The 2018-19 May Revision

LAO Economic Outlook

Our office just released a summary of our updated state fiscal outlook for the May Revision. Our fiscal outlook is premised on a set of economic assumptions. While our November fiscal outlook included multiple economic scenarios, our update for May Revision focuses on only one economic scenario: continuation of moderate economic growth.

Our May Revision economic scenario is based on the average of a collection of publicly available forecasts from various institutions and professional economists as compiled by Moody’s Analytics. Figure 1 below highlights the major economic variables in our economic scenario, as well as the administration’s economic forecasts in both January and May.

Both our outlook and the Department of Finance’s new economic forecast assume moderate growth over the next year or so. One key difference between our office and the administration is that our economic scenario assumes notably higher wage and salary growth in 2018 and 2019.

Figure 2, at the end of this post, lists the major economic variables under our new moderate growth scenario through 2022. As we discussed in November, accurately predicting the future path of the economy is not possible. The consensus scenario we use is only one possible path for the U.S. and California economies.

Key Issues for the Future Trajectory of the State’s Economy. Our economic scenario reflects the consensus belief of professional economists that the current economic expansion is likely to continue through the end of the decade. A multitude of factors, however, will influence the path of the state’s economy in ways that are very difficult to anticipate. Some of these factors are discussed below.

Tight Labor Markets. The state’s unemployment rate (4.2 percent as of March 2018) is the lowest it has been in decades. When unemployment is low and falling, economists generally expect wages and prices to rise. With a limited number of people looking for jobs, competition among employers for workers is high. This competition typically forces employers to pay higher wages to attract new workers. Rising wage costs, in turn, cause businesses to raise their prices. Recent wage and price growth has not been as high as many economists had expected given low unemployment. Nonetheless, wage and price growth is expected to pick up soon, although it is difficult to say exactly when this will happen or by how much.

Federal Reserve Actions. With growing upward pressures on prices, the Federal Reserve is likely to take actions in the coming months to temper economic activity by increasing interest rates. Higher interest rates make it more expensive for businesses to expand their operations or consumers to finance purchases. As such, these interest rate increases would slow economic growth in the U.S. and California. The precise timing and impact of Federal Reserve actions is unclear.

Trade. Several recent developments have cast uncertainty over the terms of trade between the U.S. and other countries. The federal administration currently is renegotiating the North American Free Trade Agreement, an agreement that eliminates many barriers to the exchange of goods among the U.S., Canada, and Mexico. These negotiations are ongoing. In addition, in recent months, the U. S. and China have engaged in a series of back-and-forth threats to impose tariffs (taxes on imported goods) on goods commonly traded between the U.S. and China. To date, the tariffs that actually have been implemented cover a small slice of economic activity in the U.S., but the threatened prospective tariffs on both sides are much broader. Major changes to North American Free Trade Agreement (NAFTA) or escalation of the U.S.-China disputes could have significant impacts on businesses that sell many of their goods to Canada, Mexico, and China, as well as on the prices paid by consumers and businesses for goods and services imported from these countries.

Asset Prices. Some signs suggest that two important assets—stocks and homes in certain markets—are somewhat overvalued. The price of stocks is related, over the long term, to corporate earnings. Accordingly, price-to-earnings (PE) ratios are one key metric used to evaluate stock prices. As of early May, the PE ratio of the Standard and Poor’s 500 index was 24.5. The typical PE ratio since 1990 is 21 (19 if the dot-com bubble of the late 1990s and early 2000s is excluded). Similar to the price-to-earnings ratio, the home price-to-rent ratio is used to gauge if home prices are in line with underlying demand for housing. While price-to-rent ratios for the state as a whole appear to be in line with historic norms, certain housing markets in the San Francisco Bay Area appear to be a little overheated. While these markets represent a minority of homes in the state, the Bay Area contributes disproportionately to the state’s economic activity and tax revenue.