Tuesday, 22 of January of 2019

Economics. Explained.  

Category » Commentary for the Week

Overcoming Fears

January 18, 2019

In the first three weeks of January the stock market recovered one-half of what it lost in the fourth quarter.  Investors have found renewed optimism.  The catalysts for the downturn included slower growth from China, a steady drumbeat of rate hikes by the Fed, weakness in the housing market, and concern about the impact of the government shutdown.  Some pundits feared a recession as early as the end of this year. But in the past couple of weeks many of those fears have been reduced .  While the government shutdown rolls on, it is important to remember that almost all of what is lost during the shutdown will be recovered in subsequent months.

The S&P 500 hit bottom on Christmas Eve and has been climbing slowly but steadily for three weeks.  While the downslide was unnerving, we did not see corresponding weakness in the economic statistics, so we concluded that the drop was primarily attributable to exaggerated stock market volatility and, therefore, was not a harbinger of slower growth in the months ahead.  We have no reason to change that view.

GDP growth in China is clearly slowing.  The IMF currently estimates 2018 GDP growth for China of 6.5% with even slower growth expected in 2019 and 2020.  For most countries 6.5% growth would be welcome news.  But for China that would be the slowest rate of expansion since 1990.  But two things are important.

First, much of China’s slower growth woes have been caused by the U.S.-imposed tariffs.  With trade representing nearly one-half of the Chinese economy versus about 10% in the United States, China has much more to lose in a trade war.  Since tariff talk began in the early part of last year, the Chinese yuan has declined  almost 10%.

That, in turn, has caused the Shanghai Composite stock index to fall 23%.  Slower growth in exports will negatively impact Chinese GDP growth for the foreseeable future.

The U.S. does not come out unscathed.  Growth in the U.S. will be reduced as well.  Both countries lose, but China loses far more than the U.S.  Thus, the pressure is on both countries, the Chinese in particular, to reach a deal.  The U.S. is not asking not just for a trade deal, it is asking China to completely alter its way of doing business.  The U.S. wants China to recognize our patent and copyright laws.  Quit stealing trade secrets.  Stop forcing companies to share their technology as a prerequisite for permission to do business in China.  Despite those harsh requests, we still expect some sort an agreement to be announced in the months ahead and recent talks are encouraging.  Both countries can claim victory.  Once that happens stock markets around the world will rebound as investors’ concerns about a significant slowdown in China’s GDP growth will be alleviated.

But there is more going on than just China and trade.  Late last year the markets feared that the Fed would raise rates three times this year. In mid-December the Fed lowered its expectation of rate hikes this year from three to two.  At the same time, it said that it would refrain from further rate hikes until some of the current economic uncertainty and market angst disappears, which probably means no further rate hikes until midyear.  That is also good news.

Finally, home sales took at big hit last year.  Some believe that the combo of higher home prices and higher mortgage rates has made housing less affordable for many Americans.  For those economists, recent developments should allay their concern.

As the stock market swooned and a fear of slower growth materialized in the fourth quarter, mortgage rates fell from 5.0% to 4.5% which is where they were last summer.

At the same time, the run-up in home prices has slowed dramatically.  The year-over-year increase has ebbed from a peak of 6.4% at this time last year to 4.7%.  And data for the last six months suggest a further slowdown to about 3.0%.

These developments mean that housing has become more affordable for the average American family.  The National Association of Realtors series on housing affordability has climbed from 138 a few months ago to almost 150 currently.  That means that a median-income family now has 50% more income than is required to  purchase a median-priced home.  Increased affordability should re-invigorate home sales in the months ahead.

These are all small, tentative developments but, collectively, they provide support for the notion that any slowdown in economic activity will be modest and perhaps short-lived.

Stephen Slifer


Charleston, S.C.

Recession Fears Linger

January 11, 2014

The Wall Street Journal  recently published its monthly poll of economists with the headline, “Economists See Rising Risk of Downturn”.  After getting off to a good start in the early part of the year the stock market turned south.  This highlights the extent to which recession fears are ingrained in investors’ psyche, which probably means that the stock market recovery this year will be slow going.  Ultimately, the economic data win and we expect the economy to rise 2.8% in 2019 and the stock market to achieve a new record high level later in the year.

The Journal noted that the surveyed economists saw a 25% chance of a recession in the next twelve months.   While few could identify a specific trigger, the worries included the usual cast of characters — trade tensions with China, rising interest rates, and a sharp stock market selloff last year.  But economists are always worrywarts.  When asked if they see a recession in the next year they invariably say “no”, but then add that there is some non-zero chance of one occurring.  Well, that about covers it.  There is always a chance of bad things happening and the economy unexpectedly slipping into recession.  Fair enough.  But it seems to us that economists are simply hedging their bets.   If the economy performs well, they can say that they were right.  If the economy slips into recession, they can still say they were right because they highlighted a rising risk of recession in their forecasts.  You can’t have it both ways.  Either you expect a recession, or you don’t.  For the record, we do not expect a recession in 2019.  Nor do we expect one in 2020.

A chart accompanying the Journal’s article showed that economists’ recession fears spiked in 2011 to 33%, retreated briefly,  jumped again in 2013, dropped back a second time, climbed again in 2016, fell a third time, and  then jumped to 25% in the most recent survey.  We are still waiting for that recession.  So, rest easy.  The economists’ recent renewal of anxiety is just economists being economists and envisioning doom and bloom around every corner.

We would have been happier if the surveyed economists had said that the previously-mentioned fears could result in a somewhat slower than anticipated rate of GDP growth in 2019.  That seems possible, particularly early in the year if consumers become a bit more reluctant to spend and business leaders postpone their investment plans until some of the uncertainty disappears.  That is a realistic alternative scenario.  But to stop the economy dead in its tracks and push it over the cliff into recession has such a minuscule chance of occurring that it is not worth talking about.

