A Crucial Signal For The Recovery’s Durability

Milton Ezrati

Chief Economist

Whatever one thinks of Donald Trump, none can deny that the economy has picked up since he entered office. How much of this good news stems from his policies remains a matter of debate. Presidents invariably get too much credit for economic good news and too much blame for the bad. But especially since so much of the growth surge relates to capital spending by business, surely some of it reflects the regulatory relief engineered by this White House as well as the tax reform. The crucial question now is how durable is the renewed interest by business to spend on new equipment and facilities? The answer will say much about the sustainability of the overall economic acceleration both over the near and the longer term. By extension, it will also say much about the staying power of the stock market rally.

One of the salient features of the economy’s remarkably slow recovery between 2009 and 2016 was the paucity of capital spending. It took three full years for business to recover its pre-recession high.  Usually that happens in a year or less. During this time, overall spending by American business on software and equipment, as well as structures grew in real terms at barely 5% a year on average, unusually slow by the standards of past recoveries.  The pace slowed still more after 2014. Usually, capital spending picks up as the recovery matures and business looks to keep up with output by enlarging its productive facilities. But according to the Commerce Department, things looked very different between 2014 and 2016. During this period, real capital spending of all kinds rose at only 1% a year on average and real spending on new equipment failed even to grow 0.4% a year.

During the entire period 2009-16, business spending so underperformed historic norms that the sector during much of this time held back the pace of overall economic growth. Not only did this behavior contribute to the disappointing strength of the overall economy and so employment, but the slow rate at which business modernized and added to capacity also raised questions about the economy’s capacity for future growth over the longer term. There was ample reason for concern, too. Spending on equipment and facilities and what the Commerce Department refers to as “intellectual property products” feeds not only the economy’s gross productive capacity but also worker productivity and hence real wages. Reflecting the paucity of such spending, output per hour expanded at an atypically slow 0.6% a year between 2010 and 2016 and wages after inflation did no better. With good reason, questions arose about the economy’s long-run growth potential and the outlook for the average worker’s living standards.

But starting in 2017, almost as if someone had fired a starting gun, the whole picture changed. In the first quarter of that year, real spending on structures and equipment, as well as software and the like, surged at almost a 10% annual rate, a far cry from the patterns that had prevailed between 2009 and 2016. Significantly, spending on software and the like, after years of stagnation, jumped at a 7.9% annual rate. The new, accelerated pace continued throughout the year. By the end of 2017 overall spending after inflation ran 6.4% above year-ago levels, a slight slowdown from the pace of the first quarter but much stronger than anything exhibited between 2009 and 2016. By that time, spending on new equipment had risen 9.1% above late 2016 levels.

The pace of such spending accelerated still further during the first half of this year.  Preliminary Commerce Department figures for the period show that overall capital outlays on equipment rose at a 6.4% yearly rate. Most significant, spending on software and intellectual capital jumped at a 12.6 percent yearly rate. Outlays for all sorts of facilities and new equipment went from imposing a drag on the economy’s overall pace of growth to offering a contribution.  In this year’s first half, such spending alone added 1.3 percentage points to the overall growth of real gross domestic product (GDP) accounting for more than one-third of the overall pace of expansion. More encouraging still, this capital spending surge, especially on software and other sources of intellectual capital, has at last begun to lay a foundation for future productivity growth and wage increases.

Sustaining this trend then is crucial for the economy to deliver robust growth in the future, both in the period immediately ahead and over the longer term. On this front, what little data exists for the third quarter offers some good news and some bad. New orders for civilian aircraft, which had surged in 2017 and earlier this year, seem to have hit a wall. Their drop has dragged down overall orders for new capital equipment 4.9% during the three months ended in July, the most recent period for which data exist. That is over 20% at a yearly rate. Of course, aircraft orders are notoriously volatile. They are quite capable of surging again in the next few months. Offering more solace than the inscrutable nature of civilian aircraft orders is how civilian capital equipment orders excluding aircraft have continued to expand, growing some 2.7 percent during this most recent time, an 11.2% yearly rate.

There can be no mistaking that the decline in aircraft orders, once it runs through to shipments, will slow the economy’s overall growth pace, probably during the fourth quarter and the first quarter of 2019. For the rest, a continuation of robust capital spending growth elsewhere would help secure the economy’s long-term productive future and support overall growth rates superior to the 2009-16 period. It would in time also improve labor productivity and wages. But if the aircraft drop signals a more general trend, then the economy will again look vulnerable. Growth would relapse to the paltry growth rates of the 2009-16 period and longer-term hopes for productivity growth and wage gains would dissipate.

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