Saturday, 19 of August of 2017

Economics. Explained.  

Category » Commentary for the Week

Dampening Expectations

August 18, 2017

The economy is chugging along nicely.  But non-economic events like the North Korean crisis and Charlottesville, and disquieting tweets from President Trump, are causing business leaders and politicians to wonder if he can accomplish his political agenda.  If it ever becomes clear that tax cuts are not going to happen, the stock market is going to pull back sharply.  Investment spending will be curtailed, and GDP forecasts will be trimmed.  Rather than having a legitimate hope that GDP growth could quicken from its current 2.0% pace to 2.8% or so by the end of the decade, forecasts would revert to the same slow growth rate we have seen for the past several years.

GDP growth was 1.2% in the first quarter and 2.6% in the second.  Third quarter growth is likely to be about 3.0%.  Consumer spending is holding steady at about 2.5%.  What gives us hope for faster growth ahead is the fact that investment spending surged in the first half of this year.  Nonresidential investment jumped 7.0% in the first quarter followed by 5.1% growth in the second quarter and is on track for a 4.0% increase in the third quarter.  Keep in mind that business spending was largely unchanged in 2015 and 2016.

There can be little doubt that this acceleration is due in large part to President Trump.  He came into office advocating significant health care reform, lower individual and corporate income taxes, relief from a stifling regulatory environment, and an opportunity for business leaders to repatriate overseas earnings at a favorable tax rate.  That is a very pro-business agenda.  It would enhance corporate earnings, boost growth in productivity, and trigger faster GDP growth both near-term and in the years beyond.

In response to Trump’s proposed agenda the stock market climbed 18% between the election and mid-August.  The dollar jumped 4.0%.  Both domestic and foreign investors were encouraged.  But now all are beginning to question Trump’s ability to actually implement his agenda.  He promised to quickly repeal and replace Obamacare.  That did not happen.

His steady diet of disturbing tweets is bringing further into question his ability to pass his agenda.  For example, his extraordinary warning that any further threats by North Korea against the United States would result in “fire and fury like the world has never seen” brought the U.S. the closest it has been to a nuclear confrontation since the Cuban missile crisis in the 1960’s.  Those statements were scary and drew widespread criticism.  However, they sent a strong signal to both North Korea and China that the U.S. treated those threats seriously.  For now Kim Jong-Un has backed off his threat to fire missiles at Guam and said instead that he wanted to monitor the “reckless Yankees” but left open the door for a strike later.  While the crisis is far from over it has abated for now.

Following the attack in Charlottesville Trump initially said, “We condemn in the strongest possible terms this egregious display of hatred, bigotry and violence on many sides”.  That seemed to suggest that both groups were at fault.  A day later he said “Racism is evil.  And those who cause violence in its name are criminals and thugs, including the KKK, neo-Nazis, white supremacists and other hate groups that are repugnant to everything we hold dear as Americans.”   A day later he recanted that statement and said “I think there is blame on both sides.”  His unwillingness to explicitly and consistently attribute blame to the far-right extremists has cost him the support of many business leaders as one after another chose to resign from his business councils and he was eventually forced to dissolve them.  Republican leaders like John McCain, Lindsey Graham, and Marco Rubio strongly denounced his comments.

What does all of this mean from an economic viewpoint?  It suggests that both U.S. and foreign investors are becoming increasingly nervous and concerned that Trump will be unable to accomplish what he had hoped to do.  The dollar rose sharply between the time of the election and the end of January.  It has since fallen 6.5%.  Earlier this year the Euro cost $1.06.  Today it costs $1.18.  Earlier this year one U.S. dollar bought 115 yen.  Today it purchases 110 yen.  Admittedly, not all of the drop can be attributed to a lack of faith in President Trump.  In the past several months GDP growth in Europe and Asia has gathered some momentum which enhanced the desire by foreign investors to pull back from dollar-denominated investments.

The S&P 500 index rose 18% from the time of the election through mid-August, but it has contracted by 2% in the past few days.  That is another hint that U.S. investors are beginning to question Trump’s ability to achieve tax cuts and health care reform.  We share that concern but are unwilling to abandon the idea that a diluted version of tax cuts and health care reform will pass at some point.

If it becomes increasingly apparent that Trump will have neither the legislative nor business support to pass his agenda, the markets will make the requisite adjustment.  The stock market will encounter a correction and give back much of its run-up since the election.  Business leaders will experience a renewal of uncertainty and curtail investment spending.  Economists will have to trim their expectations for GDP growth and give up on the notion of a pickup in potential growth to 2.8% by the end of the decade.  GDP forecasts will, instead, revert to the 2.0% mark for the foreseeable future with little hope of breaking out of the slump.  Let’s hope we do not have to go there.

