Wednesday, 22 of May of 2019

Economics. Explained.  

Category » Commentary for the Week

The Chinese Dilemma

May 17, 2017

The latest round of tit-for-tat tariff increases by the U.S. and China has created a significant problem for the Chinese economy.  The impact on the U.S. comes largely in the form of a pickup in inflation and higher long-term interest rates which can hardly be categorized as problems because the Fed would like both things to happen.

In 2018 the U.S. exported $120 billion of goods to China.  Given nominal GDP of $20,494 billion that means that exports to China are 0.6% of U.S. GDP.  Thus, a 20% drop in exports to China might shave U.S. GDP growth by 0.1%.  Given projected GDP growth this year of 2.7%, the imposition of these tariffs might trim it to 2.6%.  While this is not a big deal for the overall economy, it is little comfort to the industries that will be hit the hardest (think farmers, fishermen, and car makers).

Using the same arithmetic, Chinese exports to the U.S. last year were $540 billion in an economy of $13,407 billion.  That means Chinese exports to the U.S. are 4.0% of its economy.  A 20% drop in those exports would shave GDP growth by 0.8% from an already 30-year slow growth rate of 6.5% currently to 5.7%.  The tit-for-tat increase in tariffs is going to do far more damage to the Chinese economy than it will to the U.S.

So how might the Chinese respond?  One way would be to let the Chinese yuan depreciate.  That would make Chinese goods cheaper for others to purchase.  Reduced exports to the U.S. could be partially countered by higher exports elsewhere.  But that is not going to happen.

The Chinese yuan is at 6.91 per U.S. dollar.  Government officials are determined not to let it fall beyond 7.0.  A weaker yuan would encourage capital outflows which the Chinese can ill afford.  Thus, Chinese leaders and have been intervening actively to ensure that does not happen.

That raises a fear that the Chinese might have to sell U.S. Treasury securities to get the dollars required to sell in the foreign exchange market to stabilize the yuan.  Chinese holdings of U.S. Treasury securities declined $62 billion or 5.0% last year and could fall further in the months ahead.  Given that the Chinese still own $1.1 trillion of Treasury securities this development seems somewhat ominous – but also unlikely.  If they choose to reduce their holdings of U.S. Treasury securities significantly, where are they going to re-deploy those assets?  To Europe?  The U.K.?  Japan?  Bitcoin?  The alternatives are not enticing.

While Chinese holdings of Treasuries fell last year, total foreign ownership has climbed to a record high level.  Some of the offsetting purchases have come from places like the U.K. and Ireland as they prepare for a possible unfriendly Brexit outcome.  Thus, a significant drop in foreign holdings of U.S. Treasury securities as a result of the current trade difficulty with China seems unlikely.

Suppose that the Chinese change their mind and decide to let the Chinese yuan decline.  That would soften the blow of higher tariffs on the Chinese economy but would spread the impact throughout the entire community of emerging economies.  Given their close trade ties to China a weaker Chinese yuan would weaken the currencies of every other country in Asia and significantly strengthen the value of the dollar as investors around the globe conclude that the country most insulated from the consequences of a trade war is the U.S.  That is exactly what happened last year.

The dollar strengthened by 10% in 2018.  Because commodities are priced in dollars, a stronger dollar meant that the raw materials every emerging economy requires to produce the goods that they manufacture became more expensive.  With the higher cost of goods sold, they are less able to compete in the global marketplace.  As a result, the IMF reduced projected GDP growth for all of these countries and their stock markets plunged.

While slower GDP growth around the globe is never a desirable scenario, the reality is that foreign capital outflows from China and elsewhere ended up in the U.S. and cushioned the blow on the U.S. economy.  Foreign funds were used to start new businesses in the U.S., hire American workers, and invest in the U.S. stock and bond markets.  Relative to the rest of the world the U.S. won, the rest of the world lost.  Because the Chinese economy relies so heavily on foreign funds, a significant further weakening of the Chinese yuan is not a desirable outcome.  For now Chinese leaders have chosen to stabilize the value of the yuan.  But that means that the entire impact from the newly imposed U.S. tariffs will fall exclusively on China.  Given that Chinese exports to the U.S. are 4% of Chinese economy, a significant drop would sharply reduce expected GDP growth which, at 6.5%, is already at its slowest pace since 1990.  Not a good thing.

Any way you slice it, the Chinese have a problem.

