November 2018 Small Business Optimism: Declined But Remains Historically High

Report Commentary:

The general consensus among forecasters is that the fourth quarter will be solid but slower. Growth appears to have peaked early this year and will slow as we move into 2019. There are a number of reasons, primarily structural, for a slowdown including a lack of qualified workers to fill open positions and a low rate of labor force growth. The Congressional Budget Office calculates our potential GDP and its prospective growth path annually. In simple terms, potential growth (with no inflation) is determined by labor force growth and productivity growth. The dramatic decline in investment and labor force growth in 2008 and in the following years significantly altered the potential growth of the economy and its potential growth path. Each year that actual GDP was below its future potential GDP growth shrunk, as capital spending did not add enough to capacity and the labor force participation rate fell. Thus, although our GDP growth finally caught up with potential growth in early 2018, it was at a much lower level of potential growth (see chart, thanks Prof., Lew Spellman, Univ. of Texas).

So, we are at "full employment" now, but at a lower growth level of GDP than was possible in 2007 or subsequent years because capacity shrunk due to low investment and labor force growth. Based on current estimates for labor force growth and productivity improvement (technology and investment), our future growth will be constrained to be lower than in the pre- 2008 period.

Spending (supported by increased government outlays, tax cuts, reduced regulatory costs, a lower saving rate, and solid employment gains) has eliminated excess capacity and now growth depends on increasing labor force participation and productivity gains through training and investment in new capital. Reports of unfilled job openings and few qualified job applicants are at record levels. Owners report raising compensation at record rates to attract new workers. While all of this helps, it will not be sufficient to restore potential growth quickly to higher paths that were eliminated by slow growth in 2008-2016. Small business employs about half of the private workforce, so investment and training in that sector is critical to improving overall worker productivity over the next five years. In the meantime, continued spending demand will put pressure on capacity and prices, keeping the Federal Reserve ready to raise interest rates to try to keep demand from outstripping our capacity to produce which would produce more inflation.

Some other highlights of this Optimism Index include:

General Summary. Small business optimism slightly dipped in November. The Index declined 2.6 points to 104.8 with more than half the decline attributable to Expected Business Conditions and Expected Real Sales. The November reading continues the string of exceptionally strong readings that started with the 2016 election results. Labor markets remain extremely tight, with a record 25 percent of owners identifying the scarcity of qualified (not just "skilled") labor as their top business problem. Capital spending and job creation plans improved. Job openings gained 6 points, although inventory investment plans faded. Expected real sales and expected business conditions six months out did fall 7 and 5 points respectively, and the percent viewing the current period as a good time to expand lost 1 point. On balance, optimism faded modestly in November, but the decline seems unrelated to the election.

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