It has now been more than three  months since the stock market swoon began and consumer sentiment has barely budged.

Confidence has most likely been supported by the robust, 200 thousand per month pace of jobs creation which is showing no sign of slowing down.

Business confidence has slipped a bit for both manufacturing and non-manufacturing firms as evidenced the the Institute for Supply Management’s monthly surveys.  But, in both cases, the indexes are falling from very high levels and the ISM says that the December level for manufacturing firms is consistent with steamy GDP growth of 3.4% and for non-manufacturing firms it is 3.2%.  Hardly worrisome.

Small business confidence has edged lower in recent months but remains close to its recently-established 35-year high.

Fed Chair Powell and numerous other Fed officials have emphasized recently that they intend to refrain from further rate increases for some time, most likely at least until midyear.

Meanwhile, long-term interest rates have declined in the past couple of months.  The 30-year mortgage rate, for example, has fallen from 4.9% late last year, which was making potential home buyers nervous, to 4.5% which is where mortgage rates were a year ago.  That will provide support to the  housing sector.

We recognize that economists are nervous which has, in turn, made investors nervous.  But we have seen no evidence from any recently-released economic data that the economy has softened.  So, try to shake those lingering fears of recession.  The worst that could happen would be a  temporary slowdown in GDP growth and we see no evidence even that is about to occur.

Stephen Slifer


Charleston, S.C.

Recession Fears Unwarranted – Stay the Course

January 4, 2019

Stock market volatility is continuing in the early part of this year. Depending upon exactly when you look, you might conclude that a recession is in the cards by the end of this year or be reassured that the economic activity is on a relatively steady track. We remain in the latter camp. Having said that, consumer confidence edged lower in December while the manufacturing sector weakened notably. It could be that the combination of slower growth in China, the impact from tariffs on the economy, the continuing government shutdown, and gridlock in Washington will dent first quarter growth. But the government shutdown will soon end. Furthermore, pressure is on both the U.S. and China to strike a deal. As those events unfold in the months ahead consumers, businesses, and investors should conclude that there is no chance of a recession by yearend.

Consumer confidence fell eight points in December. That is the first drop since the stock market began its gyrations back in October. However, it fell from an 18-year high. The decline most likely does not mean much – but it was at least a noticeable drop.

Slightly more problematic is the decline in the purchasing managers index for December. It fell five points in that month to 54.1. The falloff was led by an 11-point drop in orders and a 6-point drop in production. These two categories tend to be more forward-looking and suggest that first quarter GDP growth could be weaker than the 2.7% pace we are projecting. Our sense is that an end to the government shutdown, reassuring economic data in the months ahead and, perhaps, some sort of a deal with China will allow this index to rebound.

When the stock market experiences a down day, the market concludes that the economy could enter a recession by the end of this year and that the Fed will lower rates by yearend. Forget it. Neither of those things are going to happen.

In mid-December the Fed suggested that the it would boost funds rate twice in 2019 from its current 2.25-2.5% target range to 2.9% by yearend. We still expect that to happen. However, in the near-term more and more Fed officials will advocate no additional rate hikes until some of the current uncertainty comes to an end. If that happens, which is what we expect, the Fed may well implement two additional rate hikes later this year.

The Fed continues to believe that potential GDP growth is 1.9%. GDP growth last year was 3.1% and it expects 2.3% growth in 2019. Both growth rates exceed potential. Because the economy is at full employment the Fed worries that inflation could begin to climb. Potential growth measures how quickly the economy can grow over the longer-term when it is at full employment. It is interested in, say, a 3-year growth rate for the labor force and productivity. We take comfort from the fact that growth for both measures has accelerated in the past year and, most likely, potential GDP growth is on the rise.

Growth in the labor force has picked up considerably. At the end of 2017 the 3-year growth rate for the labor force was 0.9%. But the labor force increased 1.6% this year as rapid GDP growth lured some previously unemployed workers back into the labor force. The 3-year growth rate in the labor force has climbed to 1.1%, and if it climbs as rapidly this year as in 2018 the 3-year growth rate will continue to climb.

Productivity growth has quickened. The 3-year growth rate remains sluggish at 0.9% because of slow growth in earlier years. But growth this past year picked up to 1.5% and surpassed the 2.0% mark in the two most recent quarters. Like growth in the labor force, productivity seems to be gathering momentum.

This suggests that potential GDP growth is on the rise. The Fed’s 1.9% estimate probably consists of 0.9% growth in the labor force and 1.0% growth in productivity. But, as described above, growth in the labor force has picked up to at least 1.1%. Productivity growth has climbed to 1.5%. Thus, potential growth is no longer 1.9%. It is probably close to the 2.5% mark. If that is accurate, the economy can grow at a sustained 2.5% pace without generating inflation. If our forecast of GDP growth for 2018 of 2.8% is accurate the Fed has little reason to further raise rates.
That is particularly true if inflation expectations remain in check. In the past couple of months inflation expectations have slipped from 2.1% to 1.8%.

Also, keep in mind that the yield curve has flattened considerably in the recent months. With the yield on the 10-year note currently at 2.6% and the funds rate at 2.4%, the yield curve is positive by just 0.2%. The Fed does not want the yield curve to invert. It knows that an inverted curve is a warning sign that a recession is likely within the next year.

If potential growth is picking up to a pace roughly in line with projected GDP growth, inflation expectations are declining, and the yield curve is extremely flat, the Fed is not going to raise the funds rate any time soon.

