Thursday, 15 of November of 2018

Economics. Explained.  

Category » Commentary for the Week

2019 Economic Outlook Conference

2019 Economic Outlook Conference

In times of uncertainty whether you are running a business or planning your investments, knowledge can be your most valuable asset. 


Stephen Slifer, Owner and Chief Economist at NumberNomics will provide insight regarding what to expect in 2019.


Growth can’t continue at this pace.  Or can it?

When will higher interest rates spoil the party?

Inflation is low for one very important reason.  What is that?

What are the two best leading indicators of recession?

All expansions end.  Is the end for this one in sight? 


DATE:     Thursday, December 6, 2018

TIME:      7:30 to 9:00 A.M.

PLACE:   Daniel Island Club, 600 Island Park Drive, Charleston, SC 29492

COST:      $40.00 includes breakfast


Stephen Slifer:  From 1980 until his retirement in 2003, Mr. Slifer was the Chief U.S. Economist for Lehman Brothers in New York City.  In that role he directed the firm’s U.S. economics group and was responsible for the firm’s forecasts and analysis of the U.S. economy.

Prior to that, he spent a decade as a senior economist at the Board of Governors of the Federal Reserve in Washington, D.C.  He has written two books about the various economic indicators and how they can be used to forecast economic activity.  He writes a regular bi-weekly economics column for the Charleston Regional Business Journal.


Proudly sponsored by:

Charleston Digital Corridor                              Charleston Regional Business Journal

Daniel Island Business Association                 Daniel Island Town Association

NumberNomics                                                Cetera Advisors

Baird                                                                Trident Technical College

Wells Fargo Advisors


To Register: Read more »

The Oil Price Roller Coaster Is Not Over

November 9, 2018

Up and down and …up again?    The stock market captured everybody’s attention in October as fears emerged that the U.S. economy might be overheating along with worries about the pace of rate hikes by the Fed, the election, and trade.  But the oil market has been on an even wilder ride.  In mid-August oil prices dipped to $65 per barrel.  By early October they soared 17% to $76.  Since that time, they have fallen steadily to $59.50 —  a drop of 22% in a single month.  What in the world is going on and, more importantly, what’s next?

In late August and September, the run- up in crude prices appears to have been driven by robust 4.2% U.S. GDP growth in the second quarter, accelerating wage pressures, a fear of higher inflation, and the possibility of faster and/or additional Fed  tightening than had been anticipated.  Those same fears precipitated a 10% correction in the stock market as investors worried that the Fed’s rate hikes might short-circuit the nearly 10-year old expansion.

As oil prices rose, oil-producing countries turned on the spigot.  OPEC countries, Saudi Arabia in particular, significantly increased production.  U.S. shale oil drillers boosted output even more dramatically.  U.S. production jumped 6.5% within a matter of weeks.

At the same time,  global economic activity ratcheted downward.  When Trump began imposing tariffs in February global investors quickly concluded that the U.S. was in a far better position to withstand a trade war than any other country around the globe.  Foreign investment money flooded into the U.S. stock and bond markets. The dollar increased by 10%.  The U.S. economy was on a roll.  But the higher dollar negatively impacted emerging economies.  Because they must pay for their imported raw materials in dollars, their cost of goods sold quickly jumped 10%.  Currencies for emerging economies fell sharply.  Their stock markets declined more than 20%,  It became clear that GDP growth in emerging economies – China in particular – was going to slow.  Indeed, in mid-October the IMF lowered its GDP forecast for emerging nations in 2019 by 0.3%.

With reduced demand and surging supply, oil prices collapsed. They fell 22% from a high of $76.50 in early October to $59.50 within a month.

What is astounding about this process is the speed with which oil-producing countries can step on the gas when they choose to.  That is certainly true for OPEC.   Technological developments in the past seven years like fracking and horizontal drilling have not only made the U.S. a player in the global oil market, the U.S. became the world’s largest producer of crude oil in March of this year, surpassing previous industry giants Russia and Saudi Arabia.  Furthermore, the Energy Department anticipates an additional 10% increase in U.S. oil output in 2019 which will further widen the production gap between the U.S. and the rest of the world.  Production can adjust up or down by huge amounts in a hurry.

The political implications of this development are enormous.  While OPEC countries will continue to have a significant influence on oil prices around the globe, they no longer will have the ability to cripple the global economy by sharply curtailing supply and lifting oil prices to $100 per barrel or beyond.  The speed with which U.S. producers can adjust output has eliminated that outcome.

While inflation fears in the U.S. are on the upswing it is quite clear that in the near-term those price pressures will be alleviated by falling oil prices.

