Economic Commentaries

20

Federal Reserve Chair Yellen delivered an economic policy message in Cleveland, Ohio on Friday July 9, 2015. In response to a question about the labor market she answered that if she had to choose only one indicator, she would select the jobless rate for guidance on labor market conditions. We think this would be a poor choice. Indeed, in our view the jobless rate is one of the least informative measures of labor market conditions in this recovery period.

The jobless rate is measured as the ratio of the number of unemployed who are looking for work to the level of the civilian labor force. In the current recovery numbers of unemployed have remained high relative to past recoveries. But the labor force has defied nearly everyone’s expectation with its lack of growth. This can be attributed to the unusual and persistent pattern of declining labor force participation.

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Posted in: General
24

Economic policy is perplexed. The jobless rate and jobless claims are the lowest since before the “Great Recession”. Yet output growth is well below normal and most recently stalled. Wage growth is moribund while overall inflation flirts with the zero bound. In this circumstance the Federal; Reserve would like to begin normalizing the interest rate structure, but it continually finds itself conflicted.

But perhaps conditions are not as perplexing as analysts forecasts. In our Commentary dated 1/18/15 we laid out several reasons for why a fully employed jobless rate and wage growth may be significantly lower than the 6% then 5.5% and now 5% rate that the Federal Reserve and others assume. If so, then considerable labor slack still exists and is contributing to stubbornly low wage growth.

Real wages are not as depressed as nominal wages because inflation is so low. But the stubborn 2% rate of nominal wage growth comes despite recent increases in the minimum wage. On reason is that wages in the petroleum and other extractive industries is higher than the average and employment in these areas is being decimated by the energy, mining, and agricultural downturns.

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Posted in: General
12

With the exception of labor market indicators every economic activity measure has been weak over the past three months. This record changed with the March labor report which fell short of expectations along with downward revisions for prior months. Economic growth may only approximate 1% annually in the January – March quarter while inflation is at about the same rate. Thus, in the last six months nominal GDP growth would only be about 2% annually which is a step down from the already sluggish 4% growth track of the past several years.

While analysts tend to focus on real GDP growth, nominal GDP is a more telling indicator in a noninflationary environment because it is crucial to affecting business investment. Absent a price expectation combined with sluggish output growth, business has difficulty generating revenue growth. And without revenue growth there is a tendency to refurbish existing fixed assets rather than to invest in new facilities and more modern equipment.

Thus business capital goods orders have declined in each of the last five months with little indication of recovery. Indeed, given the downturn in the energy complex it may even worsen. Since November the active oil drill rig count has been halved to around 800 rigs and industry capital spending plans have taken about a 30% haircut. The rig count cold fall by another 200 units. And it is estimated that about 100 to 150 workers are affected by every rig that is put in mothballs.

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Posted in: General
30

The spring thaw is arriving late, but weather conditions did begin to normalize during March. For those, like most Federal Reserve officials, who believe harsh weather was primarily responsible for the economy’s sluggish pace over the past several months, this should be welcome. Indeed, evidence of a rebound in activity indicators is surfacing, but so far it is also spotty.

Data reports for March, which have been trickling in, have largely been disappointing. For example, market based purchasing managers measures were uniformly weak, remaining below 50 in China; below general expectations in Europe and the U.S. The Richmond Federal Reserve activity index was forecast to be positive but it was actually negative. And both New York and Philadelphia regional indexes showed recovery but to a level that was modest absolutely and disappointing relative to general expectations.

Reports on jobless claims have been more encouraging, falling from around 350K weekly during the polar vortex to around 325K weekly during March. Perhaps reflecting this consumer confidence measures rebounded in March. But rising confidence has not yet translated into stronger demand. Weekly retail sales gains were anemic in March, running at about the same 1.5% yearly rate that persisted in January and February. And mortgage demand has remained muted, matching data on pending home sales which fell for an eighth consecutive month in February.

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Posted in: General
20

The Federal Reserve’s open market committee meets this week amidst high expectations that it will affirm a move toward normalizing the interest rate structure at some point this summer. There are three reasons. First. The Fed is anxious to move off the zero bound because it believes there is no longer an economic emergency. Second, job growth is strong and the jobless rate is approximating what the Fed believes is the noninflationary fully employed rate. Third, the Fed seems convinced that inflation will move toward its 2% target relatively soon.

We are fully aware of the Fed’s anxiety. But we are less convinced of the timing than most financial market participants seem to be. Economic growth in the winter quarter is running between 1% and 2% annually with inflation at the same rate but with a minus sign in front of it. If so, this would be a second consecutive quarter wherein nominal GDP approximates zero.

To be sure, adverse weather and the L.A. port strike were disruptive. These should be less of a drag going forward and indeed a measurable rebound in activity should soon be evident. However, the downturn in the energy patch has not yet been fully reflected in economic data reports. This should blunt any perceived rebound and indeed many are beginning to be dissuaded of the notion that the energy downturn will be short lived.

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Posted in: General
24

The Federal Reserve’s open market committee met last week during a rather perilous time for the global economy. Global growth prospects have withered and amidst stagnation and deflation impulses Central Banks worldwide enacted new stimulus measures. The most notable was an aggressive asset purchase program from Europe. There were also reserve additions from China and interest rate cuts from India, Canada, and Denmark to name a few.

