What went wrong? First, let’s see what happened and then speculate about why.
What: Weak fixed investment
Backers of the big cut in corporate tax rates promised an investment boom. Companies were supposed to use the money they saved in taxes to build new plants and buy new equipment – what government statisticians call “fixed investment.” That didn’t happen.
As the next chart shows, after a brief spurt in the first half of 2018, the contribution of fixed investment to GDP growth fell below the levels before the tax cut, even than the last year of the Obama administration. The latest data show that the fixed investment component has actually turned negative, making it a drag on the growth of GDP, rather than a boost. The investment rocket has crashed and fallen into the sea.
What: Weak exports
The export sector was also supposed to ignite rapid growth. The claim was that corporate tax rates, which were the highest in the world before the cut, were making American producers uncompetitive in world markets. The cuts would unleash an export boom.
That didn’t happen either. As our third chart shows, the contribution of exports to economic growth has also trended down. Exports tend to bounce around a lot from quarter to quarter, but the negative trend since the end of 2017 is clear.
President Trump would like to blame the Fed for slowing growth. Actually, that is less far-fetched than many of his claims. Between 2015 and the middle of 2018, the Fed raise its key interest rate target, the federal funds rate, from zero to 2.5 percent. Economic theory supports the idea that other things being equal, higher interest rates discourage investment. Also, other things being equal, higher rates tend to strengthen the exchange rate of the dollar relative to the currencies of trading partners, thereby undercutting the competitiveness of U.S. exports. But there are two flaws in the “blame it on the Fed” narrative.
First, although exchange rates are sensitive to changes in short-term interest rates, investment in long-lasting plant and equipment depends more on long term rates, such as those on corporate bonds. Interest payments on fixed-rate home mortgages – the most common kind – tend to move together with those on corporate bonds.
As the next chart shows, long-term rates do not closely track the short-term federal fund rate that the Fed uses as its policy target. Instead, rates on 30-year corporate bonds have been trending downward throughout the recovery. By mid-2019, 30-year bond rates were actually lower than they were five years earlier, when the federal funds rate was stuck at zero.
Second, other things are not equal. Both fixed investment and exports are much more sensitive to expectations about future business conditions than they are to interest rates, even long-term rates.
Lately, uncertainty about the state of the world economy has made investors cautious. The greatest single source of uncertainty has been the U.S.-China trading relationship. Pessimistic views have been only been reinforced by the administration’s recent announcement that it will impose still more tariffs on imports from China. The doubtful political prospects of the new U.S.-Canada-Mexico trade pact and worries over Brexit are further sources of uncertainty.
Slowing growth of U.S. manufacturing employment is yet another sign of cautious business sentiment. The odds that the economy will continue to grow for at least another year are still better than 50-50. However, the New York Fed’s estimate of the 12-month probability of a recession reached 32.9 percent in July, the highest since 2009. Without a recovery of investment and exports, that probability is likely to continue to increase.