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GDP update: faster nominal growth

This is a brief post to update one I wrote last month: "Three under-appreciated GDP facts."


Last month I highlighted the fact that nominal GDP growth in the third quarter was surprisingly strong. Today's GDP revision makes it even stronger: inflation (the GDP deflator) was largely unchanged at 2.7%, but real growth was raised from 2.7% to 3.1%. That amounts to nominal annualized GDP growth of 5.9%, the fastest in over 5 years.

The Fed has been aggressively accommodative in its provision of bank reserves to the system, with the objective to boost GDP. Last quarter it would appear to have achieved some measure of success, but it's still a bit early to say whether it was monetary policy which gave us 3.1% growth, or simply the combination of growth in the workforce (about 1%) and productivity (about 2%), both of which are very much in line with historical norms. It's not hard, however, to attribute 2.7% inflation to easy money.

In any event, 6% nominal GDP growth is rather impressive, considering how weak this recovery has been.

Housing update: more evidence of a rebound


Existing home sales are up 24% since July 2011, and from the recession low have risen almost 34%. If this isn't a genuine housing recovery, I don't know what is.


The inventory of homes for sale relative to the sales pace has fallen precipitously, and is now almost back down to the lowest levels of the past several decades. If banks don't start releasing all those properties they reportedly have been accumulating, there is going to be a real shortage of housing and sharply higher prices pretty soon.

10 comforting charts

There are plenty of things to worry about these days. The fiscal cliff negotiations and the likelihood of higher taxes on capital and small businesses; the Federal Reserve's massively expansive monetary policy; the recession in the Eurozone; the lingering threat of sovereign defaults; the political deterioration in the Middle East; the prospect of trillion-dollar federal deficits for as far as the eye can see; the gigantic unfunded liabilities of U.S. entitlement programs; the recent decline in industrial production in most developed economies; the slowdown in Chinese growth; the rising regulatory burdens; the onset of ObamaCare; the very weak U.S. dollar; the relatively tepid growth of the U.S. economy; and the huge gap between current and potential growth. 

But all is not lost, and the end of the world is not imminent. Here's a collection of 10 charts that tell a story of an economy that continues to improve on the margin. They don't point to any big growth revival, but neither do they point to an imminent recession. At the very least they are comforting.


Housing starts are up 60% from early last year, and up 22% in the past 12 months. 


Building permits typically lead starts, and they are up 27% in the past year. The future of residential construction looks very bright.


Architecture billings typically lead construction spending by 9-12 months. A majority of the firms surveyed for this index in November reported increased billings activity. The future of nonresidential construction looks better than at any time in the past 5 years.


Industrial metals prices are good indicators of global economic activity. Although they are down from recent highs, they are still orders of magnitude higher than they were 10 years ago, and they are up 113% from their Great Recession lows. At the very least, these prices tells us that global economic activity remains relatively strong.


We all know that the Eurozone is in a recession and that growth prospects are miserable. Yet Eurozone equity prices are up 26% from last year's low. This is not necessarily a sign of strength, but it does suggest at the very least that the situation in Europe is not as bad as many had feared. After all, prices today are about the same as they were in late 1997, 15 years ago! U.S. equity prices have fared better, but still, they have made zero progress in the past 12 years, despite the fact that after-tax corporate profits have more than doubled since then. My take is that equity prices are moving higher because things are not as bad as they market had feared; markets have been priced to a recession, but instead we continue to see that growth is positive albeit disappointingly weak.


Credit Default Swap spreads show no signs of any fundamental deterioration in the economy. Indeed, they are about as low as they have been since the recovery started. They are still elevated by historical standards, but on the margin they are telling us that conditions are improving.


The implied volatility of equity options—the Vix Index—is still somewhat elevated relative to what we would expect to see in "normal" times, but it is far below the levels registered at times of crisis. At the very least, this is telling us that the "fiscal cliff" negotiations are not a do-or-die event for the U.S. economy. Not good, but not bad either.


Swap spreads are very important indicators of financial market health and systemic risk, and have proven to be good leading indicators of economic strength. The very low level of swap spreads today is a reflection of very healthy liquidity conditions and very low systemic risk. It would therefore be very surprising for the economy to dip into a recession.


Inflation is neither too low nor too high. This chart shows the quarterly annualized change in the GDP deflator, the broadest measure of inflation in the U.S. economy. Year over year inflation is running a bit less than 2%, regardless of the measure you wish to use.


The pace of jobs growth is very disappointing, to be sure, but employment around the world, as well as in the U.S., continues to expand. Slow growth is much better than contraction.

Equities as an inflation hedge

My first post on this subject was in early October. Time for an update, since the meme continues.


The above chart compares the S&P 500 to the bond market's forward-looking inflation expectations. Since the third quarter of last year, both equity prices and inflation expectations have moved higher in a meaningful way. It would seem that the Fed's quantitative easing efforts deserve some credit (or should I say blame?) for this. Higher equity prices owe more to rising inflation expectations than to stronger growth expectations. Inflation are not necessarily bad for equities, as I explained in my earlier post, because corporate earnings should tend to rise as the price level rises.

Another "benefit" to higher inflation is that it boosts tax revenues. Incomes tend to rise with increases in the price level, and that moves people into higher tax brackets (thanks to our progressive tax code), with the result that federal revenues rise without the need to increase tax rates, even if the economy remains weak. That's been the story for the past few years: a very weak recovery but with ongoing inflation of 2% or so has caused federal revenues to increase at a 6.3% annualized pace over the past three years, even as nominal GDP has grown at only a 4.2% annualized pace.

