Saturday, 19 of August of 2017

Economics. Explained.  

Category » NumberNomics Notes

Dampening Expectations

August 18, 2017

The economy is chugging along nicely.  But non-economic events like the North Korean crisis and Charlottesville, and disquieting tweets from President Trump, are causing business leaders and politicians to wonder if he can accomplish his political agenda.  If it ever becomes clear that tax cuts are not going to happen, the stock market is going to pull back sharply.  Investment spending will be curtailed, and GDP forecasts will be trimmed.  Rather than having a legitimate hope that GDP growth could quicken from its current 2.0% pace to 2.8% or so by the end of the decade, forecasts would revert to the same slow growth rate we have seen for the past several years.

GDP growth was 1.2% in the first quarter and 2.6% in the second.  Third quarter growth is likely to be about 3.0%.  Consumer spending is holding steady at about 2.5%.  What gives us hope for faster growth ahead is the fact that investment spending surged in the first half of this year.  Nonresidential investment jumped 7.0% in the first quarter followed by 5.1% growth in the second quarter and is on track for a 4.0% increase in the third quarter.  Keep in mind that business spending was largely unchanged in 2015 and 2016.

There can be little doubt that this acceleration is due in large part to President Trump.  He came into office advocating significant health care reform, lower individual and corporate income taxes, relief from a stifling regulatory environment, and an opportunity for business leaders to repatriate overseas earnings at a favorable tax rate.  That is a very pro-business agenda.  It would enhance corporate earnings, boost growth in productivity, and trigger faster GDP growth both near-term and in the years beyond.

In response to Trump’s proposed agenda the stock market climbed 18% between the election and mid-August.  The dollar jumped 4.0%.  Both domestic and foreign investors were encouraged.  But now all are beginning to question Trump’s ability to actually implement his agenda.  He promised to quickly repeal and replace Obamacare.  That did not happen.

His steady diet of disturbing tweets is bringing further into question his ability to pass his agenda.  For example, his extraordinary warning that any further threats by North Korea against the United States would result in “fire and fury like the world has never seen” brought the U.S. the closest it has been to a nuclear confrontation since the Cuban missile crisis in the 1960’s.  Those statements were scary and drew widespread criticism.  However, they sent a strong signal to both North Korea and China that the U.S. treated those threats seriously.  For now Kim Jong-Un has backed off his threat to fire missiles at Guam and said instead that he wanted to monitor the “reckless Yankees” but left open the door for a strike later.  While the crisis is far from over it has abated for now.

Following the attack in Charlottesville Trump initially said, “We condemn in the strongest possible terms this egregious display of hatred, bigotry and violence on many sides”.  That seemed to suggest that both groups were at fault.  A day later he said “Racism is evil.  And those who cause violence in its name are criminals and thugs, including the KKK, neo-Nazis, white supremacists and other hate groups that are repugnant to everything we hold dear as Americans.”   A day later he recanted that statement and said “I think there is blame on both sides.”  His unwillingness to explicitly and consistently attribute blame to the far-right extremists has cost him the support of many business leaders as one after another chose to resign from his business councils and he was eventually forced to dissolve them.  Republican leaders like John McCain, Lindsey Graham, and Marco Rubio strongly denounced his comments.

What does all of this mean from an economic viewpoint?  It suggests that both U.S. and foreign investors are becoming increasingly nervous and concerned that Trump will be unable to accomplish what he had hoped to do.  The dollar rose sharply between the time of the election and the end of January.  It has since fallen 6.5%.  Earlier this year the Euro cost $1.06.  Today it costs $1.18.  Earlier this year one U.S. dollar bought 115 yen.  Today it purchases 110 yen.  Admittedly, not all of the drop can be attributed to a lack of faith in President Trump.  In the past several months GDP growth in Europe and Asia has gathered some momentum which enhanced the desire by foreign investors to pull back from dollar-denominated investments.

The S&P 500 index rose 18% from the time of the election through mid-August, but it has contracted by 2% in the past few days.  That is another hint that U.S. investors are beginning to question Trump’s ability to achieve tax cuts and health care reform.  We share that concern but are unwilling to abandon the idea that a diluted version of tax cuts and health care reform will pass at some point.

