Monday, 24 of September of 2018

Economics. Explained.  

Category » Commentary for the Week

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.

The Yield Curve Will Not Invert — Do You Care?

September 7, 2018

The markets fear many things one of which is the shape of the yield curve.  The yield curve is simply the difference between long-term interest rates and short rates.  That sounds like something that only an economist could love.  But it matters – to economists and to you.  Why?  Because if it inverts it could be a sign that a recession is rapidly approaching.  Why that is the case?  Is it likely to happen any time soon?  Rest easy.  That long-awaited recession will not be on our doorstep until 2022 at the earliest.

Today the yield on the 10-year bond is 2.9%.  The overnight federal funds rate is 1.9%.  Subtracting one from the other, long rates are 1.0% higher than short rates.  That means that the yield curve has a positive slope which is the case about 99% of the time.  Some economists use different short-term interest rates to make the comparison.  Some like to look at the difference between the 10-year bond and the 2-year note.  Others think that it is better to use the 10-year bond and the 3-month bill rate.  Pick whatever short-term interest rate you want.  They all tell the same story.

Why does the yield curve typically have a positive slope?  Because long-term securities are riskier than short-term ones.  The long-term bond holder must wait longer for the repayment of principal,   If the bond holder must sell a bond  prior to maturity they might have to sell it at a reduced price.  To compensate for this risk, long-term bonds almost always pay higher interest rates than short-term instruments.

Why does the yield curve invert?  Typically, it  happens because the Fed has tightened too much.  Perhaps the economy is overheating.  Perhaps inflation is picking up rapidly.  If the Fed falls behind the curve it must raise rates quickly to catch up.  But the economy does not respond to higher interest rates for at least a year.  As a result, the Fed often goes too far, and the economy slips into recession.  Historically, the yield curve inverts about one year prior to the onset of recession.  That is why economists attach so much significance to an inverted yield curve.

What has been happening lately?  The yield curve has been flattening for the past nine years.  In June 2009 when the recession ended long rates were 3.5% higher than short rates.  Today the difference has shrunk to 1.0%.  Most economists fear that additional Fed tightening later this year and next will raise short rates by 1.5% and cause the yield curve to invert.  They conclude that a recession is brewing by 2021.  Sorry.  We don’t buy it.

In our world there are two necessary conditions for a recession.

  1. The Fed raises the funds rate to 5.0% or higher.
  2. The yield curve inverts.

Most economists believe that Fed policy is neutral – it is neither stimulating the economy nor trying to slow it down – when the funds rate is about 3.0%.    Today it is 1.9%.  If the Fed tightens six more times between now and the end of next year in 0.25% increments, the funds rate will have risen to 3.4% which makes it just slightly higher than neutral.

But the economy does not swoon just because the funds rate reaches neutral.  In the past 50 years the U.S. economy has never gone into recession until the funds rate is above 5.0%.  For example, going into the last recession the Fed raised the funds rate to 5.25% before the economy succumbed.  The funds rate was even higher going into earlier recessions.  Thus,  5.0% is a pretty good place for us to begin a recession watch.  If at the end of  2019 the funds rate is 3.4%, we are not even close to the 5.0% danger point.

What about the yield curve?  Won’t it invert if the Fed tightens raised short rates by another 1.5%?  Probably not.  Think of the 10-year note as the average of a series of ten 1-year notes purchased back-to-back.  Thus, it becomes clear that if the Fed raises short-term interest rates, long-term interest rates will rise as well.  Second, bond holders are sensitive to the inflation rate.  If inflation rises, the amount they will get paid at maturity will be worth less than if inflation had not risen.  If the inflation rate rises between now and the end of next year, the yield on the 10-year note should rise as well.

At the end  of next year, we believe the funds rate will be 3.4%.  The yield on the 10-year note will have risen from 2.9% today to 4.0%.  Hence, the yield curve will have a positive slope of 0.6% (compared to a positive slope of 1.0% today).  The yield curve will be flatter, but it will not invert.  Thus, neither condition necessary for a recession will have been achieved.  The funds rate will be at 3.4%, still way below the 5.0% danger point.  And the yield curve will still have a positive slope of 0.6%.  A recession will not happen in that world.

