Friday, 14 of December of 2018

Economics. Explained.  

The Year Ahead – 2019

December 14, 2018

Stock market jitters are making investors nervous.  We understand why.  The expansion is approaching its 10-year anniversary which makes it geriatric.  GDP growth overseas has slowed.   Home sales have been shrinking steadily for a year.  However, we believe the stock market’s fears are overblown.

For 2019 we expect:

  1. GDP growth of 2.8%.
  2. Inflation should be steady with the core CPI rising 2.3%.
  3. The Fed will boost the funds rate twice in 2019 to 2.75%.
  4. The stock market should reach a new record high level.
  5. Sustained rapid growth in investment spending will quicken productivity and boost the economy’s speed limit to 2.8% by the end of this decade.
  6. This expansion will not end in the foreseeable future.

To forecast GDP growth, we break it down into its major components – consumer spending, investment, trade, and government spending.

Consumer spending, which is about two-thirds of the GDP, is likely to grow 2.6% in 2019.   While the stock market has fluctuated wildly for two months consumer confidence has been unfazed.  Why?

Jobs.  The economy continues to crank out 190 thousand new jobs per month.  Job creation generates the income that allows us to spend.

Some economists note that consumer debt has climbed to a record high level.

But consumer income has also risen and, as a result, debt in relation to income is near a record low level.  Consumers are not saddled with excessive debt.

If we were, delinquency rates should have begun to climb.  That has not happened.

Bottom line – look for consumer spending to grow 2.6% in 2019.  Remember, consumers account for two-thirds of  GDP.

The  housing market has declined steadily throughout year.  While disquieting, we had a similar drop in 2014.  Ex Fed Chair Bernanke said that the Fed planned to slow its purchases of its U.S. Treasury bonds.  The markets panicked.  Long-term interest rates spiked and home sales got crushed.  But eventually reality sank in and sales rebounded.  We expected something like that to happen again.

Is the recent decline attributable to a drop-off in demand?  Or is it a supply constraint?  We argue it is primarily the latter.

The National Association of Realtors )NAR) reports that there is currently a 4.3-month supply of homes available for sale and that a 6.0-month supply is necessary for supply and demand to be in balance.  Hence, there is a considerable shortage of homes available for sale.  Realtors cannot sell what is not for sale.  If enough homeowners were to put their houses on the market so that there was 6.0-month supply, sales would be 5.8-6.0 million versus 5.2 million currently. Thus, the problem is largely a supply constraint.

Some economists contend that the combo of rising home prices and higher mortgage rates has made housing unaffordable.  That is not true for most potential home buyers.  The NAR publishes a housing affordability index which includes prices, mortgage rates, and consumer income which has been rising steadily.  This index tells us that consumers have 45% more income than is necessary to purchase a median-priced home.  In 2007 that same number was 14%.  Housing was expensive at that time.  That is not the case today.

On the demand side, the average length of time between listing a home and its sale is 33 days.  In 2011 the comparable figure was 95-100 days.  Clearly the demand for housing remains robust.

For builders the primary constraint seems to be a labor shortage.  They cannot find an adequate supply of workers.  That puts a lid on how many homes than can produce.  Our sense is that housing will climb about 4.0% next year, but that is not fast enough to alleviate the extensive housing shortage.

Investment spending is another 15% of the GDP pie.  Business confidence is soaring.  That is true for manufacturers, non-manufacturing firms, small businesses, and big businesses.  Small business confidence is particularly noteworthy since it has reached a 35-year high.  Why?  The tax cuts.  All measures of confidence surged immediately after the November 2016 election.  The combination of tax cuts, repatriation of overseas earnings at a favorable tax rate, and the elimination of unnecessary, overlapping, and confusing regulations has buoyed business optimism.

