Monday, 16 of July of 2018

Economics. Explained.  

Category » Commentary for the Week

There is No “Truth” in Economics

July 13, 2018

Two weeks from today we will get our first look at second quarter GDP growth.  It appears to be somewhere around the 4.0% mark.  We can see the headlines already. “Economy Gathers Momentum in the Second Quarter”, “Inflation Soon to Rise”, “Rapid Growth Accelerates Path Towards Higher Interest Rates”.  While this is not exactly “fake news”, it is important to understand that there is no “truth” in economics.  Every economic indicator we see is an estimate to some extent despite the best efforts of the number crunchers at the Commerce Department, the Census Bureau, and the Bureau of Labor Statistics.  These dedicated people do an outstanding job of providing us with as accurate an estimate as they can.  But in the end, much of what we see is estimated.   Thus, it is imperative for us to view each economic indicator with a healthy degree of skepticism.

The press dutifully reports the published data and the big numbers – GDP, employment, retail sales, and the CPI get page one headlines.  But their job is to get you to buy their paper or watch their television broadcast.  They like to embellish the significance of the latest indicator.  Frequently, the headline number is misleading.  The caveats are buried on page 4.  Then, the broadcast media will get the talking heads to provide “color”.  They first one will support the strength (or weakness) of that number.  The next one will have exactly the opposite view.  All of that is by design and represents their attempt to be “unbiased”.  How in the world are you supposed to make sense of all that?  You need to know what is going on, but you have jobs and cannot spend your day poring over economic statistics.  You rely on economists, like us, to provide the real story.  But even then, you will get different stories depending upon exactly who you ask.  Why is all this so difficult?  Largely because economic analysis and forecasting is much more art than science which means that, like art, beauty is often in the eye of the beholder.

GDP.  Is GDP the best measure of the pace of economic activity?  A recent letter to the editor in The Wall Street Journal discussed the concept of Gross Domestic Income (GDI).  It is an alternative measure of economic activity.  Think of it this way.  You can measure GDP from the income side or the production side.    If we live on an island and have one firm that manufacturers refrigerators.  You could ask consumers how many refrigerators they bought last quarter.  We might say we bought 10 at $1,000 apiece.  Hence, our GDP would be $10,000.  Or you could go to the manufacturer and he would tell you that he produced 10 of them for $1,000 apiece which would make GDP $10,000.  You get the same answer.  But only in theory.  It does not work in the real world.  Why?  The real world is messy.  The manufacturer may have produced some refrigerators and kept them in inventory.  He may have manufactured additional refrigerators and shipped some overseas.  We may have bought some foreign-made refrigerators.  And in the real world we simply do not have the ability or the money to ask every consumer or every businessman that question.  Furthermore, some data is only available with a considerable lag.  Hence, the number crunchers are forced to make estimates based on the data that have been reported.

For example, in the first quarter after an initial estimate and two revisions, GDP growth was reported to be 2.0%.  Relatively anemic.  But GDI grew 3.6%.  Steamy.  So, which is correct?  Nobody knows, but it obviously makes a difference.  The Commerce Department also publishes an average of the two which it believes is the best estimate of all.  But it is hard enough to dissect the published GDP figure and all its components.  How in the world are we going to interpret three different estimates of the same thing?  Economists are fond of saying, “On the one hand” followed by “on the other hand”.  Perhaps you can now understand why they might want to do that.

Retail sales.  Then there is the challenge of adjusting the data for normal seasonal movements.  Department and general merchandise stores make most of their sales for the year during the holiday period.  For example, the Census Bureau expects department store sales to jump 75% between October and December, but then decline by a similar amount in January.  It makes no sense to publish changes of that magnitude, so Census tries to adjust for “normal” seasonal movements.  But if our spending habits change ever so slightly from one year to the next, it means that the published data can show some dramatic changes in the November through January period.  Every economic indicator is adjusted for this seasonality, but the statistical method of doing so is essentially an educated guess based on history.

Employment.  Another favorite release is the monthly employment report.  But there are two measures of employment.  One is known as “payroll employment” which gets the most attention.  There is a separate measure of employment that is calculated separately as part of the unemployment rate.  It is known as “civilian employment”.  The first comes from asking a sample of employers how many people were on their payroll last month.  The other comes from an entirely different survey conducted by BLS employees who knock on people’s doors and ask if they had a job last month. The answers can be wildly different.  A classic example occurred in February of this year.  Payroll employment rose 324 thousand in February.  Civilian employment rose an astonishing 785 thousand.  Both strong numbers, but one was more than double the other.    The numbers can vary widely from month to month but, over time, they grow at roughly comparable rates.

So, how are YOU supposed to interpret all this?  First, look beyond the headline number and focus instead on the most recent three months to get some idea if the trend is changing.

Second, look at other economic indicators.  If second quarter GDP growth is strong, is that strength confirmed by other economic indicators?  There are roughly 25 different indicators released each month.  If only one is strong beware of interpreting that indicator too literally.  But if 15 or 20 of the 25 indicators show strength, you can be reasonably certain that you are getting an accurate assessment of what is happening.

Third, figure out what Fed officials are saying.  Why?  Because they have 1,000 economists who dig more deeply into the numbers than any of the rest of us could possibly do.  Having spent some time in the Fed system, I have found Fed economists to be some of the smartest people in the business.  Perhaps even more important, it is their analysis that really matters.  The FOMC members will make their decision about interest rates based on the Board staff’s interpretation of what is going on.  Your view and my view are irrelevant.