If it becomes increasingly apparent that Trump will have neither the legislative nor business support to pass his agenda, the markets will make the requisite adjustment.  The stock market will encounter a correction and give back much of its run-up since the election.  Business leaders will experience a renewal of uncertainty and curtail investment spending.  Economists will have to trim their expectations for GDP growth and give up on the notion of a pickup in potential growth to 2.8% by the end of the decade.  GDP forecasts will, instead, revert to the 2.0% mark for the foreseeable future with little hope of breaking out of the slump.  Let’s hope we do not have to go there.

Stephen Slifer


Charleston, S.C.

Consumer Sentiment

August 18, 2017

Consumer sentiment for August jumped 4.2 points to 97.6 after having fallen 1.7 points in July. The resurgence in sentiment in August was entirely attributable to an increase in the expectations component.  The 98.5 reading for sentiment in January was the highest level of confidence thus far in the business cycle.

Richard Curtin, the chief economist for the Surveys of Consumers, said “Too few interviews were conducted following Charlottesville to assess how much it will weaken consumers’ economic assessments. The fallout is likely to reverse the improvement in economic expectations recorded across all political affiliations in early August. Moreover, the Charlottesville aftermath is more likely to weaken the economic expectations of Republicans, since prospects for Trump’s economic policy agenda have diminished.”

Based in part on the expectation of major changes in policy likely to be implemented eventually, we expect GDP growth for 2017 to be 2.3% and 2.8% in 2018.  We expect the economic speed limit to be raised from 1.8% to 2.8% within a few years.  That will accelerate growth in our standard of living.We expect worker compensation to increase 4.0% in 2017 vs. 3.0% last year. The core inflation rate should be reasonably steady this year at 1.9% thanks to a price war in the cell phone industry and falling prescription good prices caused by intimidation from President Trump.   However prices should rise by 2.5% in 2018.  Such a scenario would keep the Fed on track for the very gradual increases in interest rates that it has noted previously.  Specifically, we expect the funds rate to be 1.25% by the end of 2017 and 2.0% by the end of 2018.

The increase in sentiment was evident in both the current conditions and expectations components.

Consumer expectations for six months from now declined from 80.5 to 89.0.

Consumers’ assessment of current conditions rose  in August deteriorated from  113.4 to 111.0 .

Trends in the Conference Board measure of consumer confidence and the University of Michigan series on sentiment move in tandem, but there are often month-to-month fluctuations.  Both series remain at levels that are consistent with steady growth in consumer spending at a reasonable clip of  about 2.5% in the quarters ahead.

Stephen Slifer


Charleston, SC

Industrial Production

August 17, 2017

Industrial production rose 0.2% in July after having risen 0.4% in June.  Over the past year this series has risen 2.2% and is clearly on the upswing.  The year-over-year increase in the largest since January 2015 — 2-1/2 years ago.  The monthly gains sometimes seem disappointing, but the reality is that production is gradually picking up but the quickening, thus far, has been largely associated with oil well drilling.

Breaking industrial production down into its three major sub-components,  the Fed indicated that manufacturing production (which represents 75% of the index) declined 0.1% in July after having risen 0.2% in June. During the past year  factory output has risen 1.2% (red line, right scale).  It has clearly hit bottom.

The manufacturing category has been dragged down by recent cuts in the production of motor vehicles.  Manufacturing production ex motor vehicles has risen 1.7% in the past year.  Thus, factory output has been climbing, but its rate of increase has been curtailed by the recent slowdown in the sales and production of motor vehicles.

Mining (14%) output rose 0.5% in July after having risen 2.0% in June.   Over the past year mining output has risen 10.2%.  Most of the recent upturn in mining has been concentrated in oil and gas drilling activity  which declined 0.9% in July after having risen 6.8% in June.  The July drop follows gains in each of the previous thirteen months.  Over the course of the past year oil and gas well drilling has risen 100.3%.  The number of  oil rigs in operation continues to climb.

Utilities output  rose 1.6% in July after having declined 1.2% in June.  During the past year utility output has fallen 0.6%.

