Monday, 25 of March of 2019

Economics. Explained.  

Category » Commentary for the Week

Did the Fed Overreact?

March 22, 2019

In January Fed Chair Powell signaled that Fed policy would be on hold for a while.  Most economists thought that meant no rate hike through midyear, but with two rate hikes possible in the second half the funds rate would reach 2.9% by yearend.  On Wednesday the Fed said it expects the funds rate to remain at its current level of 2.4% through yearend.  What happened?

At the press conference Powell talked about slowing job growth, weaker than expected retail sales, investment falling short of last year’s pace, and sluggish growth in Europe and China.  The Fed seems to believe that the economic impact from these factors will be relatively long lasting.  As a consequence, it trimmed its 2019 GDP forecast from 2.3% to 2.1%.  Maybe the Fed is right, but we envision a more temporary slowdown.  Following 1.5% GDP growth in the first quarter, we expect growth of 3.0%, 2.8%, and 2.9% in the final three quarters of the year.  As a result, we anticipate growth of 2.6% in 2019 versus the Fed’s 2.1%.  While we may be too optimistic, it is just as likely that the Fed is too pessimistic.

We attribute most of the December and January drop-off to the precipitous 20% decline in the stock market, the Fed’s rate hike in December combined with an expectation of two additional rate increases in 2019, compounded by the negative impact on growth associated with the government shutdown.

But the stock market is now within 3.0% of erasing its fourth quarter drop and reaching a new record high level.

Consumer sentiment has bounced back sharply.  Job gains in the past three months have averaged 186 thousand which should boost income and permit consumers to spend at about a 2.5% pace this year.

The Institute for Supply Management indexes of activity for manufacturing and non-manufacturing firms have slipped from their previous lofty levels but are consistent with GDP growth in excess of 3.0%. Mortgage rates have fallen 0.5% since the end of last year to 4.4%.  And in April there is a good chance that the U.S. and China will come to some sort of a trade agreement which would remove yet another obstacle to both U.S. and global GDP growth.

Thus, we think there is a plausible case that as the year progresses GDP will register relatively vigorous 2.6% growth for the year and the core CPI inflation rate will climb to 2.3%.  The Fed expects core inflation of 2.0%.  Could this combination of faster-than-expected GDP growth and more-rapid-than-anticipated inflation cause the Fed to regroup and raise rates by yearend?  No.

Fed Chair Powell talked at some length about inflation having consistently fallen short of the Fed’s 2.0% target.   “That gives us the ability to be patient and not move until we see that our target goals are being achieved.”  That suggests that, if anything, the Fed may welcome a period of inflation that is somewhat above target.  Thus, it is very difficult to envision the funds rate above its current 2.4% pace by the end of this year regardless of who is right.  The Fed envisions one rate hike in 2020 which would boost the funds rate to 2.6% with no change in rates thereafter

No one knows exactly what constitutes a “neutral” funds rate.  For years the Fed believed it was about 3.0% because over the past 50 years, through numerous Fed tightening and easing cycles, the funds rate averaged 1.0% higher than the inflation rate.  For its policy to be “neutral” the Fed believed it should put the funds rate 1.0% above its 2.0% inflation target, or 3.0%.

But more recently estimates of the “neutral” rate have been falling.  In the last 30 years the “real” funds rate has averaged 0.5%, which could mean that for Fed policy to be “neutral” it should put the funds rate 0.5% above its 2.0% inflation target, or 2.5%.  The Fed currently believes the neutral rate is in a range from 2.5-3.0% with median estimate of 2.8%.

But consider the following.  At the end of 2021 the Fed expects the funds rate to be 2.6%.  This means that for the next 2-3/4 years the funds will remain below its estimated neutral level of 2.8%.  We have said many times in the past and will say once again — the U.S. economy has never, ever, gone into recession until such time as the funds rate has risen well above its neutral level.  The Fed’s action this past Wednesday lowered the trajectory of the funds rate by 0.5% for the next three years, and during that period of time it may never rise to its neutral level.  If previously one danger for the U.S. economy was that the Fed might tighten too much and put the economy in a tailspin, that fear is now completely off the table.   As we see it, the economy has clear sailing for years to come.

But what about the yield curve? It has flattened considerably and could be in danger of “inverting” with short rates becoming higher than long rates.  An inverted yield curve is, in fact, a good harbinger of recession.  With the yield on the 10-year note currently at 2.55% and the funds rate at 2.4%, the yield curve has a positive slope of just 0.15%.  It is close to inverting.  But in the past three business cycles the curve inverted by 0.7-1.0%.  Today it still has a positive slope of 0.15%.  That is a long way above the levels of inversion that occurred prior to the previous three business cycles.  Furthermore, once inverted a recession did not occur for at least another year.  So do not fret about the flatness of the yield curve.  It is not flashing a warning signal.  If the economy grows as quickly as we expect for the balance of this year and inflation edges upwards, our sense is that the yield curve will steepen somewhat to perhaps 0.3% by yearend.

