As constraints on demand lift, faster economic growth will hasten improvement in the labor market, bringing discouraged workers back into the labor force, while continuing to reduce the unemployment rate. The Federal Reserve will be gradual in tightening monetary policy in order to preserve the burgeoning economic expansion.
The winter deep freeze that started this year now seems a distant memory. Over the second and third quarters of 2014 the American economy grew at its fastest pace since the recovery began. The acceleration in growth reflects diminishing fiscal drag, strengthening balance sheets and rising job growth.
The pieces are in place for economic growth to remain close to 3.0%. As constraints on demand lift, faster economic growth will hasten the improvement in the labor market, bringing discouraged workers back into the labor force, while continuing to reduce the unemployment rate. By the end of next year, we expect the unemployment rate to reach 5.5%. At this point, supply factors — growth in the labor force and labor productivity — will play a greater role in determining the pace of economic growth.
All told, real GDP is expected to grow by 2.2% in 2014; however, this rate hides the considerable degree of economic momentum that has built through the year. Reflecting this, economic growth should accelerate to 2.9% next year. In 2016, real GDP growth is expected to decelerate to 2.7% as the economy moves closer to full employment.
Expanding Job Growth
The most encouraging piece of economic data so far this year has been the strength in the labor market. Through September, the U.S. economy generated over 2 million jobs, nearly 500,000 more than the average over the same period in the past three years.
There is reason to expect this strong rate of job growth will continue. In August, the rate of private job openings (relative to total employment) hit its highest level since 2001. Over time, this increase in labor demand will feed into higher wages and/or higher employment.
We expect the economy to generate an average of 205,000 jobs per month through the end of 2015. With this pace of job growth, the unemployment rate will fall to 5.5% by the end of next year. Employment growth is expected to slow modestly in 2016 to a still respectable rate of 170,000 per month, further reducing the unemployment rate to 5.2% by the fourth quarter.
Real Consumer Spending
The improvement in job and income growth sets the stage for an acceleration in consumer spending. This has been one of the missing links in the recovery so far. Since its trough during the recession in 2009, real consumer spending has grown at an annual average rate of 2.2%, well below the 3.1% rate it averaged in the five years prior to the recession.
The disappointing pace of consumer spending growth is explained in part by the severity of the wealth and income shock that occurred during the recession. What is more, just as the losses during the recession were harder on households at the lower end of the distribution than those at the high end, the rebound in wealth has also been skewed to the top. Since households with smaller levels of wealth have a stronger consumption response to changes relative to people with larger amounts, the disproportionate nature of the wealth shock (and recovery) has led to a lower level of aggregate consumer spending.
The reduced wealth effect raises the relative importance of job and income growth in driving the acceleration in consumer spending. Going forward, we expect real consumer spending growth to run at around the same pace as income growth (around 2.8% in 2015).
Housing Market Gains
The improvement in the pace of job growth is also central to the outlook for the housing market. We have long held the view that the housing recovery would have to transition from its initial investor-supported growth to something more inclusive and dependent on fundamental household demand. This transition was not expected to be smooth, and it has not been. The rise in mortgage rates last year contributed to a 14% decline in existing home sales. While sales have rebounded in recent months, they remain below their post-recession peak level last year.
Housing construction remains 50% below long-run demographic fundamentals. However, as long as there are impediments to housing demand, particularly homeownership, the rate at which construction increases will be slower. Credit conditions — while improving — remain tight for homebuyers without pristine credit histories. At the same time, high levels of student debt have made it more difficult for younger people to qualify for and carry mortgages. These folks tend to make up the bulk of first-time home buyers — a segment that is critical to underpinning a stronger housing recovery.
The bottom line is that ongoing job growth will support a rebound in the housing market, but it will be gradual. While we expect housing construction to move higher, we have shaved back our expectation for growth over the next year. In addition, given continued constraints on homeownership, the profile of housing construction is likely to maintain a strong share of multifamily units, which favors affordability and rental demand. This share, at around 40%, is the highest since the early 1980s.
Benign Inflation and a “Shadow” Labor Market
With the step-up in economic growth over the next two years, the officially reported unemployment rate will approach its long-run sustainable level. However, this does not mean that the labor market will be entirely back to normal. Measures of labor market slack that include marginally attached workers and those working part-time for economic reasons are still elevated relative to history and will be slower to return to normal.
This “shadow” labor market slack is one reason why inflation has remained soft, even as job growth has gained speed. Global events have also softened inflation. Efforts to ease monetary policy and credit conditions in Europe and Japan have led to a rise in the value of the U.S. dollar. At the same time, the slowdown in China has put downward pressure on commodity prices. Modest global growth and a rising dollar will weigh modestly on U.S. exports, but this will be offset by the benefit of lower commodity prices and higher real income growth. Moreover, the combination of global disinflationary pressures and lingering labor market slack mean the Fed can be cautious in how quickly it takes its foot off the monetary pedal.
Traditionally, the thinking has been that when the unemployment rate is back to its long-run level, interest rates would be too. However, even with an unemployment rate at 5.2%, we expect interest rates will remain well below normal. The Federal Reserve is likely to begin its rate-hiking cycle in the second half of next year and bring the fed funds rate up to just 0.75% by the end of that year. By the end of 2016, the fed funds rate is expected to be at 1.75%. The still-considerable level of monetary stimulus will help to maintain the labor market recovery and support income growth through the forecast.
The U.S. economy is on its way to self-sustaining growth. The headwinds that slowed growth earlier in the recovery — the European financial crisis, the debt ceiling, fiscal cliff and sequestration, and just plain bad weather — have faded. As they have, job creation has gained speed. The acceleration in job growth has been accompanied by broader signs of labor market improvement. Businesses are reporting high levels of job openings and increasing confidence in the durability of the economic recovery.
Continued job growth is exactly what the U.S. economy needs to repair the scars caused by the recession. Faster household income growth will support a rebound in consumer spending and housing demand. The dearth of new household formations is strongly related to the lack of job opportunities among young people that has pulled many of them back into their parents’ homes. As employment rises, the housing recovery should pick up speed.
Over time, job growth will eat up the remaining slack in the labor market. This will show up in a lower unemployment rate, but also in a rise in labor force participation. Eventually this will lead to normalization in monetary policy. The Federal Reserve will be gradual in tightening monetary policy in order to preserve the burgeoning economic expansion.
James Marple is a senior economist at TD Bank Group.