Fourth Quarter 2018 Review—Growth Continued to Slow, but Remained Solid

Summary: Growth in the Seventh Federal Reserve District continued to slow through the end of 2018, and the data indicate that the pace decelerated from well above trend to right around trend. The slowdown is primarily in the manufacturing sector, where growth was clearly stronger in the first half of 2018. Even so, the deceleration—combined with greater turmoil in the financial markets and Washington—is weighing on outlooks. According to the latest Chicago Fed Survey of Business Conditions (CFSBC) Outlook Index, our business contacts are as pessimistic as they’ve been since we started the survey five years ago. In spite of the slowdown in activity and more pessimistic outlooks, it’s still reasonable to think that 2019 will be a decent year for the District’s economy. That said, the District’s economic performance in 2019 is not likely to outpace its performance last year.

Now let’s look at the economic indicators that support this analysis.

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Third Quarter (Plus October) Review—Seventh District Still Doing Well, but Growth Has Slowed Some

Summary: Seventh Federal Reserve District growth has slowed some relative to earlier in the year. That said, the data largely indicate that the District’s economy is still growing at a healthy pace. The manufacturing sector is doing quite well, with most of its subsectors contributing to the sector’s high growth rate. Outside of manufacturing, most sectors continue to experience steady growth. Positive outlooks for U.S. and, to a lesser extent, global growth suggest that the District’s economy will continue to do well in the near term.

Now let’s look at the economic indicators that support this analysis.

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How have rising domestic and foreign tariffs affected the Chicago Fed’s business contacts?

In the spring of 2018, the Trump administration began imposing higher tariffs on imports of certain goods into the United States. In March, the administration put tariffs on imports of steel and aluminum from most countries. And then in July, it placed tariffs on $34 billion worth of Chinese imports. This was followed by tariffs on an additional $16 billion worth of Chinese goods in August and on another $200 billion worth of such goods in September. China and other affected countries responded with tariffs of their own on U.S. exports. (For a full description of the ramp-up in tariffs by the United States and other countries, see this timeline from the Peterson Institute.)

In May, we asked the Chicago Fed’s business contacts how they expected the steel and aluminum tariffs to affect their businesses, and most indicated that they expected a slightly negative impact. In the most recent Chicago Fed Survey of Business Conditions (CFSBC), we followed up and asked how the broad increase in tariffs had affected them so far. Most contacts reported that the overall impact had been fairly small, although some said it was too soon to tell. Among those affected by the tariffs, more said the impact had been negative than positive. In addition, a number of contacts reported that rising tariffs had created uncertainty about the prices of their inputs and demand for their firms’ products. The increased uncertainty had led some firms to delay hiring and capital spending.

In what follows, I’ll briefly explain how standard economic theory suggests tariffs affect businesses, and then I’ll explore the full results of our survey, which asked respondents to characterize the impact of the tariffs in terms of demand, input costs, output prices, employment, and capital spending.

In general, a tariff on a good imported to the United States helps domestic producers of that good and hurts domestic consumers. Domestic producers experience increased demand and pricing power, while domestic consumers pay higher prices. If the domestic consumer is a firm that uses the good as input for its production, it may choose to raise prices, which will reduce demand.

A tariff on a good exported from the United States hurts domestic producers and helps domestic consumers. Domestic producers experience decreased demand and pricing power, while domestic consumers pay lower prices. If the domestic consumer is a firm that uses the good as input for its production, it may choose to lower prices, which will increase demand.

What happened to the Chicago Fed’s business respondents?[1] Figure 1 shows that the majority of our contacts indicated that rising tariffs had not affected demand for their firms’ products. Among those whose demand changed, more experienced declines in demand than increases. Those who had experienced increases in demand were primarily in the manufacturing sector.

