Tax Cuts Kick In and the Economy Takes Off in the Second Quarter

By Ken McCarthy, Principal Economist

The U.S. economy accelerated sharply in the second quarter of 2018 as the effects of the tax cuts enacted at the end of 2017 were felt. U.S. gross domestic product (GDP) grew at a 4.1% annual rate, up from 2.2% in the first quarter and the strongest reading since the third quarter of 2014. A strong rebound in consumer spending drove the acceleration. Stimulated by lower taxes, stronger wage growth and a positive wealth effect, personal consumption expenditures adjusted for inflation rose by 4.0% in the second quarter, up substantially from 0.5% recorded in the first quarter. In addition, businesses, taking advantage of a more supportive tax environment continued to increase investment at a healthy pace. Investment spending increased a solid 7.2% higher than a year earlier.

There are many reasons to be optimistic .Although equity markets have become more volatile as uncertainty about trade policy makes investors nervous about the economic outlook, both business and consumer confidence in the current and near term outlook for the economy remains high. The Conference Board’s Consumer Confidence Index remains near the multi-decade highs recorded earlier this year as does small business confidence. This is expected to support to further healthy growth in spending in the second half of the year.
Employment, a key driver of demand for commercial real estate also remained very strong in the second quarter. The economy added, on average, 230,000 jobs per month in the quarter, slightly above the 218,000 per month added in Q1.

Employment growth in office using sectors (financial, professional and business services and information) also remained strong, adding 61,000 jobs per month. In addition, industrial-related employment continued to soar. Employment in transportation, warehousing and manufacturing jumped 118,000 jobs in the quarter and stood roughly 430,000 above the year-earlier level, the largest 12 months increase since the mid-1990s.

A notable feature of the second quarter was the growing shortage of workers. There have been reports of shortages of truck drivers and construction workers. As of May, the Labor Department reported there were 6.6 million job openings in the U.S and only 6.1 million unemployed people. Of course, there are many people who are not recorded as unemployed who could come into the workforce, but we have never seen a situation where there were more jobs than unemployed since the Government began reporting this data in 2001. Of course this does mask the skills mismatch.
These extraordinarily tight labor market conditions are pushing wages higher. As of June, average hourly earnings had increased 2.7% from a year ago, roughly in line with its pace at the end of 2017. The combination of more jobs and faster wage growth will boost incomes and support continuing healthy growth in consumer spending in the second half of the year.
Although not worrisome yet, inflation has begun to pick up. In June, the core consumer expenditures deflator, the Federal Reserve’s preferred inflation measure, was 1.9% above its year earlier level. While it is still below the Fed’s 2% target, this measure was 1.5% in June 2017.

The uptick in inflation is one reason the Fed has continued to raise interest rates. The Fed raised the Federal funds rate once during the quarter, pushing the range for the short term interest rates to 1.75% to 2.0% in June. Interest rates remain low by historical standards though. The current consensus is that the Fed will raise interest rates again in September and December of 2018 and will make three to four additional hikes in 2019. The healthy economy and inflationary pressures are also pushing up longer term rates, although more slowly than short-term interest rates. The 10-Year Treasury rate ended the second quarter at 2.85%, up from 2.74% at the end of the first quarter after reaching as high as 3.1% in mid May.

Uncertainty over Trump Administration policies continues to hang over the economy and could dampen the current positive outlook. Trade tensions are rising and as they have, equity markets have been flat. In addition, with midterm elections around the corner and the ongoing Mueller investigation, there are potential reasons for concern. While we remain optimistic on the U.S. economic outlook, these potentially negative developments need to be monitored closely.

Based in New York, NY,  Kenneth McCarthy is a Senior Managing Director and Principal Economist with Cushman & Wakefield.