Some have suggested that by taking two rate hikes off the table the Fed sees a substantial growth slowdown or perhaps even a recession next year.  Rubbish.  The Fed still envisions 2.1% GDP growth this year, 1.9% in 2020, and 1.8% in 2021.  It also believes potential GDP growth is 1.8%.  Thus, the Fed sees healthy growth for as far as it can see.  We agree.  Our forecast is for even more robust growth.  Rest easy. All is well.

Stephen Slifer


Charleston, S.C.

Second Half Rate Hikes Harder to Justify

March 15, 2019

It is clear that first quarter GDP growth will be relatively anemic.  We have reduced our forecast from 1.8% to 1.5%.  Some economists anticipate even softer growth of perhaps 0.5%.  However, the stock market selloff and the government shutdown have taken a toll on first quarter growth and it will certainly rebound. January was clearly a weak month and we are all guessing about February and March.  Nobody knows exactly how vigorous the upswing will be.

As an example of the current confusion consider retail sales which fell 1.6% in December amidst the stock market debacle.  That was perhaps no great surprise.  Economists expected a relatively significant rebound in January but, instead, sales rose just 0.2% in that month.  However, the January sales data were in the midst of the protracted federal government shutdown and followed the earlier sharp stock market decline which clearly biased the data downwards.  Sales will continue to climb, but by exactly how much?

Home sales fell 6.2% in January.  But, at the same time, Census revised upwards sharply the pace of sales for November and December.  As a result, the 3-month average for sales appears to have hit bottom in October.  Is the housing sector now on an upward trajectory?

Payroll employment for February rose by an anemic-looking 20 thousand.  But sales in the previous two months were surprisingly robust with gains of 227 thousand and 311 thousand, respectively.   The 3-month average increase of 186 thousand is very much in line with the other recent months.

As we look at these data, we conclude that the trend rate has not changed a lot.  However, the economic tea leaves indicate clearly that first quarter growth will be soft.  Is our 1.5% projected growth rate accurate?  Or could it be more like 0.5%.  As additional data are received, we will get a better sense of what that growth rate will be.  The combination of the stock market drop and the government shutdown have muddied the waters sufficiently that nobody can be certain exactly what the trend rate of GDP growth is at the moment.

Meanwhile, both actual inflation readings and inflation expectations have been inching their way lower.  For example, the core CPI for January rose 0.1% after having risen 0.2% in each of the previous five months.  As a measure of inflation expectations, we look at the spread between the nominal yield on the 10-year note and the comparable inflation-adjusted yield.  It has fallen in recent months from 2.1% to 1.9%.  As a result, the Fed’s intent to raise rates twice in the second half of the year seems unlikely.  It all depends on the magnitude of the rebound in growth, and whether that pushes inflation and inflation expectations higher.  We will have to see.

While two second half rate hikes seem unlikely at the moment, the second half of the year is still months away.  If the economy bounces back vigorously, actual inflation might inch its way higher and expectations might also climb.  Given that scenario one or even two rate hikes could still be in the cards.

But if the rebound falls a bit short of what we are expecting and inflation expectations remain stable, the yield on the 10-year note might remain at its current level of 2.6%.  If that is the case, there is absolutely no way the Fed would consider a rate hike at midyear.  That is because the yield curve – the different between long-term and short-term interest rates — would be likely to invert.  If the yield on the 10-year remains at 2.6% and the funds rate is 2.4% the yield curve would be 0.2%.  A a rate hike or two by the Fed would push short rates higher, lift them above long rates, and cause the yield curve to invert.  An inverted curve is a harbinger of an impending recession.  The Fed will not do anything that could knowingly jeopardize the expansion.  So, depending on the combination of GDP growth and inflation in the months ahead, it is possible that the Fed keeps rates on hold through yearend and perhaps beyond.  We will have to wait and see how all this falls out.

Stephen Slifer


Charleston, S.C.

Trade Tantrum

March 8, 2019

The latest piece of news to rattle the market was the revelation that the trade deficit for goods widened to a record $900 billion last year.  We believe that the focus on the magnitude of the trade deficit is misplaced.

First of all, we strongly believe that trade is good.  When countries trade with each other there is a wider variety of goods and services available at lower prices than there would be in the absence of trade.  Both countries win.  A trade deficit simply means that one country bought more goods from other countries than those countries bought from it.  Thus, trade deficits are not necessarily bad.  The problem with trade is that all countries do not play by the same rules.  Some countries cheat.  The Chinese, for example, steal trade secrets, they do not respect copyright or patent laws, and they require foreign firms that want to do business in China to share their technology.  Furthermore, the yawning trade gap perhaps indicates that current trade agreements like NAFTA, as well trade agreements with Europe and Japan, were not well negotiated and allowed other countries to take advantage of the U.S.    One can make a case that the U.S. has been subsiding growth in other countries at its own expense for years.  So, while the magnitude of the trade deficit is not a concern, there are fairness issues that must be addressed.

The trade deficit for goods widened to a record $900 billion in 2018.  But so what?  The wider deficit reflects the fact that our economy was growing faster than others and, as a result, imports rose sharply.  It also means that foreigners now have $900 billion dollars to invest in the U.S.  Those foreign firms could start businesses here, hire American workers, and/or invest in our stock and bond markets.  What is so bad about that?