As noted previously, with rising domestic and foreign tariffs, costs could go up or down depending which inputs are subject to tariffs. Figure 2 shows that for most firms in our survey, costs had increased, but that generally the increases had been small. This is because, as figure 3 shows, most firms do not have a large share of input costs that are subject to tariffs. In addition, among contacts for whom a large share of their input costs are subject to tariffs, all reported that they had been able to pass along most of their increased costs to their customers.

Rising tariffs could influence firms’ business decisions through demand and cost channels. Moreover, increased uncertainty about whether tariffs will change again could also have an impact on their decisions. I next look at how our contacts said rising tariffs had affected their immediate business decisions and their plans for the future.

Figure 4 shows that almost none of our contacts had changed their employment levels in response to rising tariffs. And figure 5 shows that most contacts did not change their current capital spending either, although a higher proportion had made some change. There was one firm that significantly increased hiring and capital spending: This firm is in an industry where increased foreign tariffs on its primary input led to lower domestic prices and increased U.S. tariffs on its primary output led to higher domestic prices. With much improved margins, the firm could justify a robust expansion.

Figure 6 shows that, overall, 15% of firms had delayed hiring and 23% had delayed capital spending. A number of firms noted that the rising tariffs had created uncertainty about prices for capital equipment. Other contacts said that they were hesitant to make new investments because they were unsure of how the rising tariffs would affect their clients’ businesses.

Figures 7 and 8 show that firms’ plans closely mirrored their current activities, with most firms indicating that they expected no effect of rising tariffs on future decisions. And, among those who did expect an effect, more said they anticipated a negative impact rather than a positive one.

All told, rising domestic and foreign tariffs appear to have had a small effect on the Chicago Fed’s business contacts so far. That said, the tariff changes have affected some companies significantly and have created uncertainty that is likely to affect businesses’ decisions into 2019.

[1] Note that in our survey we did not distinguish between producers and consumers of the goods subject to domestic and foreign tariffs.

First half review—A good year so far for the Seventh District

Summary: We now have data through the first half of 2018, and they indicate that the Seventh Federal Reserve District’s economy did quite well. The manufacturing sector is the primary source of the good performance—growth has been strong enough that there are now signs of some manufacturers running into capacity constraints. While the nonmanufacturing sectors are not running as hot as the manufacturing sector, they still have had a fine year so far. Positive outlooks for both U.S. growth and global growth suggest that the District’s economy will continue to do quite well in the near term. That said, respondents to the Chicago Fed Survey of Business Conditions (CFSBC) are getting more and more worried about the potential negative impacts of an escalating trade war. Continue reading

First quarter review—A good start to the year for the Seventh District

Summary: Growth in the Seventh Federal Reserve District picked up from an already healthy pace during the first quarter of 2018, with almost all indicators pointing to above-trend growth. The manufacturing sector was doing especially well, with good results spread across manufacturing subsectors. Outside manufacturing, most sectors returned to about trend growth, up from a lull that bottomed out in the summer of 2017. Overall positive outlooks for both the U.S. and global economies suggest that the Seventh District economy will continue to do well in the near term.

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How do the Chicago Fed’s business contacts expect the steel and aluminum tariffs to affect their businesses?

On March 1 of this year, the Trump administration announced its intention to implement import tariffs of 25% on steel and 10% on aluminum. The tariffs went into effect on March 23. At the moment, a number of our major trading partners are excluded from the tariffs: For the time being, Canada, Mexico, the European Union (EU), South Korea, Argentina, Australia, and Brazil are among those that do not face the tariffs. And while a number of factors affect commodity prices, prices in the Midwest are about 11% higher for steel and 7% higher for aluminum since President Trump’s March 1 announcement.

How might the steel and aluminum tariffs affect businesses in the Midwest? We asked our business contacts about that in the most recent Chicago Fed Survey of Business Conditions (CFSBC).

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How Should the State of Illinois Pay for its Unfunded Pension Liability? The Case for a Statewide Residential Property Tax

The views expressed in this post are our own and do not reflect those of the Federal Reserve Bank of Chicago or the Federal Reserve System.

