Sunday, 25 of June of 2017

Economics. Explained.  

Category » Commentary for the Week

The Debt Limit is a Sham

June 23, 2017

Here we go again.  Every year we go through the same useless exercise of raising the debt limit.  First, Congress votes to spend money.  Then, the Treasury tries to pay its bills but eventually bumps up against a constraint on how much debt it can issue.  It announces that the “debt limit” must be raised so that it can continue to pay its bills.   Finally, Congress is horrified!  It declares that expenditures must be slashed to curtail this runaway spending!

But wait a minute!  Congress authorized that spending when it passed its budget for that year.  In that process Congress authorizes each government agency to spend a certain amount of money.  If Congress believes that government spending is excessive – and it is – it should use the budget process to rein it in.  Congress should not vote to spend money, and then slap the Treasury’s hands when it is forced to borrow to finance the previously-authorized spending.  That makes no sense.  The debt limit is a superfluous piece of legislation that chews up endless days of negotiation and wasted time.  In the end the debt limit is raised.  Every year.  And it will be raised again this year.

The most important thing to know about the budget process is that when Congress approves a budget that will result in a deficit of, say, $500 billion, the Treasury must issue an additional $500 billion of debt to finance that deficit.  Thus, debt outstanding is cumulative.  It increases every single year that the U.S. government incurs a budget deficit – which is to say that it increases annually.  For the current fiscal year the Treasury faces an estimated budget deficit of $585 billion and will issue that amount of additional debt.  The Treasury estimates that it will reach the statutory debt limit by early September.

Each month, in addition to its regular bills, the Treasury must pay off maturing securities and the interest on the remaining debt outstanding.  If it cannot do so, it will default on its debt obligations.  That has never happened.  Why?  Because a default by the Treasury would be unthinkable.  If it becomes unable to pay its debts the Treasury would have to pay a higher interest rate on future debt because investors – both foreign and domestic — would demand higher interest rates given the possibility of default.  Confidence in U.S. Treasury debt as a safe haven in times of uncertainty would be shaken.  Foreign investors could reduce their willingness to buy U.S. debt.

Because the president and members of Congress are well aware of these potential adverse consequences the Treasury is not going to default.  Congress will raise the debt limit in the nick of time.

Increasing the debt limit has become an almost annual ritual.  It has been raised 72 times since 1960, of which 18 occurred between 2001 and 2017 and the Treasury has never defaulted on its debt.  And it is not going to happen this year.  Having said that, negotiations will continue right up to the last minute and make us all nervous.  Nancy Pelosi and the House Democrats say they will not increase the debt ceiling to finance tax cuts for the rich.  Senate Republicans want a vote on the debt ceiling in July, but that comes at the exact same time that it wants a vote on its proposed health care legislation.  In September the administration would like to turn its attention to its proposed cuts in individual and corporate income taxes.  These issues could become politically entangled.  We do not know exactly how this will play out but, most likely, at the last possible moment there will be a temporary increase in the debt limit.

The bottom line is, be prepared for some scary headlines during the next two months about a possible default by the Treasury on its debt obligations and a potential government shutdown.  The stock market could get hit.  Consumer confidence might decline.  But rest assured the Treasury is not going to default on its obligations and, once the debt limit is raised, the potentially nasty near term consequences will be quickly reversed.

We wholeheartedly support the notion of cutbacks in government spending in order to shrink future budget deficits which are projected to climb from $585 billion today to $1.4 trillion by 2026.  But Congress should have the courage to make the required spending cuts during the budget process.  Then eliminate the debt ceiling requirement entirely.  It is not only distracting, it is unnecessary.  It does nothing to actually constrain government spending.

Stephen Slifer


Charleston, S.C.

Fed Policy Not “Neutral” until 2020 – or Later

June 16, 2019

The Federal Reserve’s Open Market Committee met this week and, as expected, raised the funds rate to the 1.0% mark.  It continues to expect a slow but steady pace of additional rate hikes over the next several years, eventually pushing the funds rate to 3.0% sometime in the first half of 2020.  That part of the Fed’s “normalization” process has not changed.  But there is a necessary second step.  Following the Fed’s bond buying binge between October 2008 and October 2014, its balance sheet skyrocketed from $900 billion to its current level of $4.4 trillion.  It needs to shrink its portfolio dramatically and, at its meeting earlier this month, it laid out a game plan for how it intends to proceed.  It will be a very gradual, lengthy process which will drag on well into the 2020’s.  The Fed is not going to trigger a recession by shrinking its balance sheet too quickly.

As the Fed purchased its combination of U.S. Treasury and mortgage-backed securities, it flooded the banking system with surplus reserves which skyrocketed from about $0.1 billion in late 2008 to $2.25 trillion currently.  Because those funds represent the ability of the banking system to lend to consumers and businesses, they need to be eliminated to prevent a potentially inflationary spending spree at some point down the road.  The Fed will accomplish that objective by shrinking its balance sheet.  But how will it go about that?