Fourth, listen to your favorite group of economists.  Why?  Because we will delve more deeply into the numbers than you can do on your own.   We hope we are a part of that group.  But, the unfortunate reality is that economists can read the same report but reach widely divergent conclusions.

Finally, put all this information together and draw your own conclusions.  After all, it is your business to run, your investment portfolio to manage.  You are the only one that can make those decisions.  Become an economist.

You may have hated economics in school because it was so theoretical.  But, in my experience, economics is about 20% theory and 80% common sense.  And the fact of the matter is that you already are an economist – you simply do not think of yourself as one. You talk knowledgably all day long to your co-workers, your boss, your employees, your friends, and your spouse about the economy.  You know firsthand what sales in your firm are doing, you talk about the stock market, you know whether your firm is hiring or laying off workers, you know whether you plan to boost investment spending, you can sense when the inflation rate is picking up or slowing down, you have a good idea what interest rates are likely to do.  That makes you an economist.

Want to know what is happening?  Look in front of your own nose.

Stephen Slifer


Charleston, S.C.

Good Policy Will Keep the Economy Humming

July 6, 2018

The economic expansion just celebrated its ninth birthday and is far healthier today than it has been in some time.  It has shrugged off two years of stagnation and is chugging along at nearly a 3.0% clip.  At this time next year, it will enter the history books as the longest U.S. expansion on record.  But the naysayers continue to see a dark side.  They believe that the recent stimulus from tax cuts and deregulation will prove to be temporary.  Furthermore, there is a widespread consensus that the next recession will occur in 2020.  Not so fast.  As we see it, good policy and rapid technological advancements can keep the economy humming for some time to come.  While it will eventually end, the end is not yet in sight.

It does not always feel like it, but policy makers have gotten better at extending periods of growth.  Between 1850 and 1900 a typical business cycle lasted four years – two years of expansion followed by two years of recession.  But in the eleven business cycles since the end of World War II the average expansion now lasts six years followed by a one-year recession.  Expansions have gotten far longer, and recessions do not last nearly as long.  That was not an accident.  Why?  Good policy.

In the past 50 years economists’ understanding of macroeconomic policy has gotten better.  Policy makers at the Fed have gotten smarter.  They seem better able to determine the level of interest rates required to keep the economy on track.  Fiscal policy has also improved, and economists better understand the impact of government spending, tax, and trade policies on the economy.  Good policy can extend the life expectancy of an expansion.

For example, not long ago the unemployment rate was 5.0%.  Most economists thought that the labor market had reached full employment and worried that wage pressures and inflation would soon rise.  But Janet Yellen and her colleagues at the Fed argued that there were still many “underemployed” workers who wanted full time jobs but could only get part-time employment.  Hence, the Fed concluded that the economy was not yet at full employment and it elected to raise rates very cautiously for the next 15 months.  The Fed got it right.  Smart implementation of monetary policy prevented the Fed from prematurely raising rates and inadvertently choking off growth.

In 2015 and 2016 the economy grew at rates of 2.0% and 1.8%, respectively.  Business leaders were frustrated by the political gridlock in Washington.  They lacked confidence and chose not to deploy their vast cash holdings on new technology or to refurbish the assembly line.  Recognizing the lack of investment, Trump campaigned on a promise to lower taxes and significantly reduce the then stifling regulatory burden.  He has done both and suddenly investment spending has picked up to a double-digit pace and GDP growth accelerated to a 2.6% pace last year and is expected to reach 3.0% this year which would be the fastest annual growth rate since 2005.  Thus, good fiscal policy has provided a welcome boost to the pace of economic activity.

However, most economists believe the recent stimulus will prove to be temporary and within a year or two, growth will revert to its old 2.0% potential growth path.  But why should that be the case?  A lower corporate tax rate and the ability to repatriate money from overseas should stimulate investment for many more years.  Businesses should be further encouraged to spend if Trump continues to eliminate unnecessary, overlapping, and confusing Federal regulations.   And rapid technological advancements in artificial intelligence, autonomous vehicles, personal robots, 3-D printing, nanotechnology, and genome research will keep businesses spending for the foreseeable future, and that type of investment will boost productivity growth.  Thus, we believe that potential growth will pick up from 1.8% in the 2000’s to 2.8% by the end of this decade.  There is no reason that today’s surge in investment spending should be regarded as a short-lived event.

Furthermore, what is magic about this expansion reaching the 10-year old mark and becoming the longest recession on record?  The 120-month long expansion during the 1990’s surpassed the previous record (of the 1960’s) by 14 months.  Why can’t the current expansion do the same?  Expansions do not die from “old age”.  They end because of policy mistakes.

Many think that a 10-year is expansion is a big deal.  Certainly by U.S. standards that is the case.  But the Australian economy just completed a world record 27th year of expansion.   Why can’t the U.S. duplicate that astonishing achievement?  Suddenly a 10-year expansion seems modest.

Stephen Slifer


Charleston, S.C.

Confronting Old Age

June 29, 2018

A recent Wall Street Journal article noted how a generation of Americans is entering old age the least prepared in decades.  The basic assumption is that baby boomers want to retire at age 65, but soon discover they do not have the financial resources to do so.  Fair enough.  But let’s ask a more basic question, why do they want to retire at 65 anyway?  What is magic about that number?  To that group of Americans, I have a suggestion.  Work longer.