Trade is a relatively small segment of the U.S. economy and accounts for a mere 10% of GDP.  Thus, the rather impressive widening of the trade gap last year subtracted a mere 0.2% from GDP growth.  It is hard to conclude that the wider trade gap had any major negative impact on the U.S. economy.

Nevertheless, Trump initiated a trade war because he was concerned about the size of the trade deficit.  His goal was to shrink the trade deficit and bring back jobs to the U.S.  But nearly one-half of the U.S. trade deficit is with one country — China.  We do not have a trade deficit problem with Canada, Mexico, Europe, Japan, or OPEC.  Just China. If Trump was truly concerned about the magnitude of the trade deficit, we believe that he should have targeted those countries where the trade gap is largest.

But Trump didn’t do that.  He chose to impose tariffs across the board which impacted our neighbors, friends and allies alike.  Not surprisingly, the imposition of tariffs by the U.S. generated retaliation by many other countries and a trade war was underway.

While trade is a relatively small portion of the U.S. economy, it is roughly 50% elsewhere.  Once the trade war began, investors scoured the globe to figure out which country might perform best.  The answer they came up was the U.S. because trade is such a small part of the U.S. economy.  As a result, money flowed into the U.S. stock and bond markets and the dollar jumped 10% last year.

There are no winners in a trade war.  Everybody loses.  But not everybody loses equally.  GDP growth in the U.S. was reduced by about 0.2% last year.   But given that trade plays a major role in everybody else’s economy their growth rates have been reduced more sharply.  In the past six months, for example, the IMF has cut its forecast for growth in emerging economies this year by 0.5%.  Growth rates for developed countries have also been negatively impacted.  Given that growth rates everywhere around the globe are slowing, their currencies are weakening, and their stock markets have declined, the pain of tariffs is intense.  As a result, many countries are rushing to complete trade deals with the U.S.  New deals have already happened with Mexico and Canada.  Deals with the E.U. and the U.K. seem to be relatively close although Brexit may delay their completion.  A deal with China seems imminent.  We expect to see all of these deals completed soon simply because it is in the best interest of both sides.  If that happens, we could end up with freer trade and a more level playing field that what we had initially.  The process was ugly, and it may not have been the optimal way to achieve the goal but, in our view, progress was made.  If as part of those negotiations there is an agreement for other countries to purchase more U.S. products, the trade deficit may well shrink in the months and quarters ahead.

Sit back.  Breathe.  The world did not end just because the trade deficit widened to a record level last year.

Stephen Slifer


Charleston, S.C.

Approaching a Record – With Room to Run

March 1, 2019

In four short months this expansion will go into the history books as the longest expansion on record and surpass the previous record holder which was the decade of the 1990’s.  While that is a remarkable achievement, it is equally important to look ahead for danger signals that could bring about an early end to the current expansion.

From the mid 1859’s through early 1900’s the average business cycle consisted of two years of expansion (27 months) followed by two years of recession (22 months).  Up.  Down.  Every two years. But then along came the Federal Reserve in 1913 and expansions have steadily grown longer and recessions shorter.  Today the average expansion lasts 6-1/2 years (77 months) while recessions are only 1 year in duration (11 months).

It turns out that the four longest expansions on record – with data going back to the civil war — have all occurred since 1960.  The 1960’s, the 1980’s, the 1990’s, and now 2009 to date.  That is not an accident.  The Fed has progressively gotten better at managing the economy.  Still, it is not perfect.  There will always be recessions.  But over the years the Fed’s policy decisions have made recessions both less frequent and shorter in duration.

It is accurate to say that every expansion grinds to a halt because the Fed raised rates to the point where, eventually, the economy goes over the edge.  But it is also true that in each case the trigger for the Fed’s action was some factor that was pushing the inflation rate higher.  Because the Fed’s job is to keep the inflation rate from spiraling out of control, it must take away the punch bowl just as the party gets going.  To accomplish that it raises interest rates to both cool off the economy and bring the inflation rate back into alignment with its 2.0% target.  Thus, the Fed becomes the catalyst for every recession, but it is not the underlying cause.

The current expansion will reach a milestone of 120 months in June and go into the history books as the longest expansion on record.  Because there are still no signs that it is about to crack it will blow through that previous record not by months but by years. What are some of the underlying causes of recessions, and how do they look today?

A sharp rise in oil prices caused several recessions in U.S. history.  Back in the early 1970’s, for example, OPEC countries imposed an oil embargo targeted at nations that supported Israel during the Yom Kippur war.  Oil prices surged from $3 per barrel to $12.  In the late 1970’s the Iranian Revolution reduced the global supply of oil, panic followed, and oil prices more than doubled from $14 per barrel to $39.  Recessions followed in both cases.

Could a sharp rise in oil prices produce an untimely end to the current expansion?  Not likely.  Shale drilling in the past seven years has produced a dramatic increase in U.S. oil production.  In fact, today the U.S. has surpassed both Russia and Saudi Arabia and become the world’s largest producer of crude oil.    OPEC does not have the stranglehold on prices that it did when it was the dominant player in the 1970’s.