In the U.S. the tariffs could slightly reduce GDP growth, but with the U.S. economy chugging along at an expected 2.7% pace this year the negative impact on growth would be negligible,

The impact on prices and the U.S. inflation rate will be more noticeable.  As noted earlier, China exports $540 billion of goods to the United States.  Given nominal GDP of $20,494 billion such goods represent 2.6% of GDP.  A 20% increase in the price of those goods could boost the inflation rate by 0.5%.  Higher prices for goods coming from China could entice some U.S. manufacturers to raise prices as well which could exacerbate the impact on inflation.  With the core personal consumption expenditures deflator (the Fed’s preferred inflation gauge) currently at 1.6% an additional 0.5-0.7% jump in inflation to 2.1-2.3% would actually be a desirable outcome.  The Fed has already told us that it is prepared to let inflation run slightly above target for a while to compensate for the fact that it was below target for so long.

A 0.5% increase in the inflation rate would boost the rate on the 10-year Treasury note by about 0.5% from 2.4% currently to perhaps 2.9%.  With the funds rate likely to remain steady at 2.4%, that implies that the yield curve (the difference between long-term and short-term interest rates) could climb from roughly 0% today to 0.5%.  Because an inverted curve can be an indicator of an impending recession, a significantly steeper curve would allow the Fed to breathe a collective sigh of relief.

All of this suggests that the pressure in squarely on the Chinese.  They are in a box with no particularly desirable outcome.  China needs trade with the U.S. to support the economy.  Trade with the likes of Russia, Iran, Venezuela, and Cuba is no substitute.  China needs to return to the bargaining table.  While the possibility of a protracted trade war between the two countries is disquieting, it remains to be seen how long it will last.

Stephen Slifer


Charleston, S.C.

Political Decisions Muddy the Economic Waters   

May 10, 2019

 The waivers on U.S. sanctions for purchases of Iranian oil expired earlier this month.  Oil exports from that country have plunged and the drop-off in economic activity in Iran has accelerated.  But will this deteriorating economy result in the regime change that Trump desires, or merely heighten Iran’s resolve to retaliate?

Trump has raised tariffs from 10% to 25% on almost every Chinese export to the U.S.  Unlike the earlier round which targeted goods used by businesses in the production process, this round will impact a broad array of consumer products and be far more visible.  Not surprisingly, China has said it intends to retaliate but it has not yet provided details of what that might look like.  Higher tariffs will adversely impact both countries, but they will hit the Chinese economy far harder than the U.S.  Will this force the Chinese back to the bargaining table which is what Trump is trying to do?  Or simply broaden the trade war and reduce global GDP growth for the second half of this year and 2020?

Finally, North Korea has resumed testing short-range missiles which heightens tensions in yet another corner of the world.  The stock market has noticed all of these events but, thus far, the reaction has been muted.

Iran.  The sanctions on Iranian oil exports have sharply curtailed oil production in that country which has been cut almost in half from what it was a year ago and it is expected to continue shrinking throughout the summer.  The IMF expects that GDP growth in Iran will fall 6.0% in 2019 after having declined 3.9% last year.  Highlighting the importance of oil production to the Iranian economy, the unemployment rate has risen from 11.9% in 2017 to an expected 15.4% this year.  Inflation has accelerated from 9.6% in 2017 to more than 37% this year.  No wonder Iran’s leaders are furious with the United States and have threatened to retaliate which often takes the form of heightened terrorist activity against the U.S. and its allies.  While the negative impact of sanctions on the Iranian economy are obvious, they seem unlikely to result in the regime change that Trump would like.  As long as strong dictators maintain the support of the military, they are likely to remain in power.

China.  According to Trump the Chinese have reneged on parts of the trade agreement to which they had previously agreed in an effort to soften the blow on the Chinese economy.  That is a typical Chinese bargaining tactic but, in this case, they have perhaps underestimated Trump’s resolve to force the Chinese to play by the rules and quit stealing technology from U.S. companies, eliminate the requirement for U.S. firms that would like to do business in China to share their technology, and respect intellectual property rights.  But those are core principals of business for Chinese firms.  Abandoning those methods of behavior as the result of U.S. pressure would represent a significant loss of face for Chinese leaders.  They cannot accept such changes without some concessions from the U.S.     Despite this recent controversy we continue to expect some sort of a U.S./Chinese trade agreement in the months ahead because it is in the best interest of both countries to do so.  Tit-for-tat tariff escalation by the U.S. and China will hurt the Chinese economy far harder than the United States simply because trade is 10% of the U.S. economy but 50% of Chinese GDP.  These increased tariffs could slice Chinese GDP by 1.3% while U.S. growth would be reduced by only about 0.3%.  We currently anticipate U.S. GDP growth for both this year and next of 2.7%.  The tariffs could chop those growth rates to 2.4% or so which is meaningful, but the U.S. economy would be in no danger of slipping into recession.

