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Inflation update


On a year-over-year basis, inflation according to the Personal Consumption Deflator remains within the Fed's target range.



On a shorter time frame, however, the pace of inflation is picking up. Over the past six months, the headline PCE deflator is up at a 3.4% annualized rate, and the Core PCE deflator over the past three months is up at a 1.9% annualized rate. The fact that both headline (total) and core inflation (ex-food and energy) are rising at a faster rate at the same time is consistent with the fact that the Fed is indeed in an accommodative mode, and willing (and wanting) to let all prices rise. They are getting their wish, which is not surprising. The rise in measured inflation is still relatively tame, however, but it will be very important to see how this unfolds in coming months.


This last chart shows the major sub-components of the PCE Deflator (services, durables, and non-durables). Since 1995, headline inflation has been subdued by a previously-unprecedented decline in durable goods prices (i.e., this is the first time in the history of this series that the blue line has declined on a sustained basis). It is probably not a coincidence that 1995 marked the first year in which China pegged its currency to the dollar (thus stabilizing and eventually strengthening it), which in turn set the foundation for strong export-led growth. This chart also helps explain why there is so much confusion over whether we should worry about inflation or deflation, since there is evidence of both.

The chart also tells a very interesting story. Since 1995, service sector prices have risen by 55%, while durable goods prices have fallen by 26%, for a 110% relative price change (this is roughly equivalent to saying that one hour's worth of work in the service sector today buys twice as much in the way of durable goods as it did in 1995). To the degree that China's exports of durable goods have contributed to this relative price shift, it is a testament to how the increased productivity of the Chinese workforce has resulted in a significant rise in living standards for workers in the industrialized world. Contrary to what uninformed critics say, global trade is a win-win situation for all concerned.

Putting the claims number in perspective


I wasn't going to post on this subject today, but then I saw comments to the effect that today's jobless claims numbers were "ugly." I think it's hard to look at this chart and find anything ugly about it. To be sure, claims have ticked up in recent weeks, but that sort of volatility comes with the territory. Plus, nonseasonally claims (actual claims) have been flat for the past two months; the seasonally adjusted number has risen because actual claims haven't fallen as they typically do at this time of the year. The "ugliness" of the jobs numbers could be simply a seasonal adjustment artifact.


And consider this chart: the number of people receiving unemployment insurance has been steadily decreasing all year. Continuing claims for unemployment have in fact declined by slightly more than 1 million year to date. Undoubtedly, some of those people are now without jobs and without insurance, but it's equally true that even more are now likely working. After all, payrolls have been increasing for over a year.

The jobs market is slowly improving; while it may be disappointingly slow progress, it is far from ugly.

Deflation is dead


With today's release of first-quarter GDP, we see that the GDP deflator, the broadest measure of inflation available, has clearly turned up. Deflation risk was palpable in 2009, as the deflator neared zero, but it's now history. Deflation is dead, and the only uncertainty about the outlook for inflation is how high it will be in coming years.

With the death of deflation risk, the outlook for equities and corporate bonds has brightened. Deflation means shrinking cash flows and shortages of money, and both of those are bad for equity and corporate bond holders. Eliminating that risk increases the expected returns from future cash flows, even if the growth of those future cash flows might seem otherwise unimpressive.

What this recovery has taught us


This chart compares the long-term trend growth of real GDP to actual GDP, with today's Q1/11 GDP release included. What jumps out from the chart is the fact that the economy's level of output has been about 10% below its long-term "potential" output for more than two years. This is the biggest growth shortfall since the Depression, and it has persisted for more than two years despite unprecedented levels of fiscal and monetary stimulus.

Die-hard Keynesians are still unwilling to accept that stimulus has failed, and some, like Paul Krugman, still argue that the problem was that the stimulus wasn't big enough. But as I predicted in a post in January 2009, the fiscal stimulus package championed by Obama and the Democrats would prove to be a significant drag on growth, and I think the evidence now supports my prediction. You can't create growth out of thin air, or by transferring money from one person to another by government fiat. When government commandeers a big chunk of the economy's resources, as it did beginning two years ago, those resources end up being spent in a much less efficient fashion than if they had been left in the private sector. The result is slower growth. We're in a recovery, but it's a very slow recovery because government is smothering the economy.

Morever, with trillion-dollar deficits staring us in the face for as far as the eye can see, market participants, workers, and business owners can't help but fear an eventual and substantial rise in future tax burdens. Just the possibility that future tax burdens could rise meaningfully is enough to reduce the discounted, after-tax, present value of future cash flows, and to discourage, on the margin, new investments.

Monetary policy is also culpable. By adopting an unprecedented quantitative easing program, and promising repeatedly to keep short-term rates very low for an extended period, the Fed has introduced a significant amount of monetary uncertainty into the financial markets and the economy. Inflation expectations are rising, and the dollar has fallen to all-time lows, as capital decides that the U.S. economy is not a very attractive place to be. Treasury yields are still very low, despite our massive budget deficit, because an excess of spending is depressing the economy and depressing the expected returns on alternative investments.