Stephen Slifer


Charleston, S.C.

War Talk – Real?  Or Rhetoric?

August 11, 2017

This is an economics column and for the most part we shy away from political events — unless they are likely to have a significant impact on the U.S. economy.  The threats of war emanating from both Pyongyang and Washington are clearly disturbing and could have dire consequences around the globe.  This is not the same discussion as whether President Trump’s proposed tax cuts, repatriation of earnings, and de-regulation can boost GDP growth by a couple tenths of a percent.  Or whether the Fed will continue it glacially slow pace of raising interest rates.  This is about an event that could potentially leave millions of people dead and quickly spread around the globe.  We would be remiss in not discussing the possibility.

We do not expect a war outcome.  Our sense is that there is a lot of political posturing on both sides.  But the reality is we know nothing.  We do not know what is in the heart of either Kim Jong-un or President Trump.  Mr. Kim has been referred to as “a total nut job” by President Trump.  But, then again, our own president has made some rather outrageous statements in the seven months he has been in office and may be viewed similarly by others.  Both men are prone to exaggerated rhetoric.

Mr. Kim took office six years ago at the age of 27 and most people viewed him as an inexperienced leader and thought he would not last long.  They significantly underestimated him.  Now he has nuclear missiles that can strike the United States and he is not going to give them up.  Our view (or perhaps our hope) is that he is willing to contain his nuclear arsenal in exchange for an end to the sanctions that limit North Korea’s ability to trade with the world.  But the quid pro quo  is that the United States and the rest of the world will have to accept the fact that North Korea has nuclear weapons.

Given the current war of words between North Korea and the United States we do not know how we get from where we are to the less threatening outcome described above.  Should the U.S. establish a naval blockade?  Should it perhaps shoot down missiles launched by North Korea? Should it launch a limited strike against nuclear launching missile sites?  What would be the consequences if it chose any of those options?  All of them carry the risk of escalating the crisis into a full blown military confrontation.  Who is going to blink first?  The best hope is that China will intervene and use its influence to get North Korea to halt its nuclear weapons agreement.

The threat by Kim Jong-un to launch four missiles that would fly over Japan and land near Guam by mid-August is impossible to retract without losing face.  President Trump’s threat to respond with “fire and fury like the world has never seen” is equally troublesome.  Such threats cannot be taken lightly give the potential consequences.  Neither side will “win” if nuclear missiles are launched or even in the event of a non-nuclear confrontation.  Large portions of the Korean peninsula – both North and South Korea – will get flattened.  Damage could further spread to Japan, U.S. military bases in the region or even Guam, Hawaii, or Alaska.

What strikes us is the lack of concern around the globe.  The Korean Stock Exchange has declined 4.5% since the beginning of August which strikes us as a rather modest selloff.  South Koreans are apparently so used to living under constant threat from the North that they are not particularly disturbed by the current war of words.

The S&P has dipped only about 1.5% from a record high level earlier this month.

The decline in the Shanghai Composite Index has been largely imperceptible.

We certainly hope these various stock exchanges are correct in their apparent conclusion that the current war of words will, in the end, be nothing more than that.  We share the same conclusion, but are well aware that the downside risk if that view is wrong is enormous.  The downside risk that would occur if Trump cannot pass his tax cuts or is frustrated by his inability to simply the federal regulatory process is minuscule by comparison.  Given the enormous downside risk of war we would suggest that stock investors pare their positions slightly to guard against the possibility of a near-term adverse event.

We are well aware that hope is not a strategy.  Having said that, we hope that President Trump and his advisers as well as world leaders everywhere can find the wisdom to peacefully resolve this crisis.  In the meantime, a somewhat more cautious investment stance is warranted.

Stephen Slifer


Charleston, S.C.

Free Trade Is Not the Issue –Fair Trade Is the Problem

August 4, 2017

The U.S. trade imbalance has been maligned by many.  Some economists contend that the U.S. losses jobs when American companies build plants overseas rather than in the United States. They also believe that continuous trade deficits allow foreigners to accumulate so many dollars that they are “buying up America”.  The solution is, therefore, to slap massive tariffs on goods coming into the United States from China and Mexico (in particular) in an attempt to rein in the deficit.

But let’s be clear.  The trade deficit itself is not the problem.  Rather, it is a sign of a healthy economy.  The United States economy is growing more quickly than the rest of the world and, as a result, we are buying more goods from foreign countries than they are buying from us.  That is not a bad thing.  Furthermore, Americans are freely buying all those goods from China, Mexico, and elsewhere.  It is not some nefarious plot to undermine the economic health of the U.S.   The reality is that if Americans would choose to save more and spend less, we would not be purchasing so many goods from China, Mexico and elsewhere in the first place.  But, primarily to take advantage of lower prices, we willingly purchase imported products.  As a result, our imports grow rapidly and the trade gap widens.