Note: This post is based on previous work presented by the same authors at the forum “Navigating Pension Reform in Illinois: What Lies Ahead”, held on April 17, 2018 at the Chicago Fed. The original presentation is available here.

The State of Illinois has a very large unfunded pension liability and will likely have to pay much of it off by raising taxes. The Illinois Commission on Government Forecasting and Accountability estimated the state’s unfunded liability at $129.1 billion in mid-2017,[1] which was about 19% of state personal income.[2] Benefits to public employees are protected under the Illinois Constitution, and a recent attempt to reduce the unfunded liability by reducing retirees’ benefits was struck down by the Illinois Supreme Court.[3] So, assuming that the state can’t reduce its current pension obligations and that it wants to maintain its current level of services, Illinois residents are going to have to pay higher taxes. What’s the best way to do it?

Because the debt is so large, it’s unrealistic to think that new taxes (such as a tax on legalized marijuana or financial transactions) or increases that affect only a narrow segment of the population will be enough.

Illinois will have to find additional revenues from already existing tax bases, either by increasing rates, expanding the definition of what is taxable, or a combination of the two.[4] Illinois state and local governments have three primary tax revenue sources—income, sales, and property—and each presents a unique set of tradeoffs in terms of how it affects the economy and who pays it.

In our view, Illinois’s best option is to impose a statewide residential property tax that expires when its unfunded pension liability is paid off. In our baseline scenario, we estimate that the tax rate required to pay off the pension debt over 30 years would be about 1%. This means that homeowners with homes worth $250,000 would pay an additional $2,500 per year in property taxes, those with homes worth $500,000 would pay an additional $5,000, and those with homes worth $1 million would pay an additional $10,000.

Perhaps the best counterargument to adding a statewide property tax is that Illinois homeowners already pay higher local property taxes compared to the national average.[5] But remember that Illinois residents will be paying higher taxes one way or another. Would you rather pay your higher taxes through a higher sales, income, or property tax? At the very least, higher property taxes should be part of the solution, perhaps in addition to the solutions proposed by the Civic Federation.

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Mid-Winter Review—Economic Activity in the Seventh District Picked Up After a Bit of a Lull

Summary: The Seventh District economy maintained a healthy pace of growth through the end of 2017 and into January, with most signs pointing toward above-trend growth. The manufacturing sector finished 2017 well, with good news spread across its subsectors. And it’s worth noting that while the auto industry struggled in the middle of the year, it ended the year in decent shape. Outside of manufacturing, most sectors continued to experience slow but steady growth. Positive outlooks for global growth and the energy sector suggest the Midwest economy is well positioned for a good start to 2018. In addition, as noted in an earlier post, our Chicago Fed Survey of Business Conditions (CFSBC) contacts expect a boost from the federal tax reform (though it is not clear how strong the boost will be).

Now let’s look at the economic indicators that support this analysis.

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How Do the Chicago Fed’s Business Contacts Expect to Spend Their Federal Tax Windfall?

On December 22nd of last year, President Trump signed the Tax Cuts and Jobs Act, a law that makes substantial changes to the federal tax code for individuals and businesses. An important provision of the act is tax cuts for both groups worth an estimated $1.46 trillion over the next ten years. Congress’s Joint Committee on Taxation estimates that businesses will pay $330.4 billion less in taxes over that period, with more than two-thirds of the reduction coming in the first three years.

In the run-up to the tax bill’s passage, there was a substantial debate about what businesses would do with the extra money from the tax cuts. Commentators in favor of the bill generally argued that strong competition would force businesses to invest their tax savings in capital, which would result in higher worker productivity, output, and wages. Commentators opposing the bill generally argued that weak competition would allow businesses to forgo spending on capital and labor and instead allow them to pay out increased profits to shareholders.

While it is still too soon to know what business leaders will actually do, it is possible ask them what they expect to happen. We did just that: We asked the respondents to our Chicago Fed Survey of Business Conditions (CFSBC) how they expect the new tax act to affect their businesses and how they expect to spend their tax windfalls (if they get one). While the sample size is fairly small and not representative of the universe of Seventh Federal Reserve District firms, the results do offer some perspective on these very interesting questions.

