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Nobody Wins a Trade War

April 6, 2018

Sometimes when watching the stock market’s shenanigans, it is easy to lose track of the big picture.  We get it.  When the market moves up or down 500 points on successive days, it is easy to conclude that the stock market is emitting a warning signal that all is not right in the economy.   Stock market volatility is unsettling.  But sit back, take a deep breath, and try to figure out why the stock market has been reacting so violently.  Determine in your own mind whether that is likely to have any long-lasting impact on the economy.  If you are a consume are you any less willing to buy that new car or house?  Do you have any desire to postpone that long-planned summer vacation?  If you are a business person have you seen any drop-off in your order book?  Are you considering layoffs or cutting back on the hours your employees work?  Our guess is that in the current environment none of you are contemplating any of the above.  As we see it the economy is expanding nicely.

On Friday morning, April 27, we will get our first look at first quarter GDP growth.  We expect it to be 2.5%.  That means that in the last four quarters we have seen GDP growth of 3.1%, 3.2%, 2.9% and 2.5%.  That represents average growth of 2.9%.  In the previous four quarters it averaged 2.0%.  Not too shabby.  In that first quarter we anticipate consumer spending of 1.9% which is a bit on the slow side, however that follows a 4.0% increase in the fourth quarter of last year.  Consumer spending seems to be holding up nicely at about 2.5%.  Importantly, investment spending should surge to an 8.5% pace in the first quarter and register average growth of 6.8% in the past four quarters.  Remember, this is the GDP component which registered virtually no growth in 2015 and 2016.   It is amazing what tax cuts, repatriation of earnings, and regulatory relief can do to encourage business people to spend.

While first quarter GDP growth is now history, you might ask whether the recent stock market behavior is likely to impact the pace of economic activity in the second quarter and beyond.  But first note that the S&P 500 index – despite its recent ups and downs – is only 7% below its record high level.  It feels much lower than that.  Also note that, thus far, none of the high frequency data series are sending out any warning signals.

Consumer sentiment, for example, was 102.0 for the first half of March and 100.8 in the second half which gives an average level of 101.4 for the month.  That is the highest level of sentiment since January 2004.  The consumer does not seem to be bothered at all by the recent stock market volatility.

Car and truck sales climbed 2.5% in March to a respectable 17.4 million pace.  Sales have slipped in recent months in part because of lousy weather conditions in many areas of the country.  Eventually, the weather will improve, and sales will rebound.

The Institute for Supply Management index of conditions in the manufacturing sector fell 2.4 points in March to 57.3, but that was from a February level which was the highest since May 2004.  It is hard to characterize the March decline as an indication of emerging softness amongst manufacturers.

Then there is the ADP employment survey for March which revealed an increase of 241 thousand which is virtually identical to the 243 thousand average increase for the past three months.  The labor market continues to be hot and one wonders where all these hirable bodies are coming from.  Once again there is no hint of a change in business’ employment practices.

The stock market is clearly nervous about the possibility of a full-blown trade war.  Fair enough.  But the skirmish at this point seems largely focused on the Chinese.  Trump seems intent on forcing the Chinese to alter their way of doing business which is a legitimate objective because China does not play by the same rules as everybody else.  While nobody can predict exactly how this will turn out a couple of things are important.  First, nobody wins a trade war.  Trump’s tariffs may well inflict damage on the Chinese economy, but U.S. consumers and companies will also end up getting hit.  Second, this is not the piece that will end the current expansion.  Having said that, it could trim GDP growth a bit and boost inflation later in 2018 and beyond if these issues are not resolved in a timely manner.

Stephen D. Slifer


Charleston, S.C.

Volatility Creates Angst, But the Economy Chugs Along

March 30, 2018

It has been a tough quarter.  Early on there was fear that the economy was overheating and that inflation was on the rise.  That triggered the long-awaited stock market correction.  In early March President Trump imposed tariffs on all steel and aluminum imports.  A couple of weeks later he homed in on the Chinese and imposed tariffs on a wide variety of Chinese goods.  At that same time the Fed, under new leadership, raised short-term interest rates and indicated a willingness to quicken the pace of rate hikes.  A week later there was the Facebook flap that brought into question exactly what it and other tech giants like Amazon and Google are doing with the data they collect from us.  Market volatility has surged.  But is the stock market slide and heightened volatility indicative of anything more than the usual stock market angst?  Could they be early indications of economic distress?  We suggest it is market noise and nothing more than a bump along the economic road.

Following a steady increase for more than one year, the stock market ran out of steam on February 2 when the January employment report registered another strong gain and average hourly earnings recorded a larger-than-expected increase for the month.  Suddenly the fear emerged that the economy was overheating, inflation was on the rise, and the Federal Reserve would boost rates four times this year rather than three.  That combo triggered the first stock market correction in three years.