This may not be the end of the story.  U.S-imposed oil sanctions on Iran went into effect on November 5.  Iranian production has held steady in recent months at about 3.8 million barrels per day but with a hint of emerging weakness in September.  Trump’s goal is to eliminate Iranian oil exports from the world marketplace.  It is not clear the extent to which that will happen.  Saudi Arabia has pledged to counter any Iranian shortfall, but much of its surplus capacity has been idle for a long period of time and may, or may not, be easily brought on line.

In our opinion, oil prices may well be approaching a near-term low point for several reasons.  First, OPEC countries have already begun to talk about cutting production.  Given the precipitous drop in prices U.S. producers could do the same thing.  Second, Iranian oil exports could fall sharply.   Third, global demand could be stronger than anticipated.  The oil market has been on a roller coaster for the past six weeks, and it is not at all clear that the ride is over.

Stephen D. Slifer


Charleston, S.C.

Looking at the Wrong Thing!

November 2, 2018

The market’s attention recently shifted to labor costs which have begun to accelerate.  Most economists fear that rapidly rising wages will lead to a further pickup in inflation, force the Fed to quicken the pace of rate hikes, and eventually lead to the demise of the expansion.  But people are looking at the wrong thing!  They should be looking at labor costs adjusted for changes in productivity.  Doing so completely alters the conclusion.

There are lots of different measures of wage pressures.  Many people focus on average hourly earnings.  We see it every month as part of the employment report.  It is easy to track.  This measure of earnings has risen 3.1% in the past year which is the largest yearly increase in a decade.  It is clearly accelerating and making people nervous.  But this series only tells us about changes in hourly wages.  It is does not tell us anything about what is happening with benefits.

The employment cost index is less well known largely because it comes out once per quarter.  It is a broader measure of labor costs and includes changes in both hourly compensation and benefits. Recently released data for the third quarter show a year-over-year increase of 2.8% which, like average hourly earnings,  is the fastest in a decade.  Given that labor costs are about two-thirds of a firm’s overall cost, many economists now conclude that a pickup in labor costs will create an incentive for firms to raise prices.  Not so fast.  There is more to the story.

Suppose I pay you 3% higher wages.  My labor costs have risen, and I will be tempted to raise prices.  But what if I pay you 3% more money because you are 3% more productive?  I really do not care.  You are giving me 3% more output.  You have earned your fatter paycheck.  So, what we need to follow are labor costs adjusted for the changes in productivity.  Economists have a fancy word for that concept —  “unit labor costs”.  This index is even more obscure.  It is buried in the quarterly report on productivity.  This past week the Labor Department published data on productivity and unit labor costs for the third quarter.  It showed that ULC’s rose a modest 1.2% in the third quarter and have risen just 1.5% in the past year.  More interesting is the fact that this series is suddenly trending lower.  In the middle of last year unit labor costs were rising 2.5%.  They have since slowed to 1.5%.  How can that be?  Answer:  Productivity growth has accelerated.

The increase in unit labor costs can be split between two parts.  Compensation growth in the past year of 2.8% is about the same as other measures of wage costs.  But productivity has risen 1.3%.  Thus, unit labor costs – the difference between the two numbers — has risen 1.5% and, as noted earlier, they are slowing down.

Without a doubt faster growth in productivity is a result of the sustained pickup in investment spending since the November 2016 election.  It has been fueled by the cut in the corporate tax rate, repatriation of earnings from overseas by large multi-national firms, and an extraordinary pace of deregulation.

We expect these same factors to sustain growth in investment spending for the foreseeable future.  In addition, with the unemployment rate at nearly a 50-year low and workers hard to find, firms might consider spending money on technology to boost productivity growth amongst existing employees and increase output.  Additional spending on technology from this source should enhance investment spending in the quarters ahead.  Productivity will continue to climb and  upward pressure on wages should be largely offset.  Next year we expect compensation to increase 3.7% in 2018 (versus 2.8% currently) because of additional tightness in the labor market.  We also expect productivity to rise 1.8% (versus 1.5% right now).  As a result, unit labor costs by the end of next year should rise 1.8% (versus 1.5% now).  They should continue to climb at a slower pace than the Fed’s targeted inflation rate  of 2.0%.  Virtually no upward pressure on inflation from this source.

Technology has completely changed the game.  It is boosting investment and productivity.  It is raising our economic speed limit.  It is accelerating growth in our standard of living.  And it is helping to keep inflation in check by boosting productivity and offsetting much of the increase in wages.  And we are just beginning to recognize the extent to which this has occurred.

