Fed Chair Jerome Powell and others have started a new narrative about economic "headwinds."  They think past rate hikes, slower foreign growth, and "fading fiscal stimulus" should slow the Fed's rate hikes.  But is fiscal stimulus really fading?

Powell and others think the growth benefits of both the 2018 tax cuts and increased federal spending are winding down.  This is pure Keynesian analysis and we think it's wrong.  In our view it reflects a misunderstanding of both how tax cuts work and the actual path of federal spending.

The difference is between demand-side (Keynesian thinking) and supply-side thinking.  Keynesians think demand drives growth.  In other words tax cuts work by putting more money in people's pockets, which increases consumption and, therefore, GDP.  They say the first year of a tax cut boosts after-tax incomes and demand, but then, stimulus fades as this boost is removed and income falls back to the previous (slower) trend.

Keynesians also believe federal government spending stimulates growth because it, too, is part of demand.  In fact, government purchases are a direct part of GDP accounting and so it appears like government spending is a stimulus. 

By contrast, supply-siders think incentives for entrepreneurship and investment drive growth.  It is the supply of new goods and services that leads to faster economic activity.  Say's Law says "supply creates its own demand."  In other words, the tax cut led to better incentives to invest, work, and invent.  And, as long as tax rates remain low a "permanent" change in incentives has been initiated, which will boost growth rates permanently.  There is no "fade."

Before the tax cut, the corporate tax rate in the US was approximately a combined 40% (federal, state, and local).  In 2017, Canada had a corporate tax rate of 26.5%.  So, there was a 13.5% incentive to invest in Canada over the US.  And, at the margin, more investment went to Canada (and other countries with lower corporate tax rates) than would have been the case if the US tax rate was not the highest in the developed world.

Now the combined U.S. corporate tax rate is approximately 27%, radically changing incentives.  In other words, at the margin, as long as tax rates stay where they are, there is a permanent incentive to invest more in the US.  This does not mean growth will accelerate from where it is now (roughly 3% GDP), but it will not automatically revert back to 2%, where it was from 2010-2017.

The more curious and misguided argument is that fading government spending will slow and reduce GDP.  We think this comes from a misunderstanding of the budget deal which was passed last year.  Yes, that budget deal increased spending, but so far it hasn't shown up as a boost to GDP growth.

In Fiscal Year 2018, nominal GDP rose 5.0% over FY2017, while total federal spending went up just 3.2%.  Government purchases, which feed directly into GDP, rose just 4.0%.  In other words, relative to the private sector, government demand grew more slowly.

On top of this, total federal revenue was up 1% in FY2018.  While corporate tax receipts fell 22%, total individual receipts were up 6%.  In other words, while it's true that the federal government collected fewer tax receipts in FY2018 than it budgeted prior to the tax cut, it still collected more revenue than it did in FY2017.

The bottom line is that the entire demand-side basis for the fiscal stimulus argument has no data to support it.  Government spending grew slower than GDP and actual tax receipts went up.  As a result, any argument that there will be "fading" fiscal stimulus is based on a data that does not exist.

The reason growth has accelerated is because lower tax rates, and less regulation, increase entrepreneurial activity – a supply-side acceleration in growth, not Keynesian.  Anyone waiting for slower economic activity as fiscal stimulus "fades" will be waiting in vain.

The one worry we have is the exact opposite of what Keynesians argue.  A new divided government adds to pressure for bipartisan legislation.  Bipartisanship often means more government spending.  As supply-siders, we view increased government spending as a drag on growth, not a boost.  

The more government spends as a share of GDP, the smaller the private sector.  That's how growth will really fade.