Production of high tech equipment declined 0.1% in after having fallen 0.4% in June.  Over the past year high tech has risen 3.2%.   The high tech sector sector appears to have gathered some momentum during the past several months. This may be an early indication that the long slide in nonresidential investment may be coming to an end which would, in turn, signal some upturn in productivity growth.

Capacity utilization in the manufacturing sector declined 0.1% in July to 75.4% after having risen 0.1% in June.  It is still below the 77.5% that is generally regarded as effective peak capacity.

Stephen Slifer


Charleston, SC

Initial Unemployment Claims

August 17, 2017

Initial unemployment claims declined 12 thousand in the week ending August 12 to 232 thousand.  Because these weekly data can be volatile the focus should be on the 4-week moving average of claims (shown above), which is a less volatile measure.  It was unchanged at 241 thousand.  The late February average of 234 thousand was the lowest level for this series since April 14, 1973 — 44 years ago!  It is holding very close to that 44 year low.

Ordinarily, with initial unemployment claims (the red line on the chart below, using the inverted scale on the right) at 241 thousand  we would expect monthly  payroll employment gains to exceed 300 thousand.  However, employers today are having difficulty finding qualified workers.  As a result, job gains are significantly smaller than this long-term relationship suggests and are currently about 170 thousand.

With the economy essentially at full employment, employers will have steadily increasing difficulty getting the number of workers that they need.  As a result, they will be forced to offer some of their part time workers full time positions.  This series is still a bit high relative to where it was going into the recession.

They will also have to think about hiring  some of our youth (ages 16-24 years) .  But the youth unemployment rate today is the lowest it has been in 17 years so there are not many younger workers available for hire.

Finally, employers may also consider some workers who have been unemployed for an extended period of time.  But these workers do not seem to have the skills necessary for today’s work place.  Employers may have to offer some on-the-job training programs for  those whose skills may have gotten a bit rusty.  But even if they do, the reality is that the number of discouraged workers today is quite low — toughly in line with where it was going into the recession.

The number of people receiving unemployment benefits fell 3 thousand in the week ending August 5 to 1,953 thousand.  The four week moving average declined 6 thousand to 1,960 thousand. In mid-May the 4-week average came in 1,916 which was the lowest level for this 4-week average since January 12, 1974 when it was 1,881.   The only way the unemployment rate can decline is if actual GDP growth exceeds potential.  Right now the economy is climbing by about 2.0%; potential growth is  projected to be about 1.8%.  Thus, going forward  the unemployment rate will continue to decline quite slowly.

Stephen Slifer


Charleston, SC

Gasoline Prices

August 16, 2017

Gasoline prices at the retail level were unchanged in the week ending August 14 at $2.38 per gallon.   In the low country of South Carolina gasoline prices tend to about $0.25 below the national average or about $2.13. The Department of Energy expects national gasoline prices to average $2.33 this year — almost exactly where they are currently.

As the price of gasoline declined the economy got a tailwind. However,  oil prices today are 10.0% higher today than they were a year ago.  Hence, the tailwind effect on the economy has run its course but has not yet turned into a significant headwind.

Crude oil prices are currently about $47.00 mark.  The Energy Information Agency predicts that crude prices will average $48.88 in 2017.  As crude oil and gas prices have leveled off the underlying inflationary pressures have become more apparent although currently there is less upward pressure on the inflation rate than what most economists, us included, had expected.

The number of oil rigs in service dropped 79% to 404 thousand  after reaching a peak of 1,931 wells in September 2014.  However, the number of rigs in operation has actually rebounded in recent months to 949 thousand.  Thus,  higher crude oil prices are encouraging some drillers to step up slightly the pace of production.

While the number of oil rigs in production has been cut by 79% between late 2015 and the middle of last year, oil production has declined much less than that.  Since that time the rebound in oil prices has encouraged oil firms to step up the pace of production and at 9,502 million barrels it is now only about 1% lower than its June 2015 peak pace of production which was 9,610 thousand barrels.  We should match that record pace of production by early next year.  The Department of Energy expects production to average 9.3 million barrels per day in 2017 and 9.9 million barrels next year.