When Social Security was first passed in 1935 retirement age was 65; life expectancy was 67.  You retired, received your gold watch, and died a couple of years later.  But over the years retirement age has not changed.  It is still about 65 but we are likely to live until 85.  Living 20 years on greatly reduced income consisting of Social Security and a pension plan or 401(k) is challenging.  The math simply does not work.

But let’s revisit the basic question of why do people want to retire at age 65?  It has become a given that we are “supposed to” retire at age 65.  But our parents and grandparents chose to work until much closer to their end of their lifetime.  What gives baby boomers the audacity to think that they can spend one-quarter of their lifetime sitting on their butt in front of the TV?  Is that truly how they envision their retirement?  That strikes us as sad, but many people seem obsessed with retiring at 65.

Our guess is that, over time, that perception will change, in some cases by the financial reality that it is not going to happen.  But many of these older Americans may wake up to the reality that their retirement dream is not as satisfying as they expected it to be.  It is boring.

Most retirees worked 40 years at something. They identified with what they did.  They were accountants, attorneys, firemen, teachers, or economists.  But upon retirement they are not that anymore.  So who exactly will they be for the next 20 years?  That is a difficult question to answer.  While some may have given thought to that while still working, most have no idea what their retirement years will look like until they get there.

Some may have a burning desire to become an artist, take up the guitar, travel extensively. or “give back” to their community by volunteering at a local non-profit.  Those are all perfectly worthwhile choices, but they will not pay the bills.

Why not consider working a bit longer?  The health of a 65-year old today is far superior to the health of a 65-year old in 1935.   We have the ability to work far longer if we choose to do so.

A primary benefit is that working will keep these older Americans mentally engaged.  Equally important it will reduce the monthly drain on their savings.

At a national level there is a chronic shortage of skilled workers.  Employers can benefit substantially from keeping older workers around to impart their knowledge and skills to younger workers.  Even if not actually on the payroll they can keep working as consultants.

There can be little doubt that retiring baby boomers have been a contributing factor to the recent drop-off in productivity growth.  We cannot take a skilled worker with 40 years’ experience, replace them with a 35-year old, and not expect productivity growth to slow.

Finally, if older workers begin to work past age 65 it will reduce the drain on the Social Security Trust Fund and extend the date when its assets will be depleted.  It will also slow the upward trajectory of the budget deficit.  The driving force behind those higher deficits is demographics.  As more and more Americans reach age 65, they start to draw Social Security and become eligible for Medicare benefits.  If Americans choose to work longer, the deterioration will be less dramatic.

A couple of other points are worth noting.  First, the article in the Wall Street Journal looks only at the likelihood of reduced income in retirement.  But it ignores the fact that consumer net worth has been steadily on the rise for the past decade.  It continues to climb at a steamy 8.0% pace fueled by the combination of rising home prices and by the steady upswing in stock prices to record or near record levels.

Second, given the increase in net worth consumers do not feel the need to save as much from their income as in the past.  The savings rate today is 2.8% which is well below its long-term average of 5.5%.  Consumers do not need to save as much today as in the past because their net worth is providing a comfortable cushion.

Finally, baby boomers were born between 1946 and 1964.  If they choose to retire at age 65 they will retire between 2011 and 2029.  That means that they have been retiring for the past seven years and will continue to retire another decade.  But, thus far, there have not been the dire consequences predicted by the WSJ.  Our guess is that retirement will prove to be less of a challenge for the baby boomers than many expect for two reasons.  First, many of them will choose — either from desire or economic necessity – to work longer.    Second, many of them have a net worth cushion to supplement their retirement income.

We are not going to suggest that working past age 65 is an option for all, particularly those with health issues, but it is a very rational and desirable choice for many.

Keep working, you may actually enjoy it.

Stephen D. Slifer


Charleston, S.C

Trump’s Tariffs Imperil Emerging Economies

June 22, 2018

The trade war talk seems to be escalating. First, Trump imposes tariffs on steel and aluminum imports. China strikes back. Then he then announces tariffs on an additional 200 products. China responds. Meanwhile, Mexico retaliates. The E.U. plans to levy tariffs on American favorites like bourbon, Levi’s, motorcycles, and orange juice. Canada, Japan, and Turkey are preparing similar measures. Where does all this end? We do not know. Our president tends to be mercurial and can say one thing one moment but change his mind the next. The reversal of his policy on separating families at the border is the most recent case in point. For this reason, we do not want to overreact.

It is important to remember that nobody “wins” a trade war. All countries lose. Having said that, some countries are hurt more than others.

Those of us living in the United States are relatively isolated. Our economy is huge, and trade is only a small part of it (about 10%). Thus far, the tariffs have largely affected those companies that use steel and aluminum as inputs in their production process. But if the tariffs broaden and begin to ensnare consumer goods like autos and electronic products, the howls of protest will get louder as prices rise at Walmart, COSTCO, and auto dealerships, and the potential damage will increase.

Before trying to assess the possible damage, it is important to recognize that the U.S. economy is on a roll. Following moderate 2.0% GDP growth in the first quarter, growth in the second quarter should approach 4.0%. That is roughly a 3.0% pace in the first half, compared to 2.2% growth in 2017. At the same time the future looks bright. Stock markets should be at record high levels. But let’s look closer.