While OPEC countries would love for crude prices to climb from their current level of $55 or so to $85-90 per barrel that is not going to happen.  The moment oil prices rise by any significant amount U.S. producers will step in quickly to boost production, alleviate the shortfall, and stem the increase in prices.

In the early 2000’s the housing market got overheated.  Congress encouraged mortgage lenders to be less stringent in their requirements for lower income borrowers.  Adjustable rate mortgages became fashionable.  As a result, lenders made loans to a whole group of individuals that should probably never have become homeowners in the first place.  Home prices rose dramatically, and housing became unaffordable for many.  The quality of bank loans declined.  Consumers became very highly leveraged.  But none of those factors are evident today.

As credit became widely available and rates rose consumers became progressively more leveraged.  Their monthly debt service payments as a percent of income climbed to a record high level.  In the wake of the recession consumers paid down tons of debt and, as a result, debt payments in relation to income are the lowest they have been since the 1980’s.

As a new group of first-time home buyers entered the market and rates rose, housing became unaffordable.  At the onset of the 2008-09 recession potential home buyers had just 14% more income than was required to purchase a median-priced home.  Housing was very expensive and unaffordable a decade ago.  Today consumers have 50% more income than necessary.  Housing remains affordable for most home buyers.

The Fed began to raise rates between 2004-2007 and adjustable rate mortgages re-priced upwards.   Many consumers began to struggle and got behind on their payments for mortgages, auto loans, and credit card bills.  But there is no evidence of that difficulty today.

Meanwhile, banks were actively encouraged to seek out less qualified borrowers.  Presumably every American had the right to own their own home.  As banks reached to expand their mortgage portfolio, less than 25% of borrowers had a credit score above 760.  But mortgage lenders today are far choosier and almost 60% of borrowers have excellent credit ratings.  It is hard to make a case that banks are repeating their earlier bad behavior.

In the wake of the financial market crisis that occurred during the recession regulators have forced banks to increase their equity holdings which today are more than double what they were going into the recession, and leverage ratios are 40% lower today than they were at that time.

The point is that in July the current expansion will become the longest expansion on record and, as always, it is prudent to see if there are imbalances in the economy that might lead to trouble down the road.  We do not seem them.  As a result, we suggest that the current expansion will last at least another couple of years.

Stephen Slifer


Charleston, S.C,

Housing – Poised for a Modest Rebound

February 22, 2019

The housing slump continues.  Existing home sales have been falling steadily for a year.  Why?  Is the slide attributable to a drop-off in demand?  Or does it reflect some sort of a supply constraint?  We think it is primarily the latter.

The National Association of Realtors indicates that there is a 3.9-month supply of homes available for sale, but a 6.0-month supply is required for demand and supply to be in balance.  Thus, there is a significant shortage of homes on the market.

It may be more instructive to look at the actual number of homes available for sale rather than the month’s supply.  Viewed in those terms we find that the number of homes available for sale has been falling steadily for a decade.  Given that real estate agents cannot sell what is not on the market, it is no wonder that home sales are anemic!

Suppose for a moment that thousands of us suddenly decide to sell and the available supply jumps to 6.0 months.  Would those additional homes be sold?  Probably.  At 3.9 months there is a shortage of homes available for sale; at 6.0 months demand and supply are in balance.  Presumably those additional homes would get sold quickly.

What would home sales become with a 6.0-month supply?  With almost 900 thousand additional homes available, home sales would quickly jump almost 20% to 5,800 thousand.  With sales of that magnitude we would not be talking about “weakness” in the housing sector.  Thus, the primary culprit underlying the seemingly troublesome slide in home sales is the dramatic drop in the number of homes available for sale.

Why aren’t more homeowner’s selling their homes?  Higher mortgage rates could mean that some potential sellers are “rate-locked”.  There is little incentive for baby-boomers to downsize, for example, when the monthly payments on a somewhat smaller home are not much less than what they are paying currently.

Furthermore, with available homes in short supply some existing homeowners may have little motivation to sell for fear that they will be unable to find a new home that meets their needs.

What about the demand for housing?  Has the combo of higher home prices and higher mortgage rates made housing unaffordable?  No.

Home prices have been rising steadily.  A year ago, prices were rising at a steamy 6.3% pace.  But in recent months – perhaps because of the reduced pace of sales — home prices have risen more slowly.  In the past year prices have risen 4.3%.  In the past six months the rate of increase has slipped to 3.2%.

Mortgage rates reached a low of 3.5% in early 2016.  They peaked at 5.0% in November.  As the stock market plunged and many economists began to fear a recession later this year or in 2020, mortgage rates retreated by 0.5% to 4.5%.

But there is a third piece of the housing affordability triangle that the economic naysayers have chosen to overlook.  Income.  In the past year disposable income has risen by an impressive 4.8%.  Consumers can afford higher home prices and mortgage rates.

