Main menu

Why the recovery continues to be subpar

April Personal Consumption Expenditures were a bit below expectations, but the story remains the same: consumer spending has recovered from the losses of the last recession, but it is growing at a subpar rate and is about 10% below its long-term trend level, as this chart shows.

It's been a subpar recovery, and that shouldn't be surprising. I've been predicting this since early 2009. Fiscal and monetary policy levers supposedly have been set to max stimulus for over two years now, but policymakers never really understood what they were doing.

Monetary "stimulus" that involves very low short-term interest rates and lots of bond purchases can't create growth out of thin air. Pumping money into the economy only makes sense if the economy is desperately in need of money, which was the case in the latter half of 2008. (At the time, the plunge in commodity and gold prices, the surge in the dollar, and soaring swap and credit spreads were key signs of a shortage of money.) Since then, easy money has only served to weaken the dollar, pump up gold and commodity prices, raise inflation expectations, and (finally) push actual inflation higher. Easy money hasn't done anything to strengthen the economy.

Fiscal "stimulus" that involves massive borrowings to fund huge transfer payments, make-work projects, and subsidize state and local budgets also can't create growth out of thin air. Taking money from those making a lot of it (e.g., corporations which have generated record profits) and handing it out to those not doing very much (e.g., by extending unemployment benefits, funding "shovel-ready" projects, and keeping union and public-sector employees on the job) not only can't create new growth, it destroys growth by creating perverse incentives.

Printing money, making money cheap, borrowing to force-feed spending—it's all an exercise in futility and ultimately counterproductive. Growth only comes when money is spent on things which increase the productivity of labor. Our standard of living rises only if our collective efforts result in more output for a given number of hours of work. Government has a dismal record when it comes to making productive investments, because the incentives are not properly aligned; the profit motive is missing. Force-feeding money to the economy only results in more speculative activity, since it's easier to bet on rising gold and commodity prices than it is to risk setting up a new company and hiring new people. Soaring deficits don't create new demand, they only create fears of huge future tax hikes and that dampens animal spirits today.

What has been working to create growth is the inherent dynamism of the U.S. economy, and the tireless efforts of entrepreneurs and workers who strive to improve their lot in life. Businesses have been busy restructuring, laying off nonessential workers, cutting costs, and boosting their profits. The economy has shifted massive amounts of resources from the troubled financial, housing and construction sectors, and into the up-and-coming mining, technology, and manufacturing sectors. The economy is growing despite the best efforts of politicians to create growth. Financial markets have recovered not because the economy is in great shape, but because the economy is much better today than markets feared.

The good news is that the evidence of stimulus failure is plain to see, and the mountain of debt it created is a lasting monument and a lesson to all. Congress has now shifted its efforts 180ยบ: no longer is the debate about how much to spend on stimulus, but how much spending to cut. We really can't continue on the path of the last few years, and that is a great relief. We haven't yet figured out which path to take going forward, but by trial and error someone in Congress or the White House will figure it out. When somebody does, the magic formula will almost surely consist of cuts to wasteful spending and transfer payments, market-based reforms to healthcare, and lower and flatter tax rates coupled with tax-base-broadening reductions in deductions that will truly stimulate growth.

In short, out with the Keynesians, and in with the Supply-Siders.

Why the Fed's inflation targeting is not working

Years ago, in the early 2000s, the Fed told us that its preferred measure of inflation was the Core Personal Consumption deflator (though it also considered the headline PCE deflator important as well), and that its preferred target range for inflation was 1-2%. The chart above shows both the core and the headline versions of the deflator, in addition to the Fed's target range. Note that by either measure, inflation was above target for about five years, in the 2004-2008 period. Note also how volatile inflation has been in the past decade. Inflation has either been above or below its target, and erring by a lot, ever since the 1-2% inflation target was announced. So much for targeting inflation.

Actually, inflation targeting was never a good idea. Since monetary policy acts on the economy with long and variable lags, targeting inflation is akin to driving by looking in the rearview mirror. Similarly, it's akin to piloting a boat: once the boat is turning, it will keep turning for awhile, even if you turn the helm in the other direction. You can't wait for inflation to show up before doing something to prevent it, you have to anticipate where inflation is going and adjust policy proactively.