North Korea.  Finally, relations between the U.S and North Korea continue to deteriorate.  Thus far the renewed missile testing is only for short-range missiles which does not technically violate the agreement reached between Trump and Kim Jong Un to eliminate the Korean testing of long-range missiles.  These heightened tensions are the direct result of Trump and the U.S. delegation abruptly walking out of the summit in Hanoi earlier this year due to disagreements about denuclearization and sanctions.  This was a significant loss of face for Kim and he was duty bound to retaliate.

We do not know if, how, or when these global quarrels will be resolved.  But in the absence of military action our sense is that the worst-case scenario would be the loss of perhaps 0.3% from U.S. GDP growth for both this year and 2020 from the tariffs imposed on China and their almost certain retaliation on the U.S.    Having said that, heightened tensions make everybody nervous and increase the risk of a policy mistake.  That is not our call, but obviously these situations bear watching.

Stephen Slifer


Charleston, S.C.

Wanted – Higher Inflation, But How to Achieve It

May 3, 2019

Perhaps the biggest economic surprise of the past year has been the stubbornly low inflation rate.  Over the course of the past year the Fed’s preferred inflation measure, the personal consumption expenditures deflator (excluding the volatile food and energy components) has risen 1.6%.  The Fed’s target is 2.0%.  Fed Chair Powell has indicated that the 2.0% inflation goal is “symmetric”.  Given that inflation has generally run below target for most of the past six years, the Fed would welcome a 2.5% inflation rate for a period of time so that it averages 2.0% throughout the expansion.  But how exactly can it make that happen?  To say it wants 2.5% inflation is one thing.  Achieving it is something else.

As we see it, two factors are responsible for the currently low inflation rate.  First, labor costs adjusted for the change in productivity, or what economists call “unit labor costs”, have been essentially unchanged over the past year.  That comes about from a 2.5% increase in compensation almost entirely offset by a 2.4% increase in productivity. From a business viewpoint, employers are paying their workers 2.5% high compensation, but they are also getting 2.4% more output.  Business leaders are satisfied with that outcome.  Basically, workers have earned their fatter paychecks.  In the 10-years since the recession ended, unit labor costs on average have risen 1.0%.  In today’s world this means that wages can grow about 1.0% more quickly than they are currently without boosting inflation.

But if the Fed only has control over interest rates, how exactly can it entice firms to lift wages?  If for a short period of time the Fed chooses to pursue a 2.5% inflation rate it might actually like to see unit labor costs rise by 2.0% or so, presumably consisting of wage gains of 4.5% offset by 2.5% growth in productivity.  But how exactly does it entice firms to bump worker pay from 2.5% currently to 4.5%?  It does not have the tools to do that.

The other factor keeping inflation in check is technology.  When we want to buy anything in today’s world from a car to a toaster, we search the internet to find the lowest price available.  As a result, goods-producing firms today have absolutely no pricing power.  If we split the CPI between goods and services, goods inflation in the past year has been unchanged while service sector inflation has risen 2.7%.  Put it all together and in the past year the core CPI has risen 2.0%.  The Fed might like to see inflation 1.0% or so higher than it is currently but it still has the same problem – how can it make that happen?

Some have argued that the Fed should lower the funds rate.  But that would be ill-advised for a couple of reasons.  First, the funds rate is already relatively low.  The Fed has recently lowered its estimate of a “neutral” funds rate from 3.0% to a range of 2.5-3.0%.  The current funds rate is in a range from 2.25-2.5%.  Thus, the current level of the funds rate remains low and is not in any way constraining growth.  Lowering the funds rate does not seem like the right solution.

Second, if the Fed could somehow make the economy grow faster and inflation accelerate, the bulk of the inflation pickup would likely be in services.  Presumably, given technology, the goods sector of the economy will have little ability to raise prices for the foreseeable future.  If the Fed tries to boost the inflation rate by 1.0% it might end up with goods inflation still at zero percent, but with service sector inflation of 4.0-4.5%.  Is that what it wants?  That does not see like a desirable solution either.

As we see it, if the economy can continue to grow at something close to a 3.0% pace and the inflation rate remains steady at 1.6% or 0.4% below the 2.0% target, what is the matter with that?  That strikes us as being a situation that is sustainable for years to come.  An expansion that endures for an additional three, four, or five years beyond its already-achieved 10 years of growth would be an ideal outcome.  Why in the world would the Fed choose to make adjustments that could possibly short circuit the current delicate balance between growth, inflation, and interest rates?  That makes no sense.   Stick with the plan and keep rates steady!  Even Trump might like the eventual outcome.

