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What’s in Santa’s Sack?

​Fiscal and monetary policy both follow the script

Important developments in the economy unfolded as expected last week. On Friday Congress released the final version of its tax bill which it will vote on this week. The measure should pass both houses and be ready for the president to sign before Christmas. We provide analysis of the tax plan in our tax reform primer, but the broad implications between the draft and final versions have not changed. The bill should provide a stimulus boost to the economy in 2018 of up to 50 basis points above 2017 growth levels. But nothing is certain in economics and the tax reform bill could theoretically produce a large temporary boost or virtually no boost at all next year.

Irrespective of the impact next year, we remain skeptical of the bill's ability to boost economic growth beyond 2018. Once the tax changes become part of the economic base, compound growth will become more difficult. But more importantly, the bill does nothing to address the structural issues underpinning slower economic growth – slow labor force growth and weak productivity growth. While economic growth can vary significantly on a short-term basis, over the long term an economy's growth rate is determined by the number of people working and how productive those workers are. As U.S. society is aging, labor force growth is slowing which is limiting economic growth.

The key problem with the labor market today remains inadequate labor to fill open positions, not insufficient job creation. 

On the productivity side, labor productivity growth has been structurally declining over many decades (with the exception of the Internet-induced surge from the mid-1990s to the mid-2000s). The expensing (accelerated depreciation) provision for investments in the tax reform bill could have boosted investment on a structural basis, which would have the potential to boost productivity growth. But the provision sunsets after five years which means it is unlikely to structurally alter corporate investment. Corporations will likely pull investments forward in time to capitalize on this temporary benefit, but that spurt will likely be short-lived and have only a marginal impact on productivity growth.

Over the next decade the bill will perpetuate and exacerbate federal deficits, adding an estimated $1 trillion based on dynamic scoring which takes into account any growth-inducing effects from the bill. The federal government has consistently run budget deficits since the early 1960s resulting in the accumulation of debt totaling roughly $20.5 trillion on a nominal basis. 

Thus far, the debt has not imposed economic costs, but the debt is growing faster than the economy and could pose a problem at some point in the future if it continues to grow unchecked.

Three rate hikes in 2017, three more likely in 2018

As anticipated the Fed raised rates 25 basis points last week, the third rate hike of 25 basis points during 2017. That brought the target fed funds rate range to 125 to 150 basis points. The Fed has increased rates five times over the last two years with little discernable impact on the economy or the commercial real estate (CRE) markets because rates have remained low enough to be stimulative to the economy. The Fed continued to hike rates in 2017 despite slowing inflation. With the economy likely to accelerate a bit in 2018, any slack left in the economy, particularly the labor market, should continue to diminish over the next year. And wage growth and inflation already appear to be firming if not accelerating.

the Fed will probably hike rates three more times in 2018, raising by 25 basis points each time

That will bring the target fed funds rate range to 200 to 225 basis points. While that range should still be below the neutral rate (which is neither stimulative nor contractionary) the exact neutral rate is unknowable. If late-cycle fiscal stimulus results in even stronger inflation than anticipated then the Fed could increase rates at an even faster pace than we are projecting. Either way, expect a tug of war between fiscal policy and monetary policy which will effectively place a speed limit on economic growth.

What it means for CRE

The fate of CRE will ultimately depend upon this tug of war. 

As long as the economy grows quickly enough to propel CRE fundamentals then rate hikes will have little to no impact on the CRE market.

That has been the case for the last two years of Fed tightening. We expect a similar environment to persist for at least the next 12 to 18 months. However, over time if the cumulative weight of rate increases slows economic growth (particularly once the impact of the stimulus fades) then improvement in CRE fundamentals could slow, investor sentiment could sour, and cap rates could rise and values could decline. If the Fed pushes rates past the neutral rate this scenario will almost certainly occur. Somewhat ironically, if tax reform succeeds in stimulating the economy it could hasten rate increases, a slowdown in the economy, and a deterioration in the outlook for CRE.

What else happened last week

Inflation data for November presented a mixed view. The producer price index (PPI) accelerated to its fastest pace in five years on a year-over-year basis. Although producers have not yet been passing price increases on to their customers, manufacturers around the country consistently note significant escalation in the cost of inputs. The consumer price index (CPI) diverged – the headline CPI accelerated to 2.2 percent on a year-over-year basis (due to a jump in energy prices) but the core CPI (which excludes volatile components such as food and energy) fell back to 1.7 percent on a year-over-year basis. Both measures are hovering near the Fed's 2-percent target rate but have failed to consistently meet it. 

Retail sales for November grew briskly, supported by the strong kick-off to the holiday shopping season. 

This bodes well for fourth quarter GDP growth.

What we are watching this week

Housing will dominate a busy week for economic data. Housing starts and permits are both expected to have declined slightly in November. But that follows unusually strong readings in October that could have been distorted a bit by hurricane effects. Both existing and new home sales also likely declined a bit in November. Limited inventory remains the key concern for housing sales. The final reading for third quarter GDP growth should show a very minor upward revision. And on the consumer front both personal income and spending for November likely grew at a healthy pace while sentiment for December should remain at elevated levels.

Thought of the week

The yield curve has flattened considerably over the last year. The spread between 10-year and 2-year Treasury rates has fallen from a recent high of 134 points last December to just 53 basis points last week, its lowest level since October 2007.

Note: Economic Insights will not be published next week. It will return during the first week of January. Happy holidays!

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