The market quickly recovered about one-half it its earlier loss as buy-the-dip mentality prevailed.  But then it got clunked anew by the two tariff announcements and Facebook which sent the stock market into another tailspin.  Daily changes in the DOW Jones Industrial Average of 500 points became common.  Market volatility returned with a vengeance.  But does any of this mean anything for the future of the economy?

One way to gauge the impact would be to look at changes in consumer confidence.  The University of Michigan series may prove to be helpful.  It provided a mid-month reading on consumer sentiment for March on Friday, March 16.  At that time it indicated that consumer sentiment for the month was 102.0 which was the highest level since January 2004.  Two weeks later its final estimate of sentiment for March was 101.4.  This suggests that sentiment in the first half of the month was 102.0 and in the second half it slipped to 100.8.  At 101.4 sentiment for the month was still the highest since January 2004.  So while the stock market has been bouncing all over the place and making investors nervous, consumers believe that job gains will continue at a brisk pace for the foreseeable future, the Fed will raise interest rates further but the rate of increase will be slow, and they envision inflation remaining stable at a 2.7% pace – an expectation that has not changed appreciably for the past three years.  In short, they have largely shrugged off the events described previously.

Another frequent indicator is the weekly level of initial unemployment claims which is a measure of layoffs.  Initial unemployment claims declined 12 thousand in the most recent week to 215 thousand which is the lowest weekly level of claims since January 27, 1973 – that is 45 years ago!  It is hard to see any emerging weakness in the labor market.  This suggests that the employment report for March will be solid with the possible caveat of some temporary softness induced by the series of snowstorms that paralyzed the Northeast for much of the month.

Also, the Conference Board publishes the most widely recognized index of leading indicators.  This series rose 0.8% in January and an additional 0.6% in February.  It has been marching steadily higher for years and nothing appears to have changed in recent months.

Finally, on Friday, April 27, we will get our first glimpse at first quarter GDP growth.  While there is still some missing data, most estimates remain centered on a 2.5% pace with noteworthy strength in investment spending.  If that estimate is correct it means that in the most recent four quarters GDP growth has averaged 2.9% which would be the fastest 4-quarter growth rate since mid-2015.  While some of the first quarter passed prior to the stock market swoon, February and March data could have been impacted but, thus far, there seems to be little evidence that the pace of economic activity has been harmed in any meaningful way.

There will come a time when a stock market drop and additional volatility will be a leading indicator of emerging economic weakness.  But that time is unlikely to occur until 2020 or beyond once the Fed has pushed the funds rate significantly above the 3.0% mark.  At that point we should look for car sales and home sales to slide, factory orders begin to drop, and layoffs start to climb.  None of those things are happening currently.  For now, the stock market selloff and the sharp jump in volatility appear to be noise and not a harbinger of slower economic activity in the months ahead.

Stephen D. Slifer


Charleston, S.C.

Two Pieces to Read This Week — One on Trade, The Other on the Fed

March 23, 2017

Two pieces to read this week.  One on the results of this week’s FOMC meeting.  The  other is on the trade measures implemented against China.  Both topics are fresh  on the minds of investors and economists alike.

Stephen D. Slifer


Charleston, S.C.

The Fed Sees Faster Growth Now, Higher Rates Later

March 23, 2017

At the first FOMC gathering with Jerome Powell as Fed Chair, he and his colleagues on the FOMC incorporated tax cuts into its forecast for the first time.  The Fed believes that the cuts will boost GDP growth in 2018 and 2019 but will have little impact thereafter.  Its expectation for inflation was essentially unchanged at 2.1%.  Against this backdrop, the Fed indicated a willingness to boost the funds rate to 3.4% in 2020 which is 0.3% higher than it suggested three months ago.  Why is this important?  Because the Fed believes its policy is neutral when the funds rate is 2.9%.  Thus, it is suggesting that by 2020 it will venture into “tightening” mode for the first time in 13 years.  In the past when it boosted interest rates it could claim that it was not “tightening” but simply lifting the funds rate towards a more neutral policy stance.  By 2020 that will no longer be the case.

With respect to GDP growth, the Fed believes the tax cuts will stimulate GDP growth to 2.7% and 2.4% in 2018 and 2019, respectively.  Those forecasts are 0.2% and 0.3% higher than it thought previously.  However, the Fed does not believe there will be any long-term impact from the tax cuts.  By 2020 it suggests that GDP growth will revert to a 2.0% pace which is exactly what it anticipated back in December.  The Fed continues to believe that potential GDP growth will be steady at 1.8%.