Stephen Slifer


Charleston, S.C.

Foreign Appetite for Treasury Securities Remains Steady

April 26, 2019

There has been a lot of chatter lately about a moderate reduction in foreign holdings of U.S. Treasury securities last year.  Frankly, we think this is much ado about nothing.  But before exploring foreign holdings of Treasuries, who actually owns U.S. Treasury debt?

The Treasury divides outstanding debt into two broad categories – intergovernmental debt and debt held by the public.  At the end of March total debt outstanding was $22.0 trillion.  Of that, $5.8 trillion or 26% was held by a variety of government agencies.  The remaining $16.2 trillion or 74% was held by the public.

Intergovernmental Debt, $5.8 trillion.  You might wonder why more than 200 government agencies own U.S. Treasury debt.  The answer is that some agencies, like Social Security, collect more revenue from taxes each month than they need.  Rather than let that money sit idle, the agency buys U.S. Treasury securities.  Eventually these agencies will need to redeem their Treasury notes and bonds for cash.  When that happens the Treasury will have to raise taxes, cut spending, or issue more debt.  Which agencies own the most Treasuries?  Social Security — by far — which accounts for almost one-half of the total, with Federal and military retirement funds accounting for another 36%.

Publicly Owned Debt, $16.2 trillion.  These are the Treasury securities that we typically think about.  It might surprise you that $2.3 trillion or 15% of the $16.2 trillion of so-called “publicly owned” securities are owned by the Federal Reserve.  The reason for that is that those securities were initially owned by somebody else, perhaps you and me.  When the Fed went on its bond buying spree in the past couple of years it purchased those securities from private owners and they now reside at the Fed.    Another 46% is owned by a combination of mutual funds, banks, insurance companies, pension funds and similar types of financial institutions.  That means that the remaining $6.4 trillion of Treasury securities are owned by foreign institutions.

Foreign Owned Debt, $6.4 trillion.  This is the portion of U.S. Treasury debt that economists tend to worry about the most.  The fear is that if debt outstanding continues to climb by $1.0 trillion every year (the expected magnitude of future budget deficits), at some point foreign holders will worry about the U.S. government’s ability to service its debt which means it could ultimately default on its interest and principal obligations.  As a result, foreigners could stop purchasing or possibly even sell some of their Treasury securities.  Between November 2017 and November 2018 some squinty-eyed economists noted that foreign holdings declined by $100 billion from $6.3 trillion to $6.2 trillion and they sensed some heightened reluctance to hold Treasury securities.   Somehow it makes no sense to us that a 1.5% decline over the course of one year should set off alarm bells.

When trying to discern reasons for the 2018 drop one should look first at the holdings of China and Japan. each of which have roughly $1.1 trillion of U.S. Treasury securities and, combined, account for 35% of the total.  Both countries are interested in purchasing U.S. Treasury securities because doing so boosts the value of the dollar and therefore weakens their own currency.  That, in turn, keeps their exports affordable for U.S. consumers.  Are these two countries likely to stop purchasing U.S. Treasury securities any time soon?  Unlikely.  In the November 2017 – November 2018 period total holdings of treasury’s by foreigners declined by $100 billion.  China’s holdings declined $55 billion; Japan’s fell by $48. That accounts for the entire drop.  Changes elsewhere were largely offsetting.

In addition to the decline in holdings by China and Japan, Russia’s holdings of Treasuries fell $93 billion from $105 billion to $13 billion in the period of time.  Why these big declines?  Given the timing of the decline and where it occurred, it is clear that the drop was triggered by the threat of Trump-imposed trade sanctions.  In no way did the decline reflect a fear about the U.S. Treasury possibly defaulting on its debt.  Political considerations were the catalyst.

Rounding out the top five holders of Treasuries are Brazil, Ireland, and the U.K. each of which holds about $300 billion.  For these three countries, changes in Treasury holdings in that 12-month time period were +$46 billion for Brazil, -$45 billion for Ireland, and +$61 billion for the U.K. (presumably caused by the possibility of an ugly Brexit withdrawal).  Slightly further down the list (but still in the top 10) are Luxembourg and the Cayman Islands.  Both countries receive vast sums of money from global wealth and hedge funds whose owners do not want to reveal their ownership positions.

It is also worth noting that in the four months since November foreign currency holdings have surged by $184 billion and climbed to a record high level of $6.4 trillion.  So much for the theory these economists were trying to develop.

As we see it, the two biggest owners of Treasury debt, China and Japan, have a big stake in buying Treasury securities to keep their own currencies undervalued and their exports cheap for U.S. consumers to purchase.  They have no incentive to sell Treasuries.

