanes and should rebound sharply in the months ahead.

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