Basically, the Fed has two options.  First, it could go into the market and sell some of its current holdings of securities.  Doing so would shrink its balance sheet quickly.  But the Fed is concerned that such action would be disruptive to the bond market and could push long-term interest rates sharply higher which would pose a risk to the ongoing expansion. That is not the desired outcome.

Second, it could accomplish the same objective by running off some of its holdings of U.S. Treasury and mortgage-backed securities by simply not replacing them when they mature.  But given that the Fed’s portfolio has an average duration of almost ten years, this will be a very slow process.

Once this program begins later this year (presumably at its early November meeting) it will initially run off $6 billion of U.S. Treasury securities per month for the first three months.  At the same time it will run off $4 billion of its holdings of U.S. agency and mortgage-backed securities.  Thus, at the beginning it will allow a total of $10 billion of its security holdings to run off for the first three months.  It then plans to increase that total amount by $10 billion every three months until it reaches a cap of $50 billion per month.  It would reach that limit at the end of its first year of implementation.  Doing the math, it means that the Fed’s portfolio will have shrunk to the desired level by the end of 2022.

Keep in mind that the Fed does not need to shrink its balance sheet back to the $900 billion level that existed prior to the recession.  It wants its portfolio to grow roughly in line with growth in nominal GDP, or about 4.0% annually.  That means that the desired balance sheet level at the end of this year will be about $1.3 trillion and it will grow at roughly a 4.0% pace every year thereafter to $1.6 trillion by the end of 2022.

If the Fed does what it is suggesting, the Fed’s balance sheet will have shrink by $2.8 trillion from $4.4 trillion currently to the $1.6 trillion target level during the next five years.  But that is not going to happen.

According to data reported by the Fed, it has only $1.5 trillion of securities maturing within the next five years, and an additional $0.4 trillion maturing between 5-10 years.  All the rest of its security holdings have a maturity date in excess of ten years.  Thus, more realistically, Fed holdings will not return to their target level until 2031.

The point is that the Fed will have a two-pronged approach towards “neutralizing” monetary policy.  First, it intends to use the funds rate as its primary policy tool.  The funds rate should reach its so-called “neutral” level by early 2020.  Second, it will gradually return its balance sheet to a desired level.  The Fed says that should happen within five years.  But given the maturity schedule of the securities held in its portfolio that process may not be complete until 14 years from now.  Thus, the Fed has made it abundantly clear that it is unwilling to let its policy become the catalyst for the next recession – at least not in the near term.  If inflation heats up and the Fed needs to cool the economy, its policy approach will change, but that is not going to happen any time soon.

Stephen Slifer


Charleston, S.C.

Steadily Tightening Labor Market Will Boost Inflation

June 9, 2017

Most economists believe the labor market is at full employment. However, it is at least possible that it is not yet there. But, however one wants to measure it, it is close and it is steadily tightening with each passing month. Hourly wages have risen less rapidly than expected thus far, but that is likely to change in the months ahead. As that transpires, there should be additional upward pressure on the inflation rate.

At 4.3% the unemployment rate is below virtually every economist’s estimate of “full employment” which is the point at which everyone who wants a job presumably has one. The Fed believes full employment is between 4.7-5.0%. But full employment is unobservable. Economists have to estimate it. Could it be lower? Sure. As low as 4.0%? It is a long shot, but yes. After all the unemployment rate was at the 4% mark for a long while prior to the 2001 recession with only moderate upward pressure on the core inflation rate.

In the past Fed Chair Yellen suggested that the labor market was not at full employment because there were still a large number of “underemployed” workers. There are two types of such workers. First, there are “discouraged workers”. These people would like to have a job but have been out of work so long they have given up looking. As one might expect the number of discouraged workers has been steadily falling and is now essentially where it was prior to the recession.

Second, additional workers are currently employed part time but would like full time employment. This series has also been steadily declining but remains somewhat above where it was going into the recession.

Yellen’s preferred measure of unemployment includes both unemployed and underemployed workers. That rate is currently at 8.4% which is lower than the 8.8% it was going into the 2007-2008 recession. However, going into the 2001 recession it was 7.4%. Is the economy at full employment using this broader measure of employment? Maybe. But one can certainly make a plausible case that the full employment threshold for this measure is lower than its current level of 8.4%.

The bottom line is that there is no “magic level” of full employment. Economists make guesses. Most believe the economy is already at full employment, but it is possible that is not the case. However, it is close and getting closer with each passing month.

Economists are so concerned with full employment because, once attained, employers will have increasing difficulty finding an adequate supply of workers. They will ask existing employees to work longer hours. They will require them to work overtime. Eventually they will offer higher wages and/or more attractive benefits to attract the workers they need. But those actions boost labor costs and, eventually, put upward pressure on the inflation rate. All of that is already happening to some degree.

