Markets and Economy
2018 Economic Year in Review
Jim Glassman, Head Economist, Commercial Banking
December 19, 2018
At the beginning of the year, many analysts feared the expansion was nearing its end. The recovery was close to becoming the longest in modern history, and it was common to hear worries that the nation’s growth streak was running on borrowed time. But in 2018, the top of the business cycle proved resilient. Full employment appears to have arrived this year, yet there has been no sign of the financial imbalances or inflationary pressures that accompanied the peak of past business cycles.
The Upside Surprises of 2018
This was a year of surprising growth and strong economic trends, particularly in three key areas:
- The labor market: Job creation maintained an above-trend pace throughout much of 2018, with payroll growth often doubling the underlying expansion of the working-age population. Layoffs remained near an all-time low, a sign of favorable conditions and fully staffed businesses. With headline unemployment pushing into territory not seen since the 1960s, wages finally began to lift, reaching a 3.2 percent annualized growth rate. In the final months of the year, hiring began to slow as the labor market moved closer to an equilibrium rate of job creation.
- Capital expenditures: Tax relief and a resurgence in energy exploration helped drive a wave of capital investment. Coupled with steady consumer spending, the pickup in capital expenditures helped the nation’s growth rate accelerate to approximately 3 percent for the year. In 2018, GDP expansion finally pulled out of the 2 percent rut that many had assumed marked a new structural limit to growth.
- Inflation: Many analysts have questioned the wisdom of enacting tax cuts so close to the peak of the business cycle. But lower tax burdens haven’t led to inflation, and placing US corporations on equal footing with international competitors should yield benefits over the coming years.
Searching for Clouds
Past periods of full employment have always been short-lived; as the top of the business cycle arrives, it’s natural to look for recession warning signs looming on the horizon. But a tight labor market doesn’t inherently create economic instability, and many of the current concerns about the state of the economy are misplaced, including:
- Equities losing value: Stocks had a mixed year, leading to worries that the long bull market had finally peaked. However, the market doesn’t appear overvalued by historical standards—the average price-earnings ratio has only recently regained the level seen during past expansions. The long bull market has been driven by rising corporate profits, which now account for 10 percent of gross domestic income (GDI), up from their historical 6 percent average. This has naturally lifted equities’ valuations as investors gain confidence in the durability of profits’ new share of the economy.
- Businesses becoming overleveraged: Businesses have been borrowing to invest in new equipment and facilities, pushing the nonfinancial sector’s total liabilities to an all-time high in 2018. However, the sector’s assets are also appreciating, and corporate balance sheets aren’t deteriorating—as a ratio of net worth, corporate debt has held steady throughout the expansion. With interest rates lingering at historically low levels while revenues take off, the debt burden on businesses has actually been falling steadily over the past decade.
- Tax cuts causing overheating: Most surprisingly, the top of the business cycle has yet to generate any signs of overheating. Inflation remains tame, allowing the Federal Reserve to maintain historically low interest rates even as the labor market tightens.
- The Fed hitting the brakes: The yield curve is flattening as the Fed hikes short-term interest rates—at 2.25 percent, the overnight target currently rests less than a single percentage point below the 10-year Treasury yield. In the past, when the Fed pushed short-term rates closer to long-term Treasury yields, it was a sign that monetary policy had turned constrictive in an attempt to slow economic growth and contain inflation. However, today’s bond yields aren’t entirely set by market forces—a recent Federal Reserve Board staff study hinted that quantitative easing abroad may be depressing long-term yields by as much as 150 basis points. If the true equilibrium for long-term interest rates lies closer to 4.5 percent, then the yield curve is still quite steep.
Ending 2018 in an Exceptional State
This year, the US economy experienced something truly unprecedented—the top of the business cycle arrived without bringing any of the distortions or imbalances that have toppled previous expansions. It’s too early to say whether the current long expansion is truly the beginning of the Great Moderation, a theoretical dampening of economic volatility that could occur if tame inflation allows for more stable monetary policy and milder recessions. However, it’s unquestionable that the expansion is carrying tremendous momentum into its tenth year. With few signs of trouble on the horizon, 2019 is starting on a note of steady growth and favorable business conditions.
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