Seeking a Goldilocks scenario for industry growth

We have heard a lot of talk about the impact the newly passed tax legislation will have on the U.S. economy this year. I think it is fair to describe the vast majority of this talk as a lot of hype and a lot of hope.

It took a couple of months, but all this talk has triggered my instinctive contrarian alarm.

I still believe the tax code changes will provide a medium-term tailwind to the U.S. manufacturing sector, and the plastics industry will benefit. But a tailwind is not the same as an engine that drives the economy.

The manufacturing sector was gradually gaining momentum before the new tax law, and it will continue to gain gradual momentum in 2018. But the overall effect of the new tax laws will be moderate.

Therefore, my latest forecast calls for a moderate gain of no more than 5 percent in total U.S. demand for plastics machinery in 2018 when compared with last year. And lest you think this is somewhat pessimistic given all the hoopla coming out of Washington, let me say that this level of growth represents the Goldilocks scenario. It is a pace of expansion that keeps the industry on an upward trajectory, but it is not so fast that it sows the seeds of a major recession in the market soon thereafter.

According to Bureau of Economic Analysis, U.S. spending for industrial equipment in the fourth quarter of 2017 increased by 7 percent when compared with the same quarter from 2016. Spending for plastics machinery is a small subset of this category. For all of 2017, this indicator was also up 7 percent from 2016. The forecast for spending for industrial equipment calls for an inflation-adjusted rise of 4 percent in 2018.

During the past two years, the slope in the graph indicates this data experienced the fastest pace of growth since immediately after the last recession. This pace was also above the long-term average for this data.

An acceleration like this is usually an indication we are in the late stages of the business cycle, and it is usually not sustainable for more than a year or two. I am optimistic the upward slope will continue this year because our economy and our manufacturing sector have suffered from chronic under-investment for a generation. But I expect the slope will moderate this year.

My research shows that accelerating investment for plastics machinery depends on a sustained rate of growth of 3-4 percent in the output levels of plastics products. And the capacity utilization rate for the industry needs to get to a level of 84-86 percent.

Right now, the pace of growth in output of plastics products is slowly accelerating, but it is still below 2 percent per year. The capacity utilization rate for the industry is only about 81 percent.

So a rise in demand for plastics machinery this year of 5 percent is a good outcome. For anybody hoping for more exciting growth rates this year, I say this: The short-term gain would cause long-term pain.

The problems with escalating rates of growth become evident immediately if a particular industry, or the economy overall, starts to overheat. You have heard that expansions don't die of old age. They die because high levels of confidence eventually turn into overconfidence, and overconfidence causes mistakes. Investors start to speculate excessively, real estate developers overbuild, businesses take on too much debt, and households overextend themselves. This process has preceded every recession in recent decades, and it will likely be the process that precedes the next recession.

The rhetoric coming out of Washington regarding GDP growth greater than 3 percent per year is necessary for political purposes, but it is not necessarily a good idea. This talk is fueled by the fact that the recent tax cuts will result in a significant increase in the federal budget deficit that will only be offset if economic growth exceeds 3 percent per year.

The problem with this scenario is that economic growth in excess of 3 percent is faster than the long-term potential for the U.S. economy. Roughly speaking, a country's long-term potential is the rate of population growth added to the rate of productivity growth.

For many years the rate of U.S. population growth has been well below 1 percent per year. It is more difficult to measure the rate of growth in productivity, but since the end of the last recession, official measures of productivity gains have also been below 1 percent per year.

This gives us a long-term potential rate of 2 percent per year. There just has not been enough investment during the past decade to push productivity rates higher. Whether it is infrastructure, capital equipment or workforce development, all have suffered in recent years from underinvestment.

So growth that exceeds 2 percent creates a high risk of unacceptably high rates of inflation. If this happens, the Federal Reserve Board will raise interest rates more quickly than currently planned to slow the economy.

The difference between an economy's long-term potential rate and one that is higher is called the "output gap." Economies can run for a while with an output gap, but not forever. Historical data suggests that three years is about as long as an overheating economy can go. After that, it enters a recession.

This economy functioned for eight years growing by 2 percent per year without causing any signs of overheating. Time will tell whether we can sustain a higher rate of growth.

The United States may be able to spur productivity growth in the coming months to a level that will sustain 3 percent growth. But business owners and managers should pay close attention to the inflation data this year and not get blindly caught up in any euphoria that may potentially be created by faster economic expansion.