The number of job openings today exceeds the number of hires. That has never happened before. Jobs are available but they remain unfilled. Why? Workers may not have the appropriate skills. Many may not be able to pass drug tests. Others may be content to receive welfare benefits and are unwilling to work. Whatever the case, jobs are available and employers are unable to fill them.

The nonfarm workweek is already quite long. There is little room for employers to further lengthen the workweek to boost output. They need bodies.

That is particularly true in the manufacturing sector where at 40.7 hours the workweek is far longer than the 40.0 hour workweek that prevailed prior to the recession. Factory officials may be asking their employees to work longer hours because they cannot find enough qualified workers.

Overtime hours are also quite high. Factory owners are running out of options to boost output. They need more workers and will have to pay up to get them.

As labor demand intensifies one should expect wage rates to accelerate and that is the case. They had been climbing steadily at a 2.0% rate a few years ago, but have recently climbed into a range from 2.5-2.8%.

After a first quarter slump the economy appears to be re-accelerating. That will create jobs and all measures of the unemployment rate will fall further. As unemployment rates decline wage pressures will intensify.
The final piece of the puzzle has to do with productivity gains and “unit labor costs”. If wages rise 3% and workers are 3% more productive, employers do not care. They are getting 3% more output. Labor costs adjusted for productivity are known as “unit labor costs”. This is the relevant metric for measuring the upward pressure on the inflation rate caused by tightness in the labor market. Thus far, unit labor costs are rising at a 1.0% pace which is perfectly consistent with the Fed’s 2.0% inflation target. But will unit labor costs remain benign?  Probably not.

Whether the economy has reached full employment or not, it is close and labor costs will be steadily picking up. Can productivity keep pace? That may be more challenging. As we see it, the direction for labor costs and inflation is clear. They are going to accelerate but the speed of ascent has yet to be determined, and that is critical for determining how quickly the Fed will need to raise interest rates in the months ahead.

Stephen Slifer
Charleston, S.C.

Economy Rebounding in Second Quarter, Needs Fiscal Policy Help

June 2, 2016

The economy seems poised to expand at a 3.0% rate in second quarter after an upward revised 1.2% growth rate in the first quarter.  If the second quarter estimate is accurate it means that the economy will have grown at a 2.1% pace in the first half of this year – little different from the 2.0% pace registered in 2016.  However, second half growth should quicken to 2.5%.  All of this seems likely to happen despite any support from the White House or Congress.

Senate Republicans are prioritizing health care legislation but acknowledge that they may not finish prior to the August recess.  The White House claims it is working hard to provide details for the one-page outline of a tax bill that it released in April.  It still hopes to have a tax plan enacted by the end of this year.  But the legislative calendar gets crowded after the August recess.  Congress must grapple with legislation to raise the debt ceiling and then agree on spending levels before the tax bill can be considered.  These important pieces of legislation keep getting pushed farther and farther into the future.  We still expect legislation on all fronts to ultimately be adopted, but they will most likely be watered down versions in order to pass the Senate with only a simple majority.

One might argue that the longer the delay the less likely that any of this legislation will be adopted.  Maybe.  But we would suggest that Republicans promised so much during the campaign that failure to deliver will almost certainly result in a significant loss of seats in next year’s mid-term election.  Thus, we feel quite certain they will come up with something.

For now the economy is doing OK and there is every reason to expect faster growth in the second half of the year.  That outcome will be largely determined by two GDP components – consumer spending and investment.  Trade and government spending should change very little.

Consumer spending.  The underlying fundamentals appear strong.  Job gains remain solid despite smaller than expected increases in April and May which seem to reflect employers difficulty in finding an adequate supply of skilled workers in an increasingly tight labor market.  The job gains support growth in household income.  The record stock market level bolsters consumer wealth. Consumer sentiment is the highest it has been thus far in the cycle.   Interest rates remain very low by historical standards.  We have every reason to expect household spending to continue to climb at a 2.5% rate both this year and next.

Investment.  The protracted period of sluggishness in the oil sector has come to an end.  Investment spending came to a halt during the recession as falling oil prices clobbered firms in the oil patch.  But oil prices have rebounded to a level that is encouraging some drillers to re-open previously closed wells.  The drag on investment spending from the oil sector has come to a halt and even turned into a moderate amount of stimulus.

The factory sector was smacked by a 20% increase in the value of the dollar between mid-2014 and October 2016.  That made U.S. goods more expensive for foreigners to purchase and sharply curtailed growth in exports.  U.S. firms in export industries suffered the consequences.  But the dollar has been essentially unchanged since the election so the drag on GDP from reduced exports growth has come to a halt.  Furthermore, after a long period of falling employment, factory jobs have been rising by about 10 thousand per month since December of last year.

