We believe that the current expansion phase in the US may continue, but unresolved issues remain in the long run. In fact, despite the very long growth cycle, we believe that expansion can last as signaled by the mid-cycle situation of the housing market and limited leverage of private operators. President-elect Donald Trump’s expected fiscal policy is likely to boost the economy in the short run, especially via corporate tax cuts, but the long-run impact might be harmful. There is a need to address long-term flaws, notably weak investment and productivity, and it is not clear if Trump’s policies will help in this regard. However, the positive impact of fiscal expansion is likely to be limited because the economy is already at full employment and the risk of overheating could increase the odds of a hawkish Fed in 2017.
Looking at the economic conditions in the US after a weak first half of 2016 (+1% annualized GDP growth), the US economy has been accelerating. With the labor market near full employment, new jobs have continued to grow by 180k per month and wages have started to rise. Growth is sustained mainly by consumer spending, thanks to disposable income gains and a steady increase in consumer confidence.
Labor Market and Consumption Indicators Still Strong
Manufacturing, weakened by the huge oil price decline and the strength of the USD in the last two years, is slowly but steadily recovering, with ISM figures improving slightly. In addition, we still have not observed excessive leverage of private agents and a booming housing market, which are typical signs of overstretched economic cycles. This picture is confirmed by our macroeconomic models: the probability of the US economy entering a recession in the coming six months, after spiking to a degree during the summer months, is now estimated to be below 10%.
However, the real medium-term challenge is low productivity growth, partially caused by low investment spending in machinery and equipment. Therefore, in evaluating the sustainability of Trump’s proposed economic policies, it is crucial to consider their potential to boost investment and improve productivity and potential output growth as a consequence.
Finally, our forecasts for GDP growth are around 2.3% for both 2017 and 2018, and for inflation they are around 2.2% and 2.1% in 2017 and 2018, respectively.
On monetary policy, after the 25 basis point hike of December 2016, the Fed signaled, via the dot plot, three additional hikes in 2017. It justified the December move by noting that the labor market had strengthened, moderate economic growth was continuing and there were some signs of higher inflation.
Why the Fed Decided to Rise Rates in December
The market was somewhat surprised by the uptick from two to three hikes in 2017 in the dot plot. Janet Yellen indicated in her press conference that this was due to the changed forecast of “only some FOMC participants” and is only a “very modest adjustment”; she reminded markets that “Fed policy isn’t on a pre-set course”. Given the positive situation of the economy, the Fed faces no particular constraint in pursuing the normalization path. On the contrary, it might be slightly accelerated by Trump’s economic policy. Indeed, according to Yellen’s speech, fiscal stimulus is not needed to bring the economy to full employment and the Fed will adjust its course as future policies are put in place.
 Institute of Supply Management (ISM) manufacturing index.