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This year, 2018, shows every sign of producing good growth. The economy comes into it with momentum. The consumer, more than two-thirds of the gross domestic product (GDP), shows more confidence than in a long time, and if household debt has grown of late, spending should expand. Home-buying and construction should also pick up since past homebuilding has trailed family formations for some time now. Capital spending by business has also shown greater signs of strength than in a long while, something that the recent corporate tax relief should help sustain. Government spending is constrained, but all in all, prospects for the next 12 months or so look good.
But as the wise frequently warn, “nothing lasts forever.” Eventually, this recovery, already very long by historical standards, will end. Investors would do well to note, then, that the U.S. economy is running out of the capacity to sustain growth. Two measures are especially revealing in this regard: the Federal Reserve’s (Fed’s) measure of industrial capitalization and the unemployment rate. If constraints are not severe enough yet to threaten the next 12-18 months, they will intensify as the recovery continues, making 2019 more problematic and certainly 2020. Since capital markets anticipate, time for them is shorter.
According to the Fed, American industry presently operates at slightly over 77 percent of existing capacity. That percentage may seem to offer a lot of room for growth, but much of what constitutes capacity is less than modern. When industry operates above an 80% utilization rate, it engages these remnants and loses efficiency and flexibility. Current growth rates suggest that business will approach this limit by late 2019, certainly by 2020.
Factoring into this constraint is the past paucity of business spending on new equipment. During much of this long recovery real spending on new industrial and commercial structures, equipment, or even technology, has grown at historically slow rates, effectively stagnating during the last two years of the Obama administration. By some measures business and industry spent only 30% more than needed to replace worn out and obsolete facilities. In comparable periods during past cycles, they would have spent 50% more than needed for replacement. Little wonder then that the overall capacity figures tracked by the Fed have grown only slightly above 1.0%. To be sure, spending on new facilities and equipment accelerated in 2017, but this new pace would have to persist for some time to have an effect on the overall picture.
Labor markets suggest even less space for growth. With unemployment verging on 4% of the nation’s workforce, the figures imply limitations on the remaining trained workforce on which the economy might draw for future growth. Historically, the rate of unemployment seldom drops much below this level. Some have argued that this figure exaggerates the constraints, that thousands dropped out of the workforce in recent years and have ceased to count as part of it, leaving hidden labor resources that will become available in time. There is grain of truth in this. Workforce participation rates had dropped and have begun to pick up in recent months as hiring rates have increased. But some of those who have dropped out are retiring baby boomers. They are less likely to return to full-time employment than some seem to think. And as for younger, frustrated job seekers who dropped out of the search, many of them likely lack the skills required for the new jobs.
The recent acceleration in wage growth confirms these implied constraints. According to the Department of Labor, compensation costs jumped 3.4% in 2017, quite a change from the 1.0% rate of increase recorded for 2016. Wage growth like this must come as a balm to working men and women who have suffered stagnant living standards for years now. But it also says that the constrained supply of trained labor especially has already begun to have its effect. Since business’ past reluctance to buy new equipment and technology has slowed the rate of productivity growth to barely over 1.0% a year, firms will not cope well with this wage pressure.
While all these limits are clear, it is also evident from past cycles that they will have their effects only gradually. This new year then would seem to have enough elasticity to avoid their worst effects. If business sustains its new willingness to spend on equipment and technology, it should improve productivity and otherwise increase the economy’s productive capacities, delaying the day when the economy will have to reckon with capacity constraints. Nonetheless, these limits to growth will begin to bite in time, and eventually end this recovery. If matters are not yet at this point, the recovery nonetheless has surely entered a period that could be described as the beginning of its end.
Milton Ezrati is an economist and author who has worked in the financial services industry for decades and currently serves as chief economist of Vested.