In addition, the stock market has climbed to a record high level as both reported and expected future earnings have been on the rise.  The drag on earnings from both the oil and manufacturing sectors has disappeared.  Business confidence as measured by the various purchasing managers’ indexes is at a multi-year high.  Global GDP growth is showing signs of accelerating.  Interest rates remain low.  As a result, corporate earnings began to climb in the middle of last year and are likely to rise at a double-digit pace this year,

Against this backdrop it is easy to envision investment spending rising about 5% this year and next compared to no growth in 2016.

Trade and Government Spending.  The dollar has been relatively stable for the past six months so the trade component will, at most, subtract 0.1% from GDP growth in 2017.  A pickup in defense spending will be partially countered by spending cuts elsewhere so government spending might add 0.1% to growth.  Not a lot happening to either of these categories.

Thus, some pickup in GDP growth in the second half of this year is likely.  But to sustain a faster pace of spending and boost potential GDP growth from 2.0% currently to the 2.8% pace that we expect by the end of this decade the economy will need help.  It desperately needs faster growth in productivity which, in turn, depends upon steady growth in investment.  We are banking on the tax cuts Trump talked about during the election campaign, some repatriation of corporate earnings, and, hopefully, better health care.  We continue to believe that such legislation will be forthcoming, but the clock is ticking.

Stephen Slifer


Charleston, S.C.



No Weekly commentary This Week — Daughter’s Wedding

Hi all,

Sorry, no letter this week.  Our daughter is getting married in  Baltimore on Sunday.  That trump’s the weekly column!  Fortunately, it was  a quiet week.

Think happy thoughts!    Will be back in the weekly column business next Friday.



Economics and Politics

May 19, 2017

The firing of FBI Director James Comey and subsequent appointment of former FBI Director Robert Muller as a Special Prosecutor to investigate the Trump campaign’s ties to Russia clouds the economic outlook.  At the end of last year we specifically added 0.1% to GDP growth this year and 0.2% to growth in 2018 with an expectation that Trump’s tax cut proposals, repatriation of corporate earnings, and regulatory relief would boost investment spending and stimulate growth slightly in the near-term, and boost potential GDP growth from 2.0% today to 2.8% by the end of the decade.  Recent developments delay the possible implementation date of these hoped for policy changes, and it is easy to envision a scenario in which they do not happen at all.  Having said that the U.S. and global economic outlook appears to be strengthening.  Thus, we are not yet prepared to alter our GDP forecast despite Trump’s political woes.

The stock market selloff on May 17 was certainly justified.  The S&P had risen 15% since the election last November and a correction is long overdue.  However, the nearly 2% drop on May 17 appears to be nothing more than a single-day event.


The market had also become extraordinarily complacent.  As measured by the VIX index, market volatility fell in early May to its lowest level since 1993.  Following the favorable election outcome in France in early May the markets seemed to believe that they had nothing to worry about.

But President Trump’s firing of FBI Director James Comey and the subsequent hiring of Muller as a Special Prosecutor re-inserted risk into the equation for both the stock market and the economic outlook.  As we see it, it will be far more challenging for President Trump to enact the legislation noted above any time soon.  It is hard to envision any support from Democrats, and many Republicans could abandon ship.

But we do not want to impose judgment on President Trump.  Only two people were in that room and nobody knows exactly what was said.  We are supporters of the Trump policy initiatives — tax cuts, repatriation of earnings, and deregulation.  We are not supporters of the man himself.  He says, and we agree, that the mainstream press has not been particularly fair in their reporting.  It could be that there is less going on than we are being led to believe.  But we also recognize that things could be far worse.  We simply do not know.

One does not have to be a political analyst to recognize that the mid-year election campaign will begin early next year and the election itself is only 18 months away.  If Republicans lose control of the House of Representatives, Democrats will almost certainly initiate impeachment proceedings.  The Senate probably would not convict, but under those circumstances Trump’s agenda would never be enacted and he would be a one-term President.

But what if Muller does not find evidence of any significant wrongdoing by the president or his administration?  A lot of the current uncertainty disappears and a significant portion of his agenda could actually be implemented (although later than we had envisioned).

Certainly Republicans are aware that the midyear election is not far off and will double their effort to pass some of his proposed legislative changes.  If that happens our economic outlook would be largely unaffected.

In short, we believe it is premature to make significant revisions to our economic forecast at this point.  We continue to expect 2.2% GDP growth this year and 2.7% growth in 2018.  A couple of things to consider:

1.  The nearly 2% drop in the S&P 500 index on May 17 is not even remotely close to a stock market “correction” which is usually regarded as a decline of about 10%. A correction is long overdue and would be considered healthy if it were to occur.

2.  One reason the stock market is so strong is that corporate earnings were very robust in the first quarter and are on track for an easy double-digit increase this year.

3.  The strength in corporate earnings reflects in part a rebound in earnings from companies in the oil industry that were crushed as oil prices plunged in late 2014 and 2015. The rebound in oil prices has restored profitability to those companies.  It also reflects the continuation of extremely low interest rates.  While the Fed is gradually raising rates, the process will occur very slowly and gradually.  These two events are not going to change any time soon.  Thus, any stock market drop may be muted.

