Tuesday, 16 of July of 2019

Economics. Explained.  

Category » Commentary for the Week

No Need for Lower Rates, but Rate Cuts Likely Anyway

July 12, 2019

Many Fed officials are itching to cut rates.  They keep saying that they see the potential for substantially slower GDP growth later this year.  But with each passing data release there is no evidence that is happening or is on the verge of happening. It is true that inflation is running below the Fed’s target and, while we expect it to climb almost to the 2.0% target level by yearend, the Fed could justify a rate cut by saying it wants to bring inflation back to or even slightly above, target quickly.  That would make sense, but to keep harping on some fear of future economic weakness seems implausible.

If the economy were truly teetering on the brink of a significant slowdown, wouldn’t stock market investors be getting a case of the jitters?  They are not.  The stock market is at a record high level.

Wouldn’t consumers be getting worried?  They are not.  Consumer sentiment remains close to a 19-year high.  Current sentiment levels were last seen on a consistent basis in 2000.

Wouldn’t small business owners be getting nervous?  That is not happening either.  Small business confidence has edged lower in the past six months, but it has backed off from a record high level in August of last year which was the highest level of optimism since July 1983.  Confidence remains at a lofty level.

Wouldn’t we begin to see smaller employment gains as business people become more reluctant to hire?  Monthly employment gains have shrunk from the 200+ thousand gains last year to about 180 thousand.  But what did you expect?  Employers simply cannot find enough qualified workers.   Labor shortages are widespread.  Most firms would love to see more qualified workers show up on their doorstep.

The only economic weakness we can find is in the manufacturing sector.  The purchasing managers index has slipped considerably despite the fact that it is still consistent with 2.6% GDP growth.  But the problem is not the level of interest rates.  If rate levels were truly too high, wouldn’t you expect to see both the manufacturing and service sectors showing signs of softening?  That is not happening.  The manufacturing sector has weakened but the non-manufacturing sector has not.  The non-manufacturing index remains at a relatively lofty level of 58.2 while service sector employment is robust and driving the economy.

We believe that manufacturing has been hit by the imposition of tariffs that began in the spring of last year and the ensuing trade war.   Foreign investors quickly recognized that in the event of a trade war the U.S. would fare better than any other country because trade is such a small part of the U.S. economy.  As the year progressed foreign funds poured into the U.S.  That boosted the level of the dollar which meant that U.S. exports became more expensive for foreigners to purchase and, as a result, exports growth slowed.  The solution is not to lower interest rates but, rather, reach trade agreements with China, the E.U., the U.K., Mexico and Canada.   Once that happens the manufacturing sector will quickly heal.

The other piece that people focus on is the yield curve which, with the funds rate at 2.38% and the 10-year at 2.12%, is slightly inverted.  While an inverted curve is typically a reliable indicator of an impending recession, it generally happens because the Fed has raised rates too quickly and Fed policy becomes “too tight”.  But with the funds rate today at 2.38% (by most estimates still below a “neutral” level), does anybody seriously believe that interest rates are too high and thereby impeding the pace of economic activity?  Sorry, don’t buy it!  The curve may be inverted, but for all the wrong reasons.  Long rates have fallen below short rates, rather than short rates rising above long rates.

It is true that upon occasions in the past the Fed has cut rates to provide a little “insurance” in case something bad were to happen.  But when it did so rate levels were much higher than they are today, and there was at least some hint that growth had begun to fade.  The absence of any evidence that the pace of economic activity is slipping is what makes the Fed’s recent laser-like focus on lower interest rates so hard to comprehend.

It is true that the core personal consumption expenditures deflator is at 1.6% compared to the Fed’s 2.0% target.  While we expect that rate to edge upwards as the year progresses and reach 1.9% by yearend, we could at least understand an argument by Fed officials that inflation has run below target for so long that it now wants it to climb above target for a while so that its average level for the cycle is 2.0%, and it needs lower rates now to make that happen quickly.  That is, at least, a logical argument.  This myth about slower growth ahead is not.

While we firmly believe lower rates are unnecessary, the reality is that Fed Chair Powell has done nothing to counter the widespread belief that it will cut rates at the end of this month.  He certainly had ample opportunity when he presented his semi-annual report to Congress.  If the Fed does NOT lower rates at month end when such action is so widely anticipated, it can anticipate a sizable negative reaction in both the stock and bond markets.  It does not want that to happen either.  Thus, the best bet now is that the Fed will cut the funds rate by 0.25% at its July 30-31 meeting.

We have a hard time seeing how lower interest rates will boost the pace of economic activity.  Clearly, lower rates will reduce the cost of corporate borrowing which will, in turn, reduce costs and increase profits.  Thus, the stock market will benefit.  But even if firms have a desire to boost production, they will need more workers to make that happen and it will not be any easier to find qualified workers in the months ahead than it is today.  Thus, it is not clear to us that GDP growth will quicken in the quarters ahead even with lower interest rates.  If the rate cuts stimulate demand, we could envision a slightly higher inflation rate as firms, perhaps, raise wages to attract additional workers, and then test the waters to see if they can get away with slightly higher prices.  But keep in mind that productivity gains thus far have countered all of the increase in wages so that unit labor costs are actually declining.  Also, the internet allows U.S. consumers to easily find the cheapest available price.  That means that goods producing firms will continue to have little pricing power and any increase in inflation is likely to be small.