While recession chatter has become more widespread in the past month or two there is no recession on the horizon for the foreseeable future.

Stephen Slifer
Charleston, S.C.

The Fed Did It – But Was It the Right Thing to Do?

December 21, 2018

The Fed raised rates this week which puts the funds rate in a range from 2.25-2.5%.  The move was largely expected.  The Fed also anticipates two one-quarter point hikes in 2019 which would leave the funds rate at 3.0% by the end of next year.   The Fed said it was becoming more “data dependent”, but its official statement and Fed Chair Powell’s comments at the press conference gave short shrift to clear signs of slower growth overseas, a steady drop-off in the pace of  home sales, a slightly reduced rate of inflation, and the stock market’s three-month swoon.    So why did the Fed raise rates?

We do not believe the Fed was asserting its independence and sending a strong message to President Trump that it would not be intimidated.  The Fed does not engage in political gamesmanship.

There is a simpler explanation for its action.  The Fed believes that potential GDP growth is 1.9%.  The economy is at full employment.  It anticipates 3.0% GDP growth this year and 2.3% growth in 2019.  Because growth in those two years will exceed the speed limit, the Fed wants to raise the funds rate to a neutral level which it now believes is 2.75%.

Clearly, the markets do not share that outlook.  They are worried about Fed policy becoming “too tight”.  We do not quibble with the Fed’s estimate of “potential GDP growth” which this week they lowered from 3.0% to 2.75%.  But we do take issue with the Fed’s apparent dismissal of recent economic data.

The S&P has now fallen 16.5% from its peak and is approaching a “bear market” which is generally regarded as a decline of 20%.  That should give the Fed ample reason to take a breather.

The IMF recently lowered its estimate of GDP growth for China for 2018 to 6.5%.  For China that is the worst performance since 1990.  The IMF expects even slower growth in 2019 and 2020.  A slowdown of that magnitude in the world’s second largest economy will have ramifications around the globe – including the U.S.  That should give the Fed ample reason to take a breather.

Much of the weakness outside our borders is the result of a stronger dollar which has risen 10% since January.  The dollar’s ascent was triggered by Trump’s tariffs on all countries.  Other countries retaliated.  A trade war was underway.  Foreign investors concluded that the U.S. was in a far better position to withstand a trade war than other countries, so money poured into U.S. stock and bond markets in the spring and summer thereby boosting the value of the dollar.  But that crushes growth in emerging economies which need raw materials to feed their manufacturing sector.  Those raw materials are all traded in dollars.  Hence, an increase in the dollar increases the cost of materials for emerging economies, impedes their ability to compete in the global marketplace, and leads to a weaker economy.  A Fed rate hike serves to increase further the value of the dollar and accentuate that economic weakness.    That should give the Fed ample reason to take a breather.

Inflation has been coming in lower than expected.  The Fed’s preferred measure of inflation, the personal consumption expenditures deflator excluding the volatile food and energy components, has risen 1.9% in the past year.  But in the past six months that has slowed to 1.5%, and in the past three months to 1.7%.  It is certainly not accelerating!  That should give the Fed ample reason to take a breather.

The market’s expected rate of inflation for the next decade can be estimated as the difference between the yield on the Treasury’s 10-year note and its inflation-adjusted equivalent.  It had been at 2.1% for almost a year but recently slipped to 1.8%.  That should give the Fed ample reason to take a breather.

In the wake of the Fed’s rate decision short rates rose while long rates declined.  As a result, the yield curve, which is the difference between long-term interest rates and short rates, flattened by 0.6% from -1.0% to 0.4%.  The yield curve has not yet inverted – which happens when short rates become higher than long rates – but it is a lot closer now than it was on Wednesday morning.  An inverted curve is a warning signal that a recession is likely within a year or so.  That should give the Fed ample reason to take a breather.

We disagree with the Fed’s decision to raise rates at the meeting this past week.  Nevertheless, it is hard to imagine a funds rate of 2.25-2.5% or even the 3.0% rate expected by the end of next year, as being high enough to push the economy over the edge into recession.  Having said that, the relentless stock market slide combined with breathtaking volatility is bound to shake consumer and business confidence at some point.  While a recession is not in the cards, GDP growth could slip  a notch or two.  We currently project 2.8% GDP growth in 2019.  We are going to wait and see what happens in the early part of next year, but for now the risk seems to be on the downside.

The Fed did not help itself or the economy on Wednesday.

Stephen Slifer


Charleston, S.C.

The Year Ahead – 2019

December 14, 2018

Stock market jitters are making investors nervous.  We understand why.  The expansion is approaching its 10-year anniversary which makes it geriatric.  GDP growth overseas has slowed.   Home sales have been shrinking steadily for a year.  However, we believe the stock market’s fears are overblown.

For 2019 we expect:

  1. GDP growth of 2.8%.
  2. Inflation should be steady with the core CPI rising 2.3%.
  3. The Fed will boost the funds rate twice in 2019 to 2.75%.
  4. The stock market should reach a new record high level.
  5. Sustained rapid growth in investment spending will quicken productivity and boost the economy’s speed limit to 2.8% by the end of this decade.
  6. This expansion will not end in the foreseeable future.

To forecast GDP growth, we break it down into its major components – consumer spending, investment, trade, and government spending.

Consumer spending, which is about two-thirds of the GDP, is likely to grow 2.6% in 2019.   While the stock market has fluctuated wildly for two months consumer confidence has been unfazed.  Why?

Jobs.  The economy continues to crank out 190 thousand new jobs per month.  Job creation generates the income that allows us to spend.

Some economists note that consumer debt has climbed to a record high level.