How can the number of rigs go down but production be relatively steady?  Easy.  Technology in the oil sector is increasing rapidly which allows producers to boost production while simultaneously shutting down wells.  For example, output per oil rig has increased by 27% in the past twelve months.  Put another way, a year ago some frackers could not drill profitably unless crude oil prices were about $70 per barrel.  Today that number has declined to about about $44 per barrel.  Six months from now that number will be lower still.

While oil inventories gradually declined for most of 2016 the increase in production earlier this year caused inventory levels to climb to a record high level in February.  Since that time inventory levels have been steadily shrinking.  We know that OPEC output has been reduced, but its cutback has been partially offset by a significant pickup in U.S. production.  More import is strong demand.  We are seeing a quickening of GDP growth not only in the U.S. but around the world.  Oil stocks have been falling steadily, but they remain far above their five year average.

Stephen Slifer


Charleston, SC

Housing Starts

August 16, 2017

Housing starts fell 4.8% in July to 1,155 thousand after having jumped 7.4% in June. Because these data are particularly volatile on a month-to-month basis, it is best to look at a 3-month moving average of starts (which is the series shown in blue above).   That 3-month average now stands at 1,166 thousand which has fallen off from the 1,264 thousand peak pace in the cycle which was registered back in February.    So what is happening?  Is it a drop in demand?  Or a constraint on the part of builders?  We  believe it is the latter.

Both new and existing home sales continue to climb.   Thus, the demand for housing remains robust.

Builders remain enthusiastic in part because they see traffic through the model homes quite steady at a rapid rate.

Mortgage rates are at 3.9% which is quite low by any historical standard.

At the same time employment gains are about 170 thousand per month which is boosting income.  As a result, real disposable income (what is left after inflation and taxes) is growing at a 1.2% pace.  That is not particularly robust, but disposable income does hit slack periods from time to time and then rebounds.

Housing remains affordable for the median-price home buyer.  Mortgage rates may have risen, but income has been rising almost as quickly, hence affordability has not dropped much.  At 153.0 the index  indicates that a median-income buyer has 53.0% more income than is necessary to purchase a median-priced house.

The problem in housing is not a lack of demand.  Rather it is a constraint on the production side.  Builders have had difficulty finding an adequate supply of skilled labor.  Construction employment is growing by about 15 thousand per month.  Slow, but steady.

As one might expect there is a tight correlation between home builder confidence and the starts data which probably makes a great deal of sense.   Judging by the homebuilder confidence data we should expect starts to eventually climb to 1.5 million or so from about 1.2 million currently.  However,  as noted above, many home builders  report an inability to get the skilled workers they require.   Overcoming the labor shortage on a long-term basis will be challenging.  Employment in the construction industry will continue to climb, but slowly, which will limit the speed with which starts rise in the months ahead.

Another thing worth noting is that about 1.3 million new households are being formed every year.  Those families all need a place to live, either a single-family home or an apartment.  Thus, we need to see housing starts rise by 1.3 million just to keep pace with growth in households.  And because housing starts were substantially below the growth in households for so long, there is pent-up demand.  We expect starts to reach 1.2 million by the end of 2017 and 1.4 million in 2018.

What is interesting is that beginning late last year single family starts have begun to climb while multi-family buildings such as apartments have been slowing down.  It appears that many of the millennials who chose to rent for the last decade are getting older, perhaps starting families, and are now choosing to purchase a single family house.  In the past year single family starts have risen 10.4% while multi-family units have declined by 22.3%.

As a result, multi-family construction as a percent of the total has slipped from 36.2% in July of last year to 27.2%.

Building permits declined 4.1% in July to 1,223 thousand after having jumped 9.2% in July.  Because  permits are another volatile  indicator it is best to look at a 3-month average (which is shown below).  That 3-month moving average now stands at 1,222 thousand which continues to point towards slow but steady improvement in housing.   The reason people look at permits is because a builder must first attain a permit before beginning construction.  Thus, it is a leading indicator of what is likely to happen to starts several months down the road.  If permits are currently at 1,222 thousand, housing starts will gradually approach the 1.3 million mark.