Could lower rates actually make things worse?  Probably not.  Our biggest argument against a rate cut is that it provides the Fed with less ammo to use when the next downturn arrives – whenever that may be.  While the end of the expansion has never been in sight for us, a rate cut – if it actually occurs – would push rates to levels that are even farther below a level that could bite and, therefore, extend the life of the expansion even farther.

The Fed’s story is confusing to us.  Not only do we think lower rates are unnecessary, they are unlikely to help the Fed achieve its goals.  Instead, Trump should focus on trade agreements around the world.  Nonetheless, the Fed seems to have widely advertised its intention to lower rate.  Let’s see what it does at the July 30-31 meeting and re-evaluate afterwards.

Stephen Slifer


Charleston, S.C.

The Case for Lower Rates is Vanishing

July 5, 2019

The markets continue to look for a 0.5% cut in the federal funds rate by yearend.  No doubt some members of the Fed’s Open Market Committee continue to lean in that direction. While there remains an expectation that the economy is going to soften noticeably between now and yearend, there is virtually no evidence that a slowdown is underway.  Having said that, a number of Fed officials suggest that the Fed could lower rates in a determined effort to nudge inflation to or above its 2.0% target rate.  Our sense is that the economy is continuing to chug along at about a 2.5% pace, and that by yearend the inflation rate will rise on its own close to the 2.0% pace the Fed would like to see.  Thus, we anticipate no need for a rate reduction any time soon.

Two weeks ago we outlined half a dozen events/economic indicators that would influence Fed policy makers at their July 30-31 gathering.  Thus far, four of those six pieces of information have become available and the odds of a rate cut at the July meeting seem remote.

One of the primary reasons for expecting slower GDP growth in the second half of the year would be an escalation of the trade conflict with China.  But at the conclusion of the recent G-20 meeting Trump and Chinese President Xi Jinping agreed to restart trade talks between the two countries.  This clearly represents a truce in the trade war.  While serious obstacles remain, we remain convinced that an agreement of some sort will be reached in the second half of this year.  It is in the interest of both countries to make that happen.  If it does, the need for lower rates to support GDP growth that some argue is teetering on the brink of recession would largely disappear.

At the end of last month we received May data on the Fed’s preferred inflation gauge, the personal consumption expenditures deflator excluding the volatile food and energy components.  It rose 0.2% in May after a similar-sized increase in April.  While the year-over-year increase remains below target at 1.6%, this inflation measure has risen at a 2.0% pace in the past three months.  We expect monthly increases in the second half of the year to continue at a 0.2% pace which would lift the increase for 2019 as a whole to 1.9% and imply a 2.4% increase in 2020.   If so, there is no reason for the Fed to cut rates to bring inflation back to its 2.0% target.  It will get there on its own without any assistance from the Fed.

The Institute for Supply Management’s index of conditions in the manufacturing sector continued to slide in June.   It edged lower by 0.4 point to 51.7.  After reaching a peak of 60.8 in August of last year, this series has been steadily falling.  However, the ISM indicates that at its current level the index is consistent with 2.6% GDP growth, a pace that should not generate cause for alarm.  The index levels of roughly 60.0 late last year were the highest in a decade and were consistent with GDP growth of between 4.0-4.5%.  While the murky trade situation has softened the manufacturing sector it has not pushed it over a cliff.  Furthermore, the solution is not lower interest rates but a solution to the trade difficulties with China in particular.

The market jumped on the minuscule 75 thousand increase in payroll employment for May as clear evidence that a slowdown was underway.  Unfortunately for the lower rates crowd, June produced a solid increase of 224 thousand.  The three month moving average increase in payroll employment now stands at 171 thousand.  While clearly less than the 235 thousand average increase last year, with the economy at full employment it is exactly what one would expect.  There simply are not enough workers for employers to hire.  It is not a sign of weakness.  Rather, it is a sign of strength that the economy is growing as quickly as it possibly can.  Lower rates will not help.

Looking ahead we should see an increase in the core CPI index for June of 0.2%.  The year-over-year increase should remain at 2.0%.  With somewhat larger increases in recent months we expect the core CPI to rise 2.2% this year and 2.4% in 2020.

Finally, on Friday, July 26 we will get our first look at second quarter GDP growth.  We expect to see a growth rate of 1.5% following a 3.1% increase in the first quarter.  While second quarter growth did slip, that is hardly a surprise given the steamier-than-expected first quarter pace.  In the first half of the year as a whole the economy will have risen 2.3% which is roughly in line with what economists had anticipated and presumably faster than potential growth.

While many FOMC members believe that rates will be 0.5% lower by yearend, there is a slightly larger number of members who believe that no rate cuts are required.  The jury remains out, but what we have seen in the past month suggests that the no-rate-cut crowd may be supported in July by one or more of their previously dovish colleagues.

Stephen Slifer


Charleston, SC

The Case for Lower Rates

June 28, 2019

The Fed is split almost equally into two camps.  One group expects no change in rates between now and yearend.    The competing group expects a 0.5% rate reduction.  As we see it, the economy is chugging along at an acceptable pace and while inflation is running a bit below the Fed’s 2.0% target it is likely to approach the target by yearend.  There is, therefore, no need for lower rates.  The lower rates group bases its view largely on the persistent shortfall in inflation and how best to get it back on track.

The President of the Minneapolis Fed, Neel Kashkari, has been advocating a 0.5% cut in rates for some time.  He made a speech last week that clearly laid out his case.  It is an interesting read.