That confidence has, in turn, stimulated investment spending which surged in the first quarter of 2017 and continues to this day. While some economists suggest this is a short-term development triggered by the tax cuts, we do not share that view.  A reduced tax rate and further deregulation will spur investment spending for years to come.  Also, the 3.7% unemployment rate is the lowest in 50 years.  Labor shortages are extensive.  If firms cannot hire an adequate number of new workers, they might contemplate spending money on technology to make the company’s existing workers more productive.  This will provide further stimulus for investment.  Thus, we expect investment spending to grow 6.5% for the next several years.

Trade has gotten lots of attention recently.  All economists support the notion of free trade.  All countries benefit.  But free trade is not fair trade.  Not all countries play by the rules.  Some cheat.  The primary culprit is China which does not respect intellectual property rights, steals trade secrets, and forces companies who want to do business in China to share their technology.  The object of the trade negotiations is to encourage China to reform.

But Trump initially said he was concerned about the size of the trade deficit and wanted to shrink it.   To that end, he imposed steel and aluminum tariffs on our neighbors, friends, and allies as well as China.  They retaliated.  Suddenly a trade war was underway.

While all countries lose as the result of a trade war, not all countries lose equally.  As investors scoured the globe to find which countries might fare best in a trade war, their answer was the U.S.  After all, trade only represents about 10% of the U.S. economy, versus about 50% elsewhere.  As a result, money has poured into the U.S. stock and bond markets since January.  The dollar has climbed 9%.  Tariffs imposed by other countries will reduce growth of U.S. exports, but the flood of money into the U.S. by foreign firms  who start new businesses here and hire American workers will limit the damage.

That is not the case for emerging economies.  They generally import the raw materials required by their manufacturing sector.  But those commodities are all traded in dollars.  When the dollar rises, their cost of goods sold increases.  It becomes more difficult for them to compete in the global marketplace.  As a result, their currencies decline.  Their stock markets plunge.  Indeed, the emerging markets stock index has fallen 23% since February.  Slower GDP growth lies ahead.  In October the IMF lowered its projection of 2019 GDP growth for emerging economies by 0.3%.  Growth in China should slip to 6.5% this year, the slowest rate of expansion since 1990 with even slower growth expected in the years ahead.  This slower pace of growth outside U.S. borders – China in particular – is one factor weighing on the U.S. stock market.

As growth  prospects dim for these countries and the pain intensifies, there is increasing pressure on their leaders to strike a trade deal with the U.S.  Thus far that has happened with Mexico and Canada.  A deal with Europe seems close.  China not so much.  But if Trump broadens and further raises tariffs on Chinese goods at the end of this year the pressure on both sides will intensify.  We believe that by spring the U.S. and China will reach an agreement with both sides claiming victory.

Unfortunately, previously imposed tariffs on U.S. goods by China and other countries will reduce growth in U.S. exports, cause the trade gap to widen, and the trade component will subtract about 0.2% from U.S. GDP growth in 2019.

When we combine these GDP components, we come up with projected GDP growth for 2019 of 2.8%.

Our GDP forecast for the next several years differs from others because we expect rapid investment spending to continue for years, which will boost productivity growth and, eventually, raise our economic speed limit to 2.8%.  Most other economists expect investment growth to fade soon and potential growth to remain at 1.8%.

Nobody knows exactly what the economy’s potential growth rate is, but we estimate it by adding the growth rate of the labor force to growth in productivity.  If we know how many people are working and how efficient they are, we should be able to estimate how many goods and services they can produce.  In the 1990’s potential growth was believed to be 3.5%, consisting of 1.5% growth in the labor force and 2.0% growth in productivity.  The economy grew at that rate for a decade and we concluded that in the good times the economy should grow by at least 3.0%.  But in recent years potential growth rate has slipped to 1.8%.  The baby boomers are retiring, and labor force growth has slipped to 0.8%.  Productivity growth has  faded to 1.0% following a growth spurt triggered by the introduction of the internet in the mid-1990’s and the cloud and apps in the early 2000’s.