But consumer income has also risen and, as a result, debt in relation to income is near a record low level.  Consumers are not saddled with excessive debt.

If we were, delinquency rates should have begun to climb.  That has not happened.

Bottom line – look for consumer spending to grow 2.6% in 2019.  Remember, consumers account for two-thirds of  GDP.

The  housing market has declined steadily throughout year.  While disquieting, we had a similar drop in 2014.  Ex Fed Chair Bernanke said that the Fed planned to slow its purchases of its U.S. Treasury bonds.  The markets panicked.  Long-term interest rates spiked and home sales got crushed.  But eventually reality sank in and sales rebounded.  We expected something like that to happen again.

Is the recent decline attributable to a drop-off in demand?  Or is it a supply constraint?  We argue it is primarily the latter.

The National Association of Realtors )NAR) reports that there is currently a 4.3-month supply of homes available for sale and that a 6.0-month supply is necessary for supply and demand to be in balance.  Hence, there is a considerable shortage of homes available for sale.  Realtors cannot sell what is not for sale.  If enough homeowners were to put their houses on the market so that there was 6.0-month supply, sales would be 5.8-6.0 million versus 5.2 million currently. Thus, the problem is largely a supply constraint.

Some economists contend that the combo of rising home prices and higher mortgage rates has made housing unaffordable.  That is not true for most potential home buyers.  The NAR publishes a housing affordability index which includes prices, mortgage rates, and consumer income which has been rising steadily.  This index tells us that consumers have 45% more income than is necessary to purchase a median-priced home.  In 2007 that same number was 14%.  Housing was expensive at that time.  That is not the case today.

On the demand side, the average length of time between listing a home and its sale is 33 days.  In 2011 the comparable figure was 95-100 days.  Clearly the demand for housing remains robust.

For builders the primary constraint seems to be a labor shortage.  They cannot find an adequate supply of workers.  That puts a lid on how many homes than can produce.  Our sense is that housing will climb about 4.0% next year, but that is not fast enough to alleviate the extensive housing shortage.

Investment spending is another 15% of the GDP pie.  Business confidence is soaring.  That is true for manufacturers, non-manufacturing firms, small businesses, and big businesses.  Small business confidence is particularly noteworthy since it has reached a 35-year high.  Why?  The tax cuts.  All measures of confidence surged immediately after the November 2016 election.  The combination of tax cuts, repatriation of overseas earnings at a favorable tax rate, and the elimination of unnecessary, overlapping, and confusing regulations has buoyed business optimism.

That confidence has, in turn, stimulated investment spending which surged in the first quarter of 2017 and continues to this day. While some economists suggest this is a short-term development triggered by the tax cuts, we do not share that view.  A reduced tax rate and further deregulation will spur investment spending for years to come.  Also, the 3.7% unemployment rate is the lowest in 50 years.  Labor shortages are extensive.  If firms cannot hire an adequate number of new workers, they might contemplate spending money on technology to make the company’s existing workers more productive.  This will provide further stimulus for investment.  Thus, we expect investment spending to grow 6.5% for the next several years.

Trade has gotten lots of attention recently.  All economists support the notion of free trade.  All countries benefit.  But free trade is not fair trade.  Not all countries play by the rules.  Some cheat.  The primary culprit is China which does not respect intellectual property rights, steals trade secrets, and forces companies who want to do business in China to share their technology.  The object of the trade negotiations is to encourage China to reform.

But Trump initially said he was concerned about the size of the trade deficit and wanted to shrink it.   To that end, he imposed steel and aluminum tariffs on our neighbors, friends, and allies as well as China.  They retaliated.  Suddenly a trade war was underway.

While all countries lose as the result of a trade war, not all countries lose equally.  As investors scoured the globe to find which countries might fare best in a trade war, their answer was the U.S.  After all, trade only represents about 10% of the U.S. economy, versus about 50% elsewhere.  As a result, money has poured into the U.S. stock and bond markets since January.  The dollar has climbed 9%.  Tariffs imposed by other countries will reduce growth of U.S. exports, but the flood of money into the U.S. by foreign firms  who start new businesses here and hire American workers will limit the damage.

That is not the case for emerging economies.  They generally import the raw materials required by their manufacturing sector.  But those commodities are all traded in dollars.  When the dollar rises, their cost of goods sold increases.  It becomes more difficult for them to compete in the global marketplace.  As a result, their currencies decline.  Their stock markets plunge.  Indeed, the emerging markets stock index has fallen 23% since February.  Slower GDP growth lies ahead.  In October the IMF lowered its projection of 2019 GDP growth for emerging economies by 0.3%.  Growth in China should slip to 6.5% this year, the slowest rate of expansion since 1990 with even slower growth expected in the years ahead.  This slower pace of growth outside U.S. borders – China in particular – is one factor weighing on the U.S. stock market.

As growth  prospects dim for these countries and the pain intensifies, there is increasing pressure on their leaders to strike a trade deal with the U.S.  Thus far that has happened with Mexico and Canada.  A deal with Europe seems close.  China not so much.  But if Trump broadens and further raises tariffs on Chinese goods at the end of this year the pressure on both sides will intensify.  We believe that by spring the U.S. and China will reach an agreement with both sides claiming victory.

Unfortunately, previously imposed tariffs on U.S. goods by China and other countries will reduce growth in U.S. exports, cause the trade gap to widen, and the trade component will subtract about 0.2% from U.S. GDP growth in 2019.

When we combine these GDP components, we come up with projected GDP growth for 2019 of 2.8%.

Our GDP forecast for the next several years differs from others because we expect rapid investment spending to continue for years, which will boost productivity growth and, eventually, raise our economic speed limit to 2.8%.  Most other economists expect investment growth to fade soon and potential growth to remain at 1.8%.