The Fed hasn't been acting proactively, they've been reacting, and that's one reason inflation has been so volatile. A reactive Fed undermines the value of the dollar because it creates extra volatility and uncertainty, and it also boosts the demand for gold and commodity prices as investors attempt to hedge against the dollar's loss of purchasing power.

Although inflation looks to be more or less within its target range as of April, on the margin prices are rising by much faster than appears in this chart, which only shows year-over-year changes in prices. The headline deflator is rising at a 4.6% annualized rate over the past three months, and at a 3.6% annualized rate over the past six months. The core deflator is rising at a 1.9% annualized rate over the past three months, and at a 1.5% annualized rate over the past six months. Without a tightening of monetary policy, and in view of the fact that the dollar remains very weak, the yield curve very steep, gold prices very strong, and most commodity prices are still very close to all-time highs, it is not unreasonable to assume that both the red and blue lines on this chart will move well above the Fed's target inflation range over the course of the year.

Yet despite the increasing likelihood that inflation is rising and is already at the upper limit of or above the Fed's preferred range, the Fed has somehow convinced the market that there will be no policy tightening until sometime next year. Savvy investors who realize that inflation is moving higher but the Fed is apparently unwilling to do anything about it for a long time conclude there is even more reason to seek inflation protection, and that feeds back into higher gold and commodity prices, and a weaker dollar.

Investors and speculators are thus several steps ahead of the Fed, as evidenced by the strong rise in gold, silver, and commodity prices this year. That will only contribute to inflationary pressures near term, keeping inflation volatility and uncertainty alive for longer than necessary. The Fed could do us all a favor by making policy more proactive, and that means paying attention to monetary indicators which point to rising inflation pressures, such as the value of the dollar, gold prices, commodity prices, and the shape of the yield curve.

Examining the inflation entrails

Here's an update to an interesting chart that shows the three major components of the Personal Consumption Deflator. The main attraction here is the huge divergence between the level of durable goods prices, which have fallen by about 25% since 1995, and the ongoing rise in the prices of services and nondurable goods, which have risen about 50%.

As I noted last month, there is a reason why durable goods began to decline (for the first time ever) in 1995: that was the year that China first started pegging its currency to the dollar (thus stabilizing and eventually strengthening it), which in turn set the foundation for China's strong export-led growth in the years to follow. Cheap Chinese imported goods have helped keep U.S. inflation low, while at the same time boosting U.S. standards of living. The services component of the deflator is a good proxy for wages, so the chart is telling us that an hour's worth of work today buys the typical worker a whole lot more in the way of durable goods that it did 15 years ago (actually about twice as much).

Unemployment rolls have shrunk by 30%

The news that weekly claims last week were a little higher than expected is relatively insignificant (actual claims are flat over the past 3 months), and is greatly overshadowed by the ongoing decline in the number of people receiving unemployment insurance. Since early last year, the unemployment rolls have shrunk by about 30%, from 11.5 million to just under 7 million, and this is a trend that should continue. What this means is that more people are finding work, and more people are facing increasing incentives (having lost their benefits) to find and accept jobs.

Corporate profits remain very strong

As part of today's revision to Q1 GDP, we got our first look at corporate profits for the period. Total after-tax profits fell slightly from their fourth-quarter level, but as the charts above show, profits remain very strong nominally and relative to GDP. On an annualized basis and seasonally adjusted, after-tax corporate profits were $1.24 trillion, or 8.25% of GDP. In the past half century, corporate profits have only been stronger for a few quarters, in 2005-06.

It's a shame that despite the almost record-high level of profits relative to GDP, the federal budget deficit is even bigger. In fact, over the past two years, the federal deficit has totaled $2.7 trillion, while total corporate profits have been about $2.3 trillion. Considering that profits are money and money is fungible; that profits are a source of funds for the economy and deficit spending is a use of funds; this means the federal budget deficit has effectively absorbed every single dollar of corporate profits for the past two years. In my book, that goes a long way to explaining why economic growth has been so sluggish. Had the federal government not effectively appropriated the profits of the private sector to fund transfer payments and make-work projects, and to subsidize bloated state and local spending, the economy could have made tremendous progress and created millions of jobs in the process.

