Tax reform afterglow: Tax cuts expected to extend growth

Al Tubbs

On the surface, economic growth in 2018 seems just shy of a sure thing. The most obvious clue to that sentiment came just four days into the year, when the Dow Jones industrial average surpassed 25,000 for the first time in its history.

The Fed raised rates in December and has indicated it may do so up to three more times this year beginning in March, in which case rates would likely reach a range of 2.00 to 2.25 percent. Unemployment has approached multi-decade lows, pointing to a possible bump in labor costs.

In the Midwest, those trends have manifested themselves in a general economic optimism. When considering the next three to six months, business confidence is at its highest mark since January 2011, according to the December results of the Creighton University Mid-America Business Conditions Index.

“I would characterize the region as having a ‘goldilocks’ economy,” said Ernie Goss, director of Creighton’s Economic Forecasting Group. “That is, not so hot as to push the Federal Reserve to raise interest rates at a stepped-up pace, but not so cool as to slow employment gains. Both the national and regional indices indicate the manufacturing sector is advancing at a very healthy pace and will continue to spill over into the broader national and regional economies in the next three to six months.”

That spillover should benefit business lending, in particular. A Wisconsin Bankers Association survey of 100 bank CEOs and presidents found more than 60 percent deemed business loan growth as “good” or “excellent” with 53 percent expecting that demand to increase over the next six months.

Those positive indicators and anticipation came before Dec. 22, the day President Donald Trump signed the tax reform bill designed to push capital back into the economy. In theory, the hotly-contested tax relief should spur further economic growth.

“We think this tax reform should overall be quite stimulative to the economy,” said Al Tubbs, CEO and chairman of Ohnward Bancshares, Inc., Maquoketa, Iowa. Tubbs holds a Ph.D. in agricultural economics from Cornell University, Ithaca, N.Y. “People can argue about who the winners are and who the losers are and that begets a political argument that nobody wins, … but overall, I don’t see how it can help but be stimulative in the near term, anyway, when businesses are going to have significantly improved earnings because they’re paying less taxes.”

Those additional earnings can go a number of directions. The list of banks directing some of that toward their employees via one-time bonuses or increased wages continues to grow, including Ohnward giving $1,000 to every employee on payroll. Those disbursements are only a piece of the expected boost, though. The increased capital may become necessary for banks as the Fed simultaneously raises rates and gradually decreases its own balance sheet. The combination will make loan funding via deposits both more costly and more difficult to attain or retain.

Those added costs should not outweigh the gains banks feel via the tax reform, but they may mitigate it enough to warrant caution until all effects are thoroughly analyzed.

Jim Johannes

“Before I’m willing to jump on the bandwagon, I need to see those three things play out a little bit,” said Jim Johannes, professor of finance at the University of Wisconsin-Madison, and the Graduate School of Banking at UW-Madison. “I hate to use the phrase ‘cautiously optimistic,’ because it is so overused, but I would be very cautious predicting that the economy is going to get dramatically stronger.”

Johannes is not alone in his moderated skepticism. In the most recent projections from both the Federal Open Market Committee and the American Bankers Association Economic Advisory Committee, from mid-2017, the central tendencies pointed to modest short-term real GDP growth in the 2.1 to 2.2 percent range with the unemployment rate hovering around 4.2 or 4.3 percent through 2018 and rising no higher than 4.4 percent in 2019.

This will be in keeping with the trend of the seven-plus years of economic expansion since the recession. A Wells Fargo 2018 economic outlook describes the expansion as “the weakest of the post-war era,” due to its “rather tepid” 2.3 percent average annual real GDP growth.

Come 2019, the FOMC projected real GDP growth to fall to 1.8 to 2.0 percent while the ABA stuck with a similar, albeit broader, range of 1.7 to 2.1 percent. The long-term view of both the FOMC and the ABA capped real GDP growth at 2 percent while unemployment ticks upward. The FOMC sees unemployment going as high as 4.5 to 5.8 percent in the long run.

“This is the way it always works, the cyclicality,” said Jim Nowak, vice president of risk management at United Bankers’ Bank, Bloomington, Minn. Nowak said the market anticipates these successes and struggles, building them into costs long before they are genuine realities. For example, bank stocks have trended upward since Election Day 2016 because of expectations of tax reform and regulatory relief under Pres. Trump. Tax reform has only now passed, and regulatory relief efforts sputtered throughout the year. Yet, stocks continued upward.

Nowak argued the continued rise of the stock markets in early January came as a result of the cash flow stemming from the tax relief. While welcome, that may only delay an inevitable decline.

“In 2019, my leading models look a little iffy. This is probably going to be the last year of easy money,” he said, pinpointing 2018 as the economic cycle’s peak. “This is as good as it gets.”
Nowak would not go so far as to say another recession is on the horizon, but he also did not hesitate to point out similarities between the economic outlook now and the prevailing headlines and sentiments in the summer of 2007 or in late 2000, periods that preceded significant downturns.

The tax reform may change some of those factors — that was part of its intention and certainly part of widespread assumptions in response. Johannes does not expect as much of the increased liquidity to actually find its way to the market.

“Many people have argued this is good; the tax cuts are making it cheaper for businesses to invest in capital so they will invest in capital and that will help this investment rebound which has been performing very poorly,” he said. “History would tell us it’s not going to spur investment all that much, especially with the offsetting impact on interest rates.”