Thus, the Fed does not believe that the corporate tax cuts will boost the economy’s potential growth pace.  That is the primary difference between its forecast and our own.  We highlight the fact that the tax cuts boosted the pace of investment spending in 2017, and we expect faster growth in investment to continue through 2020.  In the process productivity growth will quicken from 1.0% to 2.0%, which will thereby raise the economy’s potential GDP growth rate from 1.8% to 2.8%.  It is an important difference.  If that happens, the economy can grow more quickly without triggering a pickup in inflation, which means that the Fed has no need to boost the funds rate above the neutral level.  At this point nobody knows which view might be more correct but as time passes and more data are collected the difference will be resolved.

The Fed did not appreciably alter its forecast for inflation.  It suggests that the core CPI (i.e., excluding the volatile food and energy components) will be 2.1% in both 2019 and 2020.  Previously it had both growth rates pegged at the 2.0% mark.

Given that the economy is at full employment, how can it envision faster GDP growth without any significant pickup in the pace of inflation?  Presumably it believes that higher interest rates will be required to prevent the inflation rate from accelerating.  In December it expected the funds rate in 2020 to be 3.1%.  Today it believes it will likely be 3.4%.  While that is only 0.3% higher than its earlier prediction, it is 0.5% higher than the 2.9% level that it believes is a “neutral” rate.  What this means is that by 2020 the Fed will shift into “tightening” mode for the first time since 2007.  It is easy to raise the funds rate when it is far below its so-called “neutral” level.  There is no real risk of overdoing it and possibly sending the economy into a tailspin.  But once it starts raising rates above that neutral level, the danger of going too far and inadvertently triggering a recession increase considerably.  It is a time when the Fed, and all of us, need to start paying close attention to the incoming data.

Will 2020 mark the end of the road for the expansion?  No.  In 2007 the Fed had to boost the funds to the 5.25% mark before the economy slipped over the edge into recession.  As we see it two things are important.  First, 2020 is two years down the road and everybody’s forecast will change in the interim.  Second a funds rate of 3.4% is not 5.25%.  The funds rate will probably not yet be at a danger point.  But if the Fed is willing to venture into “tightening” mode, the end of the expansion is getting closer.  Once that happens it is telling the world that it wants to slow the pace of economic activity.  That shift in attitude rarely has a happy ending.

Stephen D. Slifer


Charleston, S.C.

Fear of a Trade War Spooks the Market

March 23, 2018

Two weeks ago, President Trump announced widespread tariffs on global imports of steel and aluminum. He is currently in the process of exempting many of our closest allies and trading partners.  This week he narrowed the focus and homed in on China by imposing tariffs on $60 billion of goods imported from China, much tighter restrictions on Chinese acquisitions of U.S. firms, and controls on transfers of technology to Chinese firms.  Trump stated clearly that the Chinese have attained U.S. technology through intimidation, state financed acquisition, and subterfuge.  It is not clear how this will turn out.  The objective seems to be to force China to make concessions as it contemplates a substantial loss of exports.  If they agree to concessions many of the trade restrictions could be lifted.  As economists we do not support the wide-ranging set of tariffs introduced previously.   We support free trade.  But we also believe in fair trade and that is where the problem lies.  China, and a handful of other countries, do not play by the same rules as everybody else.  While perhaps not an optimal solution, Trump’s policies might ultimately produce a more level playing field–  and that would be a good thing.

Macroeconomists almost unanimously support the notion of free trade.  All countries can attain a wider variety of goods and services at lower prices than would occur in the absence of trade.  Thus, free trade is a good thing – at long as the rules are the same for everybody.

Some economists fret about the magnitude of the trade deficit.  We do not.  Last year the deficit was $568 billion consisting of an $811 billion deficit in goods, partially offset by a $243 billion surplus in services.  But a deficit of $568 billion means that we purchased $568 billion more of foreign goods and services than they purchased from us.  As a result, foreigners on balance accumulated $568 billion of U.S. dollars.  What do they do with those dollars?  They establish businesses in the U.S.  They hire American workers.  They may put the money in the U.S. stock market.  We fail to see why that is such a bad thing.

Furthermore, we have had a trade deficit of roughly that magnitude since the early 2000’s and nothing bad has happened.  So what is the problem?  It is not the magnitude of the trade deficit that is the issue but, rather, the terms of trade with a very small number of countries.

As noted earlier, we are big believers in free trade but that trade must also be fair.  That is not the case.  Some countries cheat.  Below is a picture of the U.S. F-35 fighter which has our most advanced technology.  The other picture is the equivalent Chinese version.  Can you tell the difference?  We cannot, and we do not think that result is an accident.