Furthermore, it is hard to argue that the size of our trade deficit is costing jobs.  With the unemployment rate at 4.3% and a shortage of available workers, that contention is a little hard to swallow.

The other side of the coin is the current account surplus.  Whenever, we buy goods from other countries they accumulate dollars.  Therefore, the current account surplus is the mirror image of the trade account deficit.  Those countries then invest those dollars in U.S. assets like real estate, the stock market, or financial assets – U.S. Treasury securities in particular.  It is important to recognize that the capital stock of the U.S. is not a fixed amount to be divvied up amongst U.S. and foreign entities.  It is constantly growing.  Thus, foreign investment in the United States is a good thing.  But right now the U.S. budget deficit is so large that these foreign capital inflows are being gobbled up largely by the government sector.  If our policy makers would take action to cut government spending and shrink the budget deficit, more of these overseas funds would flow to the private sector.  Private sector investment is what boosts productivity growth and raises our standard of living.  Thus, “free trade” is a good thing.

But free trade is not the same thing as “fair trade” and that is where the problem exists.  When countries impose tariffs on goods coming into their country to protect domestic industries they are carving out an unfair advantage for themselves.  In a recent op-ed piece in the Wall Street Journal, Commerce Secretary Wilbur Ross noted that China’s tariffs are higher than those of the U.S. in 20 of 22 major categories of goods.   Europe imposes higher tariffs in 17 of 22 categories.  In the automobile industry, for example, the E.U. charges a 10% tariff on imported American cars while the U.S. imposes a mere 2.5% tariff on European cars arriving in the United States.  China slaps U.S. automakers with a 25% tariff and an even higher tariff on luxury vehicles.

The non-tariff trade barriers are even more oppressive and come in a variety of forms like daunting procedures to register imports and requirements that foreign companies build local plants.  Both the E.U. and China boost their export industries via low-cost loans to export companies, refunds of value added taxes, and below market real estate purchases.  The U.S. simply does not provide this type of assistance to its export industries.  Secretary Ross does a nice job of highlighting these tariff and non-tariff barriers to trade.

Economists generally agree that free trade is a good thing, boosts economic growth in both countries, and reduces the prices that consumers pay.  A trip to WalMart, COSTCO or Target will quickly highlight the advantage of lower prices for imported goods.  But all countries need to play with the same set of rules.  Tariff and non-tariff barriers to trade can only be characterized as “cheating”.  None of us will willingly choose to play in any game where the deck is stacked against us.  Why should our export industries be forced to do so?  Trump is right in going after those countries that have chosen to protect their domestic industries via these mechanisms.  And that is not “protectionist”.   It is simply calling out cheaters for what they are and insisting on a level playing field.

Stephen Slifer


Charleston, S.C.

GDP Growth Rebounds, Healthy Growth Will Continue

July 28, 2017

Second quarter GDP growth came in at 2.6% which was roughly in line with what had been expected.  More importantly, the mix of spending was positive and portends a solid pace of expansion in the quarters ahead.

Consumer spending which is about two-thirds of the GDP pie climbed by a robust 2.8% rate in the second quarter.  Looking ahead, the outlook for consumer spending seems solid.  Fueled by a steadily rising stock market and increases in home prices, net worth is at a record high level.  Consumer confidence is the highest it has been thus far in the cycle.  The economy continues to crank out 170 thousand jobs per month which boosts growth in consumer income.    Interest rates remain low with mortgage rates at the 4.0% mark.  It is hard to see how consumer spending is going to slow down in the second half of this year.  We expect this spending category to climb 2.6% both this year and next.

Another GDP component that needs to be highlighted is nonresidential investment.  After having been essentially unchanged in 2015 and 2016, corporate spending jumped 7.0% in the first quarter and continued at a solid 5.1% pace in the second quarter.  Those are the fastest back-to-back growth rates in three years.  We had hoped that the prospect of corporate tax cuts, a reduced regulatory burden, and the ability to repatriate corporate earnings at a favorable tax rate would boost business confidence and enhance their willingness to spend on additional equipment and technology.  We are clearly encouraged by the first half results.

Because investment spending is a primary determinant of growth in productivity, our hope is that renewed vigor in the pace of investment spending will boost productivity growth from 0.8% currently to 1.8% or so by the end of the decade.  The additional 1.0% increase in productivity growth should boost potential GDP growth for the U.S. from 1.8% today to 2.8% by the end of the decade.  A fastest potential growth rate means faster growth in our standard of living.