The National Association of Realtors compiles a monthly index of housing affordability which includes all three factors that affect affordability – home prices, mortgage rates, and consumer income.  As home prices and mortgage rates climbed in recent years, housing became progressively less affordable.  While less affordable than it once was, did it become unaffordable?  No.  In the days leading up to the 2008-09 recession consumers had just 14% more income than required to purchase a median-priced home.  Housing was very expensive at that time.  In recent months as home prices have risen more slowly and mortgage rates have declined consumers now have 50% more income than required.  Insufficient income is not a constraint for most buyers.

Keep in mind, too, that on average home sits on the market today for just 49 days.  Indeed, 38% of the homes listed in January sold within a month.  A few years ago, it took 3-4 months to sell a home.  That suggests that even with the earlier run up in home prices and higher mortgage rates the demand for homes remains robust.

The recent slower rate of increase in home prices and lower mortgage rates should help, but don’t expect a dramatic pickup in either sales or starts. Large numbers of homeowners are not suddenly going to put their homes on the market.  And builders will be unable to find a treasure chest of currently unemployed construction workers to hire.  So, while home sales and housing starts will rise, look for moderate gains in both.

Stephen Slifer


Charleston, S.C.

A Sharp – But Temporary — Growth Slowdown

February 15, 2019

Many economic statistics for December and January were delayed by the government shutdown.  As those reports have become available, we discovered that the economy was considerably weaker at the end of last year than had been anticipated.  But keep in mind that the stock market experienced a 20% selloff that began in October, the Fed raised rates in mid-December, and the government shutdown began on December 22.  While economists expected some economic softness as a result of these factors, recent data indicate that the slowdown was far more pronounced than expected. However, the stock market has already reversed most of its earlier drop, the Fed has pledged to keep rates steady for the foreseeable future, and the government shutdown has now ended.  Thus, it is a virtual certainty that the December/January economic slump will be largely reversed in the months ahead.

Without question the biggest surprise in recent statistics is that retail sales plunged 1.2% in December.  That was the largest single-month decline since the end of the recession.  Furthermore, the drop was widespread with virtually every category of sales contributing to the decline.  Clearly, the stock drop, the expectation for further rate hikes, and the first few days of the government shutdown produced a much larger-than-expected drop-off in sales.  But despite the surprisingly large December decline we believe that retail sales and the pace of economic activity in general will rebound in the months ahead for a variety of reasons.

Consumer sentiment.  Sentiment was hit hard in January.  But the seven point drop in that month was partially offset by a 4.3-point increase in early February.  Furthermore, the University of Michigan indicated that at the time of the most recent survey there was still a lingering threat of a second government shutdown which, of course, did not happen.  Thus, sentiment should complete its recovery in March or April.

Stock market.  The stock market selloff that began in October contributed significantly to the decline in confidence.  The S&P 500 index fell 20% from its October high through mid-December as the prospect of further Fed rate hikes, a widening trade war, and a looming federal government shutdown frightened investors.  That combo produced the biggest stock market selloff since the recession.  While most economists believed the selloff would prove to be moderate, the magnitude of the decline and its extreme volatility raised concerns that a recession might be in the cards late this year or in 2020.  Subsequent events have made it clear that those earlier fears were exaggerated and, as a result, the stock market has recovered two-thirds of its earlier losses and is now only about 6% below its prior peak.  So, what changed?

The Fed.  Perhaps the biggest change is with respect to the Fed.  It raised the funds rate by one-quarter point at its meeting in mid-December and indicated that some further gradual increases in the target range for the federal funds rate would be required.  Market participants feared that the Fed was ignoring reality, could raise rates too much, and perhaps trigger an unintended early end to the expansion.  However, subsequent speeches by Fed Chair Powell have made it clear that while additional rate hikes could be necessary at some point, the Fed intends to leave rates unchanged for the foreseeable future.  The tone of his recent remarks was completely different from the policy statement made in December and became the catalyst for the recent upswing in stock prices.

Mortgage rates.  As the stock market fell in the fourth quarter economists began to fear a sharp slowdown in the pace of economic activity in the months ahead.  Such a growth slowdown would eliminate upward pressure on the inflation rate and, as a result, long-term, interest rates began to decline.  The 30-year mortgage rate, for example, has fallen 0.5% in the past six weeks from a peak of 4.9% to 4.4% which is where it was a year ago prior to much of the recent weakness in the housing market.  That should re-invigorate home sales in the months ahead although the lack of supply will continue to curtail the rebound.

Jobs.  Finally, keep in mind that monthly job gains are steady at a rate of 200 thousand per month.  Continued increases in employment of that magnitude will generate income and provide the fuel to grease consumer spending in the months ahead.

The bottom line is that the lack of timely data shrouded the extent to which the economy took a hit late last year and in the early part of this year.  But, given that all the factors contributing to the slide have been largely reversed, our sense is that the trend rate of economic activity has not changed much if at all.  We continue to expect 2.7% GDP growth for this year although first quarter growth could slip to the 1.9% mark.

Stephen Slifer


Charleston, S.C.

