CBO published its latest economic projections on January 24, along with its updated projections for the federal budget. Today and for the next two days, my colleagues and I will discuss various aspects of the economic projections.
CBO expects real GDP (gross domestic product, adjusted to remove the effects of inflation) to grow by 2.3 percent this year and by 1.9 percent next year on a fourth-quarter-to-fourth-quarter basis. That projection reflects expected cyclical developments in the economy, and it incorporates the assumption that current laws governing federal taxes and spending generally remain in place. The expected growth virtually eliminates economic slack—that is, unused productive resources, which can be measured by the shortfall between actual real GDP and potential (that is, maximum sustainable) real GDP.
In order to calculate the contributions to economic growth that will be made by the components of spending that combine in the national accounts to make up real GDP, CBO forecasts business-cycle movements over the next two years in those components. CBO then weights the growth rates of those components by their shares of nominal GDP.
Consumer spending, which accounts for over two-thirds of economic output, is expected to provide the largest contribution to economic growth, as it has generally done in the past (see the figure below). However, the pickup in economic growth that CBO projects for 2017 stems largely from faster growth in business fixed investment. A rebound in residential investment also contributes to the pickup. Total purchases by all levels of government are projected to add to the growth of real GDP in both years. In contrast, net exports (that is, exports minus imports) will restrain growth this year and to a lesser extent in the following year, CBO projects.
Consumer Spending
CBO expects the contribution to GDP growth that is made by consumer spending on goods and services to fall, as the growth rate of consumer spending slows and approaches the expected growth rate of disposable income, which likewise falls in CBO’s projections. In those projections, real consumer spending increases by 2.2 percent between the fourth quarters of 2016 and 2017, down from an estimated 2.8 percent in 2016, and at a slower rate next year (see the table below). Real disposable personal income is projected to grow more slowly over the next two years than in 2016 for several reasons, the most significant of which is that the growth of employees’ real compensation is expected to slow as employment gains slow. Also, CBO expects that energy prices will continue to rebound through the end of 2017, reducing some of the extra purchasing power that consumers gained in recent years, and that structural features of the tax code will increase personal tax liabilities.
Several other factors are expected to support consumer spending. One such factor is further increases in housing prices, which will boost households’ wealth. Another is further improvements in households’ creditworthiness and access to credit. Partly offsetting those effects are rising interest rates on mortgage and consumer loans, which restrain consumer spending in CBO’s forecast.
Business Investment
Total business investment consists of spending on structures, equipment, and intellectual property products (which is called fixed investment) and investment in inventories. CBO projects a large increase in the contribution to GDP growth made by real business fixed investment—particularly investment in equipment and structures—as that component of spending grows considerably more quickly over the next few years than it did last year. The projected growth is strongest in 2017, at 5.0 percent, and equals 2.7 percent in the following year. In 2016, real business fixed investment grew by just 0.2 percent, CBO estimates. Inventory investment is expected to boost growth this year but to have little effect on growth in 2018.
Business investment will grow strongly in 2017 for a variety of reasons, CBO anticipates:
- The number of drilling rigs in operation will probably continue the rebound begun in mid-2016 in response to rising oil prices, boosting investment in mining structures.
- Both the national office vacancy rate and the national industrial availability rate are near the lows reached during the last business cycle, suggesting a need to boost investment in nonmining structures.
- The factors that caused investment in equipment to decline in 2016—among them lower business confidence, falling commodity prices, and slow growth of productivity—will partly abate in 2017, leading to healthy growth.
- Orders for capital goods, a leading indicator of investment in equipment, began to rebound in late 2016.
- Investment in intellectual property products, such as software, will repeat the solid growth posted in 2016.
Investment is projected to grow more slowly after 2017, mainly because oil prices are projected to remain steady and because CBO estimates that the cyclical rebound in investment spending following the 2007–2009 recession will be largely complete. A slower rate of growth in the future will be sufficient to enable businesses to replace depreciated equipment and expand capacity.
Other factors also temper CBO’s projections of business investment after this year. Partial-expensing provisions in the tax code, which encourage investment by letting businesses deduct new capital expenses from their taxable income more rapidly than they could otherwise, are scheduled to gradually expire, beginning in 2018. The increase in interest rates anticipated in CBO’s forecast will also exert some downward pressure on investment.
Residential Investment
Another contribution to faster GDP growth comes from real residential investment—which consists of the construction of new dwellings, improvements of existing dwellings, and brokers’ fees and other transaction costs. CBO expects such investment to grow by 6.7 percent in 2017 and by 5.9 percent in 2018.
CBO anticipates that the construction of new dwellings will be the primary contributor to the growth of residential investment, mainly because of healthy household formation. The number of households increased by an average of about 1.2 million per year from 2014 to 2016, well above the 0.6 million average annual increase of the preceding eight years. The earlier weakness probably stemmed mainly from a sharp tightening of mortgage-lending standards during the 2007–2009 recession and from weak employment growth. As lending standards continue to loosen and as employment continues to improve, annual household formation will continue at a strong pace from 2017 onward, CBO expects. Rising mortgage rates will provide a modest drag on housing construction.
Government Purchases
In CBO’s current-law projections, total real purchases of goods and services by federal, state, and local governments grow by 0.5 percent in 2017 and by 0.8 percent in the following year. Modest increases in state and local spending, the result of rebounding tax revenues after a weak year, are projected to just outweigh a decline in real federal purchases. That projected decline incorporates the assumption that statutory caps on nominal funding for discretionary programs will make federal consumption and investment spending grow more slowly than inflation.
Net Exports
CBO expects the real value of imports to increase more sharply than the real value of exports in 2017 and 2018; that is, real net exports are projected to fall, detracting from the growth of real GDP. In 2017, CBO anticipates, real net exports will decline by $61 billion and real imports will exceed real exports by $612 billion. That gap is expected to widen to $654 billion in 2018.
CBO’s projections of net exports in 2017 and 2018 are strongly influenced by the significant increase in the exchange value of the dollar last year and by the agency’s forecast of further increases in that value during 2017. During the second half of 2016 alone, the export-weighted U.S. dollar appreciated by 4.2 percent, partly because investors raised their expectations of future interest rates in the United States. In CBO’s forecast, a similar expectation by investors—of rising long-term interest rates in the United States in relation to rates in its trading partners—continues to apply upward pressure to the dollar through 2017. As the dollar appreciates in relation to the currencies of major U.S. trading partners, foreign goods and services become relatively less expensive and U.S. exports relatively more expensive, so real net exports fall.
Christopher Williams is an analyst in CBO’s Macroeconomic Analysis Division.