The other category we would like to highlight is net exports.  The net exports deficit narrowed slightly in each of the past two quarters.  When it narrows it adds to GDP growth in that quarter.  As shown below, we expect this category to be essentially unchanged between now and yearend and in 2018.  What happens in this category is determined, to a large extent, by what happens to the dollar.

As oil prices plunged in the second half of 2014 and 2015 the dollar strengthened by more than 20%.  When that happens U.S. goods are more expensive for foreigners to purchase.  Foreign goods are cheaper for Americans to purchase.  As a result, the trade gap widened considerably during that period of time and subtracted about 0.5% from GDP growth in those two years.  Following the election the dollar initially rose sharply as foreign investors believed that the tax cuts, repatriation of earnings, and a reduced regulatory burden would substantially boost GDP growth.  But now those expectations have been curtailed and the dollar has fallen 5% in the past six months.  Initially, it looked like the dollar might strengthen this year and trade would subtract a modest amount from GDP growth in 2017.  But now the dollar is likely to change very little and trade should not subtract anything.

Putting all of this together we conclude that GDP growth in the second half of this year should climb by 2.7% and expand at roughly that same pace in 2018.  Keep in mind that GDP growth was stuck around the 2.0% mark in 2015 and 2016.

For the Fed faster GDP growth is part of the equation that will determine what they are going to do in the months and quarters ahead, the other part is inflation which has been extremely well-behaved in the first half of this year.  The core CPI rose 2.2% in 2017.  It has since backtracked and is now climbing at a modest 1.7% pace.

However, it has been distorted by changes in wireless phone and prescription drug categories.  There is currently a bidding war amongst wireless phone providers and, as a result, phone prices have declined 13% in the past year.  This will not continue forever.

At the same time prescription drug prices have declined since the election.  In October of last year prices were rising at a 7.0% pace.  Since the election prescription drug prices have fallen at a 1.0% rate.  During the election campaign Trump promised to drive down drug prices by allowing consumers to import prescription drug medicines from abroad, and having Medicare negotiate prices directly with pharmaceutical companies.  Thus far he has been quite successful.  However, this category is unlikely to remain constrained for a protracted period of time.

Thus we remain convinced that the tightness in the labor market will boost wages, and the shortage of available housing will put upward pressure on rents.  For that reason, we expect the overall CPI and the core inflation rate to increase 2.5% in 2018 which is slightly above the Fed’s target.

In short, we were pleased with the composition of the second quarter GDP report and think it bodes well for GDP growth both in the near-term and in the longer-term.  Over time the inflation rate will move above the Fed’s target.  This scenario will keep interest rates on a gradual upward trajectory and, in a new wrinkle, the Fed will start running off some its security holdings by the end of the year.

Stephen Slifer


Charleston, SC

No Commentary This Week — Vacation

Hi all,

Seems to be a rather quiet time.  Decided to take a few days off.  Back in full swing next week.

All the best.


Can Women Solve the Problem?

July 14, 2017

The economy’s speed limit has slipped from 3.5% during the 1990’s to 1.8% today.  That growth rate can be estimated by adding the growth rate of the labor force to the growth rate of productivity.  We have long argued that with so many baby boomers retiring that little could be done to stimulate growth in the labor force during the next decade.  Hence, the only viable way to boost potential growth was via increased corporate investment which would boost the growth rate of productivity.  But in a recent speech Fed Chair Yellen suggested that the U.S. could adopt policies designed to encourage women to work, boost labor force growth, and lift potential GDP growth in the United States.  Could potential growth rebound to the 3.5% pace seen in the 1990’s?  Perhaps.

Potential GDP growth represents the sum of two numbers – the growth rate of the labor force and the growth rate of productivity.   In the 1990’s the labor force was zipping along at 1.5%, productivity growth was 2.0%.  Add them up and the economy’s potential growth rate was 3.5%.  Today labor force growth has slipped to 0.8% while productivity has slowed to 1.0%.  Thus, potential growth today is 1.8%.  But it does not have to be 1.8% forever.  Policy measures can help.

With respect to the labor force side of the equation, when baby boomers retire they drop out of the labor force.  Given that the boomers will continue to retire for another decade we have argued that there is little chance for a pickup in the growth rate of the labor force.  Janet Yellen disagrees.