To get a feel for how trade is impacting companies within the United States compare the performance of the S&P 500 index to the behavior of the Russell 2000 and the NASDAQ Composite.

The S&P 500 index reached a record high level in January, dropped about 10%, and has been struggling to re-attain its previous high. What is included in the S&P are many large multi-national companies which will be negatively impacted by tariffs. It includes the winners (largely the steel and aluminum companies), and the losers (which include auto manufacturers, makers of metal cans for beer and soda, industrial machinery and equipment makers, transportation equipment manufacturers –think airplanes. trucks, busses, and motorcycles). There are a lot more of the latter than the former. The S&P 500 index has done well, but not nearly as well as other stock market indexes.

The Russell 2000 is a small-cap stock market measure. Companies in this index have no direct exposure to tariffs. This index is at a record high level.

The NASDAQ Composite Index is heavily weighted towards technology and internet stocks and includes tech giants like Apple, Amazon, Google, Microsoft, and Facebook. It, too, is at a record high level.

Thus, it seems to us that the mediocre performance of the S&P 500 — in contrast to that of small firms and tech companies — suggests that the already imposed tariffs on steel and aluminum, and the additional tariffs currently under consideration, have had a moderate negative impact on this stock market measure.

Tariffs can also impact the U.S. economy through a faster rate of inflation as the prices of imported products rise. This one is, in our opinion, somewhat more troublesome. A broad trade war could result in, say, a 10% increase in the prices of imported goods. A price hike of that magnitude which affects 10% of the economy could tack on 1.0% to the inflation rate. But inflation is already under pressure from wage hikes caused by the tight labor market, rising rents associated with the shortage of available housing units, and upward pressure on commodity prices. As it stands we expect the core CPI to rise 2.5% in 2019. But tack on an additional 1.0% and boost it to 3.5%, and the Fed would almost certainly raise rates more quickly. Thus, more rapidly rising interest rates could become the catalyst for the next recession. But let’s not overreact. Nothing is imminent, and we expect that eventually these trade issues will be resolved because it is in the best interests of all parties. Let’s hope President Trump understands that.

Outside of the U.S. the potential impact is more pronounced. Given that the United States has a goods trade deficit of $800 billion, tit-for-tit tariff hikes will end up hurting other countries more than the U.S. Tariffs impact these countries in the same two ways as in the U.S.

First, they weaken GDP growth. Their exported products become considerably more expensive for U.S. residents to purchase, which reduces exports growth and slows the pace of economic activity.

Second, if economic growth in the U.S. strengthens relative to other countries, the dollar strengthens. In fact, the trade-weighted value of the dollar has risen 4.5% since Trump announced his steel and aluminum tariffs on March 1. The dollar has risen across-the-board amongst our five largest trading partners – China, Canada, Mexico, Japan, and Europe. Of note was the 9.4% appreciation against the Mexican peso, a country that would be hit hard by the demise of NAFTA. The Canadian dollar has depreciated by 3.2%. The dollar’s ascent was enhanced by significant gains against a broad spectrum of emerging and developing economies –15.5% versus the Brazilian real, 10% against the South African rand, 14.5% against the Russian Ruble. Because commodities are traded in dollars, a rising value of the dollar means the dollar-prices for the goods they purchase to support their factory-based economies rises, which boosts the inflation rate. And as the prices of their inputs rise their demand drops, which exacerbates the negative impact on their economy.

The combined effect of slower GDP growth and higher inflation is reflected by movements in their stock markets. Since the beginning of March when the steel and aluminum tariffs were announced the S&P 500 index has declined 1.0%. The MSCI All World Index has declined 4.0%. The non-U.S. drop was not in Europe where stocks declined a modest 1.0%. Nor was it in the U.K. or in Japan where, in both cases, stock prices rose 6.0%.

Rather, the drop was concentrated in the stock markets of emerging economies. The MSCI Emerging Markets index fell 12%. This series includes giant – but still emerging – economies like China and India and a long list of smaller countries like Brazil, Indonesia, Korea, Malaysia Mexico, Russia, South Africa, Taiwan, Thailand, Turkey, and the United Arab Emirates.

Could these declines be attributable to factors other than trade? Possibly. But the declines noted above have occurred since the initial steel and aluminum tariffs were announced in early March and trade talk has dominated the headlines. The sad thing, in our opinion, is that this damage was inflicted by bad trade policy in the United States. We supported the administration’s corporate tax cuts earlier in the year, but we oppose tariffs which counter much of the positive impact from the tax cuts.

We do not want to overreact to short-term changes in stock market values – in the U.S. or elsewhere. But stock market values do reflect the fear of the potential damage that would be inflicted by a protracted trade war.

Let us repeat – nobody wins a trade war. With an $800 billion trade deficit in goods the potential fallout on other countries will be greater than in the United States, but do not for a moment believe that the U.S. economy will be unscathed.

Because one half of that $800 billion trade deficit in goods occurs with one country – China — we would support policy changes that force the Chinese to respect intellectual property rights in the form of copyrights and patents, and policies that encourage them to buy more U.S. goods. But we cannot support policy initiatives that hurt our neighbors and allies who have done no wrong. This makes no sense.

Stephen Slifer
Charleston, S.C.

