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Households' financial burdens continue to ease


Today the Fed released data for Q1/11 that show that households' financial burdens continued to ease. Total financial obligations (auto leases, homeowners' insurance, property tax, mortgage and consumer debt), as a percent of disposable income, have fallen 13% from their Sep. '07 high. As the chart above shows, debt and financial burdens have on balance been unchanged since 1985, after a rise in the mid-2000s.

The upshot of all this is that there has been some meaningful deleveraging going on in recent years. As I have pointed out before, this deleveraging occurred during a time of economic recovery—debt is not essential for a recovery, and reducing debt is not necessarily contractionary. Debt can facilitate economic activity, but it is not necessary for growth. The problem with debt comes when consumers and/or businesses increase their borrowing in the belief that their financial health will be unchanged or improved in the future, only to find out that the future did not turn out as expected. This is not a fatal problem, but it does throw a wrench into the economy's gears that can take some time to work out.

The ongoing reduction in financial burdens is a healthy sign that reflects the fact that people and businesses have been actively adjusting to changing circumstances, and it is this dynamic response to adversity that sets the stage for a new cycle of growth. I would note in that regard that the last time we saw significant household deleveraging was in the 1990-95 period; over the subsequent five years, the economy grew by more than 4% a year.

UPDATE: To answer several readers' concerns, I believe the data for this chart include student loans, since they are included in the Fed's Consumer Credit release.

Misery Index update


This index, the sum of the CPI and the unemployment rate, will likely be the focus of next year's elections. I expect that CPI will be in a modestly rising trend for the next year, and it's likely that the unemployment rate will decline modestly. If those predictions hold, the Misery Index will be at least as high as it is today, and that will be enough to fuel discontent with the economy.

While the index has risen significantly since Obama took office (from 7.8 in Jan. '09 to the current 12.7), most of the rise is due to inflation, which rose from 0 in Jan. '09 to the current 3.6%. To be fair, inflation is the purview of the Fed, not the president, as I argued yesterday. The unemployment rate has only risen from 7.8% to 9.1% on Obama's watch, whereas it rose from 4.2% to 7.8% on Bush's watch.

Housing starts are still flat, but good news is accumulating


So we've now had two and a half years of very low and very flat housing starts. It took the nation's homebuilders three years to throttle back the construction of new homes by about 75%, and they've held to those minimal levels since late 2008. Residential construction is now only about 2% of GDP, which is almost next to nothing.


If starts were going to decline further, it would have happened by now. In the meantime, new household formations have continued at a pace substantially higher than new home construction, and so the excess inventory of homes has been sharply reduced. The next shoe to drop is painfully obvious: a shortage of homes is inevitable at some point, so new construction, and housing prices, will have to start picking up. It's only a matter of when.


The housing price data from Radar Logic, shown in the chart above, offer a tantalizing hint: the long-awaited rebound in the housing market may already be underway. It's too early to be sure, since the price bounce is still very modest, but the passage of time suggests this bounce may well be the real thing.

Claims: much ado about nothing (cont.)



The April bulge in weekly unemployment claims, which kicked off the latest round of concerns that the U.S. economy is entering a double-dip recession, continues to fade away.

The top chart shows the seasonally adjusted (reported) number, while the bottom chart shows the unadjusted number. The raw data show that claims have been flat since mid-February, while the adjusted data show a big rise starting in April. The difference between those two numbers is the seasonal adjustment factor. That factor expected to see a decline in actual claims beginning in April, and instead claims turned out to be flat. So the adjusted number was bumped up. Claims were flat instead of declining because auto plants accelerated their layoffs, which would normally have occurred in July, because of the supply disruptions which cascaded through the global manufacturing system in the wake of the Japanese tsunami.

We are now beginning to see the payback for this whole charade. Actual claims rose a bit last week, but the reported number declined, which means that the seasonal factors expected to see an even bigger rise in actual claims. If the expected auto layoffs do not occur next month (because they have already happened), then the seasonal factors will produce a very large decline in reported claims. And the press will announce that the economy once again avoided a double-dip recession. When in fact nothing at all happened out of the ordinary.

Putting Greece into perspective


The big talk today is about Greece, and how default looms and social tensions are escalating. As the chart above shows, yields on 2-yr Greek government debt have soared to 28%, a sure sign that investors fully expect a significant restructuring (a polite word for default) of Greek debt within the foreseeable future.


Yet as this next chart shows, 2-yr Eurozone swap spreads have hardly budged, even as Greek default risk has soared. What this says is that while the market is convinced that Greece will default, the market is only moderately concerned that the risk that a Greek default will prove contagious or otherwise threaten the European banking system.


And despite lots of talk about how a Greek default might force Greece to leave the euro, and how this might be the start of the unravelling of the euro, the euro remains at the upper end of its valuation range against the U.S. dollar.

In short, the market is telling us that a significant Greek default is likely, but that it will have only a limited impact on the rest of Europe, and by extension, the world. Markets have had plenty of time to prepare for this event, so it is not likely to be very disruptive.