Citing a Cornell University study released in 2013 by Francine Blau and Lawrence Kahn, Yellen pointed out that between 1990 and 2010 the participation rate for women rose dramatically throughout Europe, but in the U.S. it was essentially unchanged.  For example, the non-U.S. average climbed from 67% in 1990 to 79.5%.  Furthermore, the pickup in female participation was widespread – Canada, Australia, France, Germany, Italy, and Spain all experienced a double-digit gain. Meanwhile, in the U.S. the female participation rate edged upward from 74% to 75.2%.  The survey included 22 countries.  In 1990 the U.S. ranked #6.  By 2010, it had dropped to a shocking #17.  Participation rates elsewhere not only caught up with the U.S., they surpassed it.

This result was no accident.  It came about because of family friendly policies designed specifically to incorporate women into the labor force.  Some women choose to drop out of the labor force to raise their offspring.  But others would like to work but the financial strains of doing so prevent that from happening.  Those women represent untapped potential GDP growth.

  1. Paid maternity leave.  In the U.S. employers must provide 12 weeks of unpaid maternity leave.  Elsewhere, maternity benefits were longer and usually paid.  During the survey period outside the U.S. these entitlements rose from 37.2 weeks to 57.3 weeks.   Having the right to get their job back almost certainly raises the job prospects who those women who leave the labor force during childbirth.  But several questions arise.  Does offering such a benefit encourage women to remain out of the work force longer than they otherwise would?  Does the employer benefit?  During leave time the employers must pay the person on leave as well as her replacement.  This raises the expected cost of employing women of childbearing age.
  2. Right to work part time. During the survey period many European countries adopted policies that give women the right to demand a change to a part-time work schedule.  Clearly this is a benefit to women.  But would employers be less willing to hire in a woman in the first place given that at some point down the road she could demand such a benefit?
  3. Publicly provided child care services. Such a benefit would be attractive to women because it reduces the cost of working outside the home.  And, unlike the part time benefit, it would not increase the employer’s cost of hiring women for part time positions.

Yellen noted that “policy differences – in particular, the expansion of paid leave following childbirth, steps to improve the availability and affordability of childcare, and increased availability of part-time work – go a long way toward explaining the divergence between advanced economies.”  And, “if the United States had policies in place such as those employed in many European countries, female labor force participation could be as high as 82%.”

But will higher labor force participation rates among women boost potential GDP?  Ms. Yellen thinks so. A Fed study concluded that between 1948 and 1990 the rise of female participation contributed about 0.5% per year to the potential growth rate of real gross domestic product.

So what might happen to potential GDP growth?  Suppose for a moment that the policies described above by Fed Chair Yellen boost labor force growth by 0.5%.  Let’s further assume that the combination of Trump’s proposed corporate tax cuts, repatriation of earnings, and a reduced regulatory burden boost productivity growth by 1.0% (which we have described in previous articles).  These policy changes would raise potential GDP growth by 1.5% from 1.8% currently to 3.3% or so.  That puts it back close to the glory decade of the 1990’s.  The economy may not be able to grow quickly today, but it can surely resume vigorous growth if our policy makers in Washington can get with the program.

Stephen D. Slifer


Charleston, S.C.

Gathering Momentum

July 7, 2017

GDP growth in the second quarter now seems likely to be 3.0% rather the 2.5% pace we had been projecting earlier.  This upward revision came about because of a strong employment report for June combined with upward revisions to the data for April and May.  Thus, the economy appears to have rebounded nicely from its anemic 1.4% first quarter pace.  Growth of this magnitude is sure to keep the Fed on track for another rate hike later this year, and the initial reduction in its holdings of U.S. Treasury and mortgage-backed securities in December.

For an economist, the single most important economic report for any given month is the employment report.  Not only do we discover the number of new jobs created each month, we learn how long people worked and how much they were paid.  This allows us to make reasonable estimates of GDP growth for the quarter, the monthly changes in industrial production and personal income, and refine our estimates of a host of other economic indicators.

As employment reports go, the June report was a barn-burner.  First of all employment for June climbed by 222 thousand.  Upward revisions to April and May data added another 47 jobs.  In the past three months employment has risen a solid 194 thousand.  Compare that to an average increase last year of 187 thousand.   At the very least employment gains are holding steady which is difficult to achieve given the apparent tightness in the labor market.

To satisfy demand for any given month employers always have the option of hiring additional workers or working existing employees slightly longer hours.  And, indeed, it appears that they used both options in June.  The workweek rose 0.1 hour to 34.5 hours.  That may not sound like much, but a 0.1 hour increase in the workweek represents a gain of 0.3%.  A 0.3% increase in private sector employment works out to 360 thousand.  In other words, if employers had been able to find the requisite number of bodies, employment in June would have increase by 582 thousand rather than the reported increase of 222 thousand.  That certainly creates a far more robust impression of strength in the labor market in June.  Keep in mind that the workweek for April revised upwards by 0.1 hour which has a similar effect and further enhances the outlook for GDP growth in the second quarter.