It is abundantly obvious that our trade problems exist with a very small number of countries.  In fact, of the $811 trade deficit in goods last year, almost one-half of the entire amount of the deficit was with China.  An additional 25% was with a small number of countries in Asia.  Thus, in our view, the very broad tariffs announced previously by President Trump made no sense.  We do not have a trade problem with our neighbors Canada and Mexico.  We do not have a trade problem with Europe or OPEC countries.  We do not have a trade problem with Australia.

We have a trade problem with China and a few other Asian countries.  Hence, tariffs and other measures directed at the problem countries seem to make some sense.  It would be desirable if all the countries involved sat down, had some serious discussions and, in the end, agreed to abide by the same rules.  That is not going to happen.  While perhaps not ideal, Trump’s imports on tariffs from China, and the other trade measures designed to restrict the flow of technology to that country, will certainly get the attention of Chinese leaders.  Yes, there will be repercussions as the Chinese impose similar tariffs.   Both countries will lose.  The Chinese will see a reduction in their exports of goods to the United States.  They will have less access to advanced technology.  American consumers will experience higher prices on Chinese made goods when they shop at Amazon, Walmart or Target.  In the short run both countries lose.  But in the longer-term American firms may be able to compete in the global market place with a level playing field.  In that environment, American firms can compete successfully with anybody.

In the end, focused trade restrictions will not push the U.S. economy over the edge into recession.  Trade is simply not a big enough piece of the GDP pie for that to happen.  But it will put a crimp in corporate earnings which will slow the rate of growth in the stock market.  And it will boost the inflation rate.  Those are not positive events.  But the announcement of trade measures against the Chinese is part of a negotiating process designed to bring about changes in the way the Chinese do business with the rest of the world.  We will see how successful that strategy might be.

Stephen Slifer


Charleston, S.C.

Housing Remains Affordable Despite Rise in Mortgage Rates

March 16, 2018

Mortgage rates have risen 0.5% in the first three months of this year from 4.0% to 4.5%.  Home prices are beginning to climb more quickly.  Buyers, sellers, and realtors are getting nervous.  However, it is important to remember that solid employment growth is boosting consumer income as well.   As a result, housing remains affordable and should remain so for the foreseeable future.

With respect to mortgage rates, at the end of last year they were comfortable at the 4.0% mark.  In less than three months they have climbed to 4.5%.  That is a big increase in a short period of time.  But it is important to note a couple of things.  First, by any historical standard a 4.5% 30-year mortgage rate is still very low.  Second, the early year run up in rates was triggered by a fear that the economy was overheating, inflation was beginning to climb, and the Fed would raise rates more quickly than expected.  That assessment has now changed.

Earlier this year strong economic data led many economists to anticipate first quarter GDP growth of 3.5-4.0%.  At the same time the core-CPI rose 0.3% in January which was biggest monthly increase in more than one year.  The conclusion was that the economy was overheating, inflation was on the rise, and the Fed would accelerate its pace of tightening.  Mortgage rates rose.

But subsequent data have been less robust.  First quarter GDP growth expectations have slipped to 2.0-2.5%, and the core-CPI for February rose 0.2% which was more in line with other recent months.  The early year fear of rapidly rising interest rates has quieted down.  Mortgage rates have leveled off.

However, home prices have begun to rise more quickly.  A year or so ago home prices were rising by about 4.5%.  Today they are climbing at a 6.0% pace.

This upswing in home prices reflects the extreme shortage of homes available for sale.  There is currently a 3.4-month supply of homes on the market.  The National Association of Realtors suggests that demand and supply are roughly in balance when there is 6.0-month supply.  Thus, demand exceeds supply and — not surprisingly – faster growth in home prices reflects that imbalance.

This combination of rising home prices and higher mortgage rates has understandably made some people nervous.  But there is a third part of the housing affordability equation that is overlooked and that is consumer income.  It is on the rise as well.  Employment gains have been consistently robust and seem to be gathering momentum.  For example, payroll employment rose 182 thousand per month last year. In the past six months that has averaged 205 thousand, and in the last three months it has climbed to an even steamier 242 thousand.  Employment gains generate the income that allows consumers to spend.

Primarily because of these job gains, real disposable income – which is what is left after paying taxes and adjusting for inflation – has climbed 2.3% which is close to its long-term average of 2.7%.

So, is income rising quickly enough to counter the increases in both mortgage rates and home prices?  Not quite.  The National Association of Realtors has a series on housing affordability that encompasses all three of these variables.  Right now, consumers have 60% more income than is necessary to purchase a median-priced home.  This series peaked in January 2013 when mortgage rates were at a record low level of 3.47%.  At that time consumers had 113% more income than necessary to purchase a median-priced house.  As mortgage rates have risen, housing is less affordable today that it was five years ago.  In contrast, prior to the recession – at the peak of the housing bubble – consumers had just 15% more income than needed.  Thus, housing today remains affordable.