Furthermore, size considerations are important.  Should the Chinese, Japanese, or anybody else suddenly worry about a default by the U.S., there is no other capital market large enough to accommodate purchases of $6.0 trillion.

Finally, if countries become disenchanted with the U.S. where might they go that would be safer?  The Euro?  The British pound? The Chinese yuan?  The Japanese yen?  Bitcoin?  Somehow those alternatives do not seem particularly appealing.

Given that we will soon see an uninterrupted string of $1.0 trillion U.S. budget deficits, and U.S. Treasury debt rising by $1.0 trillion every single year to finance those deficits, it is not surprising that economists (including us), and investors worry that the U.S. will eventually be unable to service its debt.   We hope that Congress will act soon to rein in the skyrocketing budget deficits.  Unfortunately, that is not going to happen any time soon.  But foreign holders of U.S. Treasury securities seem equally unlikely to pull the plug and try to diversify their holdings.  At some point perhaps, but not now.

Stephen Slifer


Charleston, S.C.

Don’t Worry, Be Happy!

April 19, 2019

Next Friday, April 26, first quarter GDP growth will be released.  Estimates of growth for this quarter have swung dramatically as additional data became available.  For example, the widely followed GDPNow estimate produced by the Atlanta Fed started at 0.3% in early March.  As subsequent data were released that estimate has steadily revised upwards.  Today it is at 2.8%.  Nobody knows exactly what growth rate we will see next week.  We project first growth of 1.9%; the consensus forecast is roughly comparable.  We believe that the Atlanta forecast – and forecasts made by other economists – were biased downwards by a belief that the end of the expansion is not that far down the road.  We do not share that view.  The economics profession in general — and readers of this commentary — would be better served by developing a somewhat more upbeat mindset.

How could first quarter growth expectations shift so dramatically?  When the Atlanta Fed forecast was released initially on March 1, most of the hard data for January had been released and those tidbits of information were uniformly weak.  But to make a forecast for the quarter as a whole, economists must make expectations for each economic indicator for February and March.  The only way the Atlanta Fed could produce a growth forecast of 0.3% would be to assume that the January weakness would continue into subsequent months.  They must have been relatively convinced that this was the beginning of the end, and that the economy would slip into recession by yearend.

That expectation turned out to be dead wrong.  The stock market reversed direction and has completely eliminated its fourth quarter decline.  Consumer and business confidence rebounded.  Home sales surged.  Retail sales surged.  Employment rebounded from its anemic February performance.  The trade gap narrowed dramatically in February and shrunk further in March.  As each indicator was released, the Atlanta Fed progressively revised its first quarter growth estimate upwards.  Today it stands at 2.8%.

Clearly, the stock market selloff late last year was both dramatic and scary.  That was followed by the protracted government shutdown which exacerbated the negative sentiment.  But shouldn’t those factors have been regarded as temporary and likely to negatively impact growth for only a relatively brief period of time?  That was our conclusion and we envisioned a snap-back in February and March.  Others apparently saw the situation differently.

We now know that GDP growth in the fourth quarter was 2.2%.  If we end up with, say, 2.0% growth in the first quarter, then the economy will have averaged 2.1% GDP growth in those two quarters despite the stock market selloff and the government shutdown.  That suggests to us that GDP growth in the final three quarters of the year should be more rapid than that.  We expect GDP growth to average 2.9% in those three quarters and growth for the year to come in at 2.7% — not too much different from last year’s 3.0% pace.

The U.S. economy has demonstrated an impressive ability to shrug off bad news.  Think of the obstacles it has overcome during the course of the expansion.  We have had repeated financial crises in a number of European economies, a sharp slowdown in growth in China, anemic growth in Europe,  fear of a nuclear war with North Korea, government shutdowns, a downgrade in the rating of U.S. Treasury debt, a dramatic increase in oil prices which at one point exceeded $100 per barrel and, now, Brexit fears.  Fragile economies do not survive those obstacles.

Why is it so difficult to believe that the U.S. economy is basically healthy and that the factors that tend to produce recessions are nowhere in sight?  Mainstream economists presumably believe the expansion will soon end simply because it is on the cusp of becoming the longest expansion on record.  Therefore, the end of the expansion must be relatively close.

While we do not want to oversimplify a complex situation, the expansion will end once the economy overheats, inflation begins to rear its ugly head, the Fed responds by pushing the funds rate higher from 2.5% today to perhaps 5.0%, and the yield curve inverts.  None of those factors are on the horizon for the foreseeable future.