Let’s go out one more year to the end of 2020.  What might that world look like?  Let’s assume that the Fed raises short rates four more times in that year and boosts the funds rate to 4.4%, still below the 5.0% danger point.  We expect the yield on the 10-year note to be 4.8%.  The yield curve will have a positive slope of 0.4%.  Still no danger of recession.

Make no mistake.  The yield curve matters.  A lot.  And when it inverts because Fed policy has become too tight, we will be warning about an imminent recession.  But if the yield curve inverts later this year it will be inverted for the wrong reason.  With the funds rate at 3.3% Fed policy will not be too tight.  Rather, the curve will be inverted because bond holders have pushed long rates below short rates.  Right now, foreign investors are piling into the United States because of dueling tariffs.  They believe that the U.S. will weather a trade war better than anybody else.  That makes dollar-denominated assets – both stocks and bonds – extremely attractive.  Historically, the yield on the 10-year note averages 2.2% higher than the inflation rate.  Over the next 10 years market participants expect the inflation rate to average 2.1%.  So, based on history, we would expect the yield on the 10-year note to be 4.3%.  It isn’t.  It is 2.9%.  If the yield curve inverts any time soon, it will be because long rates are too low, not too high.  That does not sound like a warning shot to us.  Rest easy.  Clear sailing until 2022.

Stephen Slifer


Charleston, S.C.

Economists Are Missing Something

August 31, 2018

The economy is on a roll.  GDP surged 4.2% in the second quarter.  The stock market is at a record high level.  The bull market has lasted longer than any other in history.  Yet most economists do not expect the economy to sustain this pace for long.  They believe that an aging population and meager gains in productivity are likely to hold back growth in coming years.  They cling to the notion that potential GDP growth will remain at 1.8%.  We think they have it wrong.

The difference between their view and ours centers upon the outlook for investment spending.  After failing to grow for almost two years, investment spending suddenly took off immediately after President Trump was elected.   The upswing was triggered initially by the prospect of a cut in the corporate tax rate, and it got further support when the tax cut passed Congress in December of last year.  Investment spending grew rapidly every quarter in 2017 and registered 6.3% growth for the year.  It is off to a fast start in 2018 with growth rates of 11.5% and 8.5% in the first two quarters of the year.  As a result, we expect investment spending to register 7.7% growth for 2018 and continue at a 6.3% rate in 2019.  With the labor market extremely tight and both skilled and unskilled workers in short supply, business leaders will have to spend more money on the latest technology to boost worker productivity and thereby step up the pace of production.  There is no end in sight to this process.

Corporations have no shortage of funds for  investment spending if they choose to do so.  In the past four quarters after-tax corporate earnings rose 16.1% which is the fastest growth rate since early 2012.

Corporate  cash holdings  as a percent of total assets at 10.2% are well above average and just waiting to be deployed.

If corporations continue to invest there is little doubt that productivity growth will follow.  Indeed, it has already begun to do so.  After registering essentially no growth for a while, productivity grew 1.0% in both 2016 and 2017.  In the first half of this year the growth rate has picked up to 1.3%.  Something different seems to be happening and it is not a surprising result.  When business leaders open their wallets and begin to invest, productivity growth accelerates.

Potential GDP growth is a long-run concept and, thus far, we have only talked about short-term changes.  A 3-year moving average growth rate of productivity might be a better way to measure its “long-run” growth.  That growth rate is still languishing at 0.7% — about where it has been for the past several years.  But with faster growth in productivity in 2016, 2017, and the first half of this year and our expectation for sustained growth in the second half, we estimate that the three-year growth rate will climb to 1.3% by the end of this year and 1.5% by the end of next year.  Tightness in the labor market will force business types to sock some money into technology to boost output  not just this year but every year going forward.  As the 3-year growth rate climbs other economists may finally acknowledge that the economy’s potential growth rate has accelerated.

The other part of the potential growth rate equation is growth in the labor force.  A couple of years ago the 3-year growth rate in the labor force was 0.8%.  Because the unemployment rate has fallen to an 18-year low of 3.9%, some workers who had long since given up looking for a job are now beginning to seek employment.  That means they are back in the labor force.  As a result, the 3-year growth rate has climbed to 1.1%.

So, let’s re-do the potential GDP growth rate math.  A couple of years ago the labor force was growing by 0.8%.  Productivity was climbing by 1.0%.  Add those two numbers together and potential growth – our economic speed limit – was 1.8%.  Most economists believe that it is still at 1.8%.  We think they are wrong.