Nobody knows exactly what the economy’s potential growth rate is, but we estimate it by adding the growth rate of the labor force to growth in productivity.  If we know how many people are working and how efficient they are, we should be able to estimate how many goods and services they can produce.  In the 1990’s potential growth was believed to be 3.5%, consisting of 1.5% growth in the labor force and 2.0% growth in productivity.  The economy grew at that rate for a decade and we concluded that in the good times the economy should grow by at least 3.0%.  But in recent years potential growth rate has slipped to 1.8%.  The baby boomers are retiring, and labor force growth has slipped to 0.8%.  Productivity growth has  faded to 1.0% following a growth spurt triggered by the introduction of the internet in the mid-1990’s and the cloud and apps in the early 2000’s.

While GDP growth of 1.8% is disappointing, it does not have to remain there forever.  But to increase it we need to boost either growth in the labor force or growth in productivity.  Labor force growth is unlikely to accelerate because the baby boomers will continue to retire for another decade.  Fortunately, productivity growth is determined to a large extent by growth in investment.  Our bet is that sustained rapid growth in investment will boost productivity growth from 1.0% in recent years to 2.0%, and the economy’s potential growth rate will climb from 1.8% to 2.8%.  That means that the economy can grow at a steady 2.8% pace without triggering an upswing in inflation.

We estimate that the core inflation rate will edge upwards from 2.2% this year to 2.3% in 2019.

There are components, like housing, that will put upward pressure on the inflation rate.  Rents, which represent about one-third of the entire CPI index are growing by 3.3% which reflects the shortage of rental units.

But there are two factors that have kept inflation in check which are not widely discussed.

First, is the role of technology.  Whenever we buy anything, we shop first on Amazon and can find the lowest price anywhere in the world.  As a result, goods-producing firms in the U.S. have absolutely no pricing power.  In the past year prices of goods have risen  0.2%.  Prices of services have risen 2.9%.  This means that inflation is virtually non-existent for one-third of the economy.

Second, productivity growth is countering most of the faster growth in wages.  Given the tight labor market wage growth has accelerated from 2.0% to 3.0%.  Most economists worry that this will cause an upswing in inflation.  But they are looking at the wrong thing.  If employers pay their workers 3.0% higher wages because they are 3.0% more productive, they don’t care.  They are getting 3.0% more output and have no incentive to raise prices.  Workers have earned their fatter paychecks.  Thus, we are supposed to look at “unit labor costs” which are labor costs adjusted for the increase in productivity.  In the past year unit labor costs have risen 0.9%.  The Fed has a 2.0% inflation target.  As a result, the seemingly tight labor market is not putting upward pressure on the inflation rate.  If productivity continues to climb, it will help to keep the inflation rate in check.

If in 2019 we end up with 2.8% GDP growth and inflation is relatively steady at 2.3%, the Fed will be cautious about further rate hikes.  For years the Fed thought that a “neutral” funds rate was about 3.0%.  But recent speeches by Fed governors make it clear that the Fed is rethinking that objective and may lower it to 2.75%.  Given that the funds rate currently is 2.2%, that implies only two rate hikes in 2019.  The Fed is getting close to where it wants to be.

When will the expansion end?  We do not know, but probably not before 2022.  We want to see two things to happen before we call for a recession.

  1. The funds rate should be at least 5.0%.
  2. The yield curve must invert, meaning that short rates are higher than long rates.

We have found that the U.S. economy has never gone into recession until the funds rate has been above the 5.0% mark.  If the Fed raises the funds rate to 2.75% by the end of next year and leaves it there, a 5.0% funds rate will not happen for the foreseeable future.

We have also found that when the yield curve (which we define as the difference between the yield on the 10-year note and the funds rate) inverts, a recession follows within a year.  Today the 10-year note is 3.0%, the funds rate 2.2%, so the yield curve has a positive slope of 0.8%.  By the end of next year, we expect the funds rate to be 2.75% and the yield on the 10-year note to  be 3.4%.  The curve will have a positive spread of 0.65%.  By the end of 2019 (and for 2020 and 2021), we expect neither of our preconditions for recession to be met.   For this reason, we believe the expansion will continue at least until 2022.

We have described a very positive scenario.  Potential GDP growth rises from 1.8% to 2.8%.  Inflation remains steady at 2.3%.  The Fed raises rates only twice more and the funds rate peaks at 2.75%.  The stock market will climb to a record high level during 2019.  But for this to happen, investment spending must continue to grow rapidly, and productivity must sustain a 2.0% pace.

Stephen Slifer


Charleston, S.C.

Returning to Neutral – Whatever That Is

December 7, 2018

All eyes will turn to the Federal Reserve and its rate decision this coming week.  The general expectation is that it will raise the funds rate by 0.25% to 2.25-2.5%.  We are not as convinced and think they will leave it in its current range from 2.0-2.25%.  Regardless of what they decide at this meeting it will be far more important to learn how they intend to carry out policy in the months and quarters ahead and learn their revised thinking about a neutral level of the funds rate.  For the first time in years they are going to depart from autopilot when rate hikes were entirely predictable.  Its future policy will become “data dependent”.  That means that if the economy is showing signs of strengthening and/or inflation is beginning to accelerate, they will raise rates.  But if economic activity continues to chug along at a moderate pace with no upward pressure on inflation, they will stand pat.  But how to describe that new decision-making process to us novices?  To complicate matters further the Fed and most economists have for some time believed that a “neutral” level of the funds rate is about 3.0%.  But, judging from recent speeches, every Fed official is re-thinking that level and suggesting that it might be lower.  How exactly do they figure out what a neutral rate might be?