He notes that the Fed’s preferred inflation gauge has been below target for almost a decade.  If the Fed is going to have an inflation target then it needs to make a credible effort to reach that target.  Thus far it has treated its 2.0% inflation target more as a ceiling rather than a symmetric target.  It may be time to address that issue and get inflation back on track.

Kashkari believes that the Fed should cut rates 0.5% today and pledge not to raise rates again until the core inflation rate reaches the Fed’s 2.0% target on a sustained basis.  The increased focus on inflation is a very different way of thinking for the Fed.  Given that seven FOMC members currently support a 0.5% cut in rates between now and yearend, the view seems to be gaining traction.

One of the key tenets of his case is that even though the unemployment rate is at 3.6% the economy may still not have achieved full employment.

Economists do not know exactly what that threshold level is.  A few years ago economists thought it was 5.0%.  Then it became 4.5%.  The Fed currently thinks it has slipped to 4.2%.  Kashkari has suggested it might be 3.5% — or lower.

When the labor market approaches full employment employers must bid more aggressively to get the workers they need and wages begin to climb.   Thus, rising wages are an indication that the labor market is approaching full employment.  Given that average hourly earnings have accelerated from 2.0% a couple of years ago to 3.2% today, most economists believe the labor market has already reached full employment.  Once that happens the higher labor costs should cause firms to raise prices and inflation will climb.  But that has not happened.

We have said many times that upward pressure on the inflation rate should not be gauged by the faster growth in average hourly earnings because higher wages can be offset if workers are more productive.  If, for example, a firm pays its workers 3.0% higher wages because they are 3.0% more productive there is no reason to raise prices.  Thus, the upward pressure on inflation should be measured by the increase in labor costs adjusted for the change in productivity.  Economists call this measure “unit labor costs”.   In the past year worker compensation (wages plus benefits) has risen 1.5%.  Productivity has risen 2.4%.  Thus, unit labor costs have declined 0.8%.  Perhaps Kashkari is right and the labor market is not as tight as what is generally perceived.  If it were, firms would be boosting worker compensation more quickly than they are currently.

Unit labor costs consist of two numbers – the growth rate in compensation and the growth rate for productivity.  The Fed thinks that over the longer haul productivity will average about 1.0%.  To reach 2.0% growth in unit labor costs, compensation must rise by 3.0%.  We think productivity growth going forward will average 2.0%.  In our world compensation growth of 4.0% is required to get unit labor costs to rise 2.0%.  So, for unit labor costs to rise by 2.0%, compensation must climb somewhere between 3.0% and 4.0% versus 1.5% today.  If unit labor costs climb by 2.0%, the inflation rate is likely to follow.

While the economy probably does not need lower rates to keep GDP growth humming along at a rate somewhere between 2.0-2.5%, it could need lower rates if – for the first time — the Fed is seriously going to focus on pushing the inflation rate meaningfully higher.

What are the benefits?  Lower rates would test the limit regarding the full employment threshold of the unemployment rate.  Could it be 3.5%?  Could it be even lower?

Keep in mind that the unemployment rate for blacks today is 6.2%.  For Asians it is 4.2%.  Would lower rates reduce the unemployment rates for those two groups?

The broader measure of the unemployment rate today is 7.1% versus the official rate of 3.6%.  The difference between the two represents 1.4 million workers who are not currently looking for employment.  Would lower rates bring about higher wages and thereby entice some of those marginally employed workers to seek employment?  At this point nobody knows the answer to these questions.

What is the risk?  Could inflation suddenly begin to climb rapidly?  Probably not.  Measures of inflation expectations over the next 10 years seem to have dropped recently to 1.6%.  The Fed has done a great job of convincing everyone that inflation will remain low. Changing those expectations will take time.  Meanwhile, inflation in Europe, the U.K., and Japan are all in a range between 1.0- 2.0%.  The U.S. is unlikely to experience a surge of inflation if inflation remains low elsewhere.  Given that a pickup in inflation may take some time to produce, Kashkari believes that the Fed should not seek a level of the funds rate that is “neutral”, but lower rates to a point that will clearly stimulate the economy.  If inflation should pick up quickly and breech the 2.0% mark the Fed could easily raise rates to slow things down.

We are not quite ready to jump on board with the Kashkari game plan.  But technology has fundamentally altered the U.S. economy.  Productivity growth has climbed.  The economy’s speed limit seems to be rising.  Inflation is lower than desired because goods producing firms have lost all ability to raise prices.  The world is different.  Given this new economic environment perhaps the way monetary policy is conducted needs to be changed as well.  Food for thought.

Stephen Slifer


Charleston, S.C.

Two Pieces to Read this Week

June 21, 2019

We wrote two pieces this week.  One was right after the FOMC’s decision on Wednesday which focused on the widely diverging views amongst FOMC participants.  The other written today focuses on what indicators and/or events might cause the Fed to actually pull the trigger at the next FOMC meeting.

Stephen Slifer


Charleston, S.C.


Follow the Data

June 21, 2019

The Fed did not change rates at the latest FOMC meeting.  And while it is clearly leaning towards lower rates it has not yet reached that decision.  Fed Chair Powell repeatedly noted that the incoming data will determine whether the Fed pulls the trigger.

It turns out there is a surprisingly wide gap in the views of FOMC members.  At the moment, eight members believe that rates will be unchanged between now and yearend, but seven other members are looking for two rate cuts between July and December.  So, sit tight and do nothing or cut rates twice.  Those two views are diametrically opposed to each other.