While GDP growth of 1.8% is disappointing, it does not have to remain there forever.  But to increase it we need to boost either growth in the labor force or growth in productivity.  Labor force growth is unlikely to accelerate because the baby boomers will continue to retire for another decade.  Fortunately, productivity growth is determined to a large extent by growth in investment.  Our bet is that sustained rapid growth in investment will boost productivity growth from 1.0% in recent years to 2.0%, and the economy’s potential growth rate will climb from 1.8% to 2.8%.  That means that the economy can grow at a steady 2.8% pace without triggering an upswing in inflation.

We estimate that the core inflation rate will edge upwards from 2.2% this year to 2.3% in 2019.

There are components, like housing, that will put upward pressure on the inflation rate.  Rents, which represent about one-third of the entire CPI index are growing by 3.3% which reflects the shortage of rental units.

But there are two factors that have kept inflation in check which are not widely discussed.

First, is the role of technology.  Whenever we buy anything, we shop first on Amazon and can find the lowest price anywhere in the world.  As a result, goods-producing firms in the U.S. have absolutely no pricing power.  In the past year prices of goods have risen  0.2%.  Prices of services have risen 2.9%.  This means that inflation is virtually non-existent for one-third of the economy.

Second, productivity growth is countering most of the faster growth in wages.  Given the tight labor market wage growth has accelerated from 2.0% to 3.0%.  Most economists worry that this will cause an upswing in inflation.  But they are looking at the wrong thing.  If employers pay their workers 3.0% higher wages because they are 3.0% more productive, they don’t care.  They are getting 3.0% more output and have no incentive to raise prices.  Workers have earned their fatter paychecks.  Thus, we are supposed to look at “unit labor costs” which are labor costs adjusted for the increase in productivity.  In the past year unit labor costs have risen 0.9%.  The Fed has a 2.0% inflation target.  As a result, the seemingly tight labor market is not putting upward pressure on the inflation rate.  If productivity continues to climb, it will help to keep the inflation rate in check.

If in 2019 we end up with 2.8% GDP growth and inflation is relatively steady at 2.3%, the Fed will be cautious about further rate hikes.  For years the Fed thought that a “neutral” funds rate was about 3.0%.  But recent speeches by Fed governors make it clear that the Fed is rethinking that objective and may lower it to 2.75%.  Given that the funds rate currently is 2.2%, that implies only two rate hikes in 2019.  The Fed is getting close to where it wants to be.

When will the expansion end?  We do not know, but probably not before 2022.  We want to see two things to happen before we call for a recession.

  1. The funds rate should be at least 5.0%.
  2. The yield curve must invert, meaning that short rates are higher than long rates.

We have found that the U.S. economy has never gone into recession until the funds rate has been above the 5.0% mark.  If the Fed raises the funds rate to 2.75% by the end of next year and leaves it there, a 5.0% funds rate will not happen for the foreseeable future.

We have also found that when the yield curve (which we define as the difference between the yield on the 10-year note and the funds rate) inverts, a recession follows within a year.  Today the 10-year note is 3.0%, the funds rate 2.2%, so the yield curve has a positive slope of 0.8%.  By the end of next year, we expect the funds rate to be 2.75% and the yield on the 10-year note to  be 3.4%.  The curve will have a positive spread of 0.65%.  By the end of 2019 (and for 2020 and 2021), we expect neither of our preconditions for recession to be met.   For this reason, we believe the expansion will continue at least until 2022.

We have described a very positive scenario.  Potential GDP growth rises from 1.8% to 2.8%.  Inflation remains steady at 2.3%.  The Fed raises rates only twice more and the funds rate peaks at 2.75%.  The stock market will climb to a record high level during 2019.  But for this to happen, investment spending must continue to grow rapidly, and productivity must sustain a 2.0% pace.

Stephen Slifer


Charleston, S.C.

GDP, Inflation, and Interest Rate Forecasts

December 14, 2018

The first look at GDP growth in the third quarter and the first revision came in at 3.5% which compares to second quarter GDP growth of 4.2%.  We expect GDP to rise 3.1% this year and 2.8% in 2019.

