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Summary:

The U. S. economy grew 2.5% in the fourth quarter of 2017 according to the second estimate by the Bureau of Economic Analysis. For all of 2017, real GDP increased 2.3% compared with an increase of 1.5% in 2016. Job growth remained strong in the fourth quarter of 2017 and continued into the first months of 2018. The unemployment rate held steady at 4.1% and the labor force participation rate ticked up slightly to 63%. The three-month moving average for wages and salaries increased .4% per month through January, representing a 4.9% annual rate of increase. After a long lag, wages are now starting to reflect the tight job market.

Inflation in 2017 did not exceed the Fed’s target of 2% for the core PCE. The Headline PCE for 2017 increased 1.7% with a core PCE increase of only 1.5%. Nevertheless, higher inflation in 2018 is likely due to fiscal stimulus from the tax cut, increases in the debt ceiling, relatively easy monetary policy, strong job growth, higher import prices from lower values of the dollar, tariffs, and full employment in the U.S. economy. Moderating factors for inflation include excess production capacity in both production and manufacturing. The Fed has already announced the intention to increase the Fed Fund rate three times during the remainder of 2018. If there are signs of an overheated economy with more rapid increases in wages and prices, the Fed will be more aggressive.

The consensus of forecasters calls for 2018 GDP growth near the long run potential path. Growth in the first half of 2018 should be close to 3% with slower growth closer to 2.5% in the second half. Analysts generally attribute higher growth in 2018 to higher spending linked to the tax cut. Growth will likely slow in 2019 as fiscal stimulus from lower taxes fades and as adverse effects of tariffs kick in. Households are in good wealth positions with rising wages, rising home equity values, and relatively low financing rates. Even so, the major downward correction in U.S. and global equity markets during the beginning of February demonstrates that the relationship between financial markets and the economy remains on edge. Increased volatility and increased correlations within and across asset classes provide a fragile condition where any downward movement results in a large slide. Market and economic fundamentals look strong for 2018, but the potential to turn on a dime also exists, as the February market correction demonstrated.

Both consumer and business sentiment remains high. Tax cuts sparked more enthusiasm for economic growth than pessimism for longer run fiscal deficit impacts on the economy. In the midst of so much good news, many market participants are starting to question whether the confluence of low interest rates, low inflation, good economic growth, fiscal stimulus, and monetary neutrality can be sustainable. Economic theory suggests a tradeoff between inflation and unemployment and between fiscal stimulation and low interest rates. It is natural for analysts to question how long the laws of economics can be suspended. Good economic news is not always good for the markets if the news suggests that the economy is overheating, as February jobs data illustrated. Interest rates should rise in 2018 due to both monetary policy normalization and higher inflation expectations over the longer term.