The US economy is looking in good in early 2018.
Unemployment sits at decade-lows and economic growth is accelerating, all at a time when inflationary pressures still remain incredibly muted.
It’s akin to a Goldilocks-type scenario — strong growth, low inflation where almost everyone who wants a job has one.
However, to Bank of America-Merrill Lynch (BAML) there’s now a growing risk that Goldilocks could be replaced by a more unpalatable economic scenario in the years ahead.
The culprit, it says, is recent company and personal tax cuts approved by the US Congress.
“The risk of an ugly boom-bust scenario in the US is growing,” BAML says.
“With the economy already at full employment and already growing above trend, fiscal easing could gradually cause a major overheating.”
As seen in the chart below, even before fiscal stimulus has truly left its mark on the US economy, unemployment already sits at 4.1%, contributing to a lift in wage pressures in recent months.
As BAML notes, as fiscal stimulus begins to permeate throughout the economy it will help boost aggregate demand, creating a scenario where unemployment could fall to levels where inflation and economic growth both accelerate sharply.
“Fiscal stimulus mainly boosts aggregate demand, with likely little net effect on the supply side of the economy,” BAML says. “Hence if GDP growth reaches, say, 3%, simple ‘Okun’s Law’ calculations suggest the unemployment rate will hit 3% by the end of next year.”
3% unemployment — a boom-time like level not seen in well over half a century.
However, with the boom times generally comes an increase in inflation, creating a scenario BAML says could lead the US Federal Reserve to lift interest rates far faster and higher than many currently expect, potentially creating a boom-bust scenario for the US economy.
“Business cycles don’t die of old age, they die of excesses,” the bank says, adding that “the most important of these is unacceptably high inflation and a tough Fed”.
While BAML admits that “inflation has been very slow to respond to an overheating economy” in recent years, allowing the Fed to increase interest rates gradually since late 2015, with signs that wage pressures are already starting to build, it says that could be about to change.
“There are already tentative signs of a step up in wage growth,” BAML says.
“We would expect the Fed to become much less tolerant of growth if core inflation approaches 2.5%.
“That is still a long ways off, but fiscal stimulus could bring it closer.”