Consumer spending rose 3.6% in the third quarter after having risen 3.8% in the second quarter.  We expect it to rise 2.6% in 2019.  The consumer and corporate tax cuts should lift the stock market to yet another record high level by yearend.  Stock prices should rebound which will boost household wealth.  The gains in employment are generating income which gives consumers the ability to spend.  Consumer debt is very low in relation to income.  Consumer confidence is at an 18-year high.  Interest rates  are rising very slowly but remain low.

Investment spending took a breather and slowed to 2.5% in the third quarter after having climbed 8.7% in the second quarter.  Investment spending was essentially unchanged for 2014-2016.  It appears that the corporate tax cuts, repatriation of earnings at a favorable tax rate, and a reduction in the regulatory burden are giving business leaders confidence to open their wallets and spend on new equipment and technology.  Not only will this boost GDP growth in the short term, if investment continues to climb it will boost productivity growth which will, in turn, raise the economic speed limit from about 1.8% today to 2.8% or so by the end of this decade.

The trade gap widened by $105 billion in the third quarter to -$945.8 billion after having narrowed by $61.4 billion in the second quarter.  This means that the trade component subtracted 1.9% from GDP growth in the third quarter after having added 1.4% to GDP growth in the second quarter.  We expect the trade component to subtract 0.2% from  GDP growth in 2019.

Nonfarm inventories surged by $86.6 billion in the third quarter after having declined $36.8 billion in the second quarter. Going forward we expect inventories to climb by about $75 billion per quarter.

Expect GDP growth of 3.1% in 2018 and 2.8% in 2019.

The inflation rate should be fairly steady in 2019.  There is a shortage of available homes and apartments in the housing sector which is raising rents.  That will put upward pressure on the inflation rate.  However, the pickup in inflation will be limited as internet price shopping will keep goods prices steady in 2019.  At the same time, rising productivity growth will offset much of the increase in wages.  As a result, we expect the core CPI to edge upwards from  2.2% this year to 2.3% in 2019.

With GDP growth at 2.8% and inflation relatively steady at 2.3%, the Fed may tighten only twice in 2019 which would raise the funds rate to 2.75% by the end of that year which seems to be the Fed’s new level for the “neutral rate”.

With a couple of Fed rate  hikes next year and fairly steady inflation, long-term interest rates should rise slightly in 2019 with the 10-year climbing from  3.0% at the end of this year to 3.4% in 2019.  Mortgage rates should climb from 4.9% at the end of this year to 5.1% by the end of 2019.

Stephen Slifer


Charleston, SC


Industrial Production

December 14, 2018

Industrial production jumped 0.6%  in November after having declined 0.2% in October.   During the past year industrial production has risen 3.9%.  So despite monthly wiggles, production continues to trend upwards.

Breaking industrial production down into its three major sub-components,  the Fed indicated that manufacturing production (which represents 75% of the index) was unchanged in November after having declined 0.1% in October.  During the past year  factory output has risen 2.0% (red line, right scale).   The factory sector has cooled in the past two months but the slowdown is expected to be temporary.

Mining (14%) output rose 1.7% in November after having fallen 0.7% in October.  Over the past year mining production has risen 13.2%.  Most of the recent upturn in mining has been concentrated in oil and gas drilling activity.  Oil and gas drilling rose 0.1% in November after having jumped 1.6% in October.     Over the course of the past year oil and gas well drilling has risen 19.7%.

Utilities output jumped jumped 3.3% in November as unusually cold weather boosted the need for heating.  Utility output rose 0.2% in October..  During the past year utility output has risen 4.3%.

Production of high tech equipment surged by 1.6% in November after having declined 0.3% in October.  Over the past year high tech has risen 7.5%.  Thus, the high tech sector sector appears to be expanding nicely. This is an indication that nonresidential investment is continuing to climb which is, in turn, a signal of renewed growth in productivity.

Capacity utilization in the manufacturing sector fell 0.1% in November to 75.7%.  It remains below the 77.4% level that is generally regarded as effective peak capacity.  However, factory owners will soon have to spend more money on technology and re-furbishing or expanding their assembly lines to boost output.