Stephen Slifer

Charleston, SC

Homebuilder Confidence

August 15, 2017

Homebuilder confidence jumped 4 points in August to 68 after having declined 2 points in July.  Confidence is bouncing around from month to month at a very high level.    Clearly, builders believe that the housing market will perform well in 2017.

“Our members are encouraged by rising demand in the new-home market,” said NAHB Chairman Granger MacDonald, a home builder and developer from Kerrville, Texas. “This is due to ongoing job and economic growth, attractive mortgage rates, and growing consumer confidence.”

NAHB Chief Economist Robert Dietz said  “Builders continue to face supply-side challenges, such as lot and labor shortages and rising building material costs.”

Traffic through the model homes edged higher by 1 point in July to 49 after having declined by 1 points in July.  The March reading of 53 was the highest reading thus far in the business cycle.

Not surprisingly there is a close correlation between builder confidence and housing starts.  Right now starts are lagging considerably because builders are having some difficulty finding financing, building materials, an adequate supply of finished lots, and skilled labor.  Starts  currently are at a 1.2 million pace.  They should continue to climb gradually in the months ahead and reach 1.4 million by the end of 2017.

Stephen Slifer


Charleston, SC

Retail Sales

August 15, 2017

Retail sales jumped a larger-than-expected 0.6% in July plus there were upward revisions to the two previous months.  June sales revised upwards from a decline of 0.2% to an increase of 0.3% and May revised upwards from a decline of 0.1% to no change.  During the course of the past year sales have risen a solid 4.2%.  Earlier data suggested that consumer spending had hit a soft spot, but that apparent slowdown just got revised away with the upward revisions to May and June and a strong pace in July.

Sometimes sales can be distorted by changes in autos which tend to be quite volatile.  In this particular instance the unit selling rate for car sales slipped during May and June abut rose slightly in July.  Clearly, this component has had a rough couple of months.

Fluctuations in gasoline prices can also distort the underlying pace of retail sales.  If gas prices rise, consumer spending on gasoline can increase even if the amount of gasoline purchased does not change.  Gasoline sales declined 0.4% in July after having dropped 1.5% in June.

Perhaps the best indicator of the trend in sales is retail sales excluding the volatile motor vehicles and gasoline categories.  Such sales rose 0.5% in July after having climbed by 0.3% in June.   In the last year retail sales excluding cars and gasoline have risen 4.0%.  No slowdown evident from looking at these sales data.

While there has been a lot of disappointment about earnings in the traditional brick and mortar establishments (like Macy’s, Sears, K-Mart, and Limited) the reality is that they need to develop a better business model.  The action these days is in non-store sales which have been growing rapidly. Consumers like the ease of purchasing items on line.  While sales at traditional brick and mortar general merchandise sales have risen 1.9% in the past year, on-line sales have risen a steamy 11.2%.  As a result, their share of total sales has been rising steadily and now stands at 11.0% of all retail sales.  That percentage has risen from 10.3% at this time last year.

We do not believe the recent softness in retail sales represents a change in trend for a variety of reasons.  First of all,  existing home sales are selling at the fastest rate thus far in the cycle.  Consumers do not purchase homes and cars — the two biggest ticket items in their budget — unless they are feeling confident about their job and the future pace of economic activity.  If home sales are holding up well, car sales should  rebound in the months ahead.  As noted earlier, car sales are a particularly volatile category.

Second, the stock market is at a record high level.  That increase in stock prices boosts consumer net worth.

Third, all measures of consumer confidence are close to their highest level thus far in the business cycle.

Fourth, cuts in individual income tax rates are likely later this  year or in 2018.

Finally, the economy is cranking out 170 new jobs every month which boosts consumer income.  Consumers have paid down a ton of debt and debt to income ratios are the lowest they have been in 20 years.  That means that consumers have the ability to spend more freely and boost their debt levels if they so choose.

Thus, the pace of consumer spending seems steady.  We continue to expect GDP growth to quicken to 2.3% in 2017 and 2.8% next year.