Figure 1 shows the results from our first question. It reports that 63 percent of respondents expect the tax act to have a positive impact on their firms. Most respondents who expect a positive impact anticipate a direct effect on their firms’ net incomes, though some said that while they do not anticipate a direct effect on their firms, they do expect the act to stimulate the economy, which would result in greater demand for their firms’ products. The few respondents (17%) who said they expect the tax act to have a negative impact were from multiple sectors. However, one sector that we survey—nonprofits—was particularly negative about the tax act because they believe that the large increase in the standard deduction will encourage more households to not itemize, thereby reducing the incentive to make charitable donations.

We next asked our contacts how they expect to spend their tax windfalls, if any. Sixty percent of the respondents answered this question. Businesses have options in addition to capital spending, labor expenditures, and profit payouts, such as mergers and acquisitions, price decreases, and balance-sheet repair (i.e., holding more cash, paying down debt, or buying other financial assets). Figure 2 shows the average share our contacts expect to put toward each major spending category. The largest was capital spending (27%), followed by balance-sheet repair (25%), profit payouts (18%), and labor spending (14%). Our manufacturing contacts expect to spend a greater share of their savings on capital and balance-sheet repair than our nonmanufacturing contacts.

The results shown in figure 2 suggest that there is some truth to the arguments made in favor of the act and those made in opposition to it. Our contacts expect to spend about 40% of their tax savings on capital and labor and just under 20% on profit payouts. They also expect to spend a large share on balance-sheet repair, which could be interpreted as a wait-and-see approach: Rather than spend the money now, they plan to put their firms in a better financial position for the future.

Look for a follow-up blog post about a year from now, when we will be able to learn how things went for our business contacts after a year under the new federal tax regime.

Appendix: Below is the full distribution of responses for how our contacts expect to allocate their tax savings across each of the five spending categories.

Trends in Education and Income in Chicago

Harvard economist Edward Glaeser shows that education is one of the strongest predictors of urban economic growth.   This is particularly the case for older cities like Chicago.  One of the reasons for this is that a higher density of college-educated workers is associated with higher levels of worker productivity.

There is very good news for Chicago.  Recent data for 2016 from the United States Census Bureau’s American Community Survey shows that the city of Chicago now has the highest percentage of college graduates of the seven largest cities in the United States (Table 1).  Almost 2 out of 5 adults twenty-five and older in Chicago have at least a bachelor’s degree. Chicago beats New York City, Los Angeles, San Antonio, Houston, Phoenix, and Philadelphia.  Of the ten largest cities, only San Diego and San Jose have higher levels of educational attainment as measured by the percentage of adults with at least a bachelor’s degree.

If the sample is limited to non-Hispanic whites, Chicago even beats San Diego and San Jose, the home of Silicon Valley.  For this population, over 3 in 5 have a college degree in Chicago.  In some community areas in Chicago like Lincoln Park, Lakeview, and the Loop, about 4 out of 5 have a college degree.

One of the reasons for Chicago’s success in this arena is that the city of Chicago is an attractive place to live and work for college graduates, especially young grads.  Over half of the young college graduates in the Chicago metropolitan area live in the city of Chicago.  This is up from about forty percent in 1990.

Another reason is that migrants to Chicago are more likely to have a college degree.   Last year about 3 of 4 migrants to Chicago from other states and from abroad had a college degree.  Ten years ago only about 1 in 2 migrants to Chicago had a college degree.  It is particularly noteworthy that in 2016 seventy-three percent of foreign migrants to Chicago had a college degree.

If one goes back in time, Census data indicates that adults in the city of Chicago were significantly less educated than their suburban counterparts.  This is no longer the case.  The percentage with a college degree in Chicago is higher now than in the suburbs of the Chicago metropolitan area although some suburbs have higher levels of attainment (Table 2).  For example, 2 out of 3 residents of Evanston have at least a bachelor’s degree.