So the lesson from this tepid recovery is that the more government tries to "stimulate" the economy, the worse things will be. If Washington and the American people can take this lesson to heart, then the pain and suffering of this slow-growth recovery will not have been in vain. This could end up being the best thing to have happened for the economic outlook since the early 1980s.

Bernanke and the dollar

In his first-ever press conference today following the FOMC meeting, Fed Chairman Bernanke mentioned the dollar quite a few times. You might think that would be a natural, coming from the head of the institution that has direct control over the supply of dollars to the world, and by extension the dollar's value. But in fact, the Fed rarely addresses the issue of the dollar's value in the context of the things it watches or tries to target.

So it was somewhat refreshing that today Bernanke joined with Geithner and Treasury Secretaries of the past in saying that a strong and stable dollar was in the interests of both the U.S. and the global economy. Unfortunately, he qualified that by adding that he thought the dollar's recent weakness was another one of those transitory things (like rising headline inflation and weak first quarter growth) that should reverse in the medium term. He's not targeting the dollar directly, in other words, believing instead that the dollar will find support and prove strong and stable over the long run if the Fed is successful at containing inflation and boosting the economy.

It's all too tautological for me, and for the markets, I suspect. Yes, if the Fed is successful in defending the dollar's purchasing power over time, then the dollar should find market support and its value should be relatively strong and stable. But just how are we going to get a stronger dollar tomorrow by weakening the dollar today?

As I've pointed out, the Fed has yet to commit any gross monetary error, since there is no sign of any unusual growth in the M2 money supply. But even though M2 is only growing at a a 6% rate, the decline in the dollar's value against other currencies and gold is prima facie evidence that the Fed is supplying more dollars to the world than the world is demanding. It's clear that monetary policy is accommodative, and that means the Fed is setting interest rates artificially low in order to create an over-supply of dollars, and an over-supply of dollars means the dollar's value has to decline.

This is what is troubling the world. How can we be sure that the Fed will be able to pull off the trick of weakening the dollar today in order to strengthen it tomorrow? A weaker dollar risks letting the inflation genie out of the bottle, and we know it's very hard to put back in once that happens. There is little or no theoretical or logical support for the idea that a weaker currency creates a stronger economy. Bernanke is saying the right things, but he is also asking us to trust him an awful lot. The world would feel much better if he were more specific. Holding press conferences is a good way to make the Fed more transparent, but unless there is substance (i.e., rules and/or objective measures that guide policy) behind the words, then fear, uncertainty and doubt will erode confidence in the dollar and that will exacerbate inflationary pressures. Less demand for dollars contributes to an over-supply of dollars the same way an increased supply does. In the end it's a negative feedback loop that threatens us all.


So it was not surprising to see the dollar decline in the wake of today's FOMC meeting (9:30 am Pacific Time on the chart above) and throughout Bernanke's testimony, and it was not surprising to see gold prices rise (see below). In nominal and real terms against a broad basket of currencies, the dollar is now at a new all-time low. In nominal terms gold is at a new all-time high, but in real terms it is still about one-third below the highs it (very) briefly reached in early 1980.


Ben "Trust Me" Bernanke may well pull off the greatest balancing act in history when all is said and done, but I have to believe there is an easier and more direct way to achieve a strong and stable dollar, which is ultimately the only way to enjoy low and stable inflation and a strong economy.

Capital goods orders take a breather


New orders for capital goods rose by a strong 3.7% in March, and February orders were revised upwards by 2% (upward revisions of past data have become quite common in this series over the past year), but that wasn't enough to offset the big decline in January orders. Thus the annualized growth rate of this series over the past 6 months has slipped to 4.8%, down from the heady 20+% pace of last year's third quarter. The 3-mo. moving average (shown here) also reflects this slowdown. Still, capex orders have surged 25% in the past two years, and that is pretty impressive by any standard. Whether the recent slowdown/slump is anything more than payback for the unprecedented growth spurt of last year remains to be seen, but that would be my guess at this point.

Geithner's cognitive dissonance



Treasury Secretary Tim Geithner today said that "a strong dollar is in our interest as a country," even as the dollar plumbed new, all-time, nominal and real lows against a large basket of other currencies.

We can only hope that this week's FOMC meeting will find our Fed governors less clueless about the reality of what is happening to the dollar. The dollar has never, ever, been so weak, and it's no coincidence that U.S. monetary policy has never been so expansive and so fraught with uncertainty.