Stephen Slifer


Charleston, SC

Retail Sales

December 14, 2018

Retail sales rose 0.2% in November after having jumped 1.1%  in October.  Over the  past year retail sales have risen a solid 4.2%.

Sometimes sales can be distorted by changes in autos and gasoline which tend to be quite volatile.  In this particular instance car sales rose 0.2% in November.  Gasoline sales declined 2.3%.  Changes in gas prices  impact the overall change in sales, but they typically do not reflect any significant change in the volume of gasoline sold.

Perhaps the best indicator of the trend in sales is retail sales excluding the volatile motor vehicles and gasoline categories.  Such sales rose 0.5% in November after having risen 0.7% in October.   In the last year retail sales excluding cars and gasoline have risen a solid 4.5%.

While there has been a lot of disappointment about earnings in the traditional brick and mortar establishments  the reality is that they need to develop a better business model.  The action these days is in non-store sales which have been growing rapidly. Consumers like the ease of purchasing items on line.  While sales at traditional brick and mortar general merchandise stores have risen 3.6% in the past year, on-line sales have risen 11.7%.  As a result, their share of total sales has been rising steadily and now stands at a record 11.7% of all retail sales.

We believe that retail sales will continue to chug along at a 2.6% pace for some time to come.   First, all measures of consumer confidence are at their highest levels in a decade despite the stock market selloff.

As long as the economy continues to crank out 190 thousand jobs a month, consumer income will continue to climb.

Real disposable income is currently climbing at a solid 2.8% pace which is roughly in line with its 25-year average growth of 2.7%.

If the Fed keeps raising rates very slowly consumers will be able to continue to borrow at a reasonable rate.  At 4.9% mortgage rates are well below the 6.25% average over the past 25 years.

In addition, consumers have paid down a ton of debt and debt to income ratios are very low.  That means that consumers have the ability to spend more freely and boost their debt levels if they so choose.

Thus, the pace of consumer spending seems steady.  We continue to expect GDP growth to rise 2.8% in 2019 after having climbed 3.1% this year.

Stephen Slifer


Charleston, SC

Corporate Leverage

December 13, 2018

Economists like to keep an eye on the amount of leverage amongst corporations.  When corporations take on huge amounts of debt in relation to their net worth, any economic downturn will be much more severe than it would otherwise be as corporations become unable to service their debt from cash flow.  However, in the third quarter of 2018 the ratio of corporate nonfinancial debt  to net worth was 37.9%.  This compares to an average ratio of debt to net worth since 1980 of 40.3%. There is no reason to think that the economy is at risk from excessive corporate borrowing.

Stephen Slifer


Charleston, S.C.


S&P 500 Stock Prices

December 13 2018

The S&P has fallen 9.5% after reaching a peak of 2,929 in mid-September.   The market appears to be concerned about a variety of factors.  The expansion is approaching its tenth anniversary which is geriatric, so some fear that the end of the expansion must be close.  It sees growth weakening overseas, particularly in China which is the world’s second largest economy.  It fears a trade war.  And it has seen the housing market fall steadily for most of the year.   The stock market is a leading economic indicator and when the economy is actually beginning to weaken the stock market will be one of the first places that slowdown becomes evident.  But, as they say, the stock market has predicted 10 of the past 3 recessions.  More often than not stock market gyrations are meaningless.  So which is it this time?  Our bet is that we are experiencing stock market noise.  The economic fundamentals in our view remain solid.

With respect to the Fed it is raising rates not to slow down the pace of economic activity but simply to get the funds rate back to a :neutral” level at which it is neither stimulating the economy nor trying to slow its down.  Currently the funds rate is 2.2%.  For years the Fed has believed that a neutral rate was about 3.0%.  Recent speeches by Fed officials suggest that it is rethinking the neutral rate and perhaps lowering it to 2.75%.  We should know more when it meets in mid-December.  Even if it eventually raises the funds rate to the 3.0% mark, the U.S. economy has never gone into recession unless the funds rate was 5.0% or higher.  It is not even close.  As a result, we suggest that the expansion will not end until 2021 at the earliest.

