Economic Outlook 2014: Hopes for big step forward

The economy abounds with hopeful signs as the new year arrives, enough that the Federal Reserve will begin to put its easy-money punch bowl on a higher shelf by trimming its bond purchases this month. But after five years of crisis, recession and an aren't-we-there-yet recovery, we don't fully trust the signs.

And that's why Mesirow Financial economist Diane Swonk sums up the outlook in a nutshell:

"2014 could be the breakout year,'' she says. "This is the year when we're going to find out.''

Find out what?

• Whether young adults who have put off forming households finally move out of Mom and Dad's, giving housing construction a needed boost.

• Whether the economy can really grow at an annual pace of 3% to 3.5%, generating 250,000 jobs a month and pushing unemployment to near 6% of the workforce, once freed of the drag from higher federal taxes and spending cuts that depressed 2012 and much of 2013.

• Whether the torpor of the last few years, in other words, was simply a bad hangover from an especially nasty, debt-fueled recession — or whether the economy has entered a sluggish New Normal, where 2% to 2.5% annual growth and a 7%-ish unemployment rate are as good as it gets.

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For the first time in years, forecasters got the U.S. economy basically right in 2013. The consensus outlook said the private economy would grow 3% or more, while a shrinking government would cut as much as 1.5 percentage points off growth, either directly or indirectly, leaving the overall economy growing 2% or so.

That's what has largely happened, at least until a fall surge in spending and hiring raised hopes before the final numbers are calculated.

November data were better-than-expected across the board, with hiring and retail sales beating forecasts and unemployment dropping to 7.0% for the first time in five years. And! a big upward revision in data on the economy's third-quarter growth, announced Dec. 20, to 4.1%, suggests the push began sooner.

The optimism, as always, is qualified. The bull case depends on a sustained upturn in housing, as prices that are rising, if more slowly than in early 2013, spur significantly more construction to match the ongoing surge in auto sales. That's an especially big factor in the South, where half of new homes are built. But to get there requires better wage gains to support home payments and consumer confidence as interest rates rise to more normal levels — and those wage gains have only recently begun.

Here are four reasons to expect growth to pick up — and four more to worry that it won't.

1. The housing recovery seems real this time.

The top reason the recovery feels different this year is that housing is on more solid footing. The big question is, exactly how solid is it?

The biggest missing gap in the job market is that construction employment is down 1.9 million from 2007, including 1.4 million in home building and related categories. With total private-sector employment only about 700,000 below the peak — and manufacturing output back to setting all-time highs — the importance of housing is clear.

2014 forecasts for housing starts run from just under 1 million to as high as 1.35 million, up from about 950,000 in 2013. Moody's Analytics estimates each extra start is worth about 4.5 jobs, though rival consulting firm IHS says it's closer to three (Moody's includes more of the workers in ancillary industries, such as home-improvement stores). A housing market near the high end of forecasts could generate a million new jobs, pushing unemployment down by 0.7 of a percentage point or more.

2. State and local governments have healed.

One of the biggest changes in 2013 was that state and local governments went from firing people to hiring again, adding 127,000 workers through November on a base of about 19 million. That's! because ! their spending turned slightly higher in the second and third quarter, the first two-quarter gain since the recession. Coming out of the last three recessions, state and local governments added 150,000 to 200,000 jobs a year, on a smaller base.

The state and local government recovery has room to grow more. Outgoing Fed Chairman Ben Bernanke pointed to one reason in his final press conference Dec. 18 — in the last three recessions or their immediate aftermath, government employment actually rose. This time, governments have shed about 1.1 million workers since 2010.

3. Falling energy prices and slower increases in health care costs are keeping inflation low.

The collapse in medical inflation since 2007, and the containment of total health spending it helps to enable, is one of the best things the economy has going for it. Medical inflation is at a 50-year low, with prices rising just 2.2% in the last 12 months. With the most important cost-containment measures in the Affordable Care Act just beginning to be implemented, it stands to stay low. That lessens a key cost pressure on businesses — and may free up more money to pay higher wages. Also, energy prices have fallen 4.8% in the last year, the government says, helping both household budgets and corporate income statements.

4. Washington has shut up — mostly.

Economist Joel Naroff's favorite political joke is that "the only thing we have to fear is Washington itself.'' And Washington's actions did cut growth nearly in half in 2013 by many estimates. But budget cuts coming this year are much smaller, shrunk even farther by the budget deal reached in December that reworked automatic spending cuts mandated by a 2011 law. Plus, no major tax increases are planned. Compared with 2013, less Washington drag on the economy could mean an additional percentage point or more in growth.

Four reasons why the economy won't break out:

1. Washington is not that good — and we still have the debt ceiling.

Federal! spending! cuts will still shave a few tenths of a point off GDP growth this year — reducing the growth rate about 0.3 percentage points, Naroff said. The main risk from D.C. early in 2014 is that there may be another showdown over the debt ceiling. House Budget Committee Chairman Paul Ryan said Republicans want concessions for raising the borrowing limit before March — but haven't decided what.

2. Capital investment is low.

Growth in spending on business equipment, the category of investment most closely tied to boosting productivity, plunged to near zero by the third quarter from a double-digit pace in 2010 and 2011, helping to fuel a $2.2 trillion "investment gap,'' of money not spent since 2007, according to the Progressive Policy Institute. Next year, it's expected to grow just 3.1%, the Equipment Leasing & Finance Foundation says. That's versus double-digit percentage gains in 2010 and 2011.

This problem may evaporate by the second half of the year, especially if consumer spending sustains its recent pickup into early 2014, Goldman Sachs economist Jan Hatzius argues. Historically, capital spending has depended on consumer spending and credit availability — and both are improving, he says.

3. Interest rates will rise this year, which may slow the housing recovery.

As the Federal Reserve reduces and eventually ends its $85 billion of monthly bond purchases, mortgage rates are likely to rise — just as they did in the summer, when the Fed first hinted at the so-called "taper.'' In 2013, that blip caused momentum in the housing recovery to stall briefly.

With the average rate for 30-year mortgages now 4.48%, up from 4.1% in late October, and the National Association of Realtors projecting that they will rise another percentage point next year, it's too soon to know whether higher rates will slow the hoped-for construction boom. New-home sales and construction data from the fall suggest not. But it's a risk that bears watching.

4. Wage growth is still tepid! , and a r! ecent improvement is not well-established.

After a long decline, wages and personal income have turned higher in late 2013. The hope is that workers will get better raises as unemployment falls toward 6%. But the average gain in the last 12 months is just 2% — enough to offset the expiration of the payroll tax holiday last January, but no more than that.

If employers keep the upper hand in wage talks, that hurts consumer spending and home buying — and risks another year of sluggish growth. Goldman's Hatzius says consumer spending can sustain its recent gains with inflation-adjusted wage gains around 2%, because rising household wealth and an improving jobs market let consumers save less without taking a risk.

If wages rise faster, that would be the icing on the cake, Hatzius says. Higher wages and more plentiful jobs might also prove key to people forming more households, buying more homes, and even having more babies and spending more on diapers and clothes, Swonk said. The recession and its aftermath didn't just change how people shopped — it changed how they lived, she said. A lot depends on whether young people who have struggled to build careers and begin families amid the post-2008 mess move on with their lives, she says.

We'll find out beginning this week.