Since December 2016 the Fed has talked about gradual increases in the funds rate but indicated that the funds rate would remain, for some time, below the level that should prevail in the longer run.  That is Fed-speak for a desire to return gradually to a “neutral” funds rate.  The Fed’s rate-determining body, the Federal Open Market Committee, or FOMC, meets eight times per year and they hold a press conference at every other meeting.  It fell into a pattern whereby it would raise rates only at meetings after which it held a press conference.    Thus, their policy became entirely predictable.  But the funds rate is now 2.0-2.25%.  Investors are worried that if the Fed remains on its current glide path it will eventually overdo it and the economy will slip into recession.

But Fed officials are not stupid.  They knew when the funds rate was 0% it was an easy call to raise rates when the presumed objective was something around 3.0%.  But with the funds rate 2.0-2.25% it is time to be more cautious.  The current 3.0% estimate of the neutral level is the mid-point of the Fed’s likely range for that neutral rate which is anywhere from 2.5-3.5%, but most Fed officials are clustered together between 2.75-3.0%.  The Fed is getting close.

But there is nothing magic about 3.0%.  Different economists use different methods to estimate it.  We calculate it by looking at the relationship between the funds rate and the inflation rate or the so-called “real funds rate”.  Over the past 50 years the real funds rate has averaged 1.0%.  Sometimes the Fed will be tightening, other times it will be easing.  If, through good times and bad, the funds rate averages 1.0% higher than the rate of inflation, it is reasonable to conclude that 1.0% should be a neutral level for the real funds rate.  If the Fed has a 2.0% inflation target and a neutral rate is 1.0% higher than that, voila, a neutral funds rate level should be about 3.0%.  That rate is probably in the ballpark of where it should be.  But some economic studies suggest that the neutral rate may change over time.  Just because the real funds rate averaged 1.0% during the past 50 years does not necessarily mean that it is still the appropriate level  today.

Furthermore, other economists will estimate it in a different manner.  For example, some think it should be roughly in line with nominal GDP growth.  If the economy is growing at 2.0% and inflation is rising at 2.0%, nominal GDP growth would be about 4.0%.  Their conclusion is that the funds rate should be at 4.0% to keep the economy and inflation on an even track.

All of this means that, going forward, the Fed needs to get off autopilot and begin to sniff the air.  Its policy will be determined by looking at the entire spectrum of available economic indicators.  From that data they will construct GDP forecasts, predict the future unemployment rate, and try to figure out the path of inflation.  Just like the rest of us all 12 members of the FOMC may not agree.  Fed Chairman Powell recently compared the Fed’s strategy as walking into a living room when the lights suddenly go out. “What do you do?  You slow down, and you maybe go a little bit less quickly, and you feel your way more.”  Great analogy.

We think that at its meeting this week the Fed will leave the funds rate in its current range from 2.0-2.25%.  It can site slower GDP growth overseas, falling oil prices which will alleviate any upward pressure on the inflation rate for a while, and they can note financial market jitters in both the stock market and widening corporate bond spreads.  We think it is entirely appropriate for them to leave rates where they are for a while and wait to see what happens.   Whether the Fed raises rates or not at its meeting this week or not, pay attention to its estimate of the end point.  Is their estimate of the neutral rate still 3.0%?  Probably not.  We think they might lower it to 2.75%.

At the very least the Fed’s rate decision will make it an interesting week.

Stephen Slifer


Charleston, S.C.

2019 Economic Outlook Conference


2019 Economic Outlook Conference

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


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


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

When will higher interest rates spoil the party?

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

What are the two best leading indicators of recession?

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


DATE:     Thursday, December 6, 2018

TIME:      7:30 to 9:00 A.M.

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

COST:      $40.00 includes breakfast


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

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


Proudly sponsored by:

Charleston Digital Corridor                              Charleston Regional Business Journal

Daniel Island Business Association                 Daniel Island Town Association

NumberNomics                                                Cetera Advisors

Baird                                                                Trident Technical College

Wells Fargo Advisors


To Register:    http://www.numbernomics.com/nomicsnotes/ Read more »

Inflation —  Surprisingly Well Behaved

November 30, 2018

Most economists believe that the economy is growing at a rate well in excess of its assumed potential growth path.  That should translate into upward pressure on the inflation rate.  The problem is, that is not happening.   If the upswing in inflation continues to be more gradual than the Fed expects it may postpone further rate hikes.  Why isn’t inflation rising more rapidly?

Economists believe that the “full employment” threshold is somewhere around 4.5% because at that point wages  began to climb.

Currently, the unemployment rate is 3.7% and average hourly earnings have risen steadily from 2.0% a couple of years ago to 3.1%.  Because wages are rising more rapidly than the Fed’s 2.0% inflation rate, many economists worry about upward pressure on the inflation rate.

But we have often said that by focusing on measures such as average hourly earnings, economists are looking at the wrong thing.  They should be focusing on labor costs adjusted for changes in productivity  which are known as “unit labor costs”.

If I pay you 3% higher wages, you might think that my labor costs have risen by 3.0% and I will be tempted to raise prices to offset the higher cost of labor.  But what if I  pay you 3.0% higher wages because you are 3.0% more productive?  I really do not care.  I am getting 3.0% more output.  You have earned your fatter paycheck.  In this case “unit labor costs”, labor costs adjusted for the change in productivity, are 0.0%.   I have no reason to raise prices.