4.  The labor market continues to improve and is beyond the full employment threshold. The official rate is at 4.4%.  Even the broader measure that Yellen prefers is at 8.6%.  This labor market strength generates income which allows consumers to spend freely and keeps the economy expanding at a respectable clip.

5.  The global economy is gathering momentum.  Faster growth is evident in many countries to Europe – Spain, Germany, and the U.K. in particular.  Now that the French election uncertainty has passed, labor market reforms may actually occur in that country.  In Asia, GDP growth in China is holding steady at about 6.5%, but in India growth is rebounding to 7.5% which is the fastest GDP growth rate in the world.  Emerging Asian economies are benefiting from the rebound in commodity prices.  The IMF believes global GDP growth rate will accelerate from 3.1% last year to 3.5% in 2017.

Politics matter and we will follow developments in Washington closely.  But, for now, it appears that economic fundamentals “Trump” political events.

Stephen Slifer


Charleston, S.C.

Global Growth is on the Rise

May 12, 2017

Because the U.S. is the world’s largest economy U.S. residents tend to focus almost exclusively on the domestic economy.   But in today’s increasingly global environment what happens elsewhere matters.  The IMF believes that global growth will quicken from 3.1% last year to 3.5% in 2017 and that growth pickup is not attributable solely to the United States.  That means that central banks can begin to wean themselves away from the uber-easy monetary policy that has provided life support for the global economy during the past eight years and return to a more “normal” economic environment.  Here is a quick look at non-U.S. countries that are experiencing faster GDP growth.

GDP growth rates for our neighbors to the north and south, Canada and Mexico, are moving in opposite directions.

Canada.  The U.S. and Canadian economies are closely intertwined.  To the extent that the U.S. economy is getting a lift from the expectation of lower individual and corporate taxes, repatriation of overseas corporate earnings, and abatement from needlessly complex federal regulations, that helps the Canadian economy as well.  But the Canadian economy is also highly dependent upon exports of commodities.  Rising prices for both oil and non-fuel commodities provides a further lift to the Canadian economy.  The IMF projects GDP growth in Canada of 1.9% in 2017 compared to 1.4% last year.

Mexico.  Like Canada, Mexico typically benefits from faster U.S. growth.   However, Trump’s comments earlier this year about pulling the U.S. out of NAFTA and uncertainty about U.S. immigration policy have soured relations between the two countries.  As a result, the IMF anticipates that GDP growth in Mexico will slip from 2.3% in 2016 to 1.7% this year.

Latin America.  Like Mexico, most countries in Central and South America are concerned about President Trump’s trade and immigration policies which are weighing heavily on both confidence and growth expectations throughout the region.

The situation in Brazil, the region’s largest economy by far, is different.  That country is poised to end its 2-year long recession.  Rising oil prices have contributed to the rebound.  But, equally important, in January the Brazilian Senate ended a year-long impeachment process by removing from office President Dilma Rousseff who was embroiled in the scandal at the Brazilian national petroleum company, Petrobras.    Hopefully, this development will enhance the government’s ability to implement policy and strengthen the emerging economic upswing.

Europe.  European economic growth is accelerating.  European Central Bank Chairman Draghi noted this week that euro area GDP growth, which had been stuck in a range from 0.3-0.8% for 15 consecutive quarters, picked up to 1.7% last year and should repeat that growth rate in 2017.  The unemployment rate in the Euro area is the lowest it has been since May 2009.  There are numerous success stories.

Spain.  The Spanish economy plunged into recession in 2007-2008.  The situation continued to deteriorate and the economy suffered a financial crisis in 2012 that required a bailout package from the E.U.  But the Spanish economy has recovered vigorously.  Following 3.2% and 3.1% GDP growth rates in 2015 and 2016, the Spanish economy is poised to expand at a solid 2.5% pace this year.  That is a dramatic turnaround in a surprisingly short period of time.

Germany.  The economic data for Germany accelerated in the first quarter, but the YPO Global Pulse measure of CEO confidence in Germany surged in April.  That probably had more to do with the victory by Angela Merkel’s CDU party in the Saarland state’s election in March.  Her party’s 5-seat gain in that election increased her chances of victory in the federal election in September.

United Kingdom.  The government revised up its GDP forecast for this year by 0.6% from 1.4% to 2.0%.  Meanwhile, the unemployment rate dipped to 4.7% the lowest rate since 1975.

France.  The YPO Global Pulse confidence measure for France plunged 8 points in April as CEO’s got a case of the jitters ahead of the French presidential election.  But with the overwhelming victory by centrist leader Emmanuel Macron the possibility of France leaving the European Union has disappeared.  Hopefully Macron will be able to ease some of the currently stifling labor laws in that country and bring down the 10% unemployment rate.

