The festive season has greeted us with delightful tidings, and it’s evident everywhere you look. From soaring stock prices to robust economic growth, not to mention a newly minted GOP tax reform, this week leading up to Christmas feels almost perfect.
It’s hard to recall a more splendid time. And why would we want to? Reveling in the cheer of this season feels all the more extraordinary—like singing “Joy to the World” by candlelight, enveloped in the warmth of the holiday spirit.
The current combination of record stock prices, vigorous GDP growth, and tax reforms is as satisfying as a cup of spiced eggnog. Remember when a Dow Jones Industrial Average above 25,000 seemed unattainable? In a flash, we’ve approached this significant milestone, enriching many in the process.
The U.S. economy is now flourishing, buzzing with the lively energy of Santa’s elves.
According to the Commerce Department, U.S. GDP surged at a rate of 3.2 percent in the third quarter. Furthermore, the New York Fed’s Nowcast report indicates that U.S. GDP is projected to expand in the fourth quarter at an annualized rate of 3.98 percent.
Indeed, achieving annualized GDP growth above 3 percent is both impressive and rare. The last occurrence of U.S. GDP exceeding 3 percent for an entire year dates back to 2005, several years before the launch of the iPhone.
A Cornerstone Promise of the GOP Tax Reform Bill
Despite this strong finish, 2017 will not mark the year when annual U.S. GDP growth finally surpasses the 3 percent threshold. Based on our rough estimates for Q4, we predict an annual GDP growth rate of 2.92 percent for this year. So, what does this indicate?
Certainly, robust GDP growth is a fundamental promise embedded within the GOP tax reform bill. This promise hinges on the belief that resulting economic growth will compensate for the tax cuts. However, some experts argue that expectations for 3 percent economic growth in 2018 may be overly optimistic. The Tax Foundation, a Washington-based organization, provided the following assessment:
“According to the Tax Foundation’s Taxes and Growth Model, the plan would significantly lower marginal tax rates and the cost of capital. This could result in a 1.7 percent increase in GDP over the long term, 1.5 percent higher wages, and create an additional 339,000 full-time equivalent jobs. By 2018, our model predicts that GDP would grow by 2.45 percent, compared to a baseline growth of 2.01 percent.”
We must clarify that we are unsure about the assumptions included in the Tax Foundation’s Taxes and Growth Model. Does it account for the potential effects of quantitative tightening? Does it assume three rate hikes from the Fed in 2018? What about a flattening yield curve?
In essence, will tightening credit markets counteract any advantages the tax cuts may provide? In other words, will monetary policy negate fiscal policy?
The likelihood is high. Here’s why…
Why Monetary Policy Will Cancel Out Fiscal Policy
The financial system and economy have increasingly relied on cheap and abundant credit. Consumers, the federal government, and corporations have indulged in a decade of low-interest rates and readily available credit.
Currently, Americans hold $3.8 trillion in outstanding consumer credit—some of which was certainly spent on items like light-up reindeer antlers. Over the last decade, more than $1.2 trillion in consumer spending has been borrowed from future income.
Similarly, during the last ten years, the federal government has borrowed and spent upwards of $11 trillion, escalating the federal debt from $9 trillion to, astonishingly, over $20 trillion—more than a doubling in just a decade.
Corporations have also engaged in massive borrowing and spending, with total outstanding nonfinancial corporate debt rising from approximately $3.2 trillion in 2007 to over $6 trillion today, also more than doubling in this time frame.
What makes this escalation in borrowing—across consumers, the government, and corporations—particularly concerning is that it has been fostered by the Fed’s prolonged low interest rates. The scale of this cheap credit expansion resembles a manic credit bubble.
As discussed last week, we seem to be transitioning into a phase where the cost of credit—in particular, interest rates—will rise, leading to a tightening of credit. This shift is occurring at the worst possible moment, as we’ve become entirely reliant on inexpensive, expanding credit.
As the Fed increases interest rates, borrowing costs will inevitably rise. For governments, servicing the debt will require a larger portion of the budget, limiting discretionary spending. For consumers and corporations, the higher borrowing costs will likely curtail spending and investment.
This scenario illustrates why monetary policy may nullify fiscal policy. Consequently, the foundational promise of the GOP tax reform bill may not materialize, and the outlook appears bleak.
On that note, we shall conclude our reflections.
Wishing you a Merry Christmas!
MN Gordon
for Economic Prism
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