If we know how many people are working and how many hours they worked, we should be able to make a reasonable estimate of how many goods and services they produced.  That is exactly what GDP is trying to measure.    Given the upwards revisions to employment for every month in the second quarter as well as the upward revision to hours worked in April and the increase in June, the aggregate hours index – which combiners the employment and hours worked date — rose by 3.0% in the second quarter.  If workers are more (or less) productive, than the GDP increase for the quarter can be larger (or smaller) than that 3.0%.  Productivity was unchanged in the first quarter, but has risen 1.2% in the past year.  If productivity rises at all, second quarter GDP growth will eclipse the 3.0% mark.  If, however, it falls – which is always possible in any given quarter – you get the opposite result.  The first look at second quarter GDP will be released on Friday morning, July 28.   Given all of the above we have lifted our second quarter forecast from 2.5% to 3.0%.

If you are sitting in the Fed’s seat, you may have been disturbed by the anemic 1.4% growth rate registered in the first quarter.  But a rebound to a 3.0% pace in the second quarter should give you confidence that the first quarter result was an aberration.  That would imply GDP growth of 2.2% in the first half of the year versus a 2.0% increase last year.  While that does not provide a compelling case that growth is quickening (which happens to be our contention) it is, at the very least, continuing at a respectable pace.

We remain convinced that Fed officials will opt for one additional rate hike this year probably in September, which would boost the funds rate to 1.25%.  It could then follow that up with the first of its planned reductions of $6.0 billion in U.S. Treasury securities and $4.0 billion of mortgage-backed securities at its December gathering.

Stephen Slifer


Charleston, S.C.

The Pleasant Inflation Surprise — Will It Last?

June 30, 2017

At midyear it is useful to reflect on how the economy and inflation are tracking relative to what had been expected at the end of last year.  The biggest surprise, for us, is that the inflation rate did not accelerate in the first half of this year.    What’s going on?  Should the Fed postpone further rate hikes until the inflation rate begins to climb?  We believe that the failure of the inflation to climb is attributable to two separate one-off events the positive impact of which will prove to be transitory.  As a result, the Fed is justified in continuing on its path of gradual increases in the funds rate.

In our year ahead forecast in December we projected that the “core” inflation rate (i.e., excluding volatile food and energy prices), would rise from 2.3% last year to 2.7% in 2017.  The labor market was tight which seemed likely to push wages higher and lift inflation in the process.  The shortage of available homes and apartments was steadily lifting rents at a 3.5% pace.  And the cost of medical care was surging.   Instead, the core rate has backtracked and actually slowed to 1.7% in the first five months of this year.  Two factors are largely responsible for this surprising behavior.

First, a price war has broken out amongst the nation’s wireless providers and in the past year cell phone prices have plunged 12.5%.  A drop of that magnitude has shaved 0.2% off the core inflation rate during that period of time.  Mobile phone prices have fallen for eleven months in a row capped by a whopping 7.0% decline in March alone.  This means that the core rate today would be 1.9% rather than 1.7% in the absence of the cell phone price war.

Competition in this industry is ferocious and will get even more intense now that the federal government has auctioned off rights to more wireless spectrum to new entrants such as television providers Comcast and the Dish Network.  Spectrum, or airwaves, is what these companies use to deliver wireless calls.  The price wars began in April of last year when major carriers such as AT&T, Sprint and T-Mobile slashed rates on their unlimited calling plans.  The nation’s largest provider, Verizon, joined the fray earlier this year.  The last time this happened was in 1999-2000.  Eventually the price wars ended and prices stabilized for more than a decade.  Thus, the current drop in cell phone prices will prove to be transitory.

At the same time prescription drug prices have declined since the election.  In October of last year, prior to the election, prices were rising at a 7.0% pace.  Since the election prescription drug prices have fallen at a 1.0% rate.  The chart below tracks the year-over-year change in this series so the most recent price declines are not fully reflected.  During the election campaign Trump promised to drive down drug prices.  He talked about allowing consumers to import prescription drug medicines from abroad, and having Medicare negotiate prices directly with pharmaceutical companies.  His success thus far seems to stem less from legislation than fear of being called out by the president for price gouging.  Last year EpiPen maker Mylan and Valeant Pharmaceuticals experienced public outrage over dramatic price increases.  A Trump tweet could in a nanosecond put a company in his crosshairs with potentially damaging consequences to both its reputation and stock price.  One may not approve of the method, but intimidation seems to be accomplishing his objective.

So what does the Fed do now?  We believe it will view these recent price declines as temporary and continue on its slow but steady trajectory toward higher interest rates.  Remember, Fed policy is determined not only by inflation but also by the pace of economic activity as well.