As a slightly different way of highlighting the impact of technology on inflation, split the CPI into two pieces – changes in good prices versus services.  In the past year goods prices have declined 0.3%.  Prices of services rose 3.0%.  Why?  Goods-producing firms have virtually no pricing power.  Whenever consumers want to buy anything, we shop the internet, Amazon in particular.  We can find the lowest price in our city, our state, the country, or even the world.  Thus, prices are not rising for roughly one-third of the goods and services offered for sale in our economy.  That clearly is keeping the inflation rate in check.

The inflation rate may continue to climb in the months and quarters ahead, but its acceleration will be very gradual.  Last year the CPI excluding food and energy rose 1.8%.  It should rise 2.2% this year and 2.4% in 2019.  Such a gradual pickup in inflation will not bother the Fed.  In fact, they have already said they will accept an inflation rate slightly above target for a while because it was so far below target for an extended period.

Accelerating wages bother people because they fear it will lead to more rapid inflation.  But they are getting themselves spooked because they are looking at the wrong thing.  They should be looking at labor costs adjusted for changes in  productivity or unit labor costs.  When they do that, they find that this adjusted wage measure is not only growing at a rate below the Fed’s 2.0% targeted rate of inflation, it is slowing down.  Don’t get alarmed quite yet.

Stephen D. Slifer


Charleston, S.C.

Housing Is Still Affordable

October 26, 2018

Stock market volatility in recent weeks has increased dramatically as investors try to cope with multiple worries including rising interest rates, China, the election, and some surprising weakness in housing.    Typically, stock market corrections are nothing more than the usual  ebb and flow of stock prices and have little economic significance.  But when the economy is headed into a tailspin, stocks invariably flash an early warning signal.  That concern is accentuated when it is accompanied by weakness in an interest-rate-sensitive sector like housing.  Home sales have been sliding since the end of last year.  No wonder stock investors are nervous.  This stocks/home sales combo also makes economists re-examine their crystal balls.  After taking a closer look, we still conclude that the recent housing weakness is not a harbinger of things to come.  Here’s why.

After sliding steadily since December of last year existing home sales registered  a troubling 4.3% drop in September.  The headlines were uniformly negative.  “Housing is Another Brick in the Wall of Worry”, Housing Market is Faltering and Strong Economy Offers No Cure”, “Housing Sector May Be the Skunk at the Economic Picnic”.  Cute headlines, but seriously misleading.  In all those stories nobody pointed out that almost all the September decline was in the South.  But something important happened in the South in September.  Hurricane Florence devastated the northern part of the South Carolina coast.  And the South will be weak again in October because Hurricane Michael crushed the Florida Panhandle.  I can only imagine those headlines.  So be prepared.  The two hurricanes had a significant impact on sales in those two months, but it will prove to be temporary.

Even prior to the September data home sales  have been steadily falling for months.  So, what is going on?  Is it a demand problem?  Or is there some sort of supply constraint?  We believe that for the most part it is the latter.

First, on the demand side.  Could it be that rising mortgage rates and higher home prices have made housing unaffordable?  Not really.  It is true that mortgage rates have climbed from a low of 3.5% a couple of years ago to 4.9%.  Clearly, mortgage rates are higher than they were.  But over the past 25 years mortgage rates have averaged 6.25%.  We believe that mortgage rates have not yet risen to the point where they might begin to significantly constrain demand.

At the same time, home prices have been rising by about 5.0% annually for the past several years.  Could this combo of higher mortgage rates and higher home prices push some buyers out of the market?  Yes, but not many.

When people talk about housing affordability the discussion typically centers on mortgage rates and home prices.  But there is a third variable in the equation – consumer income — and it has been rising steadily.  The National Association of Realtors publishes a monthly series on  housing affordability which encompasses all three variables.  Currently, consumers have 40% more income than is required to purchase a median-priced house  Five years ago consumers had 80-90% more income than required.  Housing is clearly less affordable today than it was at that time, but is it unaffordable?  No.  In late 2007, just prior to the recession when the housing sector was hot, consumers had just 14% more income than was required; today they have 40% more income.  Housing was relatively unaffordable in 2007.  That is not the case today.

If potential home buyers were truly getting nervous we would expect homes offered for sale to sit on the market for a longer period of time.  But that has not been happening.  The average home is on the market for 32 days before it is sold.  This series began in mid-2011.   At that time, it took 90-100 days to sell a house.  The 32-day average time between listing and sale today is one of the shortest we have seen.  That seems to suggest that the demand for housing remains solid.

We would also have thought that if the housing market were weakening builders would be reporting less traffic through their model homes.  That does not seem to be happening.  Instead, traffic seems to be bouncing around from month to month at some of the highest levels we have seen in a decade.