While mortgage rates and home prices are important in determining housing affordability, so is consumer income growth and this is the piece that people tend to miss.  If we continue to generate 200 thousand jobs a month, inflation rises moderately, and the Fed continues to pursue a go-slow approach to raising interest rates, the housing market will do just fine.  This is not to say that everybody will be able to afford to purchase a home.  They will not.  Those on the lower end of the income scale and those with lots of student debt may find home ownership more challenging.  But, in general, the housing market will remain affordable throughout 2018.

Stephen Slifer


Charleston, S.C.

Free Trade is Good; Fair Trade is Mandatory

March 9, 2018

The “free trade” crowd, which includes virtually every economist, is up in arms about President Trump’s imposition of across-the-board tariffs on steel and aluminum.  And to a large extent they are right.  Through trade Americans have attained access to a broader array of goods and services at lower prices than would otherwise have been the case.  The U.S. and the rest of the world have been moving steadily in the direction of free trade since the end of World War II and its benefits have been widely recognized by all.

But implicit within that free-trade-is-good hypothesis is an assumption that there is also “fair trade”.  But therein lies the problem.  Many countries do not play by the rules.  The primary culprit is China, but there are others.  China, for example, unfairly subsidizes its export industries.  It routinely exports raw and semi-finished materials to other countries which alter the product slightly and re-export it to the U.S. as a different product.   By doing so China can escape high U.S. tariffs.  The cheater countries show no respect for intellectual property rights and unfairly reproduce movies, books, and music. They ignore patent and copyright laws.  We do not live in the idyllic, textbook world that economists studied while they were in school.  Something needs to be done to level the playing field.  The question is, how do you penalize the bad guys while simultaneously protecting your neighbors and allies?  Trump’s initially-announced across-the-board tariffs on all steel and aluminum products were ill-advised and not the way to go.  We believe that a more targeted approach has a better chance of success.

Part of the problem is that we do not know what Trump is trying to accomplish.  His mantra has always been “America First”.  During the campaign he repeatedly threatened big tariffs on a variety of products from China.  He threatened to (and did) pull the U.S. out of the Transpacific Partnership.  He talked about pulling the U.S. out of NAFTA or, at the very least, renegotiating the agreement.  And he said that “trade wars aren’t so bad”.  Thus, he seems to embrace a much more protectionist trade policy.  His initial announcement of across-the-board tariffs on steel and aluminum is consistent with such a philosophy.   But across-the-board tariffs will not go uncontested.  Friends, neighbors, and allies are threatening to counterpunch with tariffs on quintessential American products like bourbon, Harleys, Levi’s, and who knows what else.  Tariffs applicable to steel and aluminum are one thing and, by themselves, would not have a major impact on GDP growth or inflation.  The fear is not what happens today but what happens tomorrow, and it is 100% certain that reprisals will occur if Trump follows through on across-the-board tariffs.  A trade war could emerge.  While we acknowledge that a trade war is possible, we do not think such an outcome is likely for the following reason.

Trump is notorious for shooting for the moon by saying or tweeting something outrageous, and then backtracking.  Already he has said that Mexico and Canada will not face the levies if they agree to re-negotiate NAFTA.  He pointed out that the U.S. has a trade surplus with Australia and called it a long-term partner.  Sounds like Australia may be exempt as well.  Then he noted that many countries are involved with us on trade and the military.  More countries will presumably fall through the cracks.  He claimed on Thursday that he intends to go down the list country by country and drop out various countries as circumstances warrant.  Suddenly a very different sense emerges.  Under this scenario it sounds like he intends to find the bad guys and stick it to them.  If so, bravo!  It is about time to go after the cheaters.

But where is the “real” Donald Trump.  Is he a staunch protectionist?  Or is he the guy that recognizes that some countries are not playing by the rules and he intends to level the playing field.  Let’s hope he chooses Option 2 and that seems to be the direction he is headed.  He can then claim that he fulfilled another campaign promise without doing too much damage to the economy and, in the process, enable U.S. exporters to compete fairly with the rest of the world.

It is also important to understand that trade deficits are not inherently bad.  In 2017 the U.S. had a trade deficit of $568 billion.  Specifically, it had a trade deficit of $811 billion in goods, combined with a $243 billion trade surplus in services.  What we do not hear enough people talking about is that a deficit of that magnitude means that $568 billion of foreign capital flowed into the U.S.  That money is used to stimulate GDP growth, create jobs, and boost the stock market.  What’s so bad about that?   Furthermore, that foreign investor attitude is not going to change any time soon.  With the recently enacted tax cuts GDP should grow a bit more quickly in coming years.  The U.S. stock market should continue its ascent.