Bobby McFerrin had it right — “Don’t worry, be happy”.

Stephen Slifer


Charleston, S.C.

IMF Reduces Global Growth Forecast to 3.3%

April 12, 2019

The IMF recently reduced its 2019 global GDP growth forecast by 0.2% to 3.3% after slicing it 0.2% in October.  Its forecasts receive widespread attention because the IMF has the resources and the skills to examine closely the economies of virtually every country around the globe.   As always, the growth outlook varies depending upon exactly where one chooses to look.

The IMF forecast highlighted the fact that global economic activity is expected be the slowest since the recession.  While that is technically true, the chart below shows that the projected 3.3% growth rate this year is only marginally slower than in any of the previous seven years, so do not be too alarmed.

The IMF expects the U.S. economy to climb 2.3% this year, a growth rate broadly in line with the expectation of many other economists.  For what it is worth, we believe the economy is rebounding sharply from the fourth and first quarter slump caused in large part by the 20% drop in stock prices compounded by the protracted government shutdown.  Business and consumer confidence have largely shrugged off the impact of these two events.  The stock market is closing in on a new record high level.  The labor market is charging ahead with jobs growth of 190 thousand per month which will keep consumer income rising and consumer spending steady at a 2.5% pace.  And the decline in mortgage rates from 5.0% late last year to 4.0% is giving renewed vigor to the housing sector.  As a result of all this, we anticipate U.S. GDP growth of 2.6% in 2019 versus the IMF’s forecast of 2.3%.

Outside of the U.S., the economic environment is disquieting.

The IMF expects growth in China, to slip to 6.3% in 2019.  However, the IMF expects GDP growth in China to drift steadily lower to 5.5% by 2024.  This steady growth erosion largely reflects the negative impact on growth of an aging population.

The IMF’s forecast for Europe for 2019 has been chopped by 0.6% in the past six months to 1.3% which is noticeably slower than average growth of 2.0% in the previous five years.  The IMF cited a variety of reasons for the anticipated slowdown ranging from escalating tariffs imposed by the U.S., concerns about a no-deal Brexit, a worsening fiscal outlook for some countries, and street protests in France which have disrupted retail sales and undermined consumer and business confidence.  Clearly, these are all important factors for determining GDP growth for Europe.  But keep in mind that exports are 13% of the U.S. economy, and trade with Europe is 12% of that.  Thus, the anticipated growth slowdown in Europe will retard U.S. GDP growth this year by perhaps 0.1%.

The IMF has reduced its forecast for Latin America by 0.8% in the past six months to 1.4%.  However, its projected growth rate is roughly in line with growth in the previous five years which means that Latin America’s woes have been ongoing.  The growth reduction this year was led by Mexico which is being hit by a sharp curtailment of growth in exports caused by the combination of increased tariffs imposed by Trump, threatened border closures, and the fate of the new U.S./Mexico/Canada trade agreement.

The rocky political climate in Brazil and the arrest of former President Michel Temer have pulled down consumer confidence in that country to a 6-month low.

And, in Venezuela the political standoff between President Maduro and Juan Guaido has plunged the economy into chaos.  The U.S. imposed sanctions on the Venezuelan economy are taking a toll as the country’s oil exports to the U.S. fell to zero in March.  That has severely constrained the inflow of hard currency needed to pay for imports.  Widespread and recurring power outages are curtailing production in all sectors of the economy.  Meanwhile, residents are trying to cope with a projected 10,000,000% inflation rate.

Finally, in the Middle East and North Africa growth is expected to slow to 1.5% in 2019 as oil production in the region is falling rapidly.

Oil production in Iran, for example, has been hit sharply by the impact of the U.S. imposed sanctions.  Its oil production have fallen from 3.4 million barrels per day in September to 2.6 million currently.  The U.S. wants to eliminate Iranian oil exports.  At the same time Saudi Arabia has voluntarily cut production in an effort to boost oil prices which have rebounded to $65 per barrel.

The point of all this is that the U.S. economic backdrop seems relatively benign and even more friendly if our 2.6% GDP projected growth rate for the year is accurate.  But elsewhere around the globe from Europe, to China, to Latin America, and the Middle East growth will be constrained in 2019.  While there are always economic uncertainties, those potential problems will almost certainly put a lid on global growth this year.  However, the outlook could improve considerably if trade agreements can be reached between the U.S. and China, or between the U.S. and Europe, or immigration policies between the U.S. and Mexico can be stabilized.  Under no set of circumstances should we be thinking about a recession in the U.S. or anywhere else any time for the foreseeable future.

Stephen D. Slifer


Charleston, S.C.