As we see it the economy seems to be gathering a bit of momentum. After stumbling to a 1.4% pace in the first quarter GDP growth seems poised to rebound to a 2.5% pace in the second quarter with similar growth rates likely in the second half of the year.  GDP growth in Europe and Asia seems to be quickening as well.  The unemployment rate has dipped from 4.7% at the end of last year to 4.3% which is below almost anybody’s estimate of the full employment threshold.  Wage pressures are sure to intensify and, in the process, put upward pressure on the inflation rate.  There continues to be a shortage of available housing which is boosting rents.  That is not going away any time soon.  On balance the economy seems likely to generate upward pressure on the inflation rate later this year and in 2018.

The recent prices declines in wireless services and drug prices will not continue, but they are not going to rebound either.  In the case of wireless, following the extreme price drop in 1999-2000 prices leveled off for more than a decade.  Competitive pressure in the industry prevented prices from rebounding.

With respect to drug prices Trump has intimidated the entire pharmaceutical industry and it is being forced to behave.  Going forward prices will climb slowly but they are starting from a lower base.  In December we had expected the core CPI to rise 2.7% in both 2017 and 2018.  Today we expect that core rate to increase 2.0% this year and 2.5% in 2018.  The direction is the same, but prices will not rise as quickly as had been anticipated earlier.  Either way, the core rate is likely to exceed the Fed’s 2.0% inflation target by the end of next year which should keep the Fed on its path of gradual increases in the funds rate.  It still has a long ways to go before the funds rate reaches a “neutral” rate of about 3.0%, a level which it does not expect to reach until 2020.  Inflation may be better behaved than the Fed thought, but there is no reason to alter its current path to neutrality.  Higher rates will not begin to bite for several more years.

Stephen Slifer


Charleston, S.C.

The Debt Limit is a Sham

June 23, 2017

Here we go again.  Every year we go through the same useless exercise of raising the debt limit.  First, Congress votes to spend money.  Then, the Treasury tries to pay its bills but eventually bumps up against a constraint on how much debt it can issue.  It announces that the “debt limit” must be raised so that it can continue to pay its bills.   Finally, Congress is horrified!  It declares that expenditures must be slashed to curtail this runaway spending!

But wait a minute!  Congress authorized that spending when it passed its budget for that year.  In that process Congress authorizes each government agency to spend a certain amount of money.  If Congress believes that government spending is excessive – and it is – it should use the budget process to rein it in.  Congress should not vote to spend money, and then slap the Treasury’s hands when it is forced to borrow to finance the previously-authorized spending.  That makes no sense.  The debt limit is a superfluous piece of legislation that chews up endless days of negotiation and wasted time.  In the end the debt limit is raised.  Every year.  And it will be raised again this year.

The most important thing to know about the budget process is that when Congress approves a budget that will result in a deficit of, say, $500 billion, the Treasury must issue an additional $500 billion of debt to finance that deficit.  Thus, debt outstanding is cumulative.  It increases every single year that the U.S. government incurs a budget deficit – which is to say that it increases annually.  For the current fiscal year the Treasury faces an estimated budget deficit of $585 billion and will issue that amount of additional debt.  The Treasury estimates that it will reach the statutory debt limit by early September.

Each month, in addition to its regular bills, the Treasury must pay off maturing securities and the interest on the remaining debt outstanding.  If it cannot do so, it will default on its debt obligations.  That has never happened.  Why?  Because a default by the Treasury would be unthinkable.  If it becomes unable to pay its debts the Treasury would have to pay a higher interest rate on future debt because investors – both foreign and domestic — would demand higher interest rates given the possibility of default.  Confidence in U.S. Treasury debt as a safe haven in times of uncertainty would be shaken.  Foreign investors could reduce their willingness to buy U.S. debt.

Because the president and members of Congress are well aware of these potential adverse consequences the Treasury is not going to default.  Congress will raise the debt limit in the nick of time.

Increasing the debt limit has become an almost annual ritual.  It has been raised 72 times since 1960, of which 18 occurred between 2001 and 2017 and the Treasury has never defaulted on its debt.  And it is not going to happen this year.  Having said that, negotiations will continue right up to the last minute and make us all nervous.  Nancy Pelosi and the House Democrats say they will not increase the debt ceiling to finance tax cuts for the rich.  Senate Republicans want a vote on the debt ceiling in July, but that comes at the exact same time that it wants a vote on its proposed health care legislation.  In September the administration would like to turn its attention to its proposed cuts in individual and corporate income taxes.  These issues could become politically entangled.  We do not know exactly how this will play out but, most likely, at the last possible moment there will be a temporary increase in the debt limit.