As noted above, 3-year growth in the labor force has climbed to 1.1%.  The 3-year growth rate for productivity should reach 1.2% by the end of this year.  This suggests that potential growth has already climbed to 2.3%.  If productivity growth continues to climb – as we expect — it is easy to envision potential growth of 2.8% by 2020.

If potential growth picks up lots of good things happen.  The economy will be able to grow at a sustained rate of 2.8% rather than 1.8% without generating inflation.  Faster growth in the economy will boost the rate of growth for corporate earnings.  That will push the stock market higher.  Our standard of living will grow more quickly.  And growth in wages associated with the tight labor market will not result in rising inflation because the increase in wages should be largely offset by gains in  productivity.  In other words, workers will have earned their fatter paychecks by producing more goods.

We continue to wonder how long it will take for others to share our view.

Stephen Slifer


Charleston, S.C.

The Scare Tactics Keep Coming

August 24, 2018

George Will recently wrote a column entitled “Another Epic Economic Collapse is Coming.”  He notes that the stock market rally is now the longest-lasting bull market ever, that all economic expansions inevitably come to an end, and that no one saw the last one coming.  What is bothering Will is the magnitude of the budget deficit and the fact that the ratio of debt to GDP will soon reach 100%.  While we share his concern longer term we believe the headline is grossly inflammatory.  This expansion, like all others before it, will eventually come to an end.  But it will not die because of the rising level of government debt.  It will end, like all its predecessors, because the Fed eventually tightens too much, raises interest rates too sharply, and the economy slips over the edge into recession.  Debt may eventually become an issue, but the danger point is well into the future and may never materialize if future politicians choose to rein in government spending.

The Congressional Budget Office currently projects a budget deficit for  fiscal 2019 of $1.1 trillion which gradually climbs to $1.5 trillion within a decade.   At some point in that 10-year time horizon the expansion will end.  Nobody knows exactly when.  Most economists peg it for 2020.  We would argue that the Fed will not raise short-term interest rates to a level that could endanger the expansion until several years later.  But once the expansion ends tax receipts decline, entitlements like Medicaid and unemployment benefits rise, and  the budget deficit will soar.

Because each year the Treasury must issue an equivalent amount of debt to finance the budget shortfall, debt as a percentage of GDP currently is projected to climb from 77% of GDP today to 96% of GDP by 2028.  When the expansion ends and budget deficits soar, the debt to GDP ratio will climb and a more realistic estimate is a number in excess of 100%.  The question is, at what point does the steadily eroding fiscal position of the U.S. become a problem?

Economists generally believe that a “sustainable” level of debt is something around 50% of GDP.  When it climbs to the 90% mark foreign investors presumably get nervous and become less willing to hold that country’s debt.  Once that happens interest rates must rise to attract the funds required to finance that level of debt.  But 90% is not some sort of magic number.

With that in mind, it might be useful to look at debt to GDP ratios for other developed countries.  The  currently in the middle of the pack.  Canada (at 27%) and Germany (at  42%) are doing a fine job of keeping their debt/GDP ratios below the desired 50% threshold.  France at 87% is somewhat higher than the U.S. but, thus far, investors do not seem in the least bit concerned.  Italy at 120% of GDP is beginning to get some pushback from investors.  But Italy has been at that level for the past five years with few if any adverse consequences.  Only now are investors becoming anxious.

Then there is Japan.  It has had a debt/GDP ratio of 150% for the past seven years.  Despite fears of an impending fiscal Armageddon, Japan seems to have had no difficulty financing its debt.  But Japan is a unique case.  The household savings rate in Japan is about 20% compared to 5% for the U.S.  Thus, most of its government debt is held by Japanese investors.  It need not worry about foreign investors getting nervous and suddenly deciding to dump their holdings of yen-denominated debt.  Traders have been betting on a Japanese debt crisis for years and have been repeatedly frustrated.

Given Japan’s unique circumstances with its extraordinarily high savings rate it is probably not advisable for any other country to attempt to carry such a high level of debt.  Italy at 120%  may represent a more realistic upper limit.  With the U.S. and France close to the 90% mark and neither country having any difficulty financing its debt, it seems likely that the 90% threshold is too low and that economists may be overly concerned.