Maintaining the Faith

April 5, 2019

The economy experienced a number of damaging shocks in the past six months as the stock market plunged in the fourth quarter followed by the protracted government shutdown.  As a result, GDP growth in the fourth quarter slipped to 2.2%.  We do not yet know what first quarter growth will be but it should be about 1.5%. It would be a serious mistake to interpret slower growth in those two quarters as a harbinger of subdued growth down the road.  Why?  Because recent data indicate clearly that the economy has shrugged off their temporary negative impact on growth.  We expect a relatively robust 2.9% rate of expansion in the second quarter followed by roughly similar growth in each of the final two quarters of the year.

The path forward will be determined by confidence – The combination of investor, consumer, and business confidence.

With respect to investors, after a sharp 20% selloff late last year the S&P 500 index has regained almost all of what was lost and is now less than 2.0% below its previous record high level.  Earnings season is upon us and we will see a steady diet of first quarter earnings reports in the weeks ahead.  The markets are poised for a string of disappointing data.  We are unconvinced.

The upswing in stock prices will bolster consumer confidence.  Indeed, the University of Michigan series on consumer sentiment has already fully recovered. At 98.4 in March it is just a shade below the September level of 100.1 which is where it was prior to the stock market drop.  With the reassuring increase in payroll employment for March of 196 thousand, consumer sentiment may have increased further.  We expect consumer spending to grow about 2.5% this year.

Business sentiment can be gauged by several economic indicators.  First, the purchasing managers index reflects business leader’s judgment about the combination of orders, production, employment and prices.  It has slipped in recent months to 55.3 from a high of about 60.0 at the end of the third quarter.  But before leaping to a conclusion that the manufacturing sector has weakened, keep in mind that the ISM group tells us that the current level of the index is consistent with GDP growth of about 3.0%.  Its earlier level was consistent with GDP growth of 4.5%.  So, while manufacturing sentiment has softened, it remains at a lofty level that is indicative of robust GDP growth for the foreseeable future.  The ISM group produces a similar index for non-manufacturing firms which looks virtually identical.

Business people can also vote with their feet through their hiring decisions.  When the increase in payroll employment for February slipped to 33 thousand the naysayers concluded that the economy had downshifted and quickly lowered their GDP estimates for the year.  But, lo and behold, employment registered to a stronger-than-expected increase of 196 thousand in March.  Last year the monthly average increase in employment was 223 thousand.  It certainly seems to us that employers remain eager to hire any roughly-qualified job applicant.

Economists often look at initial claims for unemployment insurance because it is a measure of layoffs.  It also happens to be a leading indicator of future employment.  At the end of March claims dropped to 202 thousand which is the lowest weekly level of claims in 50 years.  That gives us confidence that we will see a robust employment gain in April, and that the economy will make up for lost ground in the second quarter and register (we hope) GDP growth of 2.9%.

Given what has been happening to consumer confidence, business confidence, the labor market, and the stock market, it is hard for us to understand why most economists remain so worried.  As we see it, with the labor market very tight and additional workers hard to find, employers will continue to spend money on technology to boost output.  The increase in investment will boost productivity growth.  Faster growth in productivity will raise our economic speed limit within a couple of years to 2.8%.  Faster growth in productivity will simultaneously offset much of the increase wages.  Unit labor costs, labor costs adjusted for the increase in productivity, are currently rising at a 1.0% pace.  As a result, the inflation rate will continue to rise at a subdued pace for the foreseeable future.  And if the inflation rate behaves the Fed will be hard-pressed to raise rates further.

What’s not to like?

Could we be wrong?  Of course.  But if we are wrong, we are not under any set of circumstances staring at a recession by the end of this year or in 2020.  Instead, our worst-case scenario would be for GDP growth of perhaps 2.2% this year instead of the 2.6% we currently anticipate.  Alternatively, the herd of other economists that anticipate a recession within a year could just as easily be wrong.  We obviously think they are barking up the wrong tree.  They probably say the same thing about us.  We will see.

Stephen D. Slifer


Charleston, S.C.

Pessimism Prevails – But Not for Long

March 29, 2019

The expansion is now within three months of becoming the longest expansion on record.  Perhaps for that reason most economists conclude that a recession is lurking by the end of this year and try to find the dark side of every economic indicator.  We don’t buy it.  Expansions do not end simply because they reach some chronological milestone.  They end because the economy overheats, the Fed raises interest rates rapidly, goes too far, and eventually the economy slips over the edge into recession.  This is not that.