Powell noted that at the time of the May FOMC meeting the U.S. and China were on the cusp of a trade agreement but that agreement fell apart.  From the Fed’s perspective that heightened uncertainty about the trade outlook.  So, what’s next?

So, as we see it the Fed has outlined two scenarios.  First, Trump further raises tariffs on Chinese goods which weakens global growth (mostly outside of U.S. borders) and could imply a further drop off in the inflation rate from its 2.0% target path. In that event, the Fed might cut rates a couple of times between now and yearend.  Or, at the upcoming G-20 summit meeting Trump and Xi choose not to further escalate the tariff war, agree to resume their discussion and, hopefully, find a way to resolve their differences.  In that case, the Fed would most likely leave rates unchanged between now and December.

In the past the FOMC’s decisions were based on their assessment of economic conditions.  How are GDP and inflation evolving relative to what it expected, and are any rate adjustments required to return to the desired path?  The operating assumption was that fiscal and trade policy would be unchanged.  They would incorporate changes in either type of policy after the fact.  Once those changes occurred, the Fed would determine their impact on the economy and adjust accordingly.  Now the path going forward seems to depend largely on policy decisions made by the current president which may, or may not actually occur.  That is an exceedingly difficult task because one can envision any number of relatively plausible scenarios.  Whether the Fed should base monetary policy on potential changes in the president’s fiscal or trade decisions, it has clearly chosen to go down that path.

So, where does that leave us?  Everybody will be scouring the economic tea leaves between now and the July 30-31 FOMC meeting.  These events/economic indicators will be crucial.

  1. The outcome of the June 28-29 summit meeting.  If China and the U.S. agree to restart trade discussions, the no-change group at the Fed will gain support.
  2. The personal consumption expenditures deflator for May on Friday, June 28. This is the Fed’s preferred inflation target so whatever happens will be important.  We are looking for an increase in the core rate of 0.2%.  This outcome would cause the year-over-year increase to slip from 1.6% to 1.5%, but for the most recent 3-month period the run-up would climb to 1.9%.  Perhaps a bit of ammo for both sides.
  3. The purchasing managers’ index for June on Monday, July 1. After reaching a high of 60.8 in August of last year it has been trending downward and now stands at 52.1 which is, presumably, consistent with GDP growth of 2.4%.  We expect a modest increase to 52.5 which would suggest that the beleaguered manufacturing sector of the economy is not deteriorating further.  A decline would give the rate-cutters at the Fed more ammo.
  4. The June employment data released on Friday, July 5. The weaker-than-expected increase in payroll employment for May of 75 thousand was disquieting.  Will the June data be equally subdued?  For what it is worth, we anticipate an increase of 170 thousand which would provide support for the no-change camp.
  5. CPI data for June on Thursday, July 11. While the Fed’s specific inflation target is the core PCE deflator, the concern about the continuing inflation shortfall will focus attention at the CPI as well.  We expect to see a June increase in the core CPI of 0.2% which would leave the year-over-year rate at 2.0%.  That outcome would leave the inflation outlook uncertain.  No hint of a pickup but, no further shortfall either.
  6. Second quarter GDP growth on Friday, July 26. Following 3.1% growth in the first quarter we anticipate second quarter growth of 1.5%.  That probably provides some support for both groups.  Growth in the first half of the year would be 2.3% which would exceed the Fed’s estimate of potential GDP growth which is currently 1.9% and suggest no further rate cuts are necessary.  But 1.5% growth in the second quarter could encourage the rate-cut camp.

Our sense is that if the data unfold as described above, the FOMC will – once again – chose to leave rates unchanged on July 31 and await further data.  The market’s two expected rate cuts between now and December are expected at the meetings in September and December.  As always, the data will determine the outcome.

Stephen Slifer


Charleston, S.C.

What the Fed’s Rate Decision Really Means

June 19, 2019

At its June 18-19 meeting The Fed chose to leave the federal funds rate unchanged at 2.25-2.5%.  Its assessment of GDP growth for the next three years is essentially unchanged from what it was back in March.  However, the outlook for its preferred inflation measure, the personal consumption expenditures deflator excluding the volatile food and energy components, slipped to 1.8% this year from 2.0% three months ago.  The median forecast for the federal funds rate at yearend remained at 2.4%.  However, seven FOMC participants thought the rate might fall to 1.9% by yearend which means that group envisions two rate cuts in the second half of the year.  That is one of the widest divergences of opinion amongst Fed officials ever regarding the outlook for inflation just six months hence.  It also represents one of the biggest shifts in the anticipated outlook for the funds rate in a 3-month period of time.  Remember, back in March not a single Fed official envisioned lower rates by yearend and now seven of them are in that camp.

The outlook for economic growth is not the issue.  The Fed expects GDP growth this year of 2.1%, 2.0% next year, and 1.8% in 2021.  Those forecasts are virtually identical to what it reported back in March.  The Fed continues to believe that the economy’s potential growth rate is 1.9%.  Thus, all FOMC officials seem to concur that the economy will be steady for the foreseeable future.