Having said that, the debt to GDP ratio for all these other countries is projected to decline over the next decade.  The U.S. is the only country where it is almost certain to rise even in the absence of a recession.  Nobody knows what that magic number is, whether it is 90% or something higher.  But only a fool would suggest that debt doesn’t matter, and the U.S. is on the wrong track.  Right now, relatively small changes in policy can restore fiscal responsibility.  The problem is that our policy makers in Washington – all of them on both sides of the aisle –are totally incapable of restraining government spending.

George Will has a point about budget deficits and debt.  But it is a longer-term issue and not something that will bring the current expansion to an end.  Rest easy for now.

Stephen Slifer


Charleston, S.C.

Two Articles for You This Week

August 17, 2018

Two articles for you this week.  One on trade.  It appears that Trump’s trade tactics are actually working.  What will this means in the months and years ahead?

The other is on household debt which climbed to a record high level.  This spooked some economists.  We are not bothered by it in the slightest.

You might also want to read the comments on industrial production which turned out to be surprisingly strong this week, and on productivity which jumped in the second quarter.  The economy certainly seems to be on a roll.

Stephen Slifer


Charleston, S.C. 29492

Trump’s Trade Tactics Are Working

August 17, 2018

President Trump has been pre-occupied with the trade deficit.  To reduce its size he initially imposed stiff tariffs on steel and aluminum.  The Chinese and the Europeans retaliated.  Then came 25% tariffs on another $35 billion of Chinese goods.  The Chinese retaliated.  Now he has proposed a 10% tariff on an additional $200 billion of Chinese products.  He has expanded the trade war to Turkey.  The tit-for-tat tariffs continue.  We did not support his tactics.  We preferred a more focused attack on China which accounts for one-half of our trade deficit.  However, as time passes it has become clear that the U.S. economy is gathering momentum while economies elsewhere are getting slammed.  Tit-for-tat tariff hikes are not working for the rest of the world.  How much more pain can they stand?  Our sense is that as their economies weaken, they may well show up at the bargaining table sooner rather than later and, eventually, the world economy will end up closer to a true free trade environment than it was a few months ago.

As new tariffs have been imposed economists believed that while the U.S. economy might get dinged, other country’s economies would suffer a far worse fate.  This perception has led to a significant 6.0% run-up in the value of the dollar since the end of March as foreigners have poured money into the U.S. stock market and other dollar-denominated investments.

This means that the currencies of our trading partners collectively have declined 6.0%.  The yen and the euro have fallen by about that amount, but currencies of emerging economies have been crushed.  The Chinese yuan, for example, has weakened 10% from 6.3 yuan to the dollar a few months ago to 6.9 yuan.  Other emerging economies have experienced similar currency weakening —  Russia, Malaysia, Turkey, South Korea, India, Brazil, and Argentina amongst others.  Some of these countries are getting hit  directly by the Trump tariffs.  Some are being slapped by sanctions.  Still others are getting crunched by their association with China which is an important trading partner for them.

Perhaps the most dramatic currency decline has been in Turkey.  A few months ago, the Turkish Lira was 3.8 per dollar.  Today it is 6.0  – a decline of almost 60%.  President Trump’s doubling of the rate of tariffs on steel and aluminum imports from Turkey were the catalyst for the meltdown,   However, the battle seems more political than economic as Turkey has detained an American pastor on espionage charges.  Nevertheless, the tariffs have spooked currency markets around the globe.  The precipitous slide in the Turkish Lira has also exposed underlying problems in the Turkish economy which for years has relied heavily on foreign capital for investment.  It has let its money supply grow too quickly and, as a result, inflation has recently climbed from 11% to 15%.

Concerns about Turkey’s financial woes have spread throughout the European banking system which, once again, seems overexposed to debt issued by an economy with shaky economic fundamentals.  However, Turkey is not going to create a financial crisis in Europe or anywhere else.  Its economy is simply too small.  It is roughly the size of Florida.  It is hard to envision a country of that size igniting serious contagion problems.

Currency weakness has caused stock markets of emerging economies to fall by double-digits.  Why?  Largely because they all have significant amounts of dollar-denominated debt outstanding.   As their own currency weakens, they need more local currency to get the dollars required to make payments on their dollar debt.