Asia.  As the world’s second largest economy China gets most of the attention when economists discuss Asia.  But, in this case, growth in China is expected to be relatively steady at about 6.5% this year and slow gradually towards the 6.0% mark in the years ahead.  Thus far fear of Trump’s protectionist policies directed at China have not dampened growth expectations by any particular amount but they remain a concern.

India.  The real growth story in Asia comes from India.  After climbing at about a 7.5% pace in 2014 and 2015, growth will slip to 6.8% in 2016 as the result of a temporary cash shortfall as the government removed high value banknotes from circulation in an effort to curb tax evasion and graft.  But GDP growth has recovered quickly and could re-attain a 7.5% pace this year.  That makes India the fastest growing economy in Asia and one of the fastest growing in the world.

Emerging Asia.  The ASEAN nations which include Indonesia, Malaysia, Singapore, Thailand, the Philippines and Vietnam amongst others will benefit from rising commodity prices, but any resurgence in growth amongst those countries will be kept in check by the gradual growth slowdown in China which is their primary trading partner.

Conclusion.  Following Trump’s election last November the possibility of tax cuts, repatriation of corporate earnings, and relief from a stifling regulatory environment have rekindled growth expectations in the United States.  That same tendency is evident in many countries in Europe, Asia, and Latin America.  At the same time fears of rising nationalism have been dealt a series of blows in the wake of elections in Austria, the Netherlands, Germany, and France.  As those fears shrink into the background the gradual pickup in global economic activity should become more apparent.

Stephen Slifer


Charleston, S.C.

Economy Still Chugging; Fed Will Continue to Push Rates Higher

May 5, 2017

First quarter GDP growth of 0.7% was disappointing but the unanticipated shortfall came from two-factors – a sharp slowdown in the past of consumer spending, and a surprisingly small increase in inventories.  Neither factor should be long-lasting.  Furthermore, the employment report for April with a solid jobs gain and a further decline in the employment rate provides additional evidence that second quarter GDP growth will rebound to at least 3.0%.  Given this background the Fed will continue on a path of gradual rate hikes with the next increase expected in June

GDP growth always zigs and zags and first quarter growth of 0.7% was the slowest in five years. but does it have any long-term implications?  The answer is unequivocally no.

The first part of the report that was surprisingly weak was consumer spending which edged upwards by 0.3% in the first quarter.  That was the slowest pace of consumer spending since the recession.   Given the consistency of consumption growth for almost a decade could the first quarter result could be a harbinger of a more subdued pace of spending in the months ahead?  We do not believe so.

Consumer spending is driven by a combination of factors.  First, steady employment gains boost income which provides the fuel for individuals to continue their pace of spending.

The prospect of individual income tax cuts later this year has propelled the stock market to a steady series of record high levels.  As the stock market climbs consumer net worth rises.

The rising stock market has boosted confidence to its highest level in more than a decade.

Interest rates remain low. After surging immediately after the election as Americans concluded that Trump’s proposed policy changes could significantly boost GDP growth in 2017, mortgage rates surged to 4.2%.  But as time has passed it is clear that the impact of those policy changes in the near term will be more muted.  Accordingly, mortgage rates have settled back to the 4.0% mark which remains low by any historical perspective.

The second source of first quarter GDP softness was business inventories which rose by $10.3 billion after having climbed $49.6 billion in the fourth quarter of last year.  As a result, this volatile category subtracted 1.0% from GDP growth in the first quarter.  As inventories rebound in the second quarter we expect this particular category to add at least 0.5% to the pace of expansion.

Even the Fed acknowledges that the first quarter slowdown should be temporary.  In its most recent statement it said, “Household spending slowed, but the fundamentals underlying the continued growth of consumption remain solid.”

The employment report for April provides further evidence that the first quarter slowdown will not be long lasting.  Not only did the economy generate 211 thousand new jobs in April, the unemployment rate fell by 0.1% to 4.4% its lowest level since May 2007.  That is the third consecutive decline in this rate which stood at 4.8% in January.  Janet Yellen prefers a broader measure of unemployment.  It has also declined for three consecutive months from 9.2% in January to 8.5% in April.  Both levels are below the ”full employment” threshold which basically means that everyone who wants a job has one.  Both rates will continue to decline as the year progresses.

If the economy is allegedly at “full employment” where are employers finding the bodies to hire?  Two places.  First, the steady pace of economic expansion continues to entice so-called “discouraged workers” back into the labor force.

Second, employers are searching within their own firms to find hard-working, reliable, part-time workers who indicate they would like to have a full-time position.

For all of these reasons it is virtually certain that the economy will rebound in the second quarter.    The Atlanta Fed expects second quarter GDP growth to snap back to 4.2%.  We are more cautious and currently peg it at the 3.0-% mark.  Either outcome suggests that the economy remains on solid footing after stumbling in the first quarter.