Another "benefit" to higher inflation is that it reduces the burden of federal debt. That is especially the case today, since yields on Treasuries are significantly lower than current inflation. Negative real interest rates allow the federal government to pay back its debt with cheaper dollars. This, together with the revenue-boosting effect of higher inflation can result in a substantial decline in the federal deficit burden. Already we have seen the federal deficit fall from a high of 10.5% of GDP to today's 7.0%.

While it's good to see debt burdens decline—especially since they are so large—inflation is not the best way to do it. Today's 2-3% inflation, in the context of negative real interest rates on almost all maturities of Treasury securities, is transferring significant wealth from the private sector to the public sector. Over time, this will result in economic growth that is disappointingly slow. And of course that is what we have seen so far in this recovery, the weakest one in modern times.

I don't see things changing meaningfully as a result of the fiscal cliff negotiations. Both fiscal and monetary policy are contriving to continue to transfer wealth to the federal government, and this will keep the economy weak for the foreseeable future. This doesn't mean a recession, just more of the same very slow growth we have seen in recent years.

So I think it still pays to be an equity investor, even though the economic outlook is not very bright. Equities are relatively cheap (i.e., PE ratios are below average at a time when corporate profits are very strong) and they are thus one of the cheaper inflation hedges available to investors at this time.

The Fed leverages up

Ben Bernanke, head of the world's largest hedge fund (aka The Federal Reserve), last week announced that next year he plans to borrow another $1 trillion dollars—on top of the $1.5 trillion he's borrowed over the past four years—in order to fund the federal government's CY 2013 deficit and give his shareholders (aka taxpayers) a profit to boot. This plan is otherwise known as QE4.

His is a unique business, since he can force the market to lend him money—he simply buys what he wants and pays for it with his "bank reserve checkbook." By the end of next year, the Fed will own $1 trillion more bonds, and the banking system will have $1 trillion more reserves, whether it wants them or not. Bernanke can also dictate the rate at which he borrows money; for the foreseeable future that will be the rate the Fed decides to pay on reserve balances held at the Fed, currently 0.25%. Those who end up with the reserves will have essentially lent the Fed money on the Fed's terms.

To be more specific: Next year, Bernanke plans to make net purchases of $540 billion of longer-term Treasuries, and $480 billion of MBS. He will fund those purchases by issuing $1.02 trillion of newly-minted bank reserves. In effect, the Fed will be swapping reserves (which are functionally equivalent to 3-mo. T-bills, the paragon of risk-free assets, but which currently pay a slightly higher rate of interest) for bonds. Since money and bank reserves are fungible, Bernanke's planned purchases should effectively cover Treasury's deficit next year, which, perhaps not coincidentally, looks to be about $1 trillion.



It's important to note here that when the Fed issues $1 trillion of bank reserves, it is NOT "printing money." That's because bank reserves are not cash and they can't be spent anywhere: like pajamas, they are only for use "in house," since they are always kept at the Fed. Bank reserves do have a unique feature, of course, that other short-term assets don't: they can be used by banks to create new money, and in fact, acquiring more reserves is the only way that banks can increase their lending, because banks need reserves to back their deposits. Since banks now hold $1.6 trillion of reserves, of which only $0.1 trillion is required to back current deposits, banks already have an almost unlimited ability to make new loans and thereby expand the money supply. A year from now they will have an even more unlimited ability to do so.


That banks haven't yet engaged in a massive expansion of lending activity and the money supply is a testament only to the risk-averse nature of bank management and the risk-averse nature of the public, which now holds $6.5 trillion of bank savings deposits (up 64% in the past four years) paying almost nothing. As the above chart shows, in recent years the M2 measure of money supply has grown only slightly faster than its long-term average.

To put it another way: The Fed's massive provision of reserves to the banking system has not resulted in an equally large increase in inflation because the world's demand for money (cash, bank deposits, and cash equivalents like bank reserves and T-bills) has been very strong. Banks, in short, have been content to sit on $1.5 trillion of "excess" reserves because they worry that making more loans and increasing deposits might be a lot riskier.

The rationale for hedge funds is to exploit arbitrage opportunities, buying one thing and selling or borrowing another. Even small differences in prices can become lucrative, thanks to the use of lots of leverage. If done successfully, arbitrage can contribute to market efficiency, which in turn can contribute to the health of an economy. Whether the Fed will accomplish the same thing with QE4, however, is an open question. Will banks lend a lot more next year, even though they have an essentially unlimited capacity to lend today? Will increased bank lending fuel genuine economic growth, or will it just fuel more speculation? No one knows. We are in uncharted waters; what the Fed is doing today has never been done before.

When faced with issues of daunting complexity and with little or no guidance from the past, one can only begin by trying to reduce things to their simplest form. Here's what I think is a simplified description of what the Fed is planning: Next year the Fed will be purchasing a total of $1 trillion of 10-yr Treasuries and current coupon MBS. 10-yr Treasuries currently yield 1.75%, and current coupon MBS about 2.25%, so the Fed will earn roughly 2.0% on its purchases, while paying out 0.25% on the reserves it creates to buy those bonds, for a net spread of 1.75%. By the end of next year, the Fed will be raking in $17.5 billion per year in profits on their $1 trillion swap, and that will make the Fed the envy of all other hedge fund managers.

These profits, of course, are automatically remitted by the Fed to Treasury. Happily for taxpayers, those profits will completely offset Treasury's cost of borrowing, at least for the next several years. Here's the math, also in simplified form: First, let's assume that Treasury is funding its deficit with 7-yr Treasuries (that's a decent approximation, since last year they told us that they were going to lengthen the average maturity of outstanding Treasuries, which at the time was about six years). The yield on 7-yr Treasuries is currently about 1.25%, so Treasury will pay 1.25% on $1 trillion, and receive back from the Fed 1.75%, leaving a profit of about 0.5%, or $5 billion. Bottom line, we will all benefit from