On the supply side, realtors are constantly complaining about a shortage of inventory.  They cannot sell a house that is not on the market.  Today there is a 4.3-month supply of homes available for sale.  But realtors suggest that a 6.0-month supply is required for demand and supply to be in balance.  We are not even close.  There is clearly a significant shortage of homes available for sale.  Demand exceeds supply.

It is interesting to note that the absolute number of homes available for sale has been steadily declining for more than a decade.  If there were a 6.0-month supply of homes available today, the inventory level would be almost 700 thousand homes higher.  If 700 thousand homeowners suddenly put their houses on the market, would the demand be adequate to sell them?  We think so.  Remember, a 6.0-month supply is regarded as the point at which demand and supply are in balance.  If 700 thousand homes come on the market, existing home sales would surge to 5,850 thousand rather than the current level of 5,150 thousand and we would not be having this discussion about weakness in the housing market.  That would be a record pace of sales.

At first blush the drop-off in home sales is impressive and appears to be troubling.  But upon closer examination the slowdown largely reflects supply constraints rather than any softening of demand.  For now, rest easy.  The drop in housing is not as problematical as it seems.

Stephen Slifer


Charleston, S.C.

The Fed Is Not Crazy

October 19, 2018

President Trump recently tweeted, “I think the Fed is making a mistake.  They’re so tight.  I think the Fed has gone crazy”.   The Fed is not crazy.  Fed policy is not tight by any standard.  And presidential rhetoric is not going to influence Chairman Powell and his colleagues in any way.

First, a disclaimer.  I have great respect for the Fed.  I began my career at the Board of Governors many years ago.  The Fed’s economists are some of the smartest, hardest working people I have ever met.   They taught me how to think about the real world, not the theoretical one taught in school.  If we must delegate interest rate control to anyone, I am happy to entrust those decisions to my former colleagues at the Fed.

What is a “neutral” rate for the funds rate?  Surely, we can all agree that a 0% funds rate is too low.  If the Fed lowers the funds rate to 0%, it is putting the pedal to the metal and trying to stimulate quickly the pace of economic activity.  Similarly, a 10% funds rate must be too high.  For that to occur the economy must be seriously overheating and inflation on the rise.  So what exactly is a “neutral” rate, one which neither stimulates nor retards the pace of economic activity?

Most economists look at the behavior of the “real” funds rate, i.e. the level of the funds rate adjusted for inflation.  Over the past 50 years, which includes numerous expansionary periods and recessions, the funds rate has averaged 1% higher than the inflation rate.  If the Fed puts the funds rate 1% higher than its inflation target of 2.0% its policy will, presumably, be “neutral”.  That is why most economists, both inside and outside the Fed, regard a 3% funds rate as roughly “neutral”.

When the Fed lowered the funds rate to 0% in December 2008, the financial markets were collapsing, and the economy was slipping over the edge into a deep, dangerous recession.  Extraordinary measures were required.  The Fed’s move was unprecedented.  It had never lowered the funds rate to 0%.  It wanted to send a message that it was prepared to do whatever was necessary to get the economy back on track.  Fortunately, the Fed’s action helped lift the economy out of troubled times and the recession ended in June 2009.

That was then.  This is now.  The economy has been growing at a 3.0% pace for a year.  Inflation has returned to the Fed’s 2.0% target.  The economy is no longer in need of a 0% funds rate.  It is time to take the foot off the accelerator.  That is what the Fed has been doing since December 2015.

Currently the funds rate is 2.0-2.25%.  It is still well below the “neutral” level of 3.0%.  A higher funds rate does not seem “crazy” to us.  Rather, we think it is entirely rational.

The Fed plans one more rate hike in December and four more moves in 2019.  By the end of next year, the funds rate will be 3.2%.  Fed policy will, at long last, have returned to “neutral”.  At that point the Fed will pause and sniff the air.  It will scrutinize the economy for signs of overheating and/or inflation on the upswing.   For Fed policy makers rate hikes up to this point have been easy.  Raising the funds rate from 0% to its current level carried virtually no risk.  By the end of next year, the Fed will need to be more careful.   Discussions at FOMC meetings will be more spirited and there will be a broad range of opinions about what to do next.

The biggest problem for the Fed is that interest rate changes impact the economy with a lag of anywhere from 3 months to a year.  That is why the Fed often overshoots.  It may raise rates today, not see any apparent change in the economy three months hence and decide to raise rates again.  Before you know it, the Fed has gone too far, and the economy has slipped over the edge into recession.

Because  the Fed’s rate decision today is based on what the economy might look like six months to a year from now the Fed can make mistakes.  But, in our opinion, the danger of a policy mistake is unlikely to occur until the end of 2019 at the soonest.