Against this background the Fed is almost certain to continue on its path of gradual increases in short-term interest rates.  The next FOMC meeting will be held on June 13-14 which strikes us as the date for the next rate hike which would lift the funds rate to the 1.0% mark.

It is important to remember that the economy does not grow on a steady upward trajectory.  Rather, it moves in fits and starts.  It had a “fit” in the first quarter, but should rebound with a “start” in the current quarter.  However, whenever something unexpected happens economists must honestly examine the data and review their outlook.  In this case, we conclude that there is nothing to worry about.  The time for concern will eventually come, but that time is not now.

Stephen Slifer


Charleston, S.C.

The Tax Plan is a Good Thing – But Not Revenue Neutral

April 28, 2017

The long-awaited Trump tax plan is still sketchy on details but, on balance, it is a good thing.  It will stimulate investment spending which will, in turn, boost productivity growth. Faster productivity growth will lift the economic speed limit for the U.S. economy from 1.8% currently to perhaps 3.0% by the end of the decade.  Unfortunately, that is not the 3.5-4.0% growth rate that President Trump envisions. To the extent that actual growth falls short of that mark his package will not be “revenue neutral”, which means that the budget deficit and debt outstanding will increase.   The deficit is already on a path to hit $1.4 trillion annually by 2026.  Any further increase is undesirable.  However, stimulating GDP growth to a 3.0% pace will create jobs, raise wages, and increase the growth rate in our standard of living.  It seems to us that the positive impact of these proposed tax cuts on the economy far outweigh the negative impact on the deficit which, as described below, may be far smaller than the Congressional Budget Office estimates.

How fast can the economy grow?  The economy’s speed limit is the sum of two numbers:  the growth rate of the labor force plus the growth rate of productivity.  Back in the 1990’s the labor force climbed by 1.5%, productivity was growing by 2.0%, which means that the economy’s speed limit (or potential growth rate) was 3.5%.  Today, however, the labor force is climbing by 0.8%, productivity is growing by 1.0%, so the speed limit has dropped to 1.8%.  The slow labor force growth largely reflects the impact of retiring baby boomers which will continue for another decade.  To boost the speed limit policy makers must boost the growth rate of productivity.  That growth rate, in turn, is determined largely by the pace of investment spending.

That takes us to the Trump tax policy.  It is focused largely on the business community.  He proposes to cut the corporate tax from 35% to 15%.  The lower rate applies to businesses of all types – corporations, partnerships, and small businesses of all sizes.  He plans to impost a one-time tax on an estimated $2.6 trillion of corporate earnings that are currently parked overseas.  And he proposes to end taxation on offshore income by adopting what is known as a “territorial” tax system which means that U.S. companies will pay no U.S. tax on income earned overseas (rather than the 35% rate they would pay under the current system).

At the same time he plans to simplify the individual tax code from seven tax brackets currently to three – 10%, 20%, and 35%.  He would end the alternative minimum tax and eliminate the estate tax.  He would simultaneously eliminate all itemized deductions except for home mortgage interest and charitable giving.

Tax cuts of this magnitude will reduce tax revenues and boost the budget deficit.  That scares people who are legitimately concerned about budget/federal debt issues in the years ahead.  But what if the proposed tax cuts boost GDP growth from 1.8% today to something higher like 3.0%?   The additional income generated by faster GDP growth will enhance tax revenues and, at least partially, offset the impact of the tax cuts.

Trump has said he expects the tax cuts to boost GDP growth to 3.5-4.0%.  His tax plan documents do not specific his specific growth assumptions, but he has talked about numbers in that ballpark in the past.  That is a reach.  Go back to the potential growth rate equation.  Labor force growth is probably going to be stuck at about 0.8% for another decade as the boomers continue to retire.  For Trump to reach his goal he needs productivity to accelerate to 2.7-3.2%.  Therein lies the problem.  Looking back over the past 40 years there is only one period when productivity climbed at a 3.0% pace for any protracted period of time.  That was the late 1990’s and early 2000’s which reflected the introduction of the internet in the mid-1990’s followed by the cloud and apps in the early 2000’s.  That was an unprecedented period of development.  It is unreasonable to expect productivity growth of that magnitude as the result of tax cuts.  However, to believe that productivity growth could be 2.0-2.5% is not unrealistic.  That would boost potential GDP from 1.8% today to 2.8-3.3% (0.8% growth in the labor force plus 2.0-2.5% growth in productivity).  If he is successful in boosting potential GDP to roughly the 3.0% mark that makes his tax reforms and tax cuts a desirable package.

But 3.0% GDP growth is not 3.5-4.0%, and tax revenues would fall short of the White House’s projections. Given that the budget deficit is already projected to climb from about $500 billion currently to $1.4 trillion within a decade that is not a desirable outcome.  However, if GDP growth jumps to 3.0% and Trump anticipates growth or 3.5-4.0%, the shortfall should be relatively small.