What seems to be bothering them is the persistent shortfall in the inflation rate from its target.  For example, back in March the group thought that the core PCE would rise 2.0% this year.  By June that forecast was cut to 1.8%.  That is not a wide discrepancy, but the core PCE has generally been below the Fed’s 2.0% target rate for most of the past seven years.  In fairness, it climbed essentially to the 2.0% mark in May of last year and remained there through yearend, but it has slowed steadily in the first four months of this year and now stands at 1.6%. Our sense is that rising prices on goods imported from China will lift the yearend rate to 1.8%.  We do not know the logic behind the Fed’s forecast, but it ends up anticipating the same 1.8% increase in the core PCE for 2019 as a whole.

The Fed noted that market-based measures of inflation have declined.  One such measure would be the gap between the nominal yield on the 10-year note and the comparable rate on the inflation-adjusted 10 year.  The difference between the two represents the markets view of inflation for that period of time.  It has slipped to 1.77% which is the slowest anticipated inflation rate in two years.

Survey-based estimates of inflation have also declined in the past six months or so.  The Philly Fed’s survey of professional forecasters now anticipates an inflation rate of 1.68%.

So the question is, how can the Fed get the inflation rate back to its desired path.  Will it get there on its own?  Or might it need help from the Fed in the form of lower rates to make that happen.  Apparently seven Fed officials are currently inclined to think the funds rate needs to be 0.5% lower by yearend to boost inflation back to the 2.0% target.  That would put the funds rate in a range from 1.75-2.0%.  Thus, about half of the FOMC thinks that rates should be steady between now and yearend, the other half looks for rates to be 0.5% lower.

Its press release on May 1 said, “The Committee will be patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate.”

In June 19 that same sentence read, “The Committee will closely monitor the implications of incoming information for the economic outlook and will act as appropriate to sustain the expansion, with a strong labor market and inflation near its symmetric 2% objective.”

None of this should be construed as definitive that the Fed will cut rates between now and yearend.  Many members are leaning in that direction currently, but just as many are unconvinced that any rate change will be necessary.  Like the rest of us they are going to stand by and see what develops over the course of the next couple of months.

The fed funds futures market, however, is placing its own bets and seem to be more in line with the views of the more dovish Fed officials.  Market participants anticipate two rate cuts between now and yearend, and a third cut in the first half of next year.  That would put the funds rate at 1.5% a year from now.

We are not changing our view for 2.6% GDP growth this year, 1.8% core PCE inflation, and no change in the funds rate between now and yearend.  The difference between us and the market depends upon the behavior of GDP growth and inflation between now and December.  As always, we will see!

Stephen Slifer


Charleston, SC.

The Social Security Clock Continues to Tick

June 13, 2019

Every year the Social Security and Medicare Trust Funds are evaluated for their soundness.  The 2019 Trustees report showed that both programs continue to face long-term financing shortfalls.  The dates for which these trust funds are depleted vary slightly from one report to the next, but in all cases the end is in sight.  The good news is that policy makers have a broad array of options to address the projected shortfall.  If small adjustments are made early on, the pain will be relatively small.  The bad news is that policy makers have little appetite to make the required adjustments.

We typically think of “the” Social Security Trust Fund, but the reality is that there are actually two separate trust funds.  The Old-Age and Survivors Insurance (OASI) Trust Fund pays retirement and survivors benefits.  The Disability Insurance (DI) Trusts Fund pays disability benefits.  The OASI Trust Fund has $2.8 trillion in reserves.  It dwarfs the size of the DI Trust Fund which has just $97 billion.  For purposes of this report we will focus on the combination of the two.

The latest report indicates that for the two combined Social Security trust funds expenditures will exceed receipts for the first time in 2020.  At that point reserves will steadily dwindle until they are fully depleted in 2035.  Once depleted Social Security recipients will continue to receive monthly payments, but those payments will be reduced.   Steady income from payroll taxes will be sufficient to pay 80% of the scheduled benefits initially, but then gradually decline to 75% by 2093 (the final year of the 75-year projection period.

Similarly, we talk about a single Medicare Trust Fund but, like Social Security, there are two separate health insurance trust funds.  There is the Hospital Insurance (HI) Trust Fund (Medicare Part A).  It has reserves of $200 billion.  Then there is the Supplemental Insurance Trust Fund (SMI) which helps pay for physician, outpatient hospital, and home health services for the aged and disabled (Part B), as well as drug insurance coverage (Part D).  This trust fund has $104 billion of reserves.

For the HI Trust Fund expenditures began to exceed income in 2018.  The depletion date is 2026 – just seven years from now.  After depletion the allocated tax income will initially be sufficient to pay 89% of the estimated cost, decline to 78% by 2043, and climb again to 83% by 2093.

We tend to talk about the Social Security and Medicare Trust funds simultaneously and quickly note that they will be depleted in the not-too-far-distant future.  But they need to be discussed separately because the big gorilla is Social Security where the two combined trust funds have $2.9 trillion of reserves compared to the two Medicare trust funds which have just $300 billion.  The former is 10 times the size of the latter.

Given widespread recognition that these trust funds will soon be running out of money and the unwillingness of politicians to address the shortfalls, one is tempted to conclude that the solutions are intractable.  That is simply not the case.  The solutions are easy to find.  Any economist can figure out how to make these trusts funds sustainable in a heartbeat.  But the willingness to implement those changes is non-existent.