Trump initiated a trade war in February of this year by imposing tariffs on aluminum and steel.  Other countries retaliated.  Trump up-ed the ante by broadening the list of goods subject to tariffs.  A trade war was underway.  As investors around the globe tried to figure out which country might be in the best position to withstand a trade war, they concluded that country would be the U.S. primarily because trade is only 10% of our economy versus 50% or so elsewhere.  Investors flooded into the U.S. stock and bond markets.  The dollar has risen 9% since January.

The rising dollar has crushed emerging economies.  They purchase raw materials for their manufacturing sector.  But those commodities are all traded in dollars.  Hence, a rising dollar implies that their cost of goods sold has risen and they are less able to compete in the global market place.  As a result, their currencies have fallen.  Their stock markets have fallen 20-25% since January and slower growth does lie ahead.  In the case of China, the IMF expects 6.5% growth this year which would be the slowest growth rate since 1990 with even slower growth ahead in 2019 and 2020.  As growth in all emerging and developing countries has slowed, their leaders have sought trade deals with the U.S. to alleviate the pain.  So far deals have been negotiated with Mexico and Canada.  Europe seems close.  China is still a holdout, but if Trump applies tariffs to additional products and raises existing tariffs at the end of this year, our guess is that the pain will be so great that by spring the U.S. and China will reach some sort of accord.  Both will claim victory.  And the global outlook will not look so gloomy.

In any event, the tariffs imposed on U.S. goods should reduce GDP growth in the U.S. by just 0.2% in 2019.  Not exactly something the stock market should be too alarmed about.

Further, we believe the tax cuts and deregulation will boost investment spending for years to come.  That will in turn translate into faster growth in productivity. And that will raise our economic speed limit from 1.8% or so a couple of years ago to 2.8% by the end of the decade.

Finally, the housing market has slowed steadily throughout the year.  But the National Association of Realtors suggests that there is only a 4.3 month supply of homes available for sale.  Demand and supply are in balance when there is a 6.0 month supply of homes available.  If more homeowners put their houses up for sales existing home sales would be 5.8-6.0 million rather than the current 5.2 million.  The problem with housing is a supply constraint rather than a dropoff in demand.

We are well aware of the concerns being voiced by the stock market, but our conclusion is that it is nothing more than the usual stock market noise.

Stephen Slifer


Charleston, SC

Corporate Cash

December 13, 2018

Corporate cash holdings rose $49 billion in the third quarter to $2.62 trillion (above).  At 9.1% they are a shade lower than their long-run average of 9.4% of non-financial assets (below).  The problem with this series is that every time the Fed adds data for a new quarter, the history of the series going back for years will also change, and the relationship between corporate cash and financial assets will get revised.   It is hard to make any meaningful analysis when a series is subject to sizable revisions.

Stephen Slifer


Charleston, SC

Initial Unemployment Claims

December 13, 2018

Initial unemployment claims fell 27 thousand in the week of December 8 to 206 thousand.  The 4-week moving average fell 4 thousand to 225 thousand.  The lowest level for this series in the cycle was set back in mid-September at 206 thousand.  It obviously remains close to that level.  That, in turn, was the lowest level since December 6, 1969 when it was 205 thousand.

As one might expect there is a fairly close inverse relationship between initial unemployment claims and payroll employment.  With initial claims (the red line on the chart below, using the inverted scale on the right) at 225 thousand  we would expect monthly  payroll employment gains to exceed 300 thousand.  However, employers today are having difficulty finding qualified workers.  As a result, job gains are significantly smaller than this long-term relationship suggests and are currently about 190 thousand.

With the economy essentially at full employment, employers will have steadily increasing difficulty getting the number of workers that they need.  As a result, they might choose to offer some of their part time workers full time positions.  But this series is exactly where it was going into the recession so they will have limited success in finding necessary workers from this source.