Some modest good news from the housing market


As the chart above shows, new applications for mortgages have increased about 14% in the past year. This is an encouraging sign that suggests new buyers are coming into the market as banks liquidate their housing inventories. Another encouraging (though still very preliminary) sign is the rise in housing prices since January, according to the folks at Radar Logic (chart below).

Inflation is heating up, and it's the Fed's fault


Consumer price inflation topped estimates by a bit in May, but that's only part of the bigger story. As the chart above shows, over the past six months the CPI has increased at a 5.1% annualized rate, having accelerated sharply from a zero rate in the first half of last year. That is indeed a significant pick-up. Notice also that inflation has been unusually volatile over the past 10 years (standard deviation = 2.2%), especially as compared to the prior 10 years (standard deviation = 0.7%). Three times more volatile, in fact.  This is not a coincidence, since Fed policy in the 1990s was proactive and consistently tight, whereas Fed policy since 2001 has been generally reactive and mostly easy. This is like the difference between driving by looking through the windshield compared to driving by looking in the rearview mirror.


The pickup in inflation is not limited to the headline number either. As this next chart shows, the core CPI has increased 1.5% over the past year, and as the next chart shows, over the past six months the core CPI has increased at a 2.1% annualized rate; like its headline counterpart (compare to first chart), the core CPI has accelerated meaningfully from an almost-zero rate in the first half of last year. It also has experienced significantly higher volatility in the recent decade than in the prior one. So the volatility of inflation is not just coming from food and energy prices, it's most likely coming from erratic and accommodative monetary policy. Finally, as the above chart suggests, with inflation heating up we have likely seen the lows in 10-yr Treasury yields.


To further prove my point that monetary policy is the force behind inflation, note in the chart below how the dollar was generally stronger in the 1991-2001 period, while it was generally weaker from 2002 on. Tight monetary policy keeps the dollar strong and inflation stable, while accommodative monetary policy leads to a weak dollar and more volatile and higher inflation. 


UPDATE: The chart below shows inflation according to the Cleveland Fed's Median CPI.

To calculate the median CPI, the Federal Reserve Bank of Cleveland looks at the prices of the goods and services published by the BLS. But instead of calculating a weighted average of all of the prices, as the BLS does, the Cleveland Fed looks at the median price change—or the price change that’s right in the middle of the long list of all of the price changes. According to research from the Cleveland Fed, the median CPI provides a better signal of the inflation trend than either the all-items CPI or the CPI excluding food and energy.

I have long questioned whether the median CPI is the best way to judge the underlying inflation trends. I've argued that inflation was rising long before the median CPI turned up, and I based my forward-looking view of inflation on the behavior of the dollar, gold, commodity prices, and the slope of the yield curve. In any event, it's nice to see that the median CPI now agrees with the other forward-looking indicators that I follow: inflation is heating up. It's not dangerously high by any means, but there is a clear upward trend which is likely to continue.

Change on the margin is the key

Clifford Asness has a very nice op-ed in today's WSJ: "Uncertainty is not the Problem." I'm guilty of doing what he describes, which is arguing that the uncertainties created by massive quantitative easing and a huge expansion of government spending are acting as headwinds to economic growth. It's not the uncertainty surrounding bad policies (e.g., a huge increase in spending today means we could see a huge increase in future tax burdens) that is bad for the economy, it's the bad policies themselves. Unless policies change, we will see higher tax burdens and greater regulatory burdens, and that is bad; the fact that there is still some uncertainty about how bad it will be for the economy, or exactly how much tax burdens will rise, is not as important as the fact that the future looks less attractive for business.

... the stimulus was wasteful and politicized, and the American people, not being idiots, know they will have to pay for it eventually. People adjust their plans to account for the additional debt heaped on them, meaning lower investment and consumption.

He goes on to illustrate how things could improve dramatically even if the degree of improvement were still uncertain:

... consider good policies surrounded by uncertainty. Imagine we will move from here toward free-market health-care reforms appropriate for a free people. We will reduce government spending and our debt, letting people spend their own money as they see fit. We will lower taxes across the board for individuals and businesses, and we'll reduce and simplify deductions.
Imagine even more that we'll make grown-up decisions and reform entitlements to levels we might possibly afford. Now imagine that while we know the direction of each of these policy changes, alas, we are very uncertain about how far these wonderful ideas will go. Imagine this uncertainty is even higher than it is around today's bad policies. Would these changes, uncertainty and all, make things better or worse? Well, it seems pretty clear that should these changes occur in any nontrivial fashion, you would have to duck to get out of the way of the ensuing economic boom, regardless of the uncertainty.
Focusing on "uncertainty" takes our eyes off the ball. We should not seek clarity about the many new drags on our economy. We should seek to have the administration cease and desist, then reverse them.

This reinforces my belief that the plunge in equity prices in the early months of 2009 was largely driven by the horror show that was otherwise known as almost $1 trillion of fiscal "stimulus." Prices have rallied since then because a) the economy did not collapse into a black hole of depression and deflation as the market expected in late 2008, b) the market began to see that Obama's lurch to the left was meeting resistance, and c) more recently, the market has begun to believe that policies might at some point reverse, in a more growth-friendly direction. If the elections next year have the effect of reducing spending, reforming entitlements, flattening tax rates and broadening the tax base, then there is a tremendous amount of upside potential in the market. The only uncertainty is the degree to which things will improve. Already we see that the political debate has shifted meaningfully: nobody can argue successfully for more spending and new entitlement programs—the political debates now turn on whether and by how much we can cut spending and reform entitlement programs.