This next chart of PE ratios is constructed using a normalized S&P 500 index as a proxy for the value of all U.S. corporations, and after-tax corporate profits from the GDP tables as the earnings. What we see is that the equity market is trading at a fairly low multiple. Profits are very strong, yet multiples are distinctly below average. The only rational explanation for this is that the market does not believe that the current level of profits will be sustained. That may be the case, since it does appear that profits relative to GDP are a mean-reverting series (with profits averaging 6% of GDP over time), but nevertheless it shows that the market is very conservatively priced. The market is not making any heroic assumptions about the future of corporate profits, and instead is priced to the assumption that profits relative to GDP will decline significantly in coming years.

Looking inside the profits numbers, we see that nonfinancial domestic corporate profits rose significantly in the first quarter, which means that the weakness in the total number was confined to the financial sector. Also, as the above chart shows, nonfinancial domestic profits are unusually strong relative to total profits. The financial sector is still struggling in the wake of the recession, but the rest of corporate America is doing very well.

The biggest problem we have today is our bloated government, whose spending and borrowing needs are sucking the lifeblood out of the economy. Reducing the federal deficit by cutting spending would allow the private sector to reinvest the fruits of its labors, and that would in turn almost certainly fuel stronger growth.

I Am John Galt

My friend Don Luskin has a new book out that I'm reading, and I can already recommend it to anyone who likes Ayn Rand, Atlas Shrugged, free markets, capitalism, and the libertarian philosophy: I Am John Galt.

I Am John Galt: Today's Heroic Innovators Building the World and the Villainous Parasites Destroying It

Markets are still on edge, with room for improvement

This chart compares the implied volatility of equity and Treasury options, and it's not surprising that they have been highly correlated over the past 5 years, since they reflect two sides of the same capital market. Implied volatility is a good proxy for the market's level of fear, uncertainty, and doubt, and as this chart shows, FUD is still somewhat elevated compared to the relatively tranquil days of 2006 and early 2007. I take this to be an indication that the market is still conservatively priced, still somewhat concerned that something might go wrong, and not overly optimistic.

It's also not surprising that the return to conditions of relative tranquility has been slow and gradual and not yet complete. "Once burned, twice shy," as the saying goes; the memory of the recent recession is still vivid, and there are still lots of things to worry about (e.g., trillion-dollar deficits and a gigantic increase in the monetary base).

As fear continues to slowly fade, to be replaced by increased confidence, equity prices should gradually rise and bond yields should rise as well, because increased confidence will lead to more investment, more jobs, and a stronger economy. Low Treasury yields are the market's way of expressing deep concern about the economy's ability to grow, so higher yields should naturally accompany an eventual improvement in the economic outlook.

Capex slows down, but the outlook remains positive

Capital goods orders (a good proxy for business investment) have not been very strong of late, growing at roughly a 5% annual rate over the past six months. But over the past year they are still up by an impressive 11%, and the pace of recovery following the recent recession has been much stronger than what we saw coming out of the 2001 recession. Pessimists will view the slowdown as a precursor to an economic slump, while optimists will see it as a pause that refreshes after last year's outsized gains. Other, temporary, factors likely account for at least part of the slowdown, e.g., bad winter weather and the Japanese tsunami.

In defense of the optimistic view, I note that Commercial & Industrial Loans have risen at a 13% rate over the past three months, and I take that as a sign of increased business optimism and an increased willingness on the part of banks to engage in new lending. C&I Loans are made primarily to small and medium-sized businesses, so increased access to credit is likely to fuel some badly-needed growth in this vital job-producing sector of the economy.

Mortgage update -- very cheap

With the recent decline in Treasury yields, 30-yr fixed-rate mortgages are now only inches from their lowest levels ever, and the only way they are going to get much cheaper is if 10-yr Treasury yields decline further.

Rates on 30-yr mortgages are largely driven by the 10-yr Treasury yield, since the duration (a combination of the interest rate sensitivity of mortgage-backed securities and their expected average life) of MBS tends to be similar to that of a 10-yr Treasury. As the chart above shows, the spread between 10-yr Treasuries and current coupon FNMA paper (the effective interest rate that a buyer of MBS receives after origination and servicing costs) is relatively low (currently 87 bps), and judging from the history of this spread, it is unlikely to decline much further. And while on the subject of spreads, the spread between conforming and jumbo mortgages is now 38 bps, which is only slightly higher than the average 22 bps spread which prevailed prior to 2007; in other words, jumbo rates aren't going to drop much unless conforming rates do too.