Unit labor costs data are included in the productivity report.  In the past year compensation has risen 2.8% while productivity has climbed by 1.3%.  Thus, unit labor costs have increased by 1.5%.  The Fed has a 2.0% inflation rate.  Economists who look at the 3.1% increase in average hourly earnings conclude that the seemingly tight labor market will put upward pressure on the inflation rate.  But if  one factors in the increase in productivity and learns that unit labor costs are rising 1.5%, there is no upward pressure on the inflation rate despite a seemingly tight labor market.

One other thing.  The Fed believes that the economy’s “potential growth” rate is 1.8%.  That consists of 0.8% growth in the labor force combined with 1.0% growth in productivity.  Our theory is that the impressive pickup in investment spending will gradually lift productivity growth to 2.0% and, by the end of this decade, potential growth will climb from 1.8% to 2.8% consisting of 0.8% growth in the labor force combined with a 2.0% increase in productivity.  Recent data suggests that we are on the right track.  In the past two quarters productivity rose 2.9% in the third quarter and 2.2% in the fourth quarter.  The pickup in investment spending the past two years seems to be paying off in faster growth in productivity.

Having said all that, potential growth is a long-term concept and we are talking about short-term developments.  Fair enough.  But the fact that the economy has grown 3.0% in the past year with no real increase in inflation seems to suggest that the Fed’s 1.8% estimate of potential growth rate is way too low.  We suggest that it may have already reached the 2.5% mark.  For the Fed to reach the same conclusion it will need to see sustained growth in both investment spending and productivity.  If productivity can grow at a 2.0% pace for three years or so, the Fed will eventually conclude that potential growth has risen to something  like the 2.8% pace we are suggesting.

The recent increase in productivity can impact the Fed’s decision to raise interest rates. If Fed Chair Powell and his colleagues conclude that potential growth could be rising, they may refrain from further rate  hikes.  If the economy is growing by 3.0% and the Fed thinks potential growth is 1.8%, it should be tightening aggressively to prevent a pickup in inflation.  But if the economy is growing at 3.0% and potential growth may have climbed to 2.5% or higher, perhaps it should sit tight for a while.  The economy may not be exceeding the speed limit  by much.

Besides, the funds rate is currently 2.2%.  A neutral funds rate may be 3.0% but some officials suggest it could be lower, say, 2.5-2.75%.  Thus, the funds rate may not be far from where it needs to be.  Furthermore, the recent sharp drop in oil prices is almost certain to cause the overall inflation rate to decline in November and December.  Thus, the Fed has the luxury of time to reassess its strategy.   Chill.

Stephen Slifer


Charleston, S.C.

Will They, or Won’t They?

November 23, 2018

The Fed’s Open Market Committee will meet December 18-19 and the discussion should be far more spirited  than one might have imagined six weeks ago when a rate hike was virtually assured.  As always, the Fed’s decision will be based on economic fundamentals.   President Trump’s pressure on the Fed will not be a factor.  As we see it, three factors have altered the economic environment.

First, the stock market has fallen as investors worry about the future path of interest rates as well as economic weakness overseas — from China in particular.  Thus far the S&P 500 index has fallen 10% which is generally regarded as a “correction”.  Corrections occur regularly and do not carry heavy weight in the Fed’s decision-making process.  Having said that, the Fed is certainly aware of the decline.

Second, growth overseas has slowed considerably in large part because of Trump’s tariffs and foreign investors’ fear about a global trade war.   Because these investors have concluded that the U.S. is in a better position to withstand a full-blown trade war than anybody else, they have poured money into the United States since the initial tariffs were imposed back in February.  As a result, the dollar has risen 9%.

An increase in the dollar crushes emerging economies.  They must purchase raw materials for their manufacturing sector.  But those raw materials are  priced in dollars.  An increase in the value of the  dollar increases their cost of goods sold.

As a result, their currencies have plummeted.  The Chinese yuan, for example, has fallen 10% to 6.95 yuan and has been prevented from falling below the psychologically important 7.0-yuan level only because of considerable central bank support.

Fears of slower growth have taken a toll on the stock markets  of emerging economies which have plunged 25%.

Indeed, signs of slower growth overseas have recently begun to emerge.  Growth in China has slipped to 6.5% and the IMF projects even slower growth in 2019 and 2020.  For most countries 6.5% growth would be impressive, but for China it would be the slowest pace since 1990.  Stagnant growth in China is a particularly serious obstacle to growth in other emerging economies, but will be felt around the globe.

While the U.S. may be in better shape to withstand a trade war than other countries, it is not immune.  We have shaved our 2019 U.S. GDP growth forecast by 0.2% to 2.8% as a result of a reduced volume of trade.  It is reasonable to conclude that the Fed has done the same thing.

Third, oil prices have fallen by one-third since early October from $76 dollars per barrel to $51.  At the very least the headline CPI is likely to decline 0.1% or so in both November and December.  The precipitous, unexpected drop in oil prices should provide temporary relief on the inflation front.

We believe at their gathering in mid-December FOMC members will choose to hold the funds rate steady in its current range from 2.0-2.25% rather than raise it again.  Turmoil in the financial markets, slower growth in China, and falling oil prices suggest a rate pause would be appropriate.

Whether the Fed raises rates in December or not is, in some sense, irrelevant.  The Fed is, appropriately, on a path to a neutral level for the funds rate which it believes is about 3.0%.   Recent developments will not alter that view.  A Fed decision not to raise rates in December would be welcome news for the markets.  Even a decision to raise rates in December but seek a lower rate trajectory in the years ahead would be a positive outcome.