The president’s Fed-bashing is not going to have any impact on Chairman Powell and his colleagues.  Their discussions will be about the state of the U.S. economy, inflation, the global outlook, the level of interest rates, etc.  Politics and elections do not play a role.    Some argue that political pressure from Trump will cause the Fed to raise rates more slowly than they otherwise would.  Nonsense!  Others argue that Fed bashing will cause the Fed to raise rates more quickly to demonstrate the Fed’s independence.  Rubbish!  It makes nice press, but the Fed does not work that way.

However, the president’s comments make the markets nervous and, therefore, are not helpful.  The markets are dealing with considerable uncertainty right now.  Between rising interest rates, third quarter earnings, the upcoming election, trade, the state of the global economy, and a rift between the U.S. and Saudi Arabia, the markets have plenty to worry about.  Questions about the Fed’s independence and integrity should not be on the list.

Stephen Slifer


Charleston, S.C.

Stock Market Jitters Send a False Signal

October 12, 2018

A broad-based, dramatic decline in the stock market is always nerve-wracking.  Most of the time it has little economic significance and reflects nothing more than normal stock market volatility.  But when the end of an economic expansion is approaching, a similar-looking stock drop will be an early signal of trouble ahead.  For this reason, we must always focus and try to determine the cause of the slide.  In this case, we are firmly convinced that the recent decline falls into the “false signal” category.

The fundamentals are solid:

Consumer confidence is the highest it has been in 18 years.

Ditto for business confidence.  Tax cuts and deregulation are working their magic.

Short- and long-term interest rates, while rising slowly, remain low by any historical standard or when looked at in inflation adjusted terms.

Housing has softened a bit, but the problem does not seem to reflect a drop-off in demand.  Rather, it reflects an inability of builders to get enough workers to significantly boost the pace of production, and an unwillingness of existing homeowners to put their house on the market perhaps in anticipation of even higher prices down the road.  Thus, we are apparently looking at a supply constraint rather than any significant weakening in demand.

Inflation continues to be well contained.  The CPI for September, released in the middle of the recent stock market rout, rose 0.1% both overall and excluding the volatile food and energy categories.  The CPI core rate has risen 2.2% in the past year.  But remember that the Fed’s 2.0% inflation target is not for the CPI, but the so-called personal consumption expenditures deflator.  The 12-month increase in the core PCE deflator currently stands at 2.0% and has been steady at that pace for the past six months.  While inflation is inching its way higher, the operative word is “inching”.

Inflation expectations (which are important to the Fed) have been steady at the 2.1% mark for almost a year.

None of these factors are going to cause the Fed to panic. The economy is showing no sign of overheating.  The current rate of inflation as well as inflation expectations are steady at a rate close to the Fed’s target.  But because the economy continues to expand at a solid pace, and because inflation seems to be inching its way higher, it is entirely appropriate for the Fed to continue its journey to bring rates back to “neutral”.  The market’s fear that the Fed is going to accelerate its previously-announced pace of rate hikes seems unwarranted.

What about trade and an escalation of the trade war with China?  Could that negatively impact GDP growth in the U.S. and elsewhere?  Yes.  We are happy that the trade skirmish now seems focused on China rather a more broad-based attack that included Mexico, Canada, Europe and Japan.  The conflict with China is long overdue.  The Chinese are notorious for not respecting copyrights and patents.  They force U.S. tech companies to share their secrets in exchange for doing business in that country.  We clearly support the notion of “free” trade, but it must also be “fair” trade and China fails that test.  President Trump is right to curtail access to U.S. technology.  U.S. security issues are involved, and they should supersede any free trade argument.  Will that knock a couple of tenths off U.S. GDP growth?  Probably.  But it will curtail growth in China to an even greater extent which could provide some incentive for Chinese leaders to re-think their business practices.  The good news is that this trade war comes at a time when the U.S. economy is strong and any modest drop-off in growth will go largely unnoticed.

In our view, the economic fundamentals are solid and seem to be pointing towards a surprisingly favorable combination of strong growth, contained inflation, and low interest rates for the foreseeable future.

As a result, we conclude that the stock market decline this past week has been largely technical and has little if any economic significance.  We have noticed that the markets seem to become unglued late in the day and plunge several hundred points in a matter of moments.  Perhaps the increased popularity of exchange-traded funds, which try to mimic the performance, of a particular stock  index are contributing to the problem.  Fund managers are required to keep their portfolios closely aligned with whatever index they track.  They can most closely match that index by executing trades late in the day.  We see the market collapsing and gasp, but the exaggerated slide largely reflects a very normal technical trading phenomenon.

One other point worth noting.  Oil prices in recent months climbed to about $75 per barrel before sliding late in the week to $71 as investors concluded that the stock decline might trim GDP growth around the globe and thereby curtail the demand for crude oil.  However, we continue to worry about further reductions in the supply of oil in the months ahead which could once again push prices higher.