What might help eliminate the projected Social Security shortfall?  Here are a couple of obvious suggestions:

  1. Boost the retirement age gradually from 67 years currently to 69 years. Most studies recommend an adjustment of one to three months annually.
  2. Raise the maximum earnings subject to the Social Security payroll tax from $132,900 currently to $200,000. Currently, a person that makes $1 million per year pays exactly the same amount of Social Security tax as someone making $132,900.  This seems to make no sense.
  3. Reduce benefits for high income wage earners. The modest amount of Social Security benefits has little significance for individuals making income in excess of $1 million, or even those with income in excess $500,000.  Gradually reduce benefits for these high income individuals.

The solutions for Medicare are equally simple if one is willing to make people responsible for at least some portion of their health care expenditures

  1. For Medigap policies do not cover the first $500 of expenditures.
  2. For expenditures between $500-$5,000 cover 50% of the expenditure.
  3. Raise the eligibility age from 65 currently to 68.
  4. Malpractice suits must subtract from the award any workman’s comp and insurance payments received by that individual.

Interestingly, each of the suggestions above were specifically highlighted in the Erskine-Bowles Commission report back in 2010.  President Obama appointed the commission and charged it with returning fiscal policy to a sustainable path.  Everything was on the table.  The commission was expected to determine the proper individual and corporate tax rates and make specific recommendations to get the Social Security and Medicare programs back onto a sustainable track.  Think about it – 18 commission members — 9 Republicans, 9 Democrats.  Nobody expected them to find a solution, but they did.  Unfortunately, Obama rejected its recommendations because, in his view, they cut too deeply into entitlements.  The brass ring on the merry-go-around was in his grasp, but he missed it.  Nine years ago our two political parties actually talked to each other and were able to reach agreement on a contentious issue.  Such an outcome today seems inconceivable.

Nevertheless, the problems remain and D-day (depletion day) is approaching.

Stephen Slifer


Charleston, SC

The Wrong Policy Prescription

June 7, 2019

Fed Chair Powell and his colleagues are sending out strong hints that if growth slows as a result of the trade war the Fed is prepared to cut rates.  That is a dramatic turnabout from the Fed’s position in March.  Is that an accurate reading of the Fed’s intention?  If so, why the big change?  Would rate cuts even help?

Currently, the Fed pegs the funds rate in a range from 2.25-2.5%.  The December 2019 Fed funds futures contract stands at 1.71%, and the June 2020 contract at 1.49%.  So between now and this time next year the market expects the Fed to cut rates 3 times to 1.5%.   Fed Chair Powell indicated that the central bank was prepared to act to sustain the economic expansion if President trump’s trade war weakened the economy.  That is typical Fed-speak designed to send a message to the markets that the Fed is aware of the potential negative impact on the economy from tariffs and is prepared to act if necessary.  It should not be viewed as a signal that the Fed is convinced that its next move is to lower the funds rate.  While the Fed could act, of course, it will need a lot more data before it chooses to do so.

Some of his colleagues have explicitly indicated that they now believe rate cuts are necessary.  If this is an accurate reading of the Fed’s intentions that is a dramatic turnabout from what they concluded at the March FOMC meeting.  At that time they expected GDP growth this year of 2.1% (which is somewhat higher than the Fed’s expected potential GDP growth rate of 1.9%, and an increase in inflation (the core personal consumption expenditures deflator) this year of 2.0% – which would put it in line with its inflation target.  The Fed also indicated that it expected the funds rate to remain at its current level of 2.25-2.5% at the end of this year.  In March not a single one of the 17 Fed governors and Reserve Bank presidents called for a rate cut by yearend.  In fact, seven of the 17 members expected at least one rate hike during that period of time.

Given that view in March, are we to believe that the Fed has changed its mind and is now prepared to actually cut rates three times during the next year?  Our sense is that this is a gross misreading of the Fed’s intentions.  The next FOMC meeting is June 18-19 at which time we will get an update on the Fed’s GDP and inflation forecasts, as well as a revised path for the funds rate.

It is hard for us to imagine that the Fed has significantly reduced its GDP forecast for the year.  First quarter growth came in at 3.4% (far exceeding expectations and received subsequent to the FOMC meeting).  The second quarter consensus is for growth of about 1.5%.  That implies growth in the first half of the year of 2.5%.  No hint of any significant weakening in the pace of economic activity thus far.  Meanwhile the core PCE deflator is currently at 1.6%, but higher prices for imported products – from both China and now perhaps Mexico – should boost that rate of inflation very close to or slightly above the Fed’s 2.0% target by yearend.  Thus, the domestic economy does not seem to have deteriorated by any significant amount and inflation, if anything, seems likely to work its way higher. Perhaps the Fed has a different assessment.  We will soon see.

What does seem weak is economic growth outside the U.S.  For example, the World Bank recently reduced its projected global GDP growth rate for the year by 0.3% to 2.6%.  It maintained its projected GDP growth rate for the U.S. at 2.5% but cut growth almost everywhere else.  Europe was reduced 0.4%.  Japan by 0.1%.  Emerging economies were cut by 0.3% which included emerging economies in East Asia and the Pacific, Central Asia, Latin America, the Middle East, South Asia, and sub-Saharan Africa.