Not too Slow, Not too Hot

June 15, 2018

The Fed’s rate hike to 1.75-2.0% this past week was widely anticipated. The modest surprise was that FOMC members are now leaning towards a total of four rate hikes this year.  When they last met in early May the committee was split about whether to raise rates three times this year or four.  Most major news organizations interpreted the Fed’s recent statement as a signal that faster rate hikes are on the way.  That is not entirely accurate.  The Fed told us in March that they plan to lift the funds rate to 3.4% by the end of 2020.  That has not changed.  They end up in the same place but given recent economic data they added an additional rate hike later this year.  What caused the Fed to alter slightly its outlook for this year?  Is the economy overheating?  Is inflation picking up too quickly?  Will the Fed’s rate hikes jeopardize the expansion?  The short answer is – all is well and the economy is on track to expand beyond 2020.

The catalyst for the Fed was a string of strong economic statistics.  Payroll employment jumped 223 thousand in May.  The unemployment rate declined 0.1% to 3.8% and (at 3.754%) was on the cusp of a 0.2% drop to 3.7%.  Fueled by tax cuts, retail sales surged 0.8% in May.  Combining these tidbits suggests that GDP growth could quicken to a 4.0% pace in the second quarter.  Interestingly, the same folks who are now worried that the economy is overheating are the same people that were worried about slow growth a couple of quarters ago.  While the economy may be accelerating in the second quarter be careful.  First quarter GDP rose at a modest 2.2% pace.  In recent years GDP has tended to register anemic growth in the first quarter followed by a rebound in the second, and trend like growth in the second half.  Thus, the trend rate for the first half of the year is about 3.0%.  While faster than the 2.6% pace registered in 2017, it can hardly be construed as a dramatic pickup.

Meanwhile, the core CPI for May rose 0.2%.  Its year-over-year growth rate is 2.2%.  This rate has been inching its way higher, but the operative word is “inching”.  For what it is worth, we expect the core CPI to rise 2.3% in 2018.  If that is accurate it is not going to bother the Fed.  However, 3.0% GDP growth and a steady pickup in inflation ensure that the Fed remains on track for gradually rising interest rates.

What makes our forecast different from others is that we believe that an impressive pace of investment spending in the wake of the corporate tax cuts will stimulate productivity growth. That will, in turn, boost potential GDP growth from 1.8% for the past couple of years to 2.8% by the end of the decade.  If that is the case, our projected 3.0% GDP growth path will not lead to any meaningful pickup in inflation.  However, this is a forecast and could be wrong.  If productivity does not pick up, 3.0% GDP growth will almost certainly lead to higher inflation.  Thus, we must monitor closely GDP growth, productivity, and inflation in the quarters ahead.

Thus far the markets do not seem worried that the faster current rate of GDP growth and the gradual upswing in inflation will be a problem.  Comparing the nominal interest rate on the Treasury’s 10-year note to its inflation-adjusted equivalent provides a market-based estimate of inflationary expectations.  This rate has been gradually rising for the past two years but, at 2.1% currently, participants are clearly not alarmed.  The Fed would be concerned if that rate were to pick up markedly because a pickup in inflationary expectations often leads to a pickup in the actual inflation rate.  If the economy is overheating and the Fed is not raising rates quickly enough, businesses will anticipate higher inflation and begin to raise prices.   If expectations were to climb to 2.5% the Fed would almost certainly accelerate its pace of tightening and more quickly return to a neutral funds rate which it believes is around the 3.0% mark.  That is not our call, but it is something to watch.

For the economy to slip into recession we need two things.  First, the funds rate must climb a couple of percentage points above the neutral rate to perhaps 5.25%.  Second, short-term interest rates must become higher than long rates (which means that the yield curve” inverts”).  With the rate on the 10-year not at the end of 2020 likely to be 4.2% and the funds rate at 3.5%, the yield curve would retain its positive shape.  Neither of the two requirements for a recession are on the horizon.  A recession is looming out there somewhere, but not through the end of 2020.

Stephen Slifer


Charleston, S.C.

Focus on the Magnitude of the Trade Deficit is Misplaced

May 25, 2018

The good news this past week is that Treasury Secretary Mnuchin announced that the imposition of tariffs on many Chinese goods imported into the United States is “on hold” in exchange for a pledge that the Chinese would increase significantly their purchases of U.S. goods, primarily agricultural and energy products.  Any agreement that significantly expands the market for U.S. goods overseas is encouraging.  However, the agreement does not address the primary issue which, in our minds, is the Chinese lack of respect for intellectual property rights and their blatant stealing of U.S. technology.  That is what manufacturers we talk to are concerned about.

We are unrepentant believers in “free trade”.  The world has been steadily moving in that direction since World War II, and it is generally accepted that all countries have benefitted from it.  In each country there is a wider array of goods and services available at lower prices than if that country chose to go it alone.

Last year the U.S. had a trade deficit of $568 billion.  But so what?  All that means is that the U.S. purchased more goods from overseas than they purchased from us.  Thus, foreigners on balance accumulated $568 billion of dollars because of trade.  The counterpart of a $568 billion U.S. trade deficit is $568 billion of foreign capital inflows into the United States.  That money will be invested here.  Foreigners will start businesses in the U.S., they will create jobs, and/or they will invest it in the stock market. Those are all good things.  Thus, in our mind, a laser-like focus on the magnitude of the trade deficit is misplaced.  Keep in mind, too, that the U.S. has had a trade deficit of roughly its current size (or larger) since the early 2000’s and nothing bad has happened.