The rise in oil prices the past few months largely reflects curtailment in the supply of oil from Venezuela, and the fear of a sharp reduction of Iranian output once sanctions go into effect next month.

Oil production has collapsed in Venezuela as the country’s economy has sunk into depression.  However, the drop-off has been gradual and other OPEC countries have been largely able to fill the gap.

In Iran the decline in production in Iran thus far has been modest, but one wonders what will happen once the U.S.-imposed sanctions go into effect on November 4.  The goal is to reduce Iran’s oil exports to zero.  No one knows at this point how big the impact will be.  India has joined South Korea and France in ceasing to buy Iranian oil. Other countries have sharply curtailed their purchases. OPEC has said it stands ready to counter any loss of oil from Iran and claims that its spare capacity is ample.  However, those wells have been unused for some time and it is not clearly exactly how much can be tapped quickly.  Thus, there is the potential for a further run-up in oil prices between now and yearend.

In conclusion, the October stock drop is disquieting, but there is no reason to believe it is a harbinger of slower growth ahead.   As always, there are potential dangers lurking and we will continue to monitor them.  For now, breathe easy.

Stephen Slifer


Charleston, S.C.

Rising Bond Rates Generate Jitters

October 5, 2018

The combination of strong economic news and a 48-year low in the unemployment rate this past week spooked the bond market and pushed bond yields to their highest level in seven years.  The speed of ascent in bond rates created jitters in the stock market which quickly retreated from a record high level.  The theory is that steady tightening in the labor market will induce the Fed to raise rates more quickly than anticipated and potentially jeopardize the near-record length expansion.   This is the latest in a never-ending string of market fears which we do not share.  It is abundantly clear that the Fed will continue to raise short-term interest rates for at least another year.  It has told us what it intends to do.  Bond yields will also continue to climb.  However, the level of both short- and long-term interest rates will not negatively impact the economy for at least another three years.  Here is why.

The Fed recently raised the funds rate to 2.0-2.25%.  However, it believes that its policy stance is “neutral” when the funds rate is about 3.0%.  At its latest FOMC gathering on September 25-26 it outlined its expected rate of funds rate hikes through 2021.  It intends to raise the funds rate one more time this year (presumably in December), three times in 2019, and one final time in 2020.  That would lift the funds rate to 3.4%.  But that is as far as it intends to go.  Short rates will be steady in 2021.  It is important to recognize that the U.S. economy has never gone into recession until the funds rate has risen to at least the 5.0% mark.  Thus, Fed policy should not jeopardize the expansion for at least another three years.

The strong economic data and 3.7% unemployment rate caused bond yields to jump to 3.2%.  That is the highest level of long-term interest rates since 2011.  However, a 3.2% bond yield is still very low relative if one uses a somewhat longer time horizon.  Prior to the 2007-08 recession bond yields were consistently in a range from 4.0-9.0%.

To determine whether long-term interest rates are “high”, it is helpful to look at long-term interest rates in relation to inflation, which is known as the “real” rate.  In the period since 1990 the “real” 10-year rate has averaged 2.2% which means that the 10-year yield tends to be 2.2% higher than the inflation rate.  With the 10-year currently at 3.2% and the year-over-year increase in the CPI at 2.4%, the “real” rate today is 0.8%.  It is much lower than the 2.2% one would expect given this historical relationship.  Why is that?

We would suggest that the robust pace of economic expansion in the U.S., an expected steady diet of additional Fed tightening, and a gradual increase in the inflation rate have pushed long-term interest rates in the U.S. to the 3.2% mark which is far higher than bond yields available elsewhere around the globe.  As a result, foreign investors have been flocking into the U.S. 10-year and thereby compressing the real rate relatively to history.

Over the course of the next couple of years we expect the CPI to average 2.4%.  At the same time, we expect the “real” rate to climb from 0.8% to 1.8% which is close to its long-term average.  That would put the 10-year note yield at 4.2% by the end of 2021.

For that to happen the Fed needs to keep inflation expectations in check.  That means it cannot afford to back away from the planned trajectory of rate hikes over the next couple of years.  Right now, inflation expectations (as measured by the 10-year note rate less the “inflation adjusted 10-year note) have been steady at 2.1% for the past year.

As we see it, both short- and longer-term interest rate levels are going higher with most of the run-up occurring by the end of next year.  The funds rate should climb to 3.4% which is slightly higher than its “neutral” rate of about 3.0% but still well below the 5.0% level that was required to tip the economy over the edge in previous cycles.  The yield on the 10-year note should climb from 3.2% today to 4.2%.  But that means that the “real” 10-year rate would be 1.8% which is still lower than its long-term average.  Hence, neither short- nor long-term interest rates are likely to rise to levels that could endanger the expansion for at least another three years.