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

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Source: St. Louis Federal Reserve FRED Database

Implications:  Industrial production continued to climb higher in September, posting a fifth consecutive month of growth to hit a new record high.  And a look at growth in the past year shows industrial production – which counts "units" of output and is therefore a proxy for "real" growth – is up a healthy 4.1%.  It should also be noted that the Federal Reserve reported that output growth was held down in September and October due to the effects of recent hurricanes, although only slightly.  Further, upward revisions to prior months resulted in the headline index advancing at a 4.7% annual rate in Q3 versus a prior reading of 3.3%, suggesting a small upward revision to the original real GDP estimate of 3.5% for the third quarter reported a few weeks ago.  Looking closer at the details of today's report shows that manufacturing -  which makes up the largest part of overall production - rose 0.3% in October, its fifth consecutive monthly gain.  The typically volatile auto production series fell 2.8% in October.  But excluding autos, manufacturing production rose a healthy 0.6%.  Manufacturing activity seems to be accelerating across the board, with both the overall series and its auto and non-auto subcategories growing at a faster annualized pace in the past three months than in the past year.  This demonstrates that the strength in overall manufacturing is broad-based and is likely to persist.  One piece of positive news buried in the details of today's report was the recent acceleration in the production of business equipment, which rose 0.8% in October and is up at a 13.5% annual rate in the past three months, pointing to continuing demand for capital goods from US companies. This is echoed by September's durable goods report which showed shipments of non-defense capital goods excluding aircraft – which the government uses to calculate business investment in GDP – rising at 7.3% annual rate in Q3 versus the Q2 average. Look for an upward revision to the relatively weak GDP measure of business investment growth in Q3 at the end of this month when the second GDP report is released, followed by continued healthy gains due to the effects of corporate tax reform and the full expensing of capital equipment.

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Implications:  Retail sales surged in October, rising by the most in five months and bouncing back from September's hurricane-related decline.  Retail sales grew 0.8% in October beating expectations, with broad-based gains, as ten of thirteen major categories showed rising sales, led by gas stations and autos.  Don't be surprised if the series remains choppy in the short-term due to the lingering effects of hurricane season.  Overall retail sales are up a solid 4.6% from a year ago (and up an even stronger 5.9% excluding auto sales).  "Core" sales, which exclude autos, building materials, and gas stations (the most volatile sectors) were up 0.3% in October, and are up 4.8% from a year ago.  Plugging today's report into our models suggests "real" (inflation-adjusted) consumer spending, on goods and services combined, will be up at a 2.0 – 2.5% annual rate in Q4 while real GDP grows at around a 2.0% rate.  Given the tailwinds from deregulation and tax cuts, we expect an average real GDP growth rate of 3%+ in both 2018 and 2019, a pace we haven't seen since 2005.  Jobs and wages are moving up, tax cuts have taken effect, consumer balance sheets look healthy, and serious (90+ day) debt delinquencies are down substantially from post-recession highs. Some may point to household debt at a record high as reason to doubt that consumption growth can continue.  But household assets are near a record high, as well.  Relative to assets, household debt levels are near the lowest in more than 30 years.  In other words, there's plenty of room for consumer spending – and retail sales – to continue to trend higher in the months to come.  In other news today, initial jobless claims rose 2,000 last week to 216,000.  Meanwhile, continuing claims rose 46,000 to 1.68 million. These figures are consistent with continued robust job gains in November.  On the manufacturing front, the Empire State index, a measure of factory sentiment in New York, rose to a 23.3 in November from 21.1 in October, while the Philly Fed Index, a measure of East Coast factory sentiment, fell to +12.9 in November from +22.2 in October.  Both measures signal continued optimism among manufacturers.  On the inflation front, import prices rose 0.5% in October, while export prices rose 0.4%, both exceeding consensus expectations.  The large rise in import prices was led by a 3.3% increase in fuel costs.  Export prices rose 0.4% in October due to higher prices for nonagricultural exports more than fully offsetting a decline in prices for farm exports.  Import prices are up 3.5% in the past year, while export prices are up 3.1%, both signaling the need for continued rate hikes from the Fed.