We certainly support the idea of “free trade”.  Its positive impact on the global economy is well documented.   But the “free trade” concept assumes that there is also “fair trade”.  While President Trump’s leadership style often obscures his objective, we hope that he is trying to achieve a fair trade objective.  If so, we support a package of narrowly-defined tariffs and wish him well.  We vigorously oppose a more protectionist trade policy.  Nobody “wins” a trade war.  Everybody loses — including the U.S.

Stephen D. Slifer


Charleston, S.C.

Inflation is Low Now – Will That Continue to be the Case?

March 2, 2018

The Fed has embarked on a course of very slow and gradual increases in interest rates over the past two years designed to bring the funds rate into closer alignment with its historical average.  It has been able to proceed slowly because the inflation rate has remained well below the Fed’s 2.0% objective.  Specifically, the Fed’s preferred measure of inflation, the personal consumption expenditures deflator excluding food and energy, has risen 1.5% in the past year.  Given the apparent tightness in the labor market that is less than what the Fed and most private sector economists had anticipated.  In his first appearance before Congress, Fed Chairman Powell acknowledged that the Fed’s understanding of the forces currently driving inflation is imperfect.  If the Fed can better understand its recent behavior, it will be better able to predict the likely path of inflation in years ahead.

First, Powell indicated that much of the shortfall in inflation is readily explainable.  The decline in commodity prices from mid-2014 through the end of 2015 helped to keep inflation in check for a protracted period, but such prices have been on the upswing since mid-2016.  Thus, the downward bias from falling commodity prices should be temporary.

Similarly, the sharp increase in the dollar from mid-2014 through the end of 2015 lowered the prices of imported goods and helped to keep inflation in check.  But the dollar has since reversed direction and began to decline immediately after the November 2016 election.  Thus, the dollar’s impact on reducing inflation will also be temporary.

These factors help to explain much of the softness in the overall inflation measures, but the low core inflation rate in the U.S. has been more of a puzzle and harder to associate with a specific cause.

One possibility is that the full employment level of the unemployment rate – the level at which the labor market is exerting neither upward nor downward pressure on the inflation rate — could be lower than most economists estimate.  The Fed believes that rate is currently 4.6% but its estimate, as well as estimates produced in the private sector, represent nothing more than educated guesses.  Furthermore, all economists’ estimates of this full employment threshold have been trimmed by about one percentage point in the past couple of years as the seemingly tight labor market has failed to produce any significant upward pressure on wages.  If full employment were, say, 4.2% or 4.3% it would better explain why wages have been rising so slowly.

Second, developments in the global economy may be playing a role.  Economic slack abroad may help to explain the inflation shortfall.  For example, unemployment rates for many countries in Europe like France, Italy, and Spain all exceed the 10% mark.  As a result, there is downward pressure on inflation rates in those countries.  At the same time, as emerging economies become more integrated into the world economy the low wage rates available in these countries help to keep the global inflation rate in check.  However, the Fed noted that measures of globalization such as the fraction of global trade as a percent of GDP have leveled off in recent years which suggests this factor may be less relevant today than it was five or ten years ago.

Third, some economists believe that the aging population could be exerting downward pressure on the inflation rate as, perhaps, retirees are more price conscious than other consumers.  Furthermore, the recent slowdown in medical costs in the U.S. may be associated with health care reform.  It is unclear the extent to which these price declines will persist.

Finally, the Fed believes technological changes in recent years have probably reduced pricing power for many industries.  The increased prevalence of internet shopping allows consumers to easily compare prices from a variety of sellers which has limited the ability of firms to raise prices.  But the Fed also notes that while this hypothesis seems to make sense, it is hard to square with the fact that profit margins remain high.

The bottom line is that Fed economists, like private sector economists, are puzzled by the stubbornly low rate of inflation.  The FOMC concludes that inflation will, over time, move back to its target.  Both we and the Fed believe the core PCE will rise from 1.5% currently to 1.9% by the end of this year which is virtually indistinguishable from the Fed’s 2.0% objective.  Having said that, it is possible that new factors such as the ones described above (which are not currently included in the Fed’s models) could keep inflation subdued.  But, at the same time, it must remain vigilant that the factors which have kept inflation in check for the past several years may prove to be transitory, in which case inflation could rebound more sharply than anticipated.  It is a new world and we are all trying to understand it better.  For now, the Fed should maintain its policy of raising short-term interest rates slowly with three rate hikes in store this year.