Is this scenario too good to be true?  Perhaps.  There are always risks and this period is no different.  But Fed Chairman Powell said in a speech last week that Fed economists, as well as several private sector forecasters, have come to the view that the recent period of strong growth, low unemployment, and relatively stable inflation  can continue for some time to come.  We agree.

Stephen Slifer


Charleston, S.C.

Out of town this week

I am out of town this week.  Will be back next week.

The data released this past week are consistent with GDP growth in the third quarter of about 3.0%.

The Fed’s tightening move this week and the one upcoming in December are also in line with expectations.  Even at year-end the fed funds rate will remain well below the neutral level of about 3.0%.

Steve Slifer

Have the Tax Cuts Boosted Tax Revenue?

September 21, 2018

The tax cuts have been in place for almost a year.  Trump tried to sell the notion that they would stimulate growth in the economy and generate enough additional tax revenue that budget deficits would disappear in the years ahead.  Most economists did not buy into that scenario.  They believed that the tax cuts would increase future budget deficits, perhaps significantly so.  With almost a year’s worth of data now available,  it appears that the tax cuts increased the budget deficit in year one, but their impact longer term has yet to be determined.

The tax cuts have clearly stimulated the pace of economic activity.  Following unimpressive 2.0% GDP growth in 2015 and 2016 the economy has picked  up speed.  Growth accelerated to 2.5% in 2017,  is expected to climb 3.1% this year, and likely to register 3.0% growth in 2019.  The tax cuts have clearly worked their magic and lifted the economy onto a faster growth track.

But how long will this growth spurt last?  Whether the tax cuts are deemed a success will depend critically on the longer-term prospects for GDP growth.  We think that the tax cuts and deregulation will result in a faster pace of investment spending which will lift GDP growth to a sustained 3.0% pace for the foreseeable future – the new normal.

Others suggest that the stimulus to investment spending will fade by 2020 and growth will revert to 2.0% — the old normal.  It is too soon to tell whether the tax cuts have permanently lifted the economy’s speed limit.

Can the recent data on tax receipts provide an early indication of which theory might be more accurate?  Not really.

The idea that faster economic growth will bolster tax receipts by enough that budget deficits will shrink did not work out well this past year.  Tax receipts should grow roughly in line with nominal GDP.  If nominal GDP grows 5.0%, tax receipts should climb by 5.0%.  That hasn’t happened.  It appears that nominal GDP growth this year will be 6.0%, but tax receipts will edge upwards by just 0.7%.  The economy grew more quickly this year, but the tax cuts took a significant bite out of tax revenue.

While the tax cuts negatively impacted the deficit in year one, if faster GDP growth is sustained won’t future budget deficits shrink?  Perhaps.

For the record, the budget deficit this year will climb from $665 billion to $800 billion .  The Congressional Budget Office projects budget deficits exceeding $1.0 trillion every year for the next decade.

But deficit data only have significance when viewed in relation to the size of the economy.  On that basis the budget deficit will be 4.0% of GDP this year.  Economists believe that a budget deficit that is 3.0% of GDP is sustainable.  Thus, the deficit currently is a bit high but not excessively so.  The CBO expects it to quickly climb to 5.0% of GDP in the years ahead which will be a problem.  But is it a lack of tax revenue or excessive spending that makes it so high?

Currently tax revenues are 16.5% of GDP which is somewhat  lower than the long-term average of 18%.  The CBO expects nominal GDP growth of 4.0% during this decade, tax revenues to grow somewhat more quickly than that, and reach 18.5% of GDP by 2028.

The CBO expects government spending to climb from 20.6% of GDP this year to 23.5% by 2028 which would be well above its long-term average of 21%.  The pickup in spending is driven by demographics.   The baby boomers were born between 1946 and 1964; they will retire between 2011 and 2029.  As they retire they begin to receive Social Security benefits and become eligible for Medicare.  Thus, the surge in spending is built in the cake.

But consider this.  The CBO’s estimates of tax revenues are based on nominal GDP growth of 4.0% in the years ahead, presumably consisting of real GDP growth of 2.0% combined with 2.0% inflation.  But suppose we are right and real GDP growth averages 3.0% during this period rather than 2.0%.  Tax revenues in the years ahead will grow 1.0% more quickly than the CBO expects, and the deficits will be about 1.0% smaller.  So rather than 5.0% of GDP, if the tax cuts boost potential growth to the 3.0% pace we expect, the deficits as a percent of GDP might be only 4.0%.  Prior to the tax cut legislation, the CBO projected budget deficits of 5.0% of GDP.  If the tax cuts stimulate potential GDP growth to 3.0%, then over the long-haul they will result in smaller budget deficits than would otherwise have been the case.  The tax cut, however, would not – as Trump hoped — boost tax revenues sufficiently that budget deficits disappear.