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Implications:  Consumer prices rose 0.3% in October, the fastest monthly increase since January and a pickup from September's modest increase of 0.1%.  This is a textbook example of volatility in monthly data. Was there any major change between September and October that represents a shift in the pace of inflation?  No.  Some of the change is due to seasonal factors appearing to have pulled down September data and then returning to more "normal" levels in October.  That is why we focus on the trend, which shows inflation continuing to run steadily above the Fed's 2% inflation target.  In the past year, consumer prices are up 2.5%, exactly the same as the annualized pace over the past three months.  This represents a pickup from the 2.0% increase for the twelve-months ending October 2017, 1.6% for the twelve-months ending October 2016, and 0.2% for the twelve-months ending October 2015.  So, after running stubbornly below the Fed's inflation target for the first five years of the recovery, the question has shifted from "will the Fed wait on raising rates?" to "can the Fed wait on raising rates?" No, this isn't runaway inflation, but with the federal funds rate well below the pace of nominal GDP growth, the odds of higher inflation – paired with a tight labor market and widespread strength in economic data - should be enough to keep the Fed on track for slow-but steady hikes through at least the end of 2019 (we expect one more rate hike this year, and four next year).  Looking at the details of the October report shows energy prices led the rise, up 2.4% on the back of higher prices for gasoline, fuel oils, and electricity.  Energy prices are up 8.9% in the past year.  Food prices, meanwhile, declined 0.1% in October but are up 1.2% in the past year.  "Core" consumer prices – which exclude both food and energy costs – rose 0.2% in October and are up 2.1% in the past year.  A deeper dig into today's report shows the 0.2% increase in core prices was once again led by owners' equivalent rent (the amount an owner would need to pay in order to rent their home on the open market).  Meanwhile used car and truck prices rebounded 2.6% in October after September tied for the steepest decline for any month since 1969.  The worst news in today's report was that real average hourly earnings declined 0.1% in October.  These wages are up just 0.7% in the past year but are heading higher, with wages up 1.1% at an annual rate over both the past three and six-month periods.  And importantly, these earnings do not include irregular bonuses – like the ones paid by companies after the tax cut or to attract new hires – or the value of benefits.  It's an imperfect measure (to say the least), but we still expect a visible pickup in wage pressure in the year ahead.  The labor market remains strong and companies continue to report that finding available qualified labor remains a top headwind to even faster growth. Put it all together, and today's report shows an economy continuing to strengthen, brushing off the supposed concerns of trade tariffs or election rumblings.  Focus on the data, not the media narratives.

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Politics and economics are interwoven.  Government grants licenses, enforces contracts and the rule of law, provides fire and police protection, a national defense, and can call on resources to recover from crisis.  Without these institutions, activity would slow.  No one is building billion-dollar hotels in Syria, Libya, or Iraq; stability and certainty support investment.

The rule of law and stable institutions don't create growth by themselves, but they do provide the framework.  It's entrepreneurs that see opportunity and reorganize existing resources in a different, more efficient, and more profitable way.  That's how growth happens.  Human nature, however, doesn't change.  Politicians want to take direct credit for growth.  Remember when Al Gore said he helped "create" the Internet?

One of the greatest myths in all of economics is the "Government Spending Multiplier" sometimes called the "Fiscal Multiplier."  This concept came from a Keynesian, demand-side analysis of the economy that looks at something called the "marginal propensity to save."  Someone who earns $100 but only spends $90 has a 10% marginal propensity to save.  In the demand-side world, where consumption drives economic activity, the $10 in savings is seen as a negative.  Having $10 less spending means $10 less in demand.

Politicians argue that taking that $10 from the saver, and giving it to someone who will spend it, increases growth.  For example, Nancy Pelosi said back in 2013 that "unemployment benefits remain one of the best ways to grow the economy" because it "injects demand into our markets."  She said every dollar spent on unemployment creates up to an extra $2 in GDP.

This is magic, it's like turning lead into gold.  All you have to do is win election, raise taxes, put those taxes in the hands of someone with a 0% marginal propensity to save, and voila, you've created your own economic growth.

But clearly, this is a myth.  Imagine we redistributed away all the savings in an economy.  Without savings there would be no investment, and without investment there would be no long-term growth.  That's why we focus on the supply side of the economy.  From a supply-side view of the world, new inventions create growth and new inventions need savings and investment.  Demand did not create the cell phone or apps.  Before the inventors of Bird or Lime, consumers were not prowling the streets looking for electric scooters to ride.

From 2010-2017, real GDP grew just 2.1% per year, in spite of massive deficits and the largest share of GDP redistributed in the history of the U.S.  In the past year, following deregulation and tax cuts, and the number of people receiving unemployment benefits falling to its lowest level since 1973, real GDP growth has accelerated to 3%.  This is evidence that the "fiscal multiplier" is a myth.