So if you are waiting for mortgage rates to drop meaningfully from today's levels, you should start praying for a real lousy economy. As the chart above shows, 10-yr Treasury yields have rarely been lower than they are today. They were lower only during the deflation and depression era in the 30s and 40s, during the height of the financial panic of late '08, and last summer, when the market feared the economy was entering a double-dip recession. Right now I don't see signs of a recession, a depression, or deflation, so I've got to believe that 10-yr yields are unlikely to go much lower than they already are.

Borrowing money today at a 30-yr fixed rate to buy a house is just about as cheap as it's ever been, and it's unlikely to get much cheaper.

Major currencies vs. gold

This chart is a companion to my previous post on the yen, since it illustrates how much stronger the yen has been than either the dollar or the euro (and by extension the DM). The red and blue lines show the price of gold in dollars and euros, respectively, while the gold-colored line shows gold priced in yen. Both axes have the same span: 15 to 1.

Note how gold has yet to hit a new high against the yen, whereas gold has almost doubled in dollar terms from its 1980 high. Note as well how the yen strengthened powerfully against gold in from the mid-1980s through the early 2000s, and how this correlated to Japan's very low (and even negative) inflation from the early 1990s through today. As Milton Friedman taught us, monetary policy acts on inflation with "long and variable lags."

Note also how major currencies have followed a similar pattern vis a vis gold—falling in value in the inflationary 1970s, rising in value in the disinflationary 1980s and 1990s, and falling in value in the 2000s. For gold bugs, this chart provides a good reason to believe that inflation in the U.S. and in the Eurozone will be substantially higher in coming years than it will be in Japan, even though the chart also shows that all currencies are depreciating against gold. In other words, gold is telling us that inflation is likely to rise in all countries, but much more so in the U.S. and Europe than in Japan. It will certainly be interesting to see how this plays out in the years to come.

Why Japan-style deflation is not a risk in the U.S.

These two charts show why a Japanese-style deflation is not a risk in the U.S., because they illustrate the source of Japan's deflation: an extraordinarily strong currency. The strong yen, in turn, is a direct consequence of decades of tight monetary policy. With the U.S. dollar now trading at all-time lows against other currencies in both nominal and real terms, it is a safe bet that U.S. monetary policy is not at all like the monetary policy that led to decades of very low inflation and even deflation in Japan. There are no valid monetary parallels between Japan's decades of deflation and the current state of the U.S. economy.

The top chart compares the yen/dollar exchange rate to my estimate of the Purchasing Power Parity of the yen. Note that the yen's PPP (green line) rises almost continuously beginning in the late 1970s. This is a function the fact that Japanese inflation has been consistently lower than U.S. inflation since the late 1970s. (If country A has lower inflation than country B, then the currency of country A needs to appreciate vis a vis the currency of country B just to keep prices steady between the two countries.) The yen needed to appreciate against the dollar just to keep prices in both countries from deviating significantly.

Arguably, the most significant event in Japan's modern monetary history was the huge appreciation of the yen vs. the dollar beginning in 1985. The yen was 260 to the dollar in Feb. '85, and it had soared to 85 to the dollar by June '95—a tripling of the value of the yen in dollar terms. An appreciation of this magnitude, followed subsequently by decades of zero or negative inflation, is powerful evidence of very tight monetary policy.

Deflation is possible in Japan because for decades the value of the yen has risen enormously. That's the definition of deflation: when a unit of account buys more and more goods and services. In the U.S. we have exactly the opposite problem: the dollar is depreciating against most currencies and against gold and most commodities. The fact that the U.S. economy is weak is helping to keep some prices from rising, but not all. The prices that are the most depressed happen to be related to the sectors of the economy that are the most depressed (e.g., housing and construction-related sectors). That's not deflation, that's a relative change in prices that is helping redirect resources away from construction and towards other areas of the economy (e.g., mining and manufacturing).

The only constructive parallel between Japan and the U.S. today is that both countries are burdened with large and growing budget deficits, which in turn are the product of too much spending. Too much government spending can suffocate an economy, leading to many years and even decades of sub-par growth.