Stephen Slifer


Charleston, S.C.

Bond Market Frets Over Treasury Supply

February 23, 2018

Inflation fears sent the stock market into a tizzy in late January and early February.  Those same fears rattled the bond market and boosted long-term interest rates.  However, the fear of a sharp pickup in the inflation rate seems to have subsided and the stock market has recovered about half of what it lost.   A rising inflation rate troubles the bond market as well, but its attention recently has shifted to larger budget deficits and increased Treasury supply in the years ahead.  As a result, bond yields have jumped 0.5% since the end of last year.  Economists have been talking about escalating budget deficits for ages but, until now, the bond market has largely shrugged off any such concern.  Politicians occasionally express some alarm, but they have been unwilling to do anything.  Are rising bond yields an indication that budget deficits finally matter?  Will our politicians in Washington be willing to do something?  Our conclusion is that we are years away from any serious budget reform.

In late January the fear was that the economy was overheating, inflation was going to climb appreciably, and the Fed would be forced to raise rates more quickly than had been anticipated.  The stock market swooned and registered its first “correction” in a couple of years.  As is often the case the stock market overreacted.  It still believes the economy has gathered momentum, inflation is headed higher, and the Fed may raise four times this year rather than three, but it now expects the interest rate ascent over time to be more gradual.  As a result, the S&P 500 index has recovered about half of its earlier loss.

The bond market has not been so lucky.  Bond yields have jumped 0.5% since the end of last year from 2.4% to 2.9%.  While we thought that bond yields would rise in 2018, the run-up has occurred much more quickly than we had anticipated.  So, what’s bugging the bond market?  Is it inflation, or is something else to blame?  Our conclusion is that inflation has played a small role, but the bond market’s greatest fear currently is Treasury supply.

Long-term interest rates are closely tied to expectations of inflation.  The measure of inflationary expectations we like the best is the implied inflation rate from the bond market.  The Treasury has a nominal rate on the 10-year note.  It also has an inflation-adjusted rate on the 10-year note.  The difference between the two represents an implied 10-year inflation rate.  It has risen in recent months but, at 2.1%, it can hardly be called troublesome and would not bother the Fed in the slightest.

So what else is bothering the bond market?  Supply.  Economists have been talking about rising budget deficits for years.  The projections shown below are from the Congressional Budget Office before the most recent tax cuts.  In three years the deficit has climbed from $439 billion to an expected $750 billion this year.  It is expected to reach $1.4 trillion by 2026.  The steadily rising deficits are, to a large extent, the result of demographics as baby boomers enter their retirement years.  As they do so Social Security payments will climb.  More and more boomers will become eligible for Medicare.  Larger deficits are baked in the cake.  Economists have seen this coming for years, but nobody paid much attention because it was far into the future.  But it is happening now, and people have finally noticed.  What has changed?  Two things.

First, tax cuts.  The Congressional Budget Office initially estimated that they would add $1.5 trillion to budget deficits and debt outstanding during the next 10 years.  Even if it tried to estimate the “dynamic” effects of the budget buts – i.e., tax cuts will stimulate GDP growth, generate more tax revenue, and partially offset some of the loss of tax revenue caused by the lower rates — the CBO still estimated that the deficit would increase by $1.0 trillion.  While that estimate is still too high, the important point is that the recently enacted tax legislation will almost certainly boost budget deficits relative to the forecasts shown above – which were already problematical.

Second, President Trump and Congress agreed on a 2018-2019 budget deal which will increase both defense and non-defense spending.  That additional spending will boost budget deficits for the next couple of years by an additional $300-600 billion.  No wonder the bond market is spooked.  There is no longer any pretense of fiscal restraint.

Budget deficits matter because they add to the debt outstanding.  If the government runs a $1.0 trillion budget deficit, the Treasury is forced to issue an additional $1.0 trillion of debt to finance that deficit.  Debt as a percent of GDP today is 77%.  It is expected to increase to 86% by 2026 and continue climbing to 125% of GDP within 20 years.  And remember, these numbers were done prior to the tax cuts and prior to the increases in spending agreed upon over the next two years.  They will go higher.  Economists tend to believe that a debt to GDP ratio in excess of 90% can create problems.  Why?  First, the ratings agencies may (once again) choose to downgrade Treasury debt which would increase the Treasury’s cost of borrowing.    Second, the Fed will be reducing its holdings of U.S. Treasury bonds in the years ahead as it tries to shrink its balance sheet to a more sustainable level.   Third, China and other foreign governments may be less willing to hold U.S. debt.  They collectively own $6.3 trillion (or 42%) of the $14.8 billion such debt outstanding.  Foreign central banks cannot significantly reduce their holdings of U.S. Treasury debt because no other sovereign market is big enough to allow that to happen in any size.  But they could at the margin cut back on their willingness to own U.S. Treasury debt and substitute euro- or yen-denominated debt instead. With Treasury debt poised to escalate any such marginal cutback would be bad news.