The broad-based nature of these falling stock markets can be seen in the iShares MSCI Emerging Markets Index which has fallen 20% since reaching a peak in mid-January.  This index includes the stock markets of more than 20 emerging countries including China, India, Taiwan, South Korea,  Indonesia, Malaysia, Turkey, South Africa, Brazil, and Mexico amongst others.

The combination of falling currencies, plunging stock markets, and  higher inflation are a precursor of economic woes ahead for all these countries.

Contrast that to the United States.   Second quarter GDP growth came in at an impressive 4.1% pace.  GDP has risen 2.8% in the past year.  Third quarter growth seem likely to be about 3.5%.  Each month the economy generates 200 thousand jobs.  The unemployment rate is at 3.8% and has not been lower since 1969.  The S&P 500, Dow Jones Industrial Average, the Russell 2000, and the NASDAQ stock indexes are within an eyelash of record high levels.  Consumer confidence is the highest it has been since 2004.  Small business confidence has reached its loftiest level since July 1983.

The divergence in the  economic outlook between the United States and the rest of the world has widened dramatically.  Funds have been flowing into the U.S. from Europe and Asia which have bolstered the stock market, reduced the 10-year note yield, and strengthened the dollar.  So, how will countries in Europe, Asia, and the emerging world respond?    Clearly angered by Trump’s tariffs, thus far they have chosen to impose tariffs of their own which have been matched by still more tariffs from the U.S.  That is not working.  If anything, it has made the problem worse.

During the past six months other countries have begrudgingly recognized the benefits of doing business with the United States.  It strikes us that a better solution would be for them to sit down with the U.S. and negotiate some sort of trade agreement.  The U.S. and the E.U. have already agreed to stop the trade war and bargain.  Steps in that direction seem to be underway with China.  We believe that as negotiations spread the world will eventually move much closer to the “free trade” model described in economic textbooks with few tariffs and a level playing field for all.  That would be a good thing.

We readily admit that we opposed Trump’s trade tactics, preferring a targeted approach directed towards China.  But could it be that his across-the-board tactics are working?

Stephen Slifer


Charleston, S.C.

Consumer Debt – A Record Level, but Rising Slowly

August 17, 2018

The Federal Reserve Bank of New York released its quarterly report on consumer debt which rose $82 billion in the second quarter to $13.3 trillion.   This was a record high level and some analysts suggest that if this continues it will eventually be a problem for our consumer driven economy.  Nothing could be further from the truth.  Indeed, we suggest that it is a healthy sign for the economy.

The level of consumer debt is important, but the real question is whether the consumer can afford it.  One way to determine that is to look at the relationship between consumer debt and nominal GDP (which is a measure of income).  That percentage today is 65%.  It has been flat at about that level for the past five years.  It also happens to be where it was when the New York Fed began to collect these statistics in 2003.

The Board of Governors of the Fed has a slightly different measure known as the consumer’s financial obligations ratio which looks at payments on all types of consumer debt — mortgages, consumer installment debt, automobile lease payments, rent, homeowners’ insurance, and property taxes —  in relation to income.  This measure has risen slightly in the past couple of years but remains far below its average over the past 40 years of 16.6%.

Keep in mind that total household debt grew 3.5% rate in the past year.  In the past year nominal GDP (or income)  climbed by 5.4%.   Thus, consumers are proceeding cautiously and not taking on debt faster than their income is growing.  Thus, we believe that the willingness of consumers to borrow reflects confidence that the economy will continue to expand for another couple of years, and that they will have a job throughout that period.  That is a good thing.

Of the various types of consumer debt, the big gorilla is mortgage debt which accounts for 68% of the total.  During the past year, mortgage debt outstanding – like total household debt – grew 3.5%.  Most other categories of consumer borrowing — auto loans, credit card balances, and student loans all grew at modest rates between 3.5% and 5.5%.

The only category of consumer borrowing that did not grow during the past year is home equity lines of credit which declined 4.4%.  This is not new.  Home equity lines have been steadily declining since the recession ended nine years ago.  Given the extent to which home prices fell during the recession, homeowners have chosen to pull back sharply on the outstanding balances of their home equity lines of credit.

Right after the recession student loans grew at a double-digit pace for five years as students, unable to find a job, remained in school.  But because the economy has improved, most of them have found jobs, and the cost of a college education has escalated student loan growth this past year has continued to slow to 4.5%.