In this context the Fed’s FOMC unanimously agreed to remain patient in moving toward policy normalization. This implies no action until at least June. The FOMC acknowledged that inflation is well below its target and is likely to remain so. It also acknowledged the unsettled condition of global markets. But by stating that the U.S. is growing solidly, the FOMC evidently believes the U.S. remains an oasis of prosperity.

Supporting this belief, real GDP growth late last year was at a 2.6% annual rate. For all of 2014 a 2.4% growth rate was achieved which is actually a slight improvement from 2013. This is welcome news but policy should be predicated on what may lie ahead. We see some potential storm clouds.

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Posted in: General
29

2015

The consensus economic forecast for 2015 is one of solid but unspectacular economic growth. Broadly sketched, the consensus is for about 3.5% global GDP growth with China advancing by about 7% and Europe and Japan growing by about 1% respectively. U.S. real GDP growth is being pegged at slightly more than 3% with inflation at about 1.7%. The benchmark ten year Treasury rate is forecast to rise to over 3% in the coming year.

Our base case forecast is for less robust activity, lower inflation, and lower interest rates. We think U.S. nominal GDP growth will be less than 4% with real growth at about 2.4% and inflation at 1.3%. We would expect slightly faster growth in the year’s first half versus the second half assuming no significant externalities. We think the benchmark ten year treasury rate will be around 2.25% with a range of about 1.8% to 2.6% -- a full percentage point below the consensus. We do not expect the Federal Reserve to hike interest rates in 2015 and we expect the interest rate yield curve to continue flattening especially if the Fed were to hike rates as is the consensus forecast. Finally, we think the global economy will continue to struggle with global growth slightly below 3%.

This base case forecast has some noteworthy underlying assumptions. For starters we expect continued commodity price weakness while labor cost pressures remain nil and the dollar exchange rate remains strong although hopefully not too strong. We expect the Treasury budget deficit to continue falling and we expect quantitative easing from abroad. Thus, there will remain a relative shortage of sovereign debt instruments. Finally we are assuming that $75 is the new $100 for oil and that the full impact of reductions in industry capital spending will occur in the year’s second half.

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Posted in: General
19

In the midst of the Russian debt default and Asian financial crisis of 1998 then Fed Chairman Alan Greenspan asked rhetorically at a Jackson Hole symposium how long the U.S. could remain an oasis of prosperity. The answer was “not long” and during that fall the Fed eased credit. Now the same question looms as Europe slides closer to deflationary recession, parts of South America are in recession as is Russia, and measurable weakness is spreading across Asia.

From our perspective the current answer to that oasis question is again “not long” and from the latest FOMC notes a similar conclusion may be being reached. Yet the Fed is set to conclude its asset purchase program and debate within and outside the Fed is raging over the timing of raising short term interest rates. This debate seems wrongheaded.

Indeed, the spring-summer spurt in domestic activity is already showing signs of sputtering. The farm economy is in a recession. The equity performance of the cyclical airline and automotive sectors is poor relative to background indicators, suggesting weakness in the quality of demand. Housing construction and demand remain weak and evidence of a relapse in home prices is mounting as investor demand dries up and the first time homebuyer remains missing in action.

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Posted in: General
19

The Federal Reserve’s policy setting committee meets this week with some members becoming increasingly uncomfortable with the Fed’s deliberative stance. The FOMC will announce an end to its asset purchase program but beyond this we do not think the economy’s fundamentals support any other change.

There are at least five reasons in our view. First economic activity weakness and geopolitical pressures are widespread outside the United States. Asian economic activity is wobbly, and Europe is dangerously close to recession/deflation with east European military confrontation adding to this climate. The Fed does not typically like to rock the boat during such periods. And besides, these pressures have benefited the dollar exchange rate which is thus a de facto tightening of U.S. monetary policy.

Second, in the U.S. the government has extorted nearly $100 billion from the shareholders of mortgage lenders during a period when loan growth has been difficult to achieve. Now the Fed is voicing support for increasing capital requirements on major institutions beyond those demanded under international banking regulations. This is a de facto tightening of monetary policy.

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Posted in: General
19

Were it not for nagging geopolitical tensions, Fed Chair Janet Yellen’s upcoming policy discourse at the Kansas City Fed’s annual séance would be uppermost in the market’s mind. Her speech is to be delivered at the Jackson Hole, WY. Conference this Friday.

We are not expecting new policy initiatives. Rather we think Janet will reaffirm the Fed’s intention to end its asset purchase program this fall. She is likely to highlight the improving condition of the labor market while emphasizing that more healing needs to occur. She may also take a victory lap on inflation as recent market concern about an acceleration is proving alarmist. Finally, we think the Fed Chair will emphasize that the Fed’s course of future action will be cautious and deliberate.

We doubt any of this would stop analysts from speculating on the timing of future rate hikes. However, we think this speculation is wrong headed and could precipitate a policy mistake. Specifically it is important that over the past several months the yield spread between two and ten year treasury notes has narrowed by more than one-half percentage point. This yield curve flattening has occurred as short rates have edged up while long rates have fallen amidst low inflation, economic weakness abroad, and diminishing supply. Were the Fed to begin raising short rates in this environment a further narrowing of the yield differential would likely occur as markets anticipate even more sluggish activity ahead.

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Posted in: General
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