All posts by Thomas Walstrum

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.

Early Fall Review—Economic Conditions Continued to Be Good in the Seventh District

Summary: We now have data for the Seventh District economy for the early fall, and they largely indicate that the nice run of good growth in the District continued. As has been the case throughout the year, the manufacturing sector was the driving force behind the good conditions—solid global growth and a revival in the U.S. energy sector continued to support important industries, such as steel, fabricated metals, and heavy machinery. In addition, national auto sales were quite good in September and October after a difficult summer. Outside of manufacturing, most sectors continued to experience slow but steady growth.

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

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