They will also have to think about hiring  some of our youth (ages 16-24 years) .  But the September level for the youth unemployment rate today was the lowest on record (for a series that goes back to 1970) so there are not many younger workers available for hire.

Finally, employers may also consider some workers who have been unemployed for an extended period of time.  But these workers do not seem to have the skills necessary for today’s work place.  Employers may have to offer some on-the-job training programs for  those whose skills may have gotten a bit rusty.  But even if they do, the reality is that the number of discouraged workers today is quite low — it is essentially where it was going into the recession.

The number of people receiving unemployment benefits rose 25 thousand  in the week ending December 1 to 1,661 thousand.  The 4-week moving average declined 2 thousand to 1,666 thousand.  This series hit a low of 1,635 thousand in late October.  The only way the unemployment rate can decline is if actual GDP growth exceeds potential.  Right now the economy is climbing by about 2.8%; potential growth has probably picked up from 1.8% previously to perhaps 2.3% today given faster growth in productivity.  Thus, going forward  the unemployment rate should continue to decline slowly.

Stephen Slifer


Charleston, SC

Gasoline Prices

December 12 2018

Gasoline prices at the retail level fell $0.03 in the week ending December 10 to $2.42 per gallon.  In South Carolina gasoline prices tend to about $0.25 below the national average or about $2.17. The Department of Energy expects national gasoline prices to average $2.50 in 2019.

Spot prices for gasoline have fallen sharply in recent weeks primarily because of the decline in crude prices.

The selloff in the stock market that began in October pushed oil prices lower.  Investors believed that higher short- and long-term interest rates would slow the pace of economic activity and, hence, reduce the demand for oil.  More recently  oil production around the globe has surged in response to higher prices and prices  have sunk to $52 per barrel.

U.S. production, for example,  has surged from 10,900 thousand barrels to 11,600 thousand barrels per day in just a few weeks.  Saudi Arabia has also increased its production.

The Department of Energy expects U.S. production to average 10.9 million barrels this year and climb 10% further to 12.1 million barrels in 2019.  This means that the U.S. became the world’s largest oil producer in March of this year and the gap between U.S. production and that of Russia, and Saudi Arabia will widen in 2019.

There is so much oil currently flooding the market that oil inventories have risen rapidly.    However, at 1,092 million barrels crude inventories are still somewhat lower the 5-year average of 1,116 million barrels so one can hardly characterize this as an oil glut.  It is, however, a sign that currently supply continues to exceed demand.

The wild cards right now are production levels for Venezuela and Iran.  Venezuela’s oil output has been falling steadily for the past couple of years and is showing no sign of recovering.  Iran is different.  The Iran sanctions went into effect in early November.  Iranian production has not fallen too sharply yet, but the U.S.’s  goal is to reduce exports (and, hence, production) close to zero.  Thus, as we go forward Iranian output could fall sharply and counter much of the recent oversupply.  OPEC claims it has ample reserves to offset any Iranian shortfall, but its surplus equipment is old and has not been used in some time so we will see.

Stephen Slifer


Charleston, SC*

Consumer Price Index

December 12, 2018

The CPI was unchanged in November after having risen 0.3% in October.  During the past year the CPI has risen 2.2%.

Food prices rose 0.2% in November after having declined 0.1% in October.  Food prices have risen 1.4% in the past twelve months.

Energy prices fell 2.2% in November after having jumped 2.4% in October.  These prices are always volatile on a month-to-month basis.   Over the past year energy prices have risen 3.2%.    Oil prices will probably fall another 2.0% in December.

The recent drop in energy prices is  partly related to a drop-off in demand outside the U.S., principally in China.  It also reflects a huge jump in U.S. oil production combined with an increase in Saudi output which was designed to counter the reduction in oil exports from Iran caused by the U.S.-imposed sanctions.  On balance the world is now awash in oil and prices have fallen 30% or so from $76 in early October to their current level of about $52.