What about Trump’s pressure on the Fed, Fed Chair Powell in particular?  Won’t that make the Fed more inclined to raise rates to emphasize its independence?  We doubt it.  In our experience Fed interest rate decisions are based on the economic fundamentals, not political pressure.  It is unfortunate that Trump has chosen to wage war on the Fed, and some will undoubtedly see no rate hike as capitulation to the president’s wishes.  But that will not be the motivation for the Fed’s decision.  The economic outlook has changed, and the Fed should respond appropriately.  Our best guess is that, one way or the other, the Fed will indicate its intention to boost the funds rate to its presumed neutral level of 3.0% by the end of next year and do very little thereafter. That is good news.

Stephen Slifer


Charleston, S.C.

This Time Really is Different

November 16, 2018

“This time is different”.   Economists say that all the time, but it never is.  However, we believe this time really is different largely because of improved fiscal policy and technological developments.  The combination of the two is boosting GDP growth, not just for a year or two but for a protracted period, causing our standard of living to climb more rapidly,  helping to keep the inflation rate in check, and fundamentally altering the oil market.  The economic future of this country is far brighter today than it was a decade ago.

First, it is difficult to over-estimate the importance of the corporate tax cut.  In 2015 and 2016 growth in investment spending came to a screeching halt as business confidence sank.  That was  the worst performance for investment since the recession.  Productivity growth slowed to a trickle.  GDP growth shrank to a disappointing 2.0% pace which became “the new normal”.

But then Trump pushed through his corporate tax package which included a cut in the corporate tax rate from 35% to 20%, the ability for large multi-national firms to repatriate overseas earnings to the U.S. at a favorable 15% tax rate, an immediate tax deduction for equipment spending, and a massive movement to eliminate all  unnecessary, conflicting, and confusing government regulations.  Suddenly corporate confidence soared.  Business leaders opened their wallets and began to spend money on investment.

The pickup in investment spending lifted productivity growth from 1% to 2%.  That, in turn, boosted GDP growth from a sleepy 2.0% pace to 3.0%.

But is the recent faster GDP growth a temporary spurt triggered by the tax cuts, or something more long-lasting?  We believe it is the latter.  The 20% corporate tax cut is now competitive with almost all other developed countries.  Massive deregulation encourages businesses of all types – small firms in particular – to formulate long-term plans and invest accordingly.  The very tight labor market and an inability to find an adequate supply of workers encourages firms to spend money on technology to make existing employees more efficient.   By doing so they can increase output without increasing their headcount.  In economic jargon, they are substituting capital for labor which boosts productivity growth.

If the pickup in investment spending is long-lasting, productivity growth will accelerate from its anemic 1.0% pace to a steady 2.0% which will, in turn, boost the economy’s speed limit by one percentage point from 1.8%  to 2.8%.  A steady diet of near-3.0% GDP growth is welcome relief from a few years ago.

If GDP growth accelerates by 1.0%,  growth in our standard of living will also accelerate by 1.0% from 1.5% currently to 2.5% by the end of the decade.

This faster GDP growth come about partly because of the improvement in fiscal policy described above,  but also because of technology.

Technology has completely altered our way of doing business. The internet came into existence in 1995.  The cloud and apps followed in the early 2000’s.  Those developments revolutionized the way that we all communicate with each other.

Amazon was founded in 1994 followed quickly by eBay and Google.  On-line shopping skyrocketed.  Before we purchase anything today, we check prices on the internet.  We can find the lowest price anywhere around the globe.  As a result, traditional brick and mortar stores have no pricing power.  Should they choose to raise prices, they lose sales.  This is having a profound influence on the inflation rate.

In the past year the core CPI has risen 2.2%.  If we split the CPI into two parts —  goods and services – we find very disparate movements.  In the past year good prices have declined 0.3%.   In contrast, services have risen 3.0%.  This outcome highlights the complete inability of goods-producing firms to raise prices.

In the absence of online shopping, we would be looking at a 3.0% inflation rate today rather than 2.0%.  That would be far above the Fed’s 2.0% inflation target, and with 3.0% GDP growth (well in excess of the Fed’s estimated 1.8% potential growth) the Fed would be raising interest rates aggressively and the end of the expansion would almost certainly be in sight.  But technology has changed that scenario.  Inflation remains close to the Fed’s target which means the Fed can pursue a very gradual return to higher rates with little risk of inadvertently dumping the economy into recession.  All because of technology.

Finally, think about the oil market.  Technological improvements like fracking and horizontal drilling have caused U.S. oil production to double in the past seven years.

As a result, the U.S. has surpassed Saudi Arabia and Russia and become the world’s largest producer of crude oil.  Next year the U.S. Department of Energy expects U.S. output to climb an additional 10% and further widen the gap between U.S. production and that of its two closest rivals.  As a result, OPEC countries no longer have a stranglehold on global oil production.  Should they choose to curtail production to inflate oil prices, U.S. drillers quickly step on the gas and counter much of the shortfall.  The U.S. has become a major player in the global oil market.  Because of technology.


The world is a different place today than it was 10 years ago.  Improved fiscal policy caused by the tax cuts and deregulation has re-invigorated the previously dormant U.S. economy.  Technology has changed the entire economic landscape.  Because economists have no relevant history to use as a model for what might happen next,  we are all flying by the seat of our pants.  We believe sustained investment spending and faster productivity growth will boost potential GDP growth from 1.8% to 2.8% within a few years.  Others think the recent GDP surge will soon fade and that a recession is looming by 2020.  Who is right?

Then, to what extent can we count on technology to keep the inflation rate in check?

Finally, how much has enhanced U.S. oil production altered the balance of power between OPEC countries and the rest of the world?  What does that mean for oil prices?

Keep in mind that technology is not static which raises even bigger question.  What is the next big thing that will fundamentally alter the economic landscape?  These sea changes make economics fun – but also challenging.

Stephen Slifer


Charleston, S.C.