Conditions are right for stronger economic growth in 2014. 2013 was a great year for U.S. stocks, but in terms of economic performance, it was a disappointing year at home and abroad. While the euro zone slowly emerged from a crippling, 18-month recession that pushed unemployment to record high rates, the U.S. and other major economies struggled to gain momentum.
2014, however, may prove to be a break out year for economic growth. The path won’t be straight up, and significant hurdles remain—including Congress’ budget battles and the winding down of the Fed’s bond-buying program—but the U.S. economy’s fundamentals are strong.
Evidence of this underlying strength is clearest in the job market. Despite a disappointing employment report for December, employment growth has accelerated to around 200,000 net new jobs per month, and the gains are increasingly broad-based across industries and pay levels. The unemployment rate is steadily declining, even as labor force participation stabilizes. The economy is on track to reach full employment—estimated as a 5.75% jobless rate and 64% labor force participation—in three years.
The problems and imbalances that developed during the housing bubble nearly a decade ago have largely been corrected. Households have significantly reduced their debt burdens. The average share of after-tax income that households must devote to servicing debt is as low as it has been since at least 1980. Households are also locking in extraordinarily low interest rates—only a fifth of debt service is now tied to rates that adjust from year to year.
Also encouraging is the financial health of nonfinancial businesses. Corporate profit margins have never been wider, as businesses have significantly reduced their cost structures. Unit labor costs—compensation measured in relation to productivity—have barely budged since the recession. In manufacturing, costs are about where they were a quarter century ago. Businesses have also done a good job repairing their balance sheets, as debt service is low and they are awash in cash.
Of course, some problems remain. More than 2 million first mortgage loans are in or near foreclosure and a growing number of home equity loans are approaching payment resets. But given consistently rising house prices, these problems seem manageable. Rapidly rising student loan debt is also a worry, but not on a scale that will threaten the broader recovery.
Investors are especially upbeat, as stock prices continue to hit record highs. Corporate credit spreads have tightened as well, meaning that bond investors are demanding less of a risk premium to buy businesses’ debt. The Fed’s long-term asset purchases have helped to buoy financial markets, but investors also appear optimistic that better economic times are ahead.
Businesses also appear to be gaining confidence. The Moody’s Analytics weekly survey finds business confidence breaking out to the upside. In early December, positive responses to the survey’s questions outweighed negative responses by more than at any time since the housing bubble’s peak in early 2005.
Stronger growth this year also depends on the Federal Reserve’s ability to gracefully manage long-term interest rates as the job market improves. Moody’s Analytics expects the 10-year Treasury yield to rise by about 100 basis points to 3.75% as the unemployment rate falls to 6.6% by this time next year. But if rates rise too much, or even too quickly, the economy could stumble, so the Fed must be cautious in its approach. Last summer, an undesirable surge in long-term rates was triggered when Fed officials began merely to talk about slowing the pace of asset purchases.
Investors seemed to assume that tapering meant the Fed would begin raising short-term rates soon after QE ended. Consequently, fixed mortgage rates jumped higher, hurting the broader housing sector, which is a vital contributor to the broader economy.
The Fed has since worked to convince investors there are no plans to raise short-term rates soon. This appears to have worked, at least for now, as long-term rates are ending the year where policymakers want them. And if rates again start to rise too quickly for comfort, policymakers can respond using a range of tools at their disposal. But another spike in long-term rates does not seem very likely at this time given that core inflation has now slowed to only 1.2%.
The possibility that the Great Recession damaged the economy’s longer-term potential growth rate is a real concern— especially for long-term investors. Before the recession, it appeared that the economy could sustain real GDP growth as high as 3%-per-year without lowering the unemployment rate or increasing the capacity utilization rate—signs that output may be rising at a pace that is too fast to be sustainable. Since the downturn, however, this potential rate has clearly fallen. Despite only 2% economic growth, the unemployment rate has fallen and the utilization rate increased.
This suggests the economy could have been weakened in ways that will last over the longer term. The growth of both productivity and the labor force, two key components of potential, has recently come to a virtual stand-still. Unless this changes soon, the economy may reach full employment more quickly, but living standards will rise more slowly, exacerbating inequality in income and wealth.
It is, however, premature to conclude that the Great Recession permanently undermined the economy’s potential. An important test will occur over the next several years as unemployment falls and labor compensation growth (which has been stuck around the inflation rate) accelerates.
Though the coming year could see another false start, the greater likelihood is that the U.S. recovery will finally evolve into a full-blown, self-sustaining expansion. The fundamentals, such as strong personal and corporate balance sheets, low inflation, and strong profit margins, are as good as they have been for decades, and it is increasingly difficult to envisage shocks that could undermine them.
That said, worries exist, including Europe’s ongoing travails, political tensions in Asia, and possible partisan showdowns in Washington. In addition, some have sounded warnings regarding the size and vulnerability of China’s shadow banking sector. Due to China’s insular nature, and government controlled economy, it is difficult to know the extent of the problem, or even if a problem exists, but a Chinese debt crisis would certainly pose a real threat to the health of the overall global economy.
With any luck, these threats will remain at bay and the American economy can continue to strengthen through 2014.