$1.0 Trillion Deficits Looming for Years to Come

February 8, 2019

The Congressional Budget Office (CBO) recently released its annual budget forecasts for the next decade.  While marginally smaller than projections made in the spring of last year, it anticipates deficits that grow steadily and exceed $1.0 trillion each year beginning in 2022.  Given this string of consecutive deficits, Treasury debt outstanding is projected to climb and reach 93% of GDP in 2029 which would be its highest level since just after World War II.  Budget forecasts are always tricky because of both economic uncertainty and future legislative action, but it is hard to imagine anything other than a steadily deteriorating fiscal situation for years to come.

The CBO anticipates a budget deficit of roughly $900 billion for 2019 and 2020 but the deficits then exceed $1.0 trillion each year beginning in 2021.

Economists typically look at budget deficits as a percent of GDP.  Over the forecast period the projected deficits average about 4.5% of GDP.  The only other times the deficit has been so large were immediately after World War II and in the wake of the 2007-2009 recession.  Over the past 50 years the budget deficit has averaged 3.0% of GDP which most economists regard as being sustainable.  Unfortunately, 4.5% is not 3.0%.

Whenever the federal government incurs a deficit, the U.S. Treasury must issue an equivalent amount of debt to finance that shortfall.  This means that over the next decade Treasury debt outstanding will increase by roughly $1.0 trillion every single year.  As a result, debt as a percent of GDP will climb from 78% today to 93% of GDP by 2029 which is its highest level since just after World War II.  Worse yet, with the aging of the population the debt to GDP ratio could easily reach 150% of GDP by 2049 — far higher than it has ever been.  Economists suggest that a debt to GDP ratio above 90% is dangerous because foreign and domestic investors will become reluctant to purchase Treasury debt without a significant increase in interest rates to guard against the possibility of default.  To further put this number in perspective, consider the fact that Greece’s debt/GDP ratio is currently 175% of GDP.  It is abundantly clear that the U.S. fiscal position is headed in the wrong direction for the foreseeable future.

What is causing these outsized deficits?  Too little revenue?  Or too much spending?

On the revenue side, the steady growth in projected federal tax revenues is fueled by continued economic growth.  Growth generates income which, in turn, boosts individual income tax receipts.  The CBO anticipates that tax revenue will climb from 16.5% of GDP this year to 17.5% by 2025 which is roughly in line with its 50-year average.  The projected growth in revenues beyond 2025 to 18.5% is largely attributable to the expiration of nearly all the individual income tax provisions included in the 2017 tax act.  If Congress chooses to extend those tax cuts the revenue projections would be reduced, and the anticipated budget deficits would be even larger.  Thus, the projected deficits are not attributable to a shortfall of tax revenue.

Government expenditures are projected to rise over the coming decade.  Specifically, outlays are expected to rise from 20.8% in 2019 (which is roughly in line with its historical average) to 23.0% by 2029.  Most of this increase can be attributed to the aging of the population.  As our population grows an increasing number of older adults will retire and begin to receive Social Security.  At the same time they become eligible for Medicare benefits.  Meanwhile, interest rates are likely to rise to more normal levels, which will boost the interest expense on the public debt.  Because this increase in expenditures is largely driven by demographics it is inescapable.

In our view, this situation described above is unsustainable.  Furthermore, because the problem is on the spending side any serious budget improvement can be achieved only by trimming expenditures, entitlement spending in particular – Social Security, Medicare, Medicaid, welfare benefits, and veterans’ benefits – because such expenditures now comprise two-thirds of all government spending.

Spending cuts will not be on the agenda under this president which means that nothing will happen for at least two years and perhaps as many as six years.

If Democrats should win the election in 2020 with its “Green New Deal” as a platform, the budget will spiral out of control by the end of the next decade.  The sponsors want to achieve 100% clean energy by 2030, upgrade all existing buildings in the U.S. to maximal energy efficiency, expand high-speed rail so broadly that air travel would almost become obsolete, guarantee a job at a living wage for every American, and provide all people of the United States with high-quality health care.  They propose to pay for this via a higher estate tax on the wealthiest Americans and by raising the tax rate on the top 1% of wage earners.  That is not going to happen.  The moment those taxes are raised wealthy Americans will exploit loopholes to shrink their tax liability and simultaneously shift their wealth offshore.

In our view, the Republicans lack of attention to the budget situation is unacceptable.  The Democrats alternative is worse.  Our sense is that budget issues will not be addressed until a crisis arises — perhaps triggered by the next recession.

Stephen Slifer


Charleston, S.C.

Fourth Quarter Fears Are Disappearing

February 1, 2019

The stock market’s decline in the fourth quarter suggested that the economy was on the cusp of slipping into recession.  As we turn the corner into a new year it is evident that many of those fears were exaggerated.  We now know that employers ignored both the partial government shutdown and stock market turmoil and added 304 thousand jobs in January.  The Fed has made it abundantly clear that it is on hold for the foreseeable future and will have to be persuaded to raise rates again.  Manufacturing firms experienced an impressive rebound in orders and production in January.  Thus, recent indicators provide reassurance that the economy is chugging along in the first quarter at a pace roughly comparable to other recent quarters.