If, in addition to his proposed tax cuts, Trump is willing to consider cuts in so-called entitlement expenditures such as Social Security, Medicare, and Medicaid he could achieve faster GDP growth and no long-term increase in the budget deficit.  Such a combo would be deemed as “revenue neutral”.  That would be the best of all possible worlds.

Republicans and Democrats agree that tax reform is long overdue.  Hopefully, they can agree on a “revenue neutral” package of tax cuts and reduced spending similar to what was just described.  The bipartisan Erskine-Bowles Commission agreed on such a package back in 2010.  If seven years ago a bipartisan group of Republicans and Democrats could reach an agreement on what needs to be done, they can do it again.

The issue of revenue-neutrality is more than just an academic issue.  To boost the deficit outside a 10-year window requires a two-thirds majority in the Senate, i.e., it would need support from some Democrats.  A simple majority can pass the bill, but it would expire at the end of 10 years.  A major tax overhaul should clearly be a permanent change not a temporary one.

Hopefully, some agreement can be reached to make these proposed changes revenue neutral and thereby permanent.  But if that is unattainable, temporary changes in the tax code that produce faster GDP growth, more jobs, higher wages and faster growth in our standard of living are a desirable alternative.

Stephen Slifer


Charleston, S.C.

Growth Remains Moderate – Weather Distorts Data

April 21, 2017

Early in the year it appeared that the economy was in the process of taking off.  Three months later it has seemingly slowed dramatically.  But monthly data swings are the norm, not the exception.  As we see it, the economy continues to chug along at about a 2.0% pace.  Expectations were too high earlier and they are too low today.  In this case, most of the shifting expectations are attributable to nothing more than the weather which frequently tends to muddy the outlook at this time of the year.  Specifically, the warmer than normal weather early in the year boosted everything from employment, to retail sales, to housing starts, and interest rates.  Once the weather returned to normal suddenly all of those indicators seemed weak.  It is sometimes hard to look past the monthly wiggles and the associated knee-jerk reaction by the markets.  But, more often than not, it is the right thing to do.  Not to worry, growth remains at a steady – if unimpressive – pace for now with somewhat faster growth likely in the quarters ahead.

In December, January, and February virtually every economic indicator seemed strong.  Employment gains surged to about 200 thousand per month.  Housing starts climbed 10% or so from 1,150 thousand from 1,275 thousand.  Retail sales jumped 1.0% in December and an additional 0.5% in January.  The inflation rate climbed by 0.3% in December and another 0.6% in December.  With the economy at full employment the fear was that this additional strength would boost the inflation rate far above the Fed’s 2.0% target and force the Fed to raise short-term interest rates more than three times this year.  Good news.  Bad news.  The economy was doing better, but the Fed might have to raise more quickly than expected to cool things off.

The March data provided an entirely different picture.  Employment slid to just 98 thousand.  Housing starts fell almost 7%.  Retail sales declined 0.2%.  The inflation rate fell 0.3%.  Suddenly expectations shifted.  The economy wasn’t expanding too rapidly after all.  The inflation rate might not surge.  The Fed does not have to panic.  It can afford to maintain its go-slow trajectory for raising interest rates.

While perfectly understandable, it is hard not to get caught up in the enthusiasm (or disappointment) of the moment.  Which is why we always recommended looking at 3-month averages which smooth out some of the monthly distortions.  Longer-term averages, like year-over-year growth — even out the data so much that changes in trend may not be discernible for months.  That is not good either.

In this case, the apparent surge and subsequent slowdown were clearly impacted by deviations from normal winter weather patterns.   In other recent years we have seen surprisingly harsh winter weather conditions depress the early year data.  By spring the weather returned to normal and pent up demand caused sales to surge.  This year was the opposite.    January and February were much warmer than normal in most areas of the country.  Builders were able to dig some holes in the ground and begin construction on a number of new houses and apartments.  Consumers took advantage of the mild weather conditions and went shopping for cars and other goodies.  Perhaps they bought some garden equipment they might ordinarily have bought a couple of months later.   In March when those housing starts and sales would ordinarily have occurred they did not materialize because they had actually taken place a couple of months earlier.

Are those swings in economic activity legitimate?  Yes.  Do they mean much?  No.  At some point the weather will return to normal and, in this case, people should have expected the March data to be as weak as the January and February data were strong.  But markets are markets and they react to each new data point.  But you, dear readers are able (most of the time) to sift through the monthly wiggles and keep your eye on the trend.  As we see it, the housing market is steady and builders will gradually boost the pace of production.  Consumers are continuing to spend at a moderate rate.  Inflation is inching its way higher. And the Fed remains on track for three rate hikes this year which would bring the yearend funds rate to 1.25%.

The economy may deviate from our expectation as the year progresses but, for now at least, the moderate growth scenario remains intact.

Stephen Slifer


Charleston, S.C.