The bottom line is, be prepared for some scary headlines during the next two months about a possible default by the Treasury on its debt obligations and a potential government shutdown.  The stock market could get hit.  Consumer confidence might decline.  But rest assured the Treasury is not going to default on its obligations and, once the debt limit is raised, the potentially nasty near term consequences will be quickly reversed.

We wholeheartedly support the notion of cutbacks in government spending in order to shrink future budget deficits which are projected to climb from $585 billion today to $1.4 trillion by 2026.  But Congress should have the courage to make the required spending cuts during the budget process.  Then eliminate the debt ceiling requirement entirely.  It is not only distracting, it is unnecessary.  It does nothing to actually constrain government spending.

Stephen Slifer


Charleston, S.C.

Fed Policy Not “Neutral” until 2020 – or Later

June 16, 2019

The Federal Reserve’s Open Market Committee met this week and, as expected, raised the funds rate to the 1.0% mark.  It continues to expect a slow but steady pace of additional rate hikes over the next several years, eventually pushing the funds rate to 3.0% sometime in the first half of 2020.  That part of the Fed’s “normalization” process has not changed.  But there is a necessary second step.  Following the Fed’s bond buying binge between October 2008 and October 2014, its balance sheet skyrocketed from $900 billion to its current level of $4.4 trillion.  It needs to shrink its portfolio dramatically and, at its meeting earlier this month, it laid out a game plan for how it intends to proceed.  It will be a very gradual, lengthy process which will drag on well into the 2020’s.  The Fed is not going to trigger a recession by shrinking its balance sheet too quickly.

As the Fed purchased its combination of U.S. Treasury and mortgage-backed securities, it flooded the banking system with surplus reserves which skyrocketed from about $0.1 billion in late 2008 to $2.25 trillion currently.  Because those funds represent the ability of the banking system to lend to consumers and businesses, they need to be eliminated to prevent a potentially inflationary spending spree at some point down the road.  The Fed will accomplish that objective by shrinking its balance sheet.  But how will it go about that?

Basically, the Fed has two options.  First, it could go into the market and sell some of its current holdings of securities.  Doing so would shrink its balance sheet quickly.  But the Fed is concerned that such action would be disruptive to the bond market and could push long-term interest rates sharply higher which would pose a risk to the ongoing expansion. That is not the desired outcome.

Second, it could accomplish the same objective by running off some of its holdings of U.S. Treasury and mortgage-backed securities by simply not replacing them when they mature.  But given that the Fed’s portfolio has an average duration of almost ten years, this will be a very slow process.

Once this program begins later this year (presumably at its early November meeting) it will initially run off $6 billion of U.S. Treasury securities per month for the first three months.  At the same time it will run off $4 billion of its holdings of U.S. agency and mortgage-backed securities.  Thus, at the beginning it will allow a total of $10 billion of its security holdings to run off for the first three months.  It then plans to increase that total amount by $10 billion every three months until it reaches a cap of $50 billion per month.  It would reach that limit at the end of its first year of implementation.  Doing the math, it means that the Fed’s portfolio will have shrunk to the desired level by the end of 2022.

Keep in mind that the Fed does not need to shrink its balance sheet back to the $900 billion level that existed prior to the recession.  It wants its portfolio to grow roughly in line with growth in nominal GDP, or about 4.0% annually.  That means that the desired balance sheet level at the end of this year will be about $1.3 trillion and it will grow at roughly a 4.0% pace every year thereafter to $1.6 trillion by the end of 2022.

If the Fed does what it is suggesting, the Fed’s balance sheet will have shrink by $2.8 trillion from $4.4 trillion currently to the $1.6 trillion target level during the next five years.  But that is not going to happen.

According to data reported by the Fed, it has only $1.5 trillion of securities maturing within the next five years, and an additional $0.4 trillion maturing between 5-10 years.  All the rest of its security holdings have a maturity date in excess of ten years.  Thus, more realistically, Fed holdings will not return to their target level until 2031.

The point is that the Fed will have a two-pronged approach towards “neutralizing” monetary policy.  First, it intends to use the funds rate as its primary policy tool.  The funds rate should reach its so-called “neutral” level by early 2020.  Second, it will gradually return its balance sheet to a desired level.  The Fed says that should happen within five years.  But given the maturity schedule of the securities held in its portfolio that process may not be complete until 14 years from now.  Thus, the Fed has made it abundantly clear that it is unwilling to let its policy become the catalyst for the next recession – at least not in the near term.  If inflation heats up and the Fed needs to cool the economy, its policy approach will change, but that is not going to happen any time soon.

Stephen Slifer


Charleston, S.C.