While we are staunch believers in “free” trade, we are equally adamant about our belief in “fair trade”.  Therein lies the problem.  Free trade works well if all players operate using the same playbook.  That is not the case today.  Some countries blatantly cheat, the most widely recognized cheater is China.  It shows absolutely no regard for intellectual property rights. It routinely ignores patents and copyrights.  It steals our technology.   These fairness issues are what we hear about most often in our discussions with manufacturers.  The recently announced agreement between the U.S. and China does not address these issues which are critical.  Hopefully, they will be addressed in subsequent negotiations.

Having said all that, we do not want to completely dismiss the importance of what transpired this week.  Please note that the overall trade deficit of $568 billion consists of an $811 billion trade deficit for goods, and a $243 billion trade surplus for services.  Of that $800 billion trade deficit in goods, almost half is with one country – China.  We do not have trade issues with our neighbors, Canada and Mexico.  Nor do we have a problem with Europe or even OPEC.  We have a problem with China and a handful of other Asian nations.

Several months ago, President Trump proposed steep tariffs on aluminum and steel products across the board.  The Chinese quickly retaliated with tariffs on a variety of U.S. goods and the U.S. was on the cusp of a trade war not only with China but with other countries as well.  That was obviously not the desired solution.  Nobody wins a trade war.  All countries lose.  And to impose penalties on our neighbors and allies with whom we do not have a trade issue made no sense.  Given the concentrated nature of the trade deficit with just a handful of countries, the focus should have been on those countries with whom we have a problem.  Target the measures you intend to take on them.  Do not apply restrictions across the board.

What happened this week is vastly different.  The agreement is for the Chinese to shrink the bilateral trade deficit by boosting their purchases of U.S. made goods — principally agricultural products and energy.  This is not shrinking global trade, it is expanding it.  While the Chinese would not agree to a specific target for the reduction in the size of the trade deficit the U.S. was seeking improvement of about $200 billion.  Explicitly or implicitly, a $200 billion reduction in an $800 trade deficit in goods, is significant and will lead to an additional $200 billion of U.S. exports.

Some economists were disappointed that the fairness issues were not a part of the recent agreement and have criticized Treasury Secretary Mnuchin for not addressing them.  However, Mnuchin said that the previously announced tariffs on steel and aluminum imports would remain in place.  Presumably, he is using the imposition of the tariffs on those metals as a bargaining chip to crack down on the alleged trade abuses by China.  We’ll see.

Stephen D. Slifer


Charleston, S.C.

The Burden of Tighter Credit Standards Falls Largely on the Young

May 18, 2017

The New York Federal Reserve Bank recently released its quarterly report on consumer finances.  On the surface, all is well.  Consumer debt expanded at a moderate pace in the first quarter of this year.  It rose 3.8% in the past year which is roughly in line with the pace registered in the past several years.  There is no hint of the double-digit borrowing binge that occurred prior to the recession.

Mortgage lending accounts for more than two-thirds of the total.   While overall consumer borrowing also includes auto loans, credit cards, student loans, and home equity lines of credit, they all pale in size relative to mortgages.  Given its size, it is not surprising that the growth rate for mortgage lending is almost indistinguishable from the growth pattern for total loans shown above.  Over the past year, for example, mortgage loans have risen 3.6% versus 3.8% for the total.

As the economy continues to expand and consumer income rises, seriously delinquent loans as a percent of the total continue to decline and are roughly in line with where they were going into the recession.

The New York Fed also tracks credit inquiries during the past six months which it uses as a gauge of the demand for credit.  This series has been considerably slower than it was prior to the recession.  That is no surprise, but its drop in the first quarter of this year seems puzzling.  In fact, it is the smallest number of loan inquiries in the history of this series which stretches back to the beginning of 2003.  What is going on?

It appears that the subdued pace of growth in credit is primarily attributable to financial institutions demanding far higher credit scores than they did in the past.  In late 2007, just prior to the onset of recession, 30% of borrowers had a credit rating of 760 or higher.  Today that percentage has doubled to almost 60%.  If high credit score borrowers are taking a bigger slice of the pie, all other categories are receiving less.  Borrowers with credit scores below 660 almost need not apply.  Their chances of attaining a mortgage are small.  Prior to the recession borrowers with credit ratings less than 660 received 20% of mortgage originations.  Today, that portion has fallen to just 8%.  These borrowers with low credit scores are primarily young and without a well-established credit track record.

Homeownership rates have touched bottom and, while still below their 50-year average of 65.1, they have begun to recovery from a slide that began in 2004.

While the overall drop in homeownership is moderate, it is far more pronounced for younger homeowners, specifically the under 35 and 35-44 age brackets.

The same data are shown in the chart below which shows the decline in homeownership rates for every age bracket from their peak in 2004.  While the overall drop has been 5.0% (in red), homeownership for the under-35 crowd has fallen 8.3%, and for the 35-44 age bracket the drop has been 9.6%.  There can be little doubt that the burden of the tighter lending standards applied in today’s world is falling largely on the young.

Home prices have fully recovered from the recession.  As a result, homeowners now have a record amount of housing wealth, also known as home equity.  But tighter lending standards and the reduction in homeownership, particularly for the young, have shifted that housing wealth towards older, higher credit score borrowers.

For example, in 2006 homeowners over age 60 owned 24% of all home equity.  By 2017 that percentage had jumped 17 percentage points to 41%.  The equity stake of homeowners under the age of 45 fell 10 percentage points from 24% to 14%.

