Economic Commentaries

07

Economic activity was strong heading into the New Year. Households spent freely during the holiday season; payroll growth was solid across industries; and activity indexes here and abroad were strong and better than in November. Real GDP growth in the U.S. may well have notched another 3% annual reading in the October - December quarter with strong momentum going forward.

Expectations are high that tax stimulus will add to this momentum. Households should see a reduction in withholding by late January. Some of this will be spent but with heating bills soaring in much of the country and the saving rate about half last year's level, consumption will be most influenced by job and wage trends. On this score prospects are favorable as the minimum wage is up in many states; a handful of companies have announces bonuses tied to tax reform; and the job market is solid.

But the economy's real impetus should derive from business tax reduction. Corporate rate cuts, repatriated corporate cash, and full expensing for business equipment are presumed to set off a proverbial investment boom. This would be a further spur to productivity and it would generate strong wage and salary income. This is the hope and we shall be closely monitoring incoming data which should soon reflect this.

Assuming this all works as presumed the FOMC can be expected to continue its schedule of tempered rate adjustments. But several outliers could upset its schedule. What if inflation remains stubbornly low even in the face of energy and commodity price strength? What if the investment boom fizzles at the same time housing markets weaken in those states losing tax deductions? Current bullish expectations would be shocked and this would presumably be reflected in a downdraft in equity markets. With yield curves flattening further in this setting we would think the FOMC would be forced to the sidelines.

Alternatively the investment boom could be intensified if a push toward infrastructure investment gains traction. Current strength in commodity markets could intensify and if joined by a rigorous push on trade deals, the result could be a step up in cyclical inflation as the economy overheats. How the FOMC might react to such a condition would test its conviction and its independence. A slow reaction would likely scare bond investors while a quick decisive reaction could risk retribution from the White House, further upsetting bond investors.

As all this evolves and regardless of the economy's course, tax attorneys and accountants are undoubtedly hard at work figuring how best to game the system to best serve their clients. As a result, revenue projections are only a guess at this time and our guess is they come in less than anticipated. If either the economy or the capital markets do not follow an optimistic script, a hole could be blown in the federal budget. Currently financial markets seem oblivious to the policy implications for the budget. But as we all know, markets do not care until they care.

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