Although non-Hispanic whites who account for about one-third of the population of Chicago are doing well, the situation for African-Americans and Hispanics is more mixed.  Of the ten largest cities in the United States, African-Americans in Chicago rank seventh and Hispanics rank ninth in the percentage of adults with a college education.

The good news is that both the percentage and number of college-educated African-Americans and Hispanics in the city of Chicago has increased since 2010.  This is also the case for non-Hispanic whites and Asians. In Table 3, data are arrayed on the number and percentage of college graduates in the city of Chicago by race and ethnicity.  The data indicate that the largest gain in the number of college graduates was for non-Hispanic whites followed by Hispanics.  The largest relative gain was for Hispanics (over fifty percent) followed by Asians.  Overall, there was a 20% increase in the number of college graduates in the city of Chicago between 2010 and 2016.   Part of the increase is a result of growth in the number of non-Hispanic whites, Hispanics, and Asians in the city.  For the African-American population, growth in the number of college graduates cannot be attributed to population growth because the number of blacks in the city declined by ten percent during the 2010-2016 period.

In suburban areas, the story is different, as shown in Table 4.  For example, in suburban Cook County non-Hispanic whites are over twenty percentage points less likely to have a college degree than their counterparts in the city of Chicago.  Further, there has only been a one percent increase in the number of non-Hispanic whites with a college degree in the suburbs of Cook County. This is partly a result of a seven percent decline in the non-Hispanic white populations in suburban Cook County.  At the same time, there have been large increases in the number of African-American, Hispanic, and Asian college grads in suburban parts of Cook County.  For example, for the 2010-2016 period, the African-American population in suburban Cook County increased twelve percent.

Further, Chicago public schools that disproportionately serve African-American and Hispanic families have improved considerably. Over the past ten years, CPS high school graduation rates have increased from fifty-seven percent to seventy-four percent. Of high school graduates, a higher percentage are going to college. Test scores are up as well. Low-income students in Chicago outperform other low-income students in other districts in Illinois.  A Stanford study argues that CPS is the fastest-improving school district in the country.

It is worth noting that in the 1980s Secretary of Education Bennett called the Chicago public school system “the worst in the nation.”  Although it is not clear if that was ever the case, it certainly is not now.

Although there is good news on education, the evidence on income is more mixed.  This is partly a product of national trends over the past couple of decades.  For the city overall, median real household income increased three percent last year.  Since 2010, real income has increased close to eight percent  although there is substantial variation by race and ethnicity.  Non-Hispanic white income increased seven percent while Hispanic income increased almost ten percent.  Although household income in the African-American community increased this past year, it is almost five percent lower in real terms since 2010.  Over a longer period of time (since 1979) African-American income has declined even more (twenty-one percent) although non-Hispanic white income is up substantially (forty-three percent).

In the suburbs of Chicago, household income has also increased modestly (about three percent) this past year.  Over a longer period of time, non-Hispanic white income in the suburbs is about where it was at in 1979.  However, median household income for African-Americans in the suburbs has remained constant since about 1979.

Although education has increased in the city of Chicago relative to suburban Chicago, median household income in suburban areas is still significant higher than in the city of Chicago.  In 2016, household income in the city was eighty percent of median household income in the metropolitan area.  This is up two percentage points since 2010.

These changes have driven other important changes in Chicago.  On the positive side, the high concentration of talent in parts of the city is resulting in high skilled jobs following the talent, especially to areas in and around the central business district.  Further, more educated and affluent African-Americans and Hispanics have been able to move to suburban locations for better opportunities for their families.

On the negative side, the large and continued decline in income in the African-American community in many parts of the city of Chicago is cause for concern.  This is resulting in well over half of the children in community areas like Englewood and West Garfield Park growing up in poverty.  It is also resulting in large population declines in communities like Englewood and West Englewood.