Similarly, in 2006 homeowners with a credit score higher than 780 held 44% of all home equity.  By 2007 that percentage had climbed nine points to 53%.  This means that homeowners with credit ratings less than 780 saw their equity stake drop nine points to 47%.  Because home equity is a crucial form of collateral, young people today do not have access to low cost credit.

Home prices fell sharply during the recession which meant that home equity for many younger borrowers completely disappeared.  Many were “upside down” meaning they owned more than their home was worth.  They could neither sell nor re-finance.  At the same time banks were requiring far higher credit scores than in the past.  As a result, younger borrowers have experienced a sharp reduction in their ability to tap sources of low-cost credit.

Are banks being prudent?  Or have they become unduly restrictive?  Probably some of both.  Our hope is that as we go forward lending standards will become somewhat less restrictive.

Stephen Slifer


Charleston, S.C.

Is $70 Oil a Problem?  Not Really.

May 11, 2018

Crude oil prices at $70 are higher than anybody anticipated at the beginning of the year.  What is causing the increase in oil prices?  What’s next?  Does it matter for GDP growth?  Inflation?  The Fed?

Oil’s steady ascent has been caused by a combination of factors — some economic, some political.

In January the International Energy Agency in Paris thought demand and supply for oil would be roughly in balance throughout the year which suggested that oil prices should remain at about $50 per barrel.  But in the past several months demand has increased, supply has shrunk, and there is now a shortfall of $0.5 million barrels per day (the blue bars) which the IEA believes will persist through yearend.

The increase in demand appears to have been triggered largely by a faster pace of economic expansion around the globe.  Last month, for example, the IMF revised upwards its estimate of global GDP growth in 2018 by 0.2% relative to what it expected in October to 3.9%.  That would be the fastest rate of global growth since 2011.  It boosted the U.S. forecast by 0.6% to 2.9% to reflect the combination of tax cuts and a faster pace of defense spending.  It raised growth for Europe by 0.5% to 2.4% with forecasts for Germany, France, Italy, and Spain all ratcheted upwards.   It lifted the growth estimate for China by 0.1% to 6.6%.  Thus, the upward revisions to GDP growth were widely disbursed geographically.  Faster global economic growth brings with it increased demand for oil.

On the supply side much of the shortfall can be attributed to Venezuela as its downward economic and political spiral worsens.   From 2000-2015 Venezuelan oil production averaged 2.4 million barrels of oil per day.  But by March of this year that figure had fallen 38% to 1.5 million b/d — its slowest rate of production in decades, and many expect it to fall below $1.0 million b/d by yearend as the economy contracts by an estimated 15% this year and the inflation rate soars to 14,000%.

Political factors have also come into play.  Encouraged by higher oil prices, OPEC ministers recently suggested that the group could choose to extend its production cuts through 2019, or even trim them further. The OPEC ministers also noted that just because the inventory glut has been eliminated, that does not necessarily mean the end of the cutbacks. Those comments spooked the markets which now fear that oil prices could continue to climb to $80.    Saudi Arabia is using higher prices in the near term to cover domestic spending.  Higher prices have also made Russia a power broker for what happens in the mid-East.

Finally, this past week President Trump announced that the United States would exit the nuclear pact with Iran and re-impose sanctions on Tehran.  Those sanctions would presumably not reduce the supply of oil from Iran until much later this year, but the risk of such an event means crude prices could continue to climb.

Another factor that is critical to the outlook for oil prices is U.S. oil production which is skyrocketing.  Prior to the big drop in prices that began in late 2014, frackers could not drill profitably unless crude oil prices were about $65 per barrel.  But with improved technology in the form of fracking and horizontal drilling, that number has declined to about $48 per barrel.  Thus, prices of $70 are a bonanza for the oil industry and drillers are ramping up production as fast as they can.

Production is expected to surge 15% this year to a record 10.7 million barrels per day versus 9.3 million in 2017.  The Energy Information Administration (EIA) expects production to climb an additional 10% next year to 11.9 million b/d.  If those forecasts are accurate the U.S. would surpass both Russia and Saudi Arabia and become the world’s largest producer of oil.  Surging U.S. oil production should put a cap on how high oil prices can go.

Are oil prices at $70 per barrel a problem for either GDP growth or the inflation rate?  Not really.  Oil prices were routinely in a range from $90-105 per barrel from mid-2011 to late-2014.  GDP growth in those three years was 1.7%, 1.3%, and 2.7%.  Unimpressive to be sure.  But the economy weathered the storm.  Today with tailwinds from tax cuts, de-regulation, and re-patriation of corporate earnings, oil prices at $70 or even $80 per barrel should not be a problem for the economy.

The EIA expects crude prices to average $65.58 per barrel this year versus about $70 currently.  Thus, prices should remain high or go a bit higher in the short-term, but then begin to fall somewhat in the final few months of the year.

For those of you planning a summer driving vacation this year, the EIA expects gasoline prices to peak at about $3.00 per gallon by late June (versus $2.85 currently), but then decline slowly to about $2.75 by the end of September.  Clearly, those prices are higher than last year, but probably not high enough to deter us from doing whatever we had planned (although if we spend a bit more on gas we might have to spend a bit less elsewhere).