The seventh fatal flaw of ObamaCare

This post from last November summarizes six fatal flaws of ObamaCare, and I have related comments here. Yesterday the WSJ ran an article by Daniel Kessler, "How Health Reform Punishes Work," which exposes a fatal flaw that I had not fully appreciated before: the devastating impact of government healthcare subsidies on effective marginal tax rates for the middle class. Some excerpts:

The health law establishes insurance exchanges—regulated marketplaces in which individuals and small businesses can shop for coverage—and minimum standards for the insurance policies that can be offered. Because the policies will be so costly, there's a subsidy for buyers that phases out as family income rises. This sounds reasonable—but the subsidies required to make a "qualifying" insurance policy affordable are so large that their phaseout creates chaos.
Starting in 2014, subsidies will be available to families with incomes between 134% and 400% of the federal poverty line. For example, a family of four headed by a 55-year-old earning $31,389 in 2014 dollars (134% of the federal poverty line) in a high-cost area will get a subsidy of $22,740. A similar family earning $93,699 (400% of poverty) gets a subsidy of $14,799. But a family earning $1 more—$93,700—gets no subsidy.
Consider a wife in a family with $90,000 in income. If she were to earn an additional $3,700, her family would lose the insurance subsidy and be more than $10,000 poorer.
To phase out the subsidy smoothly for families with incomes of 134% to 400% of poverty, the law would have to take away $22,700 in subsidies as a family's income rose to $93,700 from $31,389. In other words, for every dollar earned in this income range, a family's subsidy would have to decline by 36 cents. On top of 25% federal income taxes, 5% state income taxes, and 15% Social Security taxes, this implies a reward to work of less than 20 cents on the dollar—in economists' language, an implicit marginal tax rate of over 80%.

In other words, the existence of sizable subsidies would create extremely high marginal tax rates for a large number of people. Many families could find themselves in a situation where working more or getting a pay raise would actually (and significantly) reduce their take-home pay. This would be not only damaging to the economy and our living standards, but unacceptable from the point of view of simple logic and basic notions of fairness. It's a trap, not a subsidy. Memo to starry-eyed liberals: subsidies may sound like a great way to redistribute income, but they bring with them a host of unintended, perverse, and outrageous consequences.

Real estate update -- more and more attractive


This chart shows two different measures of housing prices, as calculated by the folks at Case Shiller and Radar Logic. Both are showing some softness in pricing in recent months (but they both report prices 2-3 months after the fact), and this appears to be raising concerns in the market about whether housing is entering a new downturn. I'm not as worried about that as I am impressed by how similar the two indices are, by how relatively stable they have been for the past two years, and by the fact that both show the housing price bust to have been of roughly the same magnitude (Case Shiller -31%, Radar Logic -36%).


Let's stipulate, based on this information, that housing prices in major markets across the U.S. have fallen by one-third from the high they reached in 2006. In real terms, that works out to approximately a 40% decline, as shown in the next chart. Over the same period, disposable personal income has risen by about 15%, and 30-yr fixed mortgage rates have fallen from 6.5% to 4.8%. Do the math however you want, that adds up to a gigantic decline in the cost for the average family of buying a home (available measures of housing affordability show that homes have never been so cheap). Maybe housing prices are going to fall another 10%, who knows? But prices have already fallen by several orders of magnitude, and another 10% is not going to make much of a difference in the long run, especially if the Fed succeeds in reflating the economy. A sustained rise in inflation, coupled with what could easily be a housing shortage (given the extremely low level of new home construction relative to new housing formations) could translate into hefty gains for housing prices over the next 5-10 years.


This last chart compares the Case Shiller measure of home prices to Moody's Commercial Property Index. According to this latter measure, commercial real estate has suffered an even greater decline (-45%) than housing prices, with commercial property values having erased all the gains of the past decade. Maybe prices will slip a bit further before this is all over, but there's no denying that there has been a humongous price adjustment. Surely the lion's share of the downward price action is now water under the bridge.

What strikes me most about the action in the real estate market is that it is the opposite of the action in the gold and commodities market, yet real estate, gold, and commodities are all classic inflation hedges. If inflation is heating up and the Fed has trouble reining it in, I have to believe that a rising inflation tide would provide strong support for all tangible asset prices, especially real estate. Of all the things available to an investor who is worried about inflation, commercial real estate looks like the cheapest inflation hedge out there.

Full disclosure: I am long VNQ and a few miscellaneous REITs at the time of this writing.

Confidence improves, but still very low


Consumer confidence picked up a bit in April, according to the Conference Board's survey, but as this chart reminds us, confidence is still quite low from an historical perspective. Consumer confidence is not a leading, but rather a lagging indicator, so the value of this information is rather limited. But it does underscore the points I've been making for a long time, namely that there is no shortage of pessimism out there, no shortage of things to worry about, and it's difficult to find any signs of "irrational exuberance" in market pricing. The market, like the public in general, is still climbing walls of worry. This gives the edge to bulls, as long as the economy avoids significant deterioration. 

Gold and commodities update


As this chart shows, gold has a tendency to lead the price action in commodities. This in turn suggests that there is a monetary common denominator that is at work behind the scenes. Many—including the Fed—argue that commodity prices are rising solely because of strong demand in emerging market economies that has outstripped supply, but that doesn't explain why demand for gold should have arisen first, and so strongly. Nor does it explain why the prices of hundreds of commodities should be moving together, nor why thousands of commodity producers should have been outfoxed by demand all at the same time. Then there is the coincidence that gold and commodities started to rally in 2001, which just happened to be when the Fed started easing in earnest, after having pursued a very tight policy for the previous 5-6 years. And let's not forget that the dollar peaked in early 2002, and has been trending down ever since.