For purposes of comparison, the debt to GDP ratio for Greece is currently 180%.  Prior to the recession the debt/GDP ratio in Greece was 103%.  The recession boosted its budget deficits, triggered a crisis, and Greece had to be bailed out by its European Union partners.  A recession in the U.S. at some point, which is inevitable, would exacerbate its debt woes.  The U.S. may not be Greece, but there are lessons to be learned.  Countries that do not prudently manage their government spending typically experience an unhappy ending.

Without wanting to be unduly alarmist, the U.S. has a problem.  And the saddest part is that nobody in Washington seems willing to do anything about it.  Because entitlement spending represents two-thirds of all government spending, the above situation is not going to be resolved without cutbacks in Social Security, Medicare, Medicaid, veterans’ benefits, and welfare benefits. And that is not going to change under this president.  Any effort to reign in government spending is years down the road.

Stephen D. Slifer


Charleston, S.C.

Consumer Finances in Good Shape

February 16, 2018

The Federal Reserve Bank of New York recently released its quarterly report on household debt and credit.  It noted that household debt balances increased last year and are at a record high level.  That is an eye-catching headline and is factually correct.  However, it is grossly misleading.  By any metric consumers can easily afford this higher level of debt.  Debt in relation to income is far below its historical average.  Stock market gains and rising home prices in recent years have boosted consumer net worth.  And delinquency rates on consumer debt are the lowest they have been in a decade.

The New York Fed report accurately noted that consumer debt outstanding climbed last year to a record high level.

This debt is highly concentrated.  Mortgage loans are by far the biggest category and account for $8.9 trillion – or almost 70% — of $13.1 trillion of consumer debt outstanding.

Rather than focus on the amount of debt outstanding it is more appropriate to focus on its growth rate which last year was 4.5%, only marginally faster than in other recent years.  Consumers have not suddenly become spendthrifts.  Can consumers afford this higher, record amount of debt?  Absolutely!

The New York Fed does not point out that while consumer indebtedness has been climbing, steady job gains have also boosted consumer income.  As a result, debt in relation to income remains quite low.  The financial obligations ratio shown below measures consumer payments on mortgage and consumer loans, auto lease payments, rent, homeowners’ insurance, and property taxes in relation to income.  That ratio has been gradually rising for the past two years but, at 15.9%, it is not only below its long-term average of 16.5%, it is essentially where it was back in the mid-1990’s.  It will take several years for this ratio to return to its trendline, and even longer for it to reach an uncomfortable level.

Furthermore, the stock market has been on a steady uptrend since the recession ended in June 2009.  Stock market gains combined with rising home prices have boosted consumer net worth for the past eight years.   It is currently climbing at an 8.0% pace.  As a result, consumers feel good about their financial position and are more willing to spend a bit more freely.

Some economists have noted that the savings rate has fallen to a historically low level of 2.4% which is far below the 5.5% average rate for the past 15 years.  They further suggest that consumers will have to cut back their spending in the months ahead to boost savings.  We disagree.  Given what has been happening to their net worth, consumers do not have a compelling need to save as much of their paycheck as in the past.  That is certainly an understandable reaction.  Remember, the consumer is not dipping into savings.  Rather, he or she is simply saving 2.4% of their paycheck today rather than tucking away the more normal portion of 5.5%.  Note, too, that prior to the most recent recession the savings rate stayed at a comparable level for about three years before the economy finally slipped into recession.  A low savings rate is not a harbinger of slower growth any time soon.

The real proof of the pudding is in delinquency rates.  The percent of consumer loans 90 days or more delinquent has been steadily falling since the recession ended and is now at its lowest level in a decade.

As shown below, delinquency rates have been falling for all types of consumer debt, mortgages and credit cards in particular.

As an aside, whenever the discussion turns to delinquency rates on consumer debt, student loans quickly come to mind.  Two points are worth noting.  First the growth rate of student loans has been steadily slowing from a 15% pace shortly after the end of the recession to about 5.0% currently.  Second, as shown in red on the chart above, the delinquency rate on student debt, while high at 11.0%, has not changed in the past five years.

The important point to note is that consumer debt continues to climb, but steadily rising consumer income and net worth ensure that this higher level of debt is affordable.  There is nothing in the consumer’s financial position today that should warrant concern.

Stephen Slifer


Charleston, S.C.