On the inflation front, it is important to remember that energy prices are only a small part of our various measures of inflation.  For example, the energy component of the CPI (which includes gasoline prices as well as the price of natural gas and electricity) is only 8% of the total.  Food accounts for another 13%, and the CPI excluding food and energy represents the remaining 79%.  Given the recent runup in gas prices we have raised our forecast of the overall CPI for the year by 0.1% from 2.5% to 2.6%.  Oil prices will have to move a lot higher to have any meaningful impact on either GDP growth or inflation.  Our forecast for the core CPI remains at 2.4%.

What does the Fed do with all of this?  Nothing.  It needs to continue on its path towards a 3.0% funds rate.  That will include two or perhaps 3 more rate hikes this year which will boost the funds rate to 2.1% by yearend and raise rates an additional three times or so in 2019 to get to the 3.0% mark.  The tiny uptick in the overall inflation rate caused by the recent runup in oil prices will not alter its game plan.  Remember, its inflation target is the so-called core rate which excludes the volatile food and energy components.

Crude prices of $70 and gasoline prices approaching $3.00 per gallon are disturbing and capture headlines.  But stay calm and remember that their impact on the pace of economic activity and inflation will be well contained and not induce the Fed to adopt a more aggressive policy stance.

Stephen Slifer


Charleston, S.C.

Wages Pressures Accelerate – Inflation Not so Much

May 4, 2018

The unemployment rate declined 0.2% in April to 3.9%.  That is the lowest it has been since December 2000.  Economists generally believe that the full employment threshold – the rate at which everyone who wants a job has one – is about 4.5%.  Surely, the economy has reached that mark.  With monthly job gains continuing to exceed the average monthly increase in the labor force, the unemployment rate will continue to decline in the months ahead.

If that is true, wage pressures should be quickening.  That seems to be the case.  Average hourly earnings have risen 2.7% in the past year and are on a gradual upswing.

The employment cost index is a broader measure of labor costs which includes the cost of wages for both hourly and salaried workers and the cost of many benefits.  It is the broadest measure of wage pressures.  Like average hourly earnings, this series has risen 2.7% in the past year.  That happens to be the biggest year-over-year increase in labor costs in a decade.

It would be logical to assume that since labor costs represent about two-thirds of a firm’s overall costs, accelerating labor costs will put upward pressure on the inflation rate.  But be careful.  The various measures of labor costs can be misleading.  What we need to watch are “unit labor costs” which are labor costs adjusted for changes in productivity.   If an employer pays its workers 3.0% higher wages because they are 3.0% more productive, there will be no reason for the employer to raise prices because he or she is getting 3.0% more output.  Workers have earned their fatter paychecks.  In this case “unit labor costs” are 0.0% — 3.0% higher wages exactly matched by a 3.0% increase in productivity.  We recently received data on unit labor costs for the first quarter.  In the past year unit labor costs have risen 1.1%, considerably less than one might expect by looking at the various measures of labor costs.  That 1.1% increase in unit labor costs consisted of a 2.5% increase in compensation partially offset by a 1.3% increase in productivity.  Going forward we expect compensation to increase 3.5% in 2018, productivity to increase 1.5%, which means that ULC’s for the year will increase 2.0%.  This will not result in much upward pressure on the inflation rate because unit labor costs will be rising at the same 2.0% pace as the Fed’s inflation target.

One final point, the overall CPI index is on track to increase 2.5% this year.  While this is slightly faster than the Fed’s 2.0% inflation target, it is important to remember that the Fed’s specific inflation objective is not the CPI.

Rather, the Fed targets the personal consumption expenditures deflator excluding the volatile food and energy categories.  This is a weighted measure of inflation which means that if, as prices rise, consumers substitute a lower priced good for a higher priced one to save money (the old substitution of margarine for butter example that many of us learned about in Econ 101) then a weighted measure of inflation will rise more slowly than the fixed-weight CPI measure because it will give greater weight to the lower-priced good.  Over time the “core” personal consumption expenditures deflator tends to rise about 0.5% more slowly than the CPI.  Thus, we expect the “core” PCE deflator to increase 2.0% this year which is exactly in line with the Fed’s stated 2.0% inflation target.

What all of this means is that the Fed does not have to be in hurry to raise short-term interest rates.  Yes, the economy will grow more quickly this year, the unemployment rate will continue to decline, wage pressures will accelerate, and inflation will rise.  But if inflation climbs at the Fed’s targeted 2.0% pace it does not have to panic.  In fact, because this inflation measure has been far below target for so long the Fed will probably will be thrilled with that outcome.

Given the above, the Fed will maintain its path of gradually raising the funds rate.  Whether it will raise rates two or three more times in 2018 is irrelevant.  The Fed plans to gradually boost the funds rate to the 3.0% mark or a bit higher.  However, the funds rate will not reach that level until the end of next year or sometime in early 2020.  That is a long time down the road.

Stephen Slifer


Charleston, S.C.

Two Pieces to Read This Week

April 27, 2018

There are two pieces for you to read this week.  The market has begun to worry about a 3.0% rate on the 10-year note.  It has also noticed the recent sharp run-up in gasoline prices.  It worries about a pickup in the rate of inflation which could become a catalyst for the Fed to raise rates more rapidly.

Should we worry?  Not really, but these are clearly two factors to watch.

Also, our first look at first quarter GDP growth may be of interest.  It came in at 2.3% which is not far from what economists had expected.

Stephen Slifer


Charleston, S.C.