Two things are fascinating about the 304 thousand increase in employment in January.  First, the partial federal government shutdown had no impact on hiring.  Second, the jobs market seems to be strengthening.  The economy cranked out 183 thousand jobs monthly in 2017, followed by 220 thousand per month in 2018, and 266 thousand in the most recent 3-month period.  Perhaps the labor market is not nearly as tight as what most economists believe.

Where are all these workers coming from?  The participation rate (which measures the share of the population that is working or looking for a job) was supposed to decline as the baby boomers retired.  Instead, it has been on the rise.  Prime age workers who had been on the sidelines have become encouraged by the clear economic strength in recent years and are now not only looking for jobs they are finding them.

Following the December FOMC meeting the Fed raised the funds rate one-quarter point to a range of 2.25-2.5%.  Fed Chair Powell indicated at that time that while the Fed may keep rates steady for a while, he expected two additional rate hikes in 2019.  However, this past week he said that the Fed will sit tight for some time and will need to be persuaded to raise rates beyond their current level.  That is a distinctly different tone.

The Institute for Supply Management reported that its index for conditions in the manufacturing sector of the economy rose 2.3 points in January to 56.6.  The increase was led by the two most forward-looking components – orders and production – which registered gains of roughly seven points.  The overall series remains below levels attained late last summer.  However, the current level of the index is consistent with 4.0% GDP growth.  While no one anticipates 4.0% GDP growth this year, this index certainly seems to throw cold water on the notion that the pace of economic activity is succumbing to stock market gyrations, slower growth in China, tariffs, or rising inflation.

On the inflation front the employment cost index rose 2.7% in the fourth quarter and 2.9% for 2018.  Clearly, the seemingly tight labor market is forcing employers to pay up to attract the workers they need.  That means that workers are receiving fatter paychecks and that is a good thing.  At the same time some worry that rising labor costs will push the inflation rate upwards.

But thus far, there is no evidence that is happening because productivity growth is countering the increased labor costs.  Unit labor costs, which measures labor costs adjusted for the increase in productivity, have risen just 0.9% in the past year – a 2.2% increase in compensation partially offset by 1.3% growth in productivity.  The Fed has a 2.0% inflation target.  If unit labor costs are rising by 0.9%, it is quite clear that the tight labor market is not putting upward pressure on the inflation rate.

It is also worth noting that the ISM price component for January fell 5.3 points to 49.6 after having declined 5.8 points in December.   That is the lowest reading for the price component since February 2016 and suggests that the PPI for January will register a decline.  Clearly, there is no hint that the inflation rate is on the verge of accelerating any time soon.

All these tidbits of information are restoring the faith of stock market investors.  The S&P 500 index has recovered about 60% of what it lost during the fourth quarter and now stands just 7.5% below its previous peak level.

The stock market’s slide late last year was unnerving and suggested to many investors as well as economists that an economic downturn was likely by the end of this year.  Our sense was that the economic fundamentals remained solid and that the selloff was nothing more than exaggerated stock market noise.  We are breathing a sigh of relief that, perhaps, we are on the right track.

Stephen Slifer


Charleston, S.C.

Impact of the Government Shutdown on GDP Growth is Small

January 25, 2019

The federal government has been largely shut down for more than a month.  But the stock market does not seem to have noticed.  Nor has the bond market.  Or currencies.  Or commodities.  The participants in these markets have shrugged off the shutdown because they correctly expect that it will eventually end, and government workers will go back to work.  Thus far the impact on the economy seems relatively small.

We feel for the 800,000 government workers who are not getting paid.  Their lives have been needlessly disrupted and we would certainly not like to be in their shoes.  Our government hired them; it should pay them.  But how big an impact will all of this have on the pace of economic activity?

We believe that the potential negative impact is grossly exaggerated.  Kevin Hassett, chair of the Council of Economic Advisers, said that “If the prolonged partial government shutdown extends for the whole first quarter you could end up with a number very close to zero percent.”  He went on to say that if the government reopened, “The second quarter number would be humongous.  It would be like 4% or 5%.”  Hasset is correct that first quarter growth will be biased downwards by the shutdown and that second quarter growth will rebound.  But exactly how big will those distortions be?

One thing is clear.  First quarter growth will not be even remotely close to 0%.  Consider the following.  There were 150 million workers on company payrolls in December.  Of those roughly 22 million, or 15%, are government workers.  But of that 22 million government workers 19.6 million were employed by state and local governments.  Thus, there are only 2.8 million federal government workers.  And of those federal workers only 0.8 million are not getting paid.  We are talking 0.5% of American workers that were not paid in January.  Admittedly, there are additional government contractors in the private sector that are also not getting paid.  But any way we slice it, only a very small portion of American workers are being impacted.  Even if the shutdown were to drag on first quarter GDP growth will not be 0%.

Let’s go back to the fourth quarter for a moment.  The initial estimate of fourth quarter GDP growth has been delayed but is widely expected to be about 2.5%.  So, at least through the fourth quarter the economy was on track despite the stock market selloff, weakness in China, Fed rate hikes, a slowdown in home sales, and the prospect of a government shutdown.  And, judging by the 300+ increase in payroll employment for December, the quarter ended on a strong note.

