U.S. Gross Domestic Product (GDP) growth in 2Q18 is at 4.1% -- the highest quarterly read since 3Q14. There is no doubt that the economy is in great shape, but the real question is whether this hot reading is sustainable.
First, let’s look at the four drivers of GDP growth: personal consumption, private investment, government consumption and net exports. Personal consumption is getting more and more important and now accounts for almost 70.0% of GDP. As depicted by the chart, personal consumption contributed 2.7% of the 4.1%. Personal consumption is highly correlated to real wage growth and the unemployment rate. Real wage growth is tepid and the unemployment rate is already very low by historical standards. One good sign, however, is that the U.S. personal savings rate is at 7.0%, according to the Bureau of Economic Analysis (BEA). A down shock to the personal savings rate can generate a strong push toward personal consumption. The tax reform approved at the end of 2017 should be a tailwind for private investment. In terms of government consumption, we might see a massive infrastructure bill if the government can find the budget. In regards to net exports, the trade war against China and other ongoing trade negotiations seek to improve the trade deficit. In the short-term, each of these drivers will support GDP growth.
If we take a longer-term view, the story is a little different. By definition, GDP is essentially how much value the economy produces. From a different perspective, GDP growth can be classified by changes in four variables: human capital, physical capital, productivity and output gap. Regarding human capital, the Bureau of Labor Statistics projects that the growth of the U.S. labor force will slow down to an average annual rate of 0.5% due to the retiring baby boomer generation. Growth of physical capital depends on capital investment. I believe we will see higher capital investment than the historical average of 0.6% as a result of the tightening labor market and higher savings from the aging population. Productivity is improving at 1.0% on average historically, although it is volatile and related to many different factors. History tells us that rapid productivity growth typically happens in a tight labor market. The industrial revolution was based on the idea that resources, such as coal, were cheaper than labor. The internet boom prospered from the mid-1990s to early 2000s, when the unemployment rate was alarmingly low to policy makers. However, there is no guarantee that a tight labor market will lead to rapid productivity growth. In terms of output gap, its average should hover around zero, as a positive output gap suggests that the economy is overheating. It is difficult to accurately measure, and many have suggested that the U.S. economy is moderately overheating now.
In the latest Federal Open Market Committee statement, the word “strong” appeared five times in describing different aspects of the U.S. economy, and shortly after, the over 4.0% reading on 2Q18 GDP growth was announced. In the short-term, relatively accommodative monetary policy and massive fiscal stimulus may keep the number elevated for a while. From a longer-term fundamental view, 2.0% to 2.5% growth is more sustainable, with productivity growth being the most critical and unpredictable factor.
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