The New York Fed also reports the number of credit inquiries in the past six months which it interprets as an indicator of the consumer’s demand for credit.  It was roughly flat and remains among the lowest seen in the 19-year history of the data.

Finally, the percent of loans that are more than 90 days delinquent has been trending downward for the past several years.

That steady decline is most evident for mortgages and home equity lines of credit where delinquency rates have been falling steadily for years.  Student loan delinquencies are still the highest at 11.0%, but that percentage has not changed appreciably in the past six years.

It is true that consumer debt outstanding has been growing and now stands at a record high level.  But growth in that debt has been in line with consumers’ growth in income and they are easily able to afford the monthly payments.  Furthermore, delinquency rates continue to decline which indicates that consumers are having no difficulty with a record level of debt.  The financial press and economists in general continue to struggle with the notion that the economy is not only doing well, it is likely to continue growing at a sustainable pace for the foreseeable future.

Stephen Slifer


Charleston, S.C.

Rising to Potential

August 10, 2018

There seems to be an emerging consensus that the combination of tax cuts passed last year, and Trump’s deregulation initiative might boost investment spending and GDP growth for an extended period. That has been our position since the tax cuts were adopted and we are happy to see others shift into our camp. A protracted period of robust business investment will boost the economy’s potential growth rate which has already begun to climb.

Potential GDP growth can be estimated by adding the growth rate in the labor force to the growth rate in productivity. It is a measure of how quickly the economy can grow when it is at full employment.

From 2014 through 2016, investment spending slumped as the combination of a high corporate tax rate and a stifling regulatory environment choked off any desire by businesses to invest. But in the wake of the November 2016 election, the expectation of a lower corporate tax rate and deregulation lifted investment spending out of its slump. After three years of essentially no growth, nonresidential investment has surged to a 7.0% pace. It has been growing steadily at that rate for the past six quarters and is showing no sign of slowing down. Why? In an extremely tight labor market where skilled workers are in short supply, what do you as a business person do? You boost investment spending. You spend money on technology to help boost output to satisfy the elevated demand. Meanwhile, the surging U.S. stock market is attracting additional investment from overseas. Foreign firms are starting new businesses and hiring American workers. We anticipate 7.0% growth in investment spending to continue for the foreseeable future.

As investment spending surges it should be no surprise that productivity growth is picking up as well. If firms give their workers better technology and additional capital to do their jobs, they will produce more goods and services. The year-over-year increases in productivity have risen from essentially no growth a couple of years ago to steady gains of 1.3% since the beginning of last year. If investment spending continues to climb productivity growth will remain robust.

So, what does all this mean for the economy’s potential growth rate? It is climbing. Prior to the 2016 election potential growth was widely estimated to be 1.8% which consisted of 0.8% growth in the labor force plus 1.0% growth in productivity. We believe that with a faster pace of investment spending productivity growth will eventually climb from 1.0% to 2.0%, which when combined with 0.8% growth in labor force, should boost potential growth to 2.8% by the end of the decade. So how are we doing?

The labor force part of the equation seems to be picking up. After rising at an 0.8% rate for an extended period, labor force growth has quickened to 1.1% since the beginning of this year. Why? Faster growth in the economy has almost certainly encouraged some discouraged workers to re-join the labor force, and with enhanced opportunities from specific job-oriented programs offered by many technical colleges, and apprenticeship programs at a wide variety of manufacturing firms, those new labor force entrants have found jobs. As new educational opportunities continue to expand, it is not unreasonable to expect labor force growth of 1.1% to continue for several years.

Productivity growth has averaged 1.3% for the past two years. Given that we have already seen labor force growth pick up to 1.1% and productivity climb to 1.3%, potential GDP growth may have already picked up from 1.8% a couple of years ago to 2.4%.

Having said that, potential growth is a longer-term concept and what we have been talking about thus far is relatively short-term improvement. But the upswing in both labor force growth and productivity clearly suggest that potential growth is on the rise. At this juncture we have no reason to alter our view that potential growth will pick up to 2.8% by the end of this decade consisting of 1.0% growth in the labor force and 1.8% growth in productivity. It appears that we are already well on the way.

Stephen Slifer
Charleston, S.C.