We know virtually nothing yet about the first quarter.  But we do know that initial unemployment claims (a measure of layoffs), declined to 199 thousand in the week of January 19 which is its lowest level in 50 years.  Thus, it appears that first quarter growth is off to a good start and we expect payroll employment to continue rising at roughly a 200 thousand pace.   If that is the case, a 0% GDP growth rate in the first quarter seems mathematically impossible.  That is not to say that first quarter growth will be unaffected.  We have trimmed our first quarter GDP forecast from 2.7% GDP growth to 2.0% even though we have virtually no data to support that revision.  At the same time, we raised our second quarter growth rate to 3.1%.

We will have to wait and see how all this turns out.  But first quarter GDP growth is not going to be 0%.  The federal government portion of our economy is far too small for that to happen.  Instead, we suggest that the impact of the shutdown may be far smaller than expected.

If that is right, then we have one other question.  What were all those 800,000 workers doing in the first place?  We are not going to dispute the need for air traffic controllers, TSA agents, law enforcement, food inspectors, and the Coast Guard.  Their need has been well documented.  But to have 800,000 government workers be unpaid for a month and have only a modest negative impact on GDP growth, suggests to us that, perhaps, many of those government jobs were unnecessary in the first place.  We would hope that our leaders in Washington take this opportunity to re-examine which government services are truly critical and pare back government employment elsewhere.  Nice thought, but we all know that is not going to happen.

Stephen Slifer


Charleston, S.C.

Overcoming Fears

January 18, 2019

In the first three weeks of January the stock market recovered one-half of what it lost in the fourth quarter.  Investors have found renewed optimism.  The catalysts for the downturn included slower growth from China, a steady drumbeat of rate hikes by the Fed, weakness in the housing market, and concern about the impact of the government shutdown.  Some pundits feared a recession as early as the end of this year. But in the past couple of weeks many of those fears have been reduced .  While the government shutdown rolls on, it is important to remember that almost all of what is lost during the shutdown will be recovered in subsequent months.

The S&P 500 hit bottom on Christmas Eve and has been climbing slowly but steadily for three weeks.  While the downslide was unnerving, we did not see corresponding weakness in the economic statistics, so we concluded that the drop was primarily attributable to exaggerated stock market volatility and, therefore, was not a harbinger of slower growth in the months ahead.  We have no reason to change that view.

GDP growth in China is clearly slowing.  The IMF currently estimates 2018 GDP growth for China of 6.5% with even slower growth expected in 2019 and 2020.  For most countries 6.5% growth would be welcome news.  But for China that would be the slowest rate of expansion since 1990.  But two things are important.

First, much of China’s slower growth woes have been caused by the U.S.-imposed tariffs.  With trade representing nearly one-half of the Chinese economy versus about 10% in the United States, China has much more to lose in a trade war.  Since tariff talk began in the early part of last year, the Chinese yuan has declined  almost 10%.

That, in turn, has caused the Shanghai Composite stock index to fall 23%.  Slower growth in exports will negatively impact Chinese GDP growth for the foreseeable future.

The U.S. does not come out unscathed.  Growth in the U.S. will be reduced as well.  Both countries lose, but China loses far more than the U.S.  Thus, the pressure is on both countries, the Chinese in particular, to reach a deal.  The U.S. is not asking not just for a trade deal, it is asking China to completely alter its way of doing business.  The U.S. wants China to recognize our patent and copyright laws.  Quit stealing trade secrets.  Stop forcing companies to share their technology as a prerequisite for permission to do business in China.  Despite those harsh requests, we still expect some sort an agreement to be announced in the months ahead and recent talks are encouraging.  Both countries can claim victory.  Once that happens stock markets around the world will rebound as investors’ concerns about a significant slowdown in China’s GDP growth will be alleviated.

But there is more going on than just China and trade.  Late last year the markets feared that the Fed would raise rates three times this year. In mid-December the Fed lowered its expectation of rate hikes this year from three to two.  At the same time, it said that it would refrain from further rate hikes until some of the current economic uncertainty and market angst disappears, which probably means no further rate hikes until midyear.  That is also good news.

Finally, home sales took at big hit last year.  Some believe that the combo of higher home prices and higher mortgage rates has made housing less affordable for many Americans.  For those economists, recent developments should allay their concern.

As the stock market swooned and a fear of slower growth materialized in the fourth quarter, mortgage rates fell from 5.0% to 4.5% which is where they were last summer.

At the same time, the run-up in home prices has slowed dramatically.  The year-over-year increase has ebbed from a peak of 6.4% at this time last year to 4.7%.  And data for the last six months suggest a further slowdown to about 3.0%.

These developments mean that housing has become more affordable for the average American family.  The National Association of Realtors series on housing affordability has climbed from 138 a few months ago to almost 150 currently.  That means that a median-income family now has 50% more income than is required to  purchase a median-priced home.  Increased affordability should re-invigorate home sales in the months ahead.

These are all small, tentative developments but, collectively, they provide support for the notion that any slowdown in economic activity will be modest and perhaps short-lived.

Stephen Slifer


Charleston, S.C.