Excluding food and energy the CPI rose  0.2% in both October and November.  Over the past year this so-called core rate of inflation has risen 2.2%.  We expect the core CPI will rise 2.2% in 2018 and 2.3% in 2019.

The most interesting development in the CPI in recent years has been the dichotomy between the prices of goods (excluding the volatile food and energy components) and services.  For example, in the past year prices for goods have risen 0.2% while prices for services have risen 2.9%.

With respect to goods prices, it appears that the internet has played a big role in reducing the prices of many goods.  Shoppers can instantly check the price of any particular item across a wide array of online and brick and mortar stores.  If merchants do not match the lowest price available, they risk losing the sale.  Thus, they are constantly competing with the lowest price available on the internet.  Looking at specific items in the CPI we find that prices have been unchanged for almost every major category in the past year.  New cars have risen 0.3%, televisions have declined 18.2%, audio equipment has dropped 8.6%,  toys have fallen 10.4%, information technology commodities (personal computers, software, and telephones) have declined 5.5%.  Prices for all of these items are widely available on the internet and can be used as bargaining chips with traditional brick and mortar retailers.

In sharp contrast prices of most services have risen.  Specifically, prices of services have risen 2.9% in the past year.  The increase in this  broad category has been led by shelter costs which have climbed 3.3%.  This undoubtedly reflects the shortages of both rental properties and homeowner occupied housing. Indeed, the vacancy rate for rental property is at a 30-year low. This steady rise in the cost of shelter  will continue for some time to come and, unlike monthly blips in food or energy, it is unlikely to reverse itself any time soon.

The CPI, both overall and the core rate, will have an upward bias  in the months ahead because of what has been happening to shelter prices, gradually rising labor costs, and rising producer prices.  But on the flip side, the internet is keeping a lid on the prices of goods.  We look for an increase in the core CPI of 2.2% in 2018 and 2.3% in 2019.

The Fed’s preferred measure of inflation is not the CPI, but rather the personal consumption expenditures deflator, specifically the PCE deflator excluding the volatile food and energy components which is currently expanding at a 1.8% rate.  We expect it to climb 2.2% in 2019.  The Fed has a 2.0% inflation target.  However, going forward we have to watch out for the further increases in shelter which, as noted above, is being pushed higher by the shortage of both rental properties and homeowner-occupied housing.   Shelter is a long-lasting problem and given its 33% weighting in the CPI it will introduce an upward bias to inflation for some time to come.  Also,  higher wages triggered by the shortages of available workers in the labor market could also put upward pressure on the inflation rate unless (as we expect) most  of that upward pressure is countered by gains in productivity.

Why the difference between the CPI and the personal consumption expenditures deflator?  The CPI is a pure measure of inflation.  It measures changes in prices of a fixed basket of goods and services each month.

The personal consumption expenditures deflator is a weighted measure of inflation.  If consumers feel less wealthy in some month and decide to purchase inexpensive margarine instead of pricey butter, a weighted measure of inflation will give more weight to the lower priced good and, all other things being unchanged, will actually register a decline in that month.  Thus, what the deflator measures is a combination of both changes in prices and changes in consumer behavior.

As we see it, inflation is a measure of price change (the CPI).  It is not a mixture of price changes and changes in consumer behavior (the PCE deflator).  The core PCE should increase 1.9% in 2018 and 2.2% in 2019.  That compares to the Fed’s targeted rate of 2.0%.

Keep in mind that real short-term interest rates are negative.  With the funds rate today at 2.0% and the year-over-year increase in the CPI at 2.2% the “real” or inflation-adjusted funds rate is negative 0.2%.  Over the past 57 years that “real” rate has averaged about plus 1.0% which should be regarded as a “neutral” real rate.  Given a likely pickup in GDP growth this year and next and a gradual increase in the inflation rate, we regard a negative real interest rate inappropriate in today’s world.  The Fed should continue to push rates somewhat higher and gradually run off some of its longer term securities.

Stephen Slifer


Charleston, SC