Stephen Slifer


Charleston, SC

War Talk – Real?  Or Rhetoric?

August 11, 2017

This is an economics column and for the most part we shy away from political events — unless they are likely to have a significant impact on the U.S. economy.  The threats of war emanating from both Pyongyang and Washington are clearly disturbing and could have dire consequences around the globe.  This is not the same discussion as whether President Trump’s proposed tax cuts, repatriation of earnings, and de-regulation can boost GDP growth by a couple tenths of a percent.  Or whether the Fed will continue it glacially slow pace of raising interest rates.  This is about an event that could potentially leave millions of people dead and quickly spread around the globe.  We would be remiss in not discussing the possibility.

We do not expect a war outcome.  Our sense is that there is a lot of political posturing on both sides.  But the reality is we know nothing.  We do not know what is in the heart of either Kim Jong-un or President Trump.  Mr. Kim has been referred to as “a total nut job” by President Trump.  But, then again, our own president has made some rather outrageous statements in the seven months he has been in office and may be viewed similarly by others.  Both men are prone to exaggerated rhetoric.

Mr. Kim took office six years ago at the age of 27 and most people viewed him as an inexperienced leader and thought he would not last long.  They significantly underestimated him.  Now he has nuclear missiles that can strike the United States and he is not going to give them up.  Our view (or perhaps our hope) is that he is willing to contain his nuclear arsenal in exchange for an end to the sanctions that limit North Korea’s ability to trade with the world.  But the quid pro quo  is that the United States and the rest of the world will have to accept the fact that North Korea has nuclear weapons.

Given the current war of words between North Korea and the United States we do not know how we get from where we are to the less threatening outcome described above.  Should the U.S. establish a naval blockade?  Should it perhaps shoot down missiles launched by North Korea? Should it launch a limited strike against nuclear launching missile sites?  What would be the consequences if it chose any of those options?  All of them carry the risk of escalating the crisis into a full blown military confrontation.  Who is going to blink first?  The best hope is that China will intervene and use its influence to get North Korea to halt its nuclear weapons agreement.

The threat by Kim Jong-un to launch four missiles that would fly over Japan and land near Guam by mid-August is impossible to retract without losing face.  President Trump’s threat to respond with “fire and fury like the world has never seen” is equally troublesome.  Such threats cannot be taken lightly give the potential consequences.  Neither side will “win” if nuclear missiles are launched or even in the event of a non-nuclear confrontation.  Large portions of the Korean peninsula – both North and South Korea – will get flattened.  Damage could further spread to Japan, U.S. military bases in the region or even Guam, Hawaii, or Alaska.

What strikes us is the lack of concern around the globe.  The Korean Stock Exchange has declined 4.5% since the beginning of August which strikes us as a rather modest selloff.  South Koreans are apparently so used to living under constant threat from the North that they are not particularly disturbed by the current war of words.

The S&P has dipped only about 1.5% from a record high level earlier this month.

The decline in the Shanghai Composite Index has been largely imperceptible.

We certainly hope these various stock exchanges are correct in their apparent conclusion that the current war of words will, in the end, be nothing more than that.  We share the same conclusion, but are well aware that the downside risk if that view is wrong is enormous.  The downside risk that would occur if Trump cannot pass his tax cuts or is frustrated by his inability to simply the federal regulatory process is minuscule by comparison.  Given the enormous downside risk of war we would suggest that stock investors pare their positions slightly to guard against the possibility of a near-term adverse event.

We are well aware that hope is not a strategy.  Having said that, we hope that President Trump and his advisers as well as world leaders everywhere can find the wisdom to peacefully resolve this crisis.  In the meantime, a somewhat more cautious investment stance is warranted.

Stephen Slifer


Charleston, S.C.

Consumer Price Index

August 11, 2017

The CPI rose 0.1% in July after having been unchanged in June.  During the past year the CPI has risen 1.7%.  The year-over-year increase climbed to 2.8% in February before settling back in the past five months. .  Excluding food and energy the CPI rose 0.1% for the fourth consecutive month.  Over the past year this so-called core rate of inflation has also risen 1.7%.