Let’s start with GDP growth.  Fourth quarter GDP growth was revised downward from an initially-published 2.6% to 2.2%.  Economists quickly pointed out that growth has slowed steadily from 4.2% in the second quarter, to 3.4% in the third, to 2.2% in the fourth, with even more anemic growth of 1.5% expected in the first quarter of this year.  However, those economists ignore the fact that the recent slowdown may have been negatively impacted by the 20% drop in stock prices and the government shutdown.  Those temporary restraining factors have since been reversed.

In response to the combination of slower growth overseas, a rate hike by the Fed in mid-December, its announcement that two more rate hikes were likely this year and the government shutdown, the stock market went into a 20% tailspin.  But the Fed now says it plans no further rate hikes this year and the government shutdown has ended.  Stocks have rebounded quickly and are now just 4% below their mid-September record high level.

Like stock prices, measures of consumer confidence dipped briefly but have since rebounded and remain close to their previous high levels and are consistent with consumer spending climbing at a steady 2.5% pace this year.

The Institute for supply Management’s index of activity in the manufacturing sector slipped from a near-record level of about 60 in the fall, to 54.2 in February.  But, according to the ISM group, its current level is consistent with 3.3% GDP growth.  An identically constructed index for non-manufacturing activity has completely erased its earlier decline and is consistent with 3.9% GDP growth.   Business leaders remain positive.

The housing sector has been under downward pressure for more than a year.  But things are looking up.  Existing home sales jumped almost 12% in February and erased much of the drop experienced throughout 2018.  New home sales have rebounded just as sharply.

Furthermore, mortgage rates have fallen 0.9% in the past couple of months from 4.9% to the 4.0% mark.  That is the lowest rate since January of last year.  That will undoubtedly provide support to home sales in the months ahead.  As a result, we expect housing starts to climb by about 9% this year despite a shortage of available construction workers.

None of this sounds remotely close to a recession scenario.  Indeed, following an expected 1.5% growth rate in the first quarter of this year, we anticipate GDP growth of 2.8%, 2.9%, and 2.8% in the final three quarters of the year.  That would give us 2.6% growth for the year.  The Fed, which is less optimistic, looks for GDP growth of 2.1% this year.  Because the Fed believes the economic speed limit currently is 1.8%, a 2.1% growth rate for the year in Fed terms is relatively robust and inconsistent with a lower rates scenario.

Some economists think that the inflation rate will continue to slow.  That seems unlikely.  The implied rate for inflation expectations over the next 10 years remains relatively steady at 1.9%.  The Fed looks for the core personal consumption expenditures deflator (its preferred inflation gauge) to rise 2.0% in 2019 (it is currently climbing at a 1.8% pace).  Its inflation target is 2.0%.   A significantly slowdown in inflation is not going to happen.

Many economists base their recession forecasts on the slight inversion of the yield curve. While it is true that an inverted curve is a leading indicator of recession, we think they are reaching the wrong conclusion because they are not looking at why the yield curve has inverted.  Typically, the economy grows at a reasonably rapid pace, inflation begins to climb, the Fed responds by raising rates quickly and, at some point, goes too far.  Hence, an inverted curve is usually a sign that the Fed has tightened “too much”.

Please note that we have two pre-conditions for a recession– a funds rate above the 5.0% mark and an inverted yield curve.  The funds rate today is 2.4%.  Most economist believe a “neutral rate” – one which neither stimulates the economy nor slows it down – is about 2.8%.  Fed policy is not even close to being “too tight”.

And regarding the inversion of the yield curve, it has not inverted in the usual way by having short rates rise rapidly and eventually become higher than long rates.  Instead, an expectation of slower GDP growth, lower-than-expected inflation, and an eventual Fed easing move, has pushed long rates below short rates.  Indeed, in the past six months the yield on the 10-year note has fallen by 0.8% from 3.2% to 2.4%.  A yield curve that inverts because long-term interest rates have fallen dramatically, does not carry the same meaning as an inverted curve caused by rising short rates and “too tight” Fed policy.  The slight inversion of the curve that is occurring currently is not a harbinger of recession.

Economists currently want to find the dark side of every economic indicator that is released because they are sure a recession is just around the corner.  But as the year progresses a rebound in the pace of economic activity and steady inflation should cause them to re-evaluate their gloomy outlook.  However, they will only do so grudgingly.  Keep the faith.  All is well.

Stephen Slifer


Charleston, S.C.

Did the Fed Overreact?

March 22, 2019

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

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

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

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

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

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

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

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

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

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

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

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

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

Stephen Slifer


Charleston, S.C.

Second Half Rate Hikes Harder to Justify

March 15, 2019

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

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

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

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

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

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

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

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

Stephen Slifer


Charleston, S.C.