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Third Quarter Economic Outlook

​Keep on, Keeping on to 2018

Economy remains on track for solid 2017

With roughly one month left in 2017, the economy remains poised for another quarter of solid economic growth. We expect the economy to grow by roughly 3 percent on an annualized basis in the fourth quarter. That would bring 2017’s growth rate to roughly 2.2 percent, almost identical to the average annual growth rate since the economy began expanding in mid-2009. We continue to believe that by the end of the year, Congress will pass tax legislation that should provide a modest boost to growth 2018. The potential upside should be roughly 50 basis points above 2017’s growth rate and we therefore see the economy growing in the 2.6 percent to 2.8 percent range depending upon the details of the legislation. We continue to predict a low probability (roughly 15-20 percent) of a recession over the next 12 to 18 months. 

The economic environment should continue to provide a foundation for further improvement in the commercial real estate (CRE) market, although momentum has slowed at this relatively late stage of the economic expansion. Market participants are exercising caution and we don’t view that as a negative. Relative to previous CRE cycles, exuberance has not turned excessive: pricing is expensive, but not misaligned with fundamentals; rents continue to grow but growth is tempered by appropriate space demands from users. We have not observed the “aspirational” underwriting standards or excessive use of leverage that contributed to the CRE pricing bubble last cycle, nor do we see leasing in anticipation of future needs, the two features that characterized the previous two CRE expansions. Generally speaking, supply growth should pose more of a risk than weak demand, though any instances of overbuilding remain a localized phenomenon. 

While random policy shocks will remain a concern throughout the next 12-18 months, higher interest rates present the biggest risk to the expansion. Incrementally, interest rate increases pose little threat. Over time, the risk rises that economic growth cannot offset the drag that rate increases impose. Any fiscal stimulus passed by Congress could potentially cause a greater number of rate increases relative to a baseline scenario of no stimulus. That could ironically hasten the end of the current expansion. Therefore, the probability of a slowdown increases in the latter half of 2019.

What’s driving our outlook?

Economic drivers appear to be shifting

During most of the current economic expansion, personal consumption by U.S. consumers drove growth. But the gears could finally be shifting. Although consumers continued to spend at a fairly healthy pace in 2017, that rate did not accelerate. But corporate investment awoke from its slumber this year and could post its best performance since 2012. The tax package being discussed by Congress could further stimulate investment in 2018 even as personal consumption growth steadies. If investment growth accelerates while consumption maintains its pace of growth, overall economic growth would also accelerate. Any change in the contribution to growth (positive or negative) from government expenditures and net exports should remain relatively modest.

Fiscal policy takes center stage

The House has already passed its version of the tax reform bill. The Senate will vote this week. Even if the Senate version passes, the bills will still need to be reconciled. But if the bill that ultimately passes resembles the bills currently under discussion, expect growth to accelerate modestly in 2018. This upside should stem primarily from private investment because the tax plan should have a larger impact on companies than consumers. By cutting the corporate tax rates (without closing many of the existing loopholes) and allowing full expensing of certain investments (essentially deducting the cost of investments) corporations should be encouraged to spend more money in 2018. The impact on consumer spending should be more modest, but could also provide a short-term boost to economic growth. However, Congress has not yet approved the budget for 2018 and any budget proposal cannot pass without Democratic votes. Congress has until December 8 to resolve this problem. While a government shutdown seems unlikely, the hiccups in approving the budget could disrupt and distract from other priorities, including tax reform.

Wage growth could accelerate but job growth is slowing

The ongoing strength in the labor market propped up consumer confidence and consumer spending in 2017. Wages continued to grow, but the number of jobs created continued to decline over time. Even if wage growth accelerates in 2018 job growth should continue to slow down because of the lack of qualified job candidates. As of September roughly 6.1 million jobs remained open, but unfilled. The unemployment rate for college graduates recently fell to 2 percent, its lowest level since April 2008. And wages for many blue collar jobs are finally accelerating because demand for workers in these industries exceeds supply even as employment in blue-collar industries increases. But the increase in manufacturing employment this year did not occur across most of the country. Only a handful of states are driving demand for blue-collar labor.  Many individuals who are counted as out of the labor force (neither employed nor actively looking for employment) will have to move to where demand for labor is concentrated if the labor participation rate is going to continue to increase.

This tug of war between wage growth and employment growth will likely place a speed limit on consumption growth. Consumers have been propping up their spending partially by dipping into their savings and taking on new debt. But savings continue to dwindle, credit card balances are nearing pre-recession levels, and credit card delinquency rates are on the rise. Therefore, consumers should utilize savings and debt at lower rates in the coming years. 

The looming tax cuts could provide a bit of a boost to consumer spending, but the majority of households should see only modest gains in after-tax income. 

And a number of households (including many higher-income households that drive discretionary spending) will actually face higher tax bills if the lower cap on mortgage interest deduction and the elimination of the deduction of state and local taxes remain in the final version of the bill, which seems likely.

Private investment could accelerate

Private investment rebounded in 2017, spurred by stronger global growth outside the U.S., a weaker dollar (which makes U.S. goods less expensive to foreign buyers), a resurgence in oil prices, and rising business confidence in anticipation of tax cuts. 

Investment should further accelerate in 2018 if the current version of tax reform passes.

Not only will the bill lower headline rates for many businesses while leaving intact many loopholes, but the bill will permit full expensing of certain investments. This provision should encourage spending by businesses in 2018 because corporations can only reap this benefit if they actually spend money – in order to deduct the cost of investment purchases from taxes, a company must purchase something.

Monetary policy remains benign…for now

The Fed remained on hold since the spring because inflation decelerated throughout most of 2017. Despite tepid current inflation, the Fed has clearly communicated to the market that it intends to hike rates once more next month. The market currently assigns a roughly 93 percent chance of a hike of 25 basis points at December's meeting. That would take the target Fed funds rate range to 125 to 150 basis points. This desire to raise, even in the face of tame inflation, confounded many in the market because of the Fed's "data dependent" mantra. Many expected the Fed to only raise rates if inflation was accelerating. 

The Fed's desire to raise rates in anticipation of future acceleration in inflation caused many to wonder what "data dependent" truly means. Some had to change their definition. 

The Fed's hiking of rates while inflation remained tame caused the yield curve to unsurprisingly flatten. Rates at the short end of the curve responded strongly to the Fed's increases, but rates at the long end of the curve have increased by a lower amount. As a result, the 10-2 Treasury spread has fallen to roughly 60 basis points, its lowest level since before the recession. Normally such a compression would give central bankers pause. But the wild card remains the potential fiscal stimulus from the tax reform bill. Although the bill is likely to spur some short-term economic growth, it could also potentially stoke inflation because the economy is operating near capacity. If the bill ultimately results in higher inflation rates, then the Fed will likely hike faster than they would in the absence of the bill. That could ironically hasten the next recession – interest rate increases become a more durable feature of the economy, but once the impact of the tax bill becomes part of the economic base, maintaining elevated growth rates actually becomes more challenging. We expect 2 to 3 rate hikes next year, depending upon the specific impact of the tax reform bill.

Risks and closing thoughts

Policy risk has not abated in 2017. Any missteps could produce a moderate to severe drag on economic growth, depending upon the exact scenario. Congress could fail to pass tax reform which would take some of the wind out of the sails of business confidence. And even if the tax reform bill passes, it could become a pyrrhic victory if it boosts growth in 2018 but ultimately slows growth in 2019. For now that remains our baseline expectation – faster growth in 2018 followed by some slowing in 2019.

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