Food prices rose 0.2% in July after having been unchanged in June.  Food prices have risen 1.1% in the past twelve months.

Energy prices fell 0.1% in July after having declined 1.6% in June.  These prices are always volatile on a month-to-month basis.   Over the past year energy prices have risen 3.4%.  Energy prices should be relatively flat between now and yearend.

Excluding the volatile food and energy components, the so-called “core” CPI rose 0.1% in April, May, June, and July.  The year-over-year increase now stands at 1.7%.  The year-over-year increase in the core CPI had risen to as high as 2.3% in January before retreating.  But a lot of this softening reflects a price war amongst telecommunications firms and thereby distorts the overall run-up.  But that exaggerated price drop appears to have run its course as phone prices have only edged lower in each of the past three months.

The core CPI has also benefited from a sharp slowdown in the rate of increase of prescription drug prices.  That appears to reflect President Trump’s threat to the pharmaceutical industry that he intends to cut the prices of prescription drugs by allowing consumers to purchase such drugs overseas, and by having Medicare negotiate prices directly with the insurance companies.  That caused prescription drug prices to slow markedly late last year and in the first five months of this year.  However, such prices rose 1.0% in June and 1.3% in July.  This downward bias to the CPI stemming from a reduced rate of increase in drug prices also appears to have run its course.

While the CPI, both overall and the core rate, have been very well contained in the first half of this year we believe that as the year progresses the core rate of inflation will have an upward bias  because of what has been happening to both shelter prices and gradually rising labor costs which reflects the tightness in the labor market.

Shelter costs rose 0.1% in July after having risen 0.2% in both May and June.  In the  past year they have climbed 3.2%.  This undoubtedly reflects the shortages of both rental properties and homeowner occupied housing. Indeed, the vacancy rate for rental property is at a 30-year low. This steady rise in the cost of shelter  will continue for some time to come and, unlike monthly blips in food or energy, it is unlikely to reverse itself any time soon.


The Fed’s preferred measure of inflation is not the CPI, but rather the personal consumption expenditures deflator, specifically the PCE deflator excluding the volatile food and energy components which is currently expanding at a 1.5% rate and is poised to head higher.  The Fed has a 2.0% inflation target.  However, going forward we have to watch out for the steady increases in shelter which, as noted above, is being pushed higher by the shortage of both rental properties and homeowner-occupied housing.   Shelter is a long-lasting problem and given its 33% weighting in the CPI it will introduce an upward bias to inflation for some time to come.  We also have to watch rising medical costs and the impact of higher wages triggered by the shortages of available workers in the labor market.

Why the difference between the CPI and the personal consumption expenditures deflator?  The CPI is a pure measure of inflation.  It measures changes in prices of a fixed basket of goods and services each month.

The personal consumption expenditures deflator is a weighted measure of inflation.  If consumers feel less wealthy in some month and decide to purchase inexpensive margarine instead of pricy butter, a weighted measure of inflation will give more weight to the lower priced good and, all other things being unchanged, will actually register a decline in that month.  Thus, what the deflator measures is a combination of both changes in prices and changes in consumer behavior.

As we see it, inflation is a measure of price change (the CPI).  It is not a mixture of price changes and changes in consumer behavior (the PCE deflator).  The core CPI currently is at 1.7%.  However, with the economy growing steadily, rents rising, and the unemployment rate falling, the core inflation rate should pick up during 2017 and rise by 1.8% in 2017 and 2.5% in 2018.  And because the core PCE increases at a rate slightly slower than the core CPI, the core PCE should increase  1.7% in 2017 and  1.9% in 2018.  Both rates are trending higher.

Keep in mind that real short-term interest rates are negative.  With the funds rate today at 1.0% and the year-over-year increase in the CPI at 1.7% the “real” or inflation-adjusted funds rate is negative 0.7%.  Over the past 57 years that “real” rate has averaged about 1.0% which should be regarded as a “neutral” real rate.  Given a likely pickup in GDP growth this year and next and a gradual increase in the inflation rate, we regard a negative real interest rate inappropriate in today’s world.  The Fed should continue to push rates higher.

Stephen Slifer


Charleston, SC