Why is virtually every country outside the U.S. having such a tough time?  Easy.  U.S. tariffs.  Global GDP growth is reduced by a trade war.  Everybody loses.  But trade is a mere 10% of the U.S. economy and roughly 50% elsewhere.  So while everybody loses, the U.S. gets hurt far less than everybody else.  Once global investors figured this out last year, foreign funds flowed into the U.S. and the dollar rose nearly 10%.  Emerging economies purchase raw materials to feed their manufacturing sector.  But those raw materials are all traded in dollars.  When the dollar rises it represents an increase in their cost of goods sold.  They are less able to compete in the global marketplace than they were previously.  Their currencies get crushed.  Their stock markets get clobbered.  In the end, GDP growth outside the U.S. – emerging countries in particular — is certain to slow.  That is what the World Bank just incorporated into its forecast.

But that raises a question.  If global growth is softening, how in the world does a rate cut in the U.S. solve that problem? First of all, it is unlikely to actually stimulate GDP growth.  Given that the economy is at full employment policy makers can only stimulate growth by boosting growth in the labor force or boosting growth in productivity.  With the unemployment rate at a 50-year low everybody who wants a job already has one.  It is hard to see how lower rates are going to boost growth in the labor force.  The labor force could also grow more quickly by increasing the number of immigrants.  But current policy seems likely to result in fewer immigrants entering the country, not more.  Growth in productivity is dependent upon business confidence and their willingness to invest.  But Trump’s erratic and unpredictable trade policy is generating uncertainty which could actually slow the growth rate of both investment and productivity.  Lower rates typically stimulate the pace of economic activity.  But with the economy at full employment and uncertainty rising that may not actually occur.

If lower rates stimulate consumer demand for goods and services GDP growth may not quicken but, in an effort to increase production, employers may boost wages to attract workers from other firms.  If the higher wages are not countered by a further pickup in the growth rate of productivity (which seems unlikely) inflation will rise.

Furthermore, it seems to us that lower rates are the wrong prescription for the problem.  A rate cut in the U.S. is not going to boost GDP growth outside of the U.S. – which is the root of the problem.  Growth outside the U.S. has been clobbered because of U.S. trade policy.  To solve that problem countries around the globe need to sit down with the U.S. and resolve their trade differences.  The most pressing problems at the moment are obviously the ones between the U.S., China, and Mexico.

Before we get too carried away with an expectation that the economy is falling off a cliff and desperately in need of lower interest rates, let’s see what actually happens.  We doubt that the economy will slow and inflation will sag as much as the market expects.  While the stock and bond markets can be leading indicators of what might happen in the economy, they often send false signals.  One does not need a long memory to recall the 20% decline in the stock market in the fourth quarter of last year which presumably foreshadowed an imminent slowdown in the pace of economic activity.  That theory was blown apart by the subsequent rebound in stocks and the 3.4% GDP growth rate in the first quarter.  This time it is the bond traders that are leading the charge and expecting an extremely pessimistic economic scenario to unfold.   We don’t believe the bond market’s view of the world either but, as always, time will tell.

Stephen Slifer


Charleston, S.C.

The Fed Will Not Cut Rates This Year

May 31, 2019

The markets believe that the Fed will cut rates twice by this time next year.  The federal funds rate currently is in a range from 2.25-2.5%.  However, the December 2019 federal funds rate futures contract stands at 2.06%; the June 2020 contract is 1.77%.  Thus, the markets envision some combination of slower GDP growth and lower inflation that will convince the Fed that it needs to lower rates to re-invigorate the economy and/or boost inflation.  We are having a tough time with that scenario.

The best way to gauge whether the funds rate is too high is to determine a “neutral” level at which it will neither stimulate nor retard economic activity.  The Fed calculates that by looking at the “real” funds rate, or the funds rate adjusted for inflation, over a very long time span.  Over the past 50 years, through good times and bad, the “real” funds rate has averaged 1.0%.  Thus, the Fed believes that for its policy to be “neutral” it should put the funds rate 1.0% higher than its 2.0% inflation target or 3.0%.  For years the Fed has talked about a 3.0% funds rate as being a neutral rate.

But there is nothing magic about using a 50-year average.  If one were to select a more recent, shorter period from 1990 to date – which incorporates four business cycles – the real funds rate averaged 0.5%.   From 2000 to date the average drops farther to -0.5%, but that period incorporates only two business cycles.  Thus, the all-important “neutral rate” seems to be falling.  The Fed is not going to be comfortable using a calculation that incorporates only two cycles, but four cycles might be realistic.  In that case, a 0.5% real rate combined with a 2.0% inflation rate would suggest the neutral rate has slipped to 2.5%.  Perhaps for this reason the Fed currently believes a “neutral” funds rate is somewhere between 2.5-3.0%.  Its current funds rate objective of 2.25-2.5% is slightly below the low end of its neutral rate range.  If that is true, it will be difficult to convince Fed officials that the current level of the funds rate is “too high”.

Keep in mind also that over the past year GDP growth has averaged 3.2%.  It is kind of hard to argue convincingly that with GDP expanding at that pace that lower rates are necessary to stimulate the pace of economic activity.

The other part of the story for those economists that are advocating lower rates is that the Fed’s targeted inflation rate in the past year, the so-called “core” personal consumption expenditures deflator, has risen 1.6%.  It has generally been below its 2.0% target for the past decade, although it was at or very close to the 2.0% target for most of last year.

However, the recent increase in tariffs on goods imported from China could boost the inflation rate in the months ahead.  We import $540 billion of goods from China.  That represents 2.5% of GDP.  A 20% tariff on those goods could, therefore, boost the inflation rate by 0.5%.

