The 2019-20 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 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.

The figures at the end of this post show our office’s key economic assumptions and compare them to those from Department of Finance’s May Revision economic forecast. Our outlook and the Department of Finance’s are similar on most key economic variables.

Knowing the future path of the economy with certainty is not possible. While multiple signs point to a slowing in the rate of economic growth as assumed in our outlook, our scenario is only one possible path for the California economy. Several key issues, discussed below, create uncertainties about the future path of the state’s economy.

Federal Reserve Actions. Interest rates can influence the pace of economic growth as they determine the cost businesses face to expand or consumers face to finance purchases. After taking multiple actions in both 2017 and 2018 to increase interest rates, the Federal Reserve has paused on further rate increases in 2019 amid slowing in some parts of the economy, particularly housing. With wage growth appearing to decelerate and inflation remaining low, many economists anticipate the Federal Reserve will hold interest rates near their current levels for the foreseeable future.

Housing. Following the series of interest rate hikes in 2017 and 2018, housing markets started to show signs of weakening in the summer of 2018. Home price growth slowed, while new construction and sales saw year-over-year declines in the second half of 2018 and the beginning of 2019. Should the Federal Reserve pause interest rate increases, it could prevent further erosions in the lending environment for buyers and builders. This, in turn, could stabilize housing markets. Our May economic scenario anticipates that home price growth will continue at current levels for the next few years, avoiding further deceleration. We similarly anticipate that declines in new construction will abate. Should the condition of housing markets continue to worsen, however, it could have significant negative ramifications for the state’s economy.

Stock Markets. After dipping significantly at the end of 2018, stock prices now have nearly rebounded to the historically high levels seen in the fall of 2018. Some signs suggest that stocks, at current prices, 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 whether stock may be overpriced. The PE ratio (Shiller PE ratio) currently is 30, whereas the average since 1990 is 25. Overpriced or not, stock markets perennially create uncertainty for the economy and the state’s budget, as stock prices are subject to large, unpredictable swings at any time. For example, stock markets unexpectedly dropped this week, perhaps in response to the escalating trade tensions between the US and China.