This brings us to infrastructure spending, which many think will be one of the first things the newly divided government will agree on.  Of course, good infrastructure helps promote efficient economic activity.  But it won't create net new jobs.  By borrowing or taxing money from the private sector to build the infrastructure, politicians harm growth elsewhere.  In the long run it may be positive, but in the short-run, at best, it's neutral.  Beware of politicians saying they can create jobs and speed growth.  That's demand-side thinking, and it hasn't worked anywhere in the world up to this point.

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

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Source: St. Louis Federal Reserve FRED Database

Implications:  Producer prices surged 0.6% in October, the largest single-month increase in more than six years.  And while the typically volatile food (up 1.0% in October) and energy (up 2.7%) components helped push prices higher, stripping out these components shows "core" prices rose 0.5% in October – matching the largest single-month increases since this series was introduced in 2010 - and are up 2.6% in the past year.  So what caused the jump?  A look at the details for October shows the rise was led by increased margins to wholesalers, which rose 1.6%.  This could be a sign of rising demand paired with limited supply; ISM reports have shown strong order and business activity, but companies struggling to hire and ship products due to a tight labor market. Or it could simply be companies adjusting prices higher following months of rising input costs cutting into margins; remember, these wholesaler margins fell at a 3.7% annual rate over the prior three months.  But it's not just margins, rising prices were broad-based as services prices rose 0.7% in October while goods prices increased 0.6%.  No matter which way you cut – headline prices up 2.9% in the past year or "core" prices up 2.6% -- trend inflation clearly stands above the Fed's 2% target.  These data support our expectation for one more hike this year and four hikes in 2019.  In recent employment news, initial jobless claims fell 1,000 last week to 214,000.  Meanwhile, continuing claims fell 8,000 to 1.62 million, the lowest reading since 1973!  These figures are consistent with continued robust job gains in November.

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No fireworks in today's FOMC statement, as Chairman Powell and company held rates steady while reinforcing their outlook.  Unemployment remains low, household spending remains strong, and inflation is running in-line with their 2% inflation target.  In other words, today's near unanimously expected pause looks almost certain to be followed by a rate hike at the December meeting.
 
In the meantime, the Federal Reserve continues to shrink its balance sheet at a measured pace of $50 billion per month (comprised of $30 billion in Treasuries and $20 billion of agency and mortgage backed securities rolling off monthly).  That said, the Fed balance sheet still exceeds $4 trillion – compared to roughly $900 billion before the implementation of QE – and the very modest pace of "normalization" is unlikely to have any material impact on the markets. And with more than $1.7 trillion in excess reserves in the system and nominal economic growth (which includes real GDP growth and inflation) averaging 4.8% over the past two years, monetary policy remains far from tight.  In recent weeks, the long-term "normal" size of the balance sheet has become a more frequent topic of Fed conversation, and we wouldn't be surprised to see guidance later this year or early next on both how long the normalization process will take and what the final balance sheet size may look like, though – in typical Fed fashion – expect the wording to allow plenty of wiggle room.  
 
Looking forward, the mid-December meeting of the FOMC will get plenty of attention. In addition to an expected rate hike, the Fed will provide updated economic projections that show their best guess at how far rates will rise in 2019. While we believe four rate hikes are warranted – the same pace as 2018 if a December hike holds true – we expect the Fed will continue to signal expectations for three hikes, and will subsequently revise expectations higher in mid-2019 as they see sustained economic growth, just as they did in 2018.     
 
Some in the media will argue that recent market volatility justifies a slower pace of hikes from the Fed, but we say phooey. The midterm elections raised emotions, but did virtually nothing to change the outlook for an economy on track to show the fastest annual pace of growth in more than a decade. A split Congress means no further tax cuts, but that tax rates won't be raised either. Rhetoric will continue to escalate, but so too will corporate profits. Neither party has the votes needed to make drastic legislative changes, but – with the tax cuts and deregulation already in place - no changes are needed for this economy (and the Fed) to stay the course through 2019.

Brian S. Wesbury, Chief Economist
Robert Stein, Dep. Chief Economist

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