For this reason, we believe that the core PCE deflator will accelerate in the second half of this year which will boost the inflation rate for 2019 as a whole to 1.9% and cause it to quicken farther to a 2.3% pace in 2020.  If that is the case, the notion that the Fed must lower rates to lift inflation back to the 2.0% target completely falls apart.

Our sense is that as the year progresses the markets will be surprised on the upside by relatively robust GDP growth and higher inflation.  We are looking for GDP to increase 2.6% this year.  The Fed thinks potential growth is still 1.8% so, from its perspective, a 2.6% pace is not only steamy but likely to boost inflation.  At the same time, we expect the core PCE deflator to gradually accelerate in the second half of the year and climb from 1.6% today to 1.9% by yearend, and then accelerate to 2.3% in 2020.

As the inflation rate begins to accelerate long-term interest rates should climb as well.  The yield on the 10-year note of 2.3% today is likely to climb 0.5% by yearend to 2.8%.  With the funds rate at 2.4% the yield curve would, once again, have a positive slope of 0.4%.

We believe the Fed will do exactly what it has said it is going to do – wait and see what happens.  If the economic situation unfolds the way we expect, the Fed will have little incentive to alter rates in either direction for the foreseeable future.  Keep in mind that at their meeting on March 20, of the 17 Fed governors and Federal Reserve bank presidents, eleven thought the funds rate at yearend would be 2.25-2.5%, four voted for 2.5-2.75%, and two thought it would be 2.75-3.0%.  Not a single FOMC member or Reserve Bank president thought rates would be lower by yearend.  For the Fed to actually cut rates the economy will have to weaken considerably and the inflation rate must continue to slide.  That is not going to happen.

Stephen Slifer


Charleston, SC

Corporate Debt – A Potential Problem?

May 24, 2019

In a recent speech Fed Chair Powell highlighted the recent rapid growth of corporate debt.  Not surprisingly, that concern captured headlines in the press.  Less noted was his conclusion that such debt was not out of line given a long-lasting expansion, and – unlike 10 years ago — the banking system is well positioned to withstand any business sector downturn.  Powell views the risk of rising corporate debt as moderate.  He and his colleagues at the Federal Reserve are doing exactly what they should be doing — looking under every rock for any potential problem that could threaten the now decade old expansion.

Corporate debt has grown rapidly in recent years.  Its growth rate averaged 4.5% during the past 20 years, but in recent years growth it has accelerated to between 6.5-8.0%

Consumers constantly monitor debt in relation to income.  They can take on additional debt as their income grows, but they must make sure that debt does not become excessive.

We can measure the exact same concept for the corporate world by looking at corporate debt as a percent of GDP.  That percentage has risen steadily and some now view its current level as alarming.  However, with interest rates still at very low levels the cost of servicing that level of debt is historically low.  Thus, the relatively high amount of debt is not yet bothersome, but if the Fed were to raise interest rates sharply that could change.  Fortunately, higher rates do not appear to be in the cards any time soon.

The concern about corporate debt stems largely from what are known as collateralized loan obligations or CLO’s.  The terminology may sound familiar.  A decade ago the problem came from collateralized mortgage obligations or CMO’s.  At that time financial firms were packaging a large number of mortgage loans, turning them into a debt security, giving that security an investment grade rating because the risk was supposedly “diversified” amongst a large number of borrowers, and then selling those securities to investors.  We know how that turned out.

A CLO is essentially the same thing, but the underlying debt in this case is not a mortgage but a corporate loan.  These loans typically have a low credit rating and are often issued in connection with a leveraged buyout where a private equity firm takes control of an existing company.  CMO’s became a problem when the Fed sharply increased short-term interest rates in 2005 and 2006 which put pressure on homeowners who had chosen a variable rate mortgage.  As rates rose and variable rate mortgages repriced upwards, less credit worthy homeowners were increasingly unable to afford the higher mortgage payments, and eventually defaulted on the loan.  If interest rates should once again begin to climb, CLO’s carry the same risk for less credit worthy corporate borrowers.

In addition to monitoring debt in relation to income one can also monitor the level of debt relative to net worth.  This is a measure of debt in relation to assets, and its current level is not nearly as alarming.  As stock prices rise a firm’s net worth increases, and it is better able to safely carry an elevated level of debt.

While the rising level of corporate debt can be viewed in a number of different ways, some more problematic than others, Powell’s conclusion is that “business debt has clearly reached a level that should give businesses and investors reason to pause and reflect.”  An unexpected downturn could cause significant problems for overly indebted firms.  Powell views the recent growth in corporate debt as a moderate risk.  Quite clearly, if the Fed is watching this development, we should do the same.

The other point worth noting is that the financial system today is far better able to deal with any potential business sector losses than it was a decade ago.  Bank capital has risen significantly since the recession.  Banks hold substantial amounts of highly liquid assets.

Banks are far less leveraged today than they were previously.

And the Fed’s “stress test” is below zero which means that there is a below-average level of financial market stress.  In short, the financial system is well positioned to deal with any problems that are likely to occur during the next downturn.

Fed Chair Powell appropriately flagged a growing level of corporate debt.  While he does not view the rapidly growing level of corporate debt as a problem, it is a situation that needs to be monitored closely in the months and quarters ahead.  By noting this potential problem he has alerted business leaders to an emerging problem which could well encourage them to rein in some of the recent rapid growth in debt.

The even better news is that the likely catalyst for the next downtown – a sharp increase in short-term interest rates – is not yet on the horizon.

Stephen Slifer


Charleston, S.C.