Future budget deficits currently look problematical.  We need faster potential growth to shrink them to a more manageable level.  Time will tell.

Stephen Slifer


Charleston, S.C.

Florence Will Result in a Temporary Growth Slowdown

September 14, 2018

We have heard about Hurricane Florence for weeks.  The good news is that it did not come ashore as the Category 4 or possibly Category 5 storm that had been feared early in the month.  Rather, it hit Wilmington as a Category 1 storm.  The bad news is that it hit Wilmington as a Category 1 storm.  For those of us in Charleston we appear to have been spared from anything more serious than tropical storm conditions.  Unfortunately, our good fortune is someone else’s misery.  A hurricane of any size can be devastating for the area that is impacted.

However, this is not Hurricane Katrina that flooded New Orleans in 2005, Hurricane Sandy that blasted the east coast of the U.S. from Washington to Boston in 2012, Hurricane Harvey that crushed Houston in 2017, or even Hurricane Irma that lashed all of Florida, Georgia, and South Carolina last year.  In this case, Florence was a Category 1 storm that missed major metropolitan areas.

Presumably fearing the frequently erratic and largely unpredictable paths followed by hurricanes in other recent years and the sheer magnitude and size of the approaching storm, the governors of South Carolina, North Caroline, and Virginia issued evacuation orders as early as Tuesday, September 11, for a storm that did not make landfall until Friday, September 14.  In hindsight, the evacuation orders seem grossly premature.  For the beach areas along the coast from the Outer Banks to Charleston, the loss of almost all tourist business for a protracted period in a season that lasts 13 weeks was heartbreaking.  The early evacuation orders exacerbated the damage on these areas.  But by missing major metropolitan areas the economic slowdown will be hardly noticeable for the economy as a whole.

The first place to look for economic weakness associated with the storm will be initial unemployment claims which is a measure of layoffs.  Almost certainly claims will rise significantly from a 49-year low level of 204 thousand in the week of September 8 to perhaps 240 thousand within a week or two.

An increase in claims suggests that the employment report for September will reveal a slowdown from the 190 thousand per month pace in other recent months to perhaps 150 thousand in September.  That report will be released on Friday morning, October 5.  The nonfarm workweek should also slip from a lengthy 34.5 hours in August to perhaps 34.3 hours.

In mid-October retail sales for September could be relatively unchanged or even decline slightly.  Ditto for industrial production for that month.

The softness in employment, hours worked, retail sales and industrial production suggest that the overall pace of economic activity declined in September.  Third quarter GDP will consist of two robust months —  July and August – followed by a weak month.  Thus, Hurricane Florence will have had some modest negative impact on GDP growth for the third quarter.  Based on the presumption that September would have been another month of steady growth we were expecting GDP growth for the third quarter to be 3.1%.  But if we replace one month of that quarter with a much slower pace of expansion, we will shave that forecast by 0.2% from 3.1% to 2.9%.  We will see the first estimate of GDP growth for that quarter on Friday morning, October 26.

But all the indicators mentioned – payroll employment, hours worked, retail sales ,and industrial production — will then rebound in October and the economy will get back on track.  So, whatever GDP growth was lost in the third quarter should be recaptured in the fourth quarter.  Accordingly, we have raised our projected GDP growth for the fourth quarter from 3.0% to 3.2%.   That figure will be released in late January.

What does all this mean?  Simply that in the month of October we will see some relatively anemic-looking economic indicators.  That could create an impression that the pace of economic activity is softening a bit, perhaps in response to the Fed’s series of rate hikes.  In our opinion, such a conclusion is unwarranted and in the following month (data for October, released in November), the soft data will be replaced by equally strong reports.  Growth will simply have shifted from one month to another (September to October), and because those months happen to be in different quarters, GDP growth will also have shifted from one quarter to the next (from the third quarter to the fourth).  Don’t be fooled into thinking that the upcoming data are indicative of any long-lasting economic slowdown.  That will not be the case.

Furthermore, none of this will dissuade the Fed from raising interest rates again at its September 25-26 gathering.  Even the reduced 2.9% GDP growth in the third quarter exceeds their estimate of potential growth (which appears to be 1.8%), and inflation has now climbed back to its 2.0% target and is poised to move higher.  Look another modest increase in rates of 0.25% at that meeting from 1.75-2.0% currently to 2.0-2.25%.

Stephen Slifer


Charleston, S.C.