submitted by
Uric Dufrene, Ph.D., Sanders Chair in Business, Indiana University Southeast
The Atlanta Federal Reserve maintains the GDPNow tracker, a tool that provides a running estimate of upcoming GDP. As data are released throughout the period, GDPNow changes to reflect the release of the most recent data. The tool is useful as it provides an ongoing estimate of GDP, and an early snapshot of the economic picture of the economy. The latest GDPNow is indicating that 2024 4th quarter GDP is at 3%, just about at the long-run quarterly average of GDP growth.
For the first 3 quarters of 2024, the consumer was the main driver of economic growth, responsible for about 75% of the percent change in quarterly growth. This strong consumer spending occurred during a period when consumer sentiment was quite weak, brought about by prices that were about 20% higher than the start of the pandemic. Higher rates of interest made housing more expensive, in addition to the financing of consumer durables. Despite these consumer headwinds, spending continued and drove a good bit of economic growth from last year. We’ll offer a possible explanation.
There are two primary factors that help explain the robustness of the consumer: the labor market, and household balance sheets. First, consumers remain confident about the labor market. The Conference Board Consumer Confidence measure reflects consumer views of the labor market and has been running quite strongly, compared to the Michigan survey of consumer sentiment. While the nation’s unemployment is higher than a year ago, rates are still at historically low levels. Monthly job creation continues to forge ahead, with last month’s number surprising analysts to the upside. Job openings, which have declined from a post-pandemic high of 11.7 million, continue to exceed the number of unemployed. Since August 2024, job openings have increased by approximately 1,000,000.
While the labor market continues to run strong, there are increasing challenges to employment seekers. Hires have declined from a post-pandemic high of 6.8 million down to 5.2 million. And job quits, which can be viewed as another confidence measure, have declined from a post-pandemic high of 4.5 million down to 3 million. Employees are less confident in finding employment, and hence job quits are lower. While hires and quits have declined, the labor market remains tight. The hires-to-openings ratio, a measure of labor market conditions, remains under 1, indicating labor market tightness. To be sure, there are more labor market challenges today than a year ago, but tightness remains, and consumers maintain overall confidence, helping feed consumer spending.
The second reason for sustained consumer spending is the household balance sheet. Assets are equal to liabilities plus equity, and equity represents the net worth of the household. We can view net worth as a summary measure that captures the impact of consumer assets and liabilities. Equity, or household net worth, is the highest on record. During Covid, net worth declined by almost 7%, as equity markets plummeted, but quickly bounced back. Since that time, household net worth has increased by a staggering 52%. This is not universal across all households but at the economy-wide macro level. Stronger net worth across households, coupled with a strong labor market, have fueled consumer spending, and this is one of the reasons why consumer spending dominated GDP growth last year.
Small Business Optimism, CPI, and the Supply Side
The National Federation of Independent Businesses conducts a monthly survey of small business members, and a closely watched measure from this is the Small Business Optimism Index. Most of the job creation in the economy emanates from small business. So, the optimism of small business owners could be viewed as an early signal of future business conditions. The most recent Optimism Index showed the largest monthly increase in the Index, at least going back to 1995. There was a similar surge after the 2016 election, but not as large as the most recent. Small business owners are optimistic that the new administration will introduce policies that are supportive of small business formation and growth, such as a deregulatory environment, and tax policies favorable to small business.
During the first Trump administration, the optimism trend of small business owners was largely positive until the first set of tariffs implemented in early 2018. Tariffs were first implemented in early 2018, but the second round of tariffs on $16 billion of Chinese goods came in late August. Small business optimism peaked around August of 2018, and then plummeted. There was a collapse of optimism during the Covid pandemic, and then the trend was largely negative during the Biden administration, attributed to the 40-year high inflation that followed supply shocks and government stimulated demand. In fact, in response to the question of “the single most important problem” of small business owners, inflation received the highest recorded response since 1995, in mid-2022, the height of inflation. The most recent surge in the optimism index is the highest level since 2018, and its sustainability depends on fulfillment of high expectations of a more favorable climate for small business, including deregulation, tax cuts, and curtailing inflation.
After a volatile December and the absence of any Santa Claus rally, the equity markets showed some recovery with the recent release of two inflation indicators, the Producer Price Index (PPI) and the Consumer Price Index (CPI). Both measures came in a bit softer than expected, and equity markets liked what they saw. Since the release of the PPI, the market has added almost 1,000 points to the Dow. The softer inflation shows up in the retrenchment of the 10-year Treasury yield. After this latest round of softer inflation reports, the 10-year yield did retreat off the recent high of 4.77%. This is important because of the link between the 10-year yield and what customers ultimately pay to finance assets, such as consumer loans and home mortgages. If disinflation continues, the 30-year mortgage rate will resume the downward trend that we saw in the 3rd and 4th quarters of 2024.
The 10-year yield is a function of growth and inflation expectations in the economy. If market participants are optimistic about economic projections, this will typically lead to higher interest rates, due to higher expected growth and inflation expectations. With strong optimism, and a robust economy, what will it take to put the inflation genie back in the bottle?
The key is on the supply side of the economy. Policies of the new administration will need to stimulate both labor and capital. Policies that encourage investment and capital formation will increase the nation’s productive capacity, providing additional headwinds to inflation. Policies that result in an expanding labor force, by increasing the labor force participation rate, will place downward pressure on the growth of average hourly earnings, providing additional headwinds to price hikes. Reducing the taxation on capital will increase the return on capital and thereby motivate and attract capital investment. Jobs are created when entrepreneurs and investors are rewarded for capital they place at risk. There is a reason why shareholders are referred to as residual claimants of the firm. They are compensated for the investment of capital only after employees, suppliers, interest, and taxes, are paid. Shareholders are last in line, and their residual claim is often pennies on the dollar. Rewarding capital through higher returns will motivate the investment of additional capital, going a long way to expand the supply side of the economy. Optimism is riding on it.
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