Retail sales remain very strong



These charts show the rather exceptional strength of retail sales excluding autos (which make sense to exclude because of the tsunami-related slowdown in auto production and sales in recent months). Nominal sales have surged over 8% in the past year, while real sales are up 5.6% and have now staged a complete recovery to their 2007 highs. This is not a picture of an economy teetering on the verge of a double-dip recession. Sales have recovered to pre-recession highs because employment is once again growing, and those who are working are much more productive—non-farm productivity is up 8.6% since the end of 2007. This is another testament to the inherent dynamism and strength of the U.S. economy, and the tenacity of workers and entrepreneurs who continue to seek to improve their lot in life despite the fiscal policy headwinds.

Producer price inflation remains strong


Inflation at the producer level remains alive and well. Overall prices are up 7% over the past year, and they have risen at a 10.8% annualized pace over the past six months. Food, energy and commodity price gains comprise the lion's share of the gains, to be sure, but even excluding food and energy, the core PPI is up 2% over the past year, and inflation by this measure has risen at a relatively strong annualized pace of 3.5% over the past six months.

As I've mentioned before, it is noteworthy that both headline and core measures of inflation are accelerating, since this confirms that monetary policy is indeed accommodative. If the Fed were trying to keep inflation low and stable, then an increase in food and energy prices would force a decrease in other prices, with the result that core inflation measures would have to decelerate if headline price increases were accelerating. Yet that is clearly not the case today. The Fed is allowing non-energy prices to rise.


At the intermediate stage of processing, producer goods inflation is running at a blistering 17.3% annualized pace. As the chart above shows, we've rarely seen such rapid inflation in this measure. At the early stages of processing, crude goods inflation is chugging along at 22.5% over the past year. There is lots of inflationary pressure in the pipeline.

Perhaps the most significant conclusion to be drawn from all this is that prices are rising in many areas of the economy (and quite strongly), despite the fact that there currently is an unusually large amount of so-called economic "slack." (In my estimation, the economy is operating about 10% below its potential, meaning there are lots of underutilized resources, including many millions of sidelined workers.) This directly contradicts the Keynesian/Phillips Curve theories of inflation, and exposes a fundamental flaw in the Fed's thinking. Fed governors continue to believe that lots of economic slack will prevent inflation from gaining traction, and that's the only reason for the Fed to insist that it will keep interest rates very low for a considerable period. But as these charts suggest, by the time they decide to tighten policy, it may well be too late to prevent a sustained rise in inflation at all levels of the economy.

Investors need to draw several lessons from this. One, deflation is not a risk that one need worry about. Two, since Treasury yields are priced to the expectation that inflation will be very low and stable for a very long time, Treasuries should be avoided like the plague. Three, with inflation pressures building, investors need exposure to rising nominal GDP, which can be gained from equities, corporate bonds (since corporate profits are in large part determined by nominal GDP), and real estate. Corporate bonds will benefit from accelerating inflation since inflation tends to benefit debtors in general (and thus reduces default risk, to the benefit of the bond holder). As a corollary, high-yield and emerging market bonds should benefit the most since their issuers are usually highly leveraged. With real estate prices still down significantly from their 2006-7 highs, real estate might be considered undervalued given a rising inflation scenario. Precious metals are a classic inflation hedge, but their prices have already—in my view—anticipated a significant amount of inflation and are thus quite risky.

C&I Loan growth is accelerating



Both of these charts show Commercial & Industrial Loans, which are a good measure of bank lending to small and medium-sized businesses. (Latest datapoint is June 1st.) The top chart gives some historical perspective, while the bottom chart plots weekly values since last September, which marked the point when loans began to grow after falling for the previous two years.

Over the past three months, C&I Loans have grown at a 12.2% annualized rate, and they have grown at a 10.1% annualized rate over the past six months. Each of those growth rates is almost twice the rate recorded at the end of March (6.8% and 5.8%), so it is clear that lending activity is really picking up.

This is good news not because loans are needed to fuel growth, but because it shows that a) banks are more willing to lend and b) businesses are more willing to borrow. That adds up to a big increase in confidence, and that is what it takes for new investment, which in turn is what it takes for new jobs.

This news is a welcome change to the seemingly overwhelming supply of bad news and pessimism which prevail these days. The economy is of course still laboring under the weight of many structural problems (e.g., questionable monetary policy, bloated government spending, crushing regulatory burdens, and the threat of higher tax burdens), but news such as this is important to stress, because it shows the despite all the problems, economic life goes on and there are still many people willing to pursue new business and profit opportunities. This is key to understanding why the U.S. economy is still one of the world's most dynamic. Imagine if those headwinds were to diminish under a new administration with a laser focus on cutting spending, reducing regulatory burdens, cutting taxes ....