Fourth Quarter ’17 GDP and December Durable Goods Orders

KEY DATA: GDP: +2.6%; Consumption: +3.8%; Imports: 13.9%; Consumer Prices: +2.8%/ Orders: +2.9%; Excluding Aircraft: +1.4%; Capital Spending: -0.3%

IN A NUTSHELL: “The economy expanded at a solid pace last year and with orders rising and tax cuts kicking in, we should see better growth this year.”

WHAT IT MEANS: So, how did the economy do in 2017? Pretty well. Fourth quarter GDP growth came in a little less than expected, but the headline number hides the true strength. Consumers, businesses and even the government spent money like crazy. Demand for durable consumer goods surged by double-digits as did residential construction. Businesses poured tons of cash into capital goods and technology. So, why did the economy not break the 3% pace as it had in the previous two quarters? Well, you have to get the goods from somewhere and it looks like we got a lot of it from two sources: foreign companies and warehouses. Imports surged and inventories shrunk. Together, those two components reduced growth by 1.8 percentage points. A measure of internal demand, sales to domestic purchasers, was up significantly. As for prices, they rose sharply, especially for consumer products. That is something the Fed is going to have to watch carefully.

Orders for big-ticket items accelerated in December. Durable goods orders jumped, led by sharply rising aircraft demand. Excluding aircraft, the increases were not spread widely across the economy. Demand for metals, machinery and vehicles rose, but orders for electrical equipment, communications equipment computers were off. And the measure that most closely mirrors business capital spending also declined. So, this was a decent, but not great report.

MARKETS AND FED POLICY IMPLICATIONS: The GDP numbers point to an economy that is in very good shape. But they also show how hard it will be to expand by 3% or more for any extended period. The 2.25% pace posted in 2017 was the same as was averaged the previous seven years. There was no acceleration. Yes, it was faster than the 1.5% in 2016, but also less than the 2.9% in 2015. Looking forward, there are some concerns. A lot of the additional purchases came from foreign companies and that is not going to change much in the next few years. The capacity to meet sharply rising demand is just not there. Yes, industrial production should strengthen, but we will also have to get a lot of the rising demand from the rest of the world. So, expect imports to grow rapidly and the trade deficit to widen. There is doubt about the ability of households to continue spending like crazy. Yes, tax cuts will help. However, the minimal savings on the part of low and moderate-income households raises questions about the use of their fatter paychecks. Will they use the money to buy more goods and services or pay down debt and rebuild balance sheets? Given that most of the tax cuts will go to upper income households, who tend to invest, the prospects of a rise in consumer demand anywhere near what we saw in the last quarter are not great. It will take an awful lot of business capital spending to offset those factors and right now, we haven’t heard that companies are making plans to spend a large amount of their windfall profits on building new plants, warehouses or investing in technology. There will be an increase, but how much is just not certain. Then there is the rising rate of consumer inflation. It is not at a threatening level yet, but the falling dollar, increasing energy costs and surging imports imply inflation will accelerate further this year. And that is before we get into the need to pay more for workers. The economy is moving ahead solidly and this year growth should be a lot better, probably around 3%. But unless there is a massive increase in productive capacity and/or a sudden surge in labor supply, much of the new growth will not be met domestically. That means overall economic activity could have an upper bound, which when approached, could translate into higher prices rather than stronger growth. And if that happens, Jerome Powell will have to make some really tough decisions about interest rates.