Gathering Momentum

August 3, 2017

In the past couple of weeks, we have learned that the economy may be growing more quickly than we had anticipated.  That raises the fear that inflation could begin to rise more rapidly which, in turn, could cause the Fed to accelerate its previously-described path towards higher interest rates.  But, thus far, the inflation rate has remained very much in check which should keep the Fed on a go-slow approach towards higher rates.

Second quarter GDP growth came in at a solid 4.1%.  But we should not forget that first quarter growth was relatively anemic at 2.2%.  Thus, GDP growth in the first half of the year now stands at 3.1%.  In the past year GDP growth has averaged 2.8%.  So, while growth appears to be gathering some momentum, the economy does not appear to be in danger of overheating.  Consistent GDP growth of 4.0% would be a problem; growth of 3.0% is sustainable.

Some economists are quick to point out that the trade gap narrowed significantly in the second quarter as businesses adjusted the timing of their exports and imports in advance of the implementation of tariffs.  As a result, trade boosted GDP growth by 1.2% in the second quarter.  It will not do that again in subsequent quarters, so they conclude that second quarter growth was an aberration.  Their comments about the trade component’s contribution to GDP growth are accurate.

However, business inventories declined $27.9 billion in the second quarter and subtracted 1.0% from GDP growth in that quarter.  That, too, will not be repeated later this year.  In the third and fourth quarters rebounding inventory levels should boost GDP growth by as much as they subtracted from GDP growth in the second quarter.  We have no hard data yet for the third quarter.  However, we will take a stab at third quarter GDP growth of 3.1% and something like that in the fourth quarter.  If all of that is correct, GDP growth in 2018 will be 3.1% compared to a 2.5% growth rate last year.

The second piece of robust economic news was the employment report for July.  While employment climbed by a modest 157 thousand in July, upward revisions to May and June mean that in the past three months payroll employment has risen 224 thousand per month.  That is steamy.  Given a steady died of robust gains in employment and an unemployment rate that is currently 3.9% and falling, shouldn’t we worry about escalating wage pressures?  Yes.  But it does not necessarily follow that upward pressure on wages will translate into a problematical increase in inflation.  Here’s why.

This past week we also got the employment cost index which measures the gains in wages, benefits, and total labor costs.  Total employment costs rose 2.4% in the second quarter and they have climbed 2.8% in the past year as both wages and benefits are on the rise.  The tightness in the labor market is causing upward pressure on labor costs.

However, as we have noted on numerous occasions, we should be looking at labor costs adjusted for the increase in productivity which economists call “unit labor costs”.  Why?  Because higher labor costs can be offset by increased productivity.  If an employer pays its workers 3.0% higher wages because they are 3.0% more productive, he or she really does not care.  The firm is getting more output.  The worker has earned his fatter paycheck.  In that case, unit labor costs, or labor costs adjusted for the increase in productivity are unchanged, and there will be absolutely no reason for that employer to raise prices.  So, what is happening to unit labor costs currently?

The productivity report points out that compensation has risen 2.5% in the past year, but recent quarters have been around the 3.2% mark.

Productivity in the past year has risen 1.3%.

If compensation in the past four quarters has risen 2.5% and productivity has climbed by 1.3%, then unit labor costs in that same time have risen 1.2%.  Remember, the Fed has a 2.0% inflation target.  If labor costs after adjustment for productivity are rising 1.2%, there is no way the current degree of tightness in the labor market will push the inflation rate higher.

For what it is worth, we expect compensation to increase 3.5% in 2018 as the tightness in the labor market pushes wage compensation steadily higher.  But we also expect productivity to rise 1.3%.  This means that labor costs this year should rise just 2.2%.  It does not appear that the tightness in the labor market will cause a problem for inflation any time soon.

If all the above is true, the Fed is not going to be concerned about the combination of faster GDP growth and rising wages.  It needs to have some reason to think that the inflation rate is going to pick up substantially.  We believe that the “core” personal consumption expenditures deflator will rise 2.2% this year compared to the Fed’s target of 2.0%.  The Fed will not regard that as a problem.  Having said that, the Fed should maintain the interest rate glide path it has described which will boost the funds rate to the 3.2% mark by the end of next year and on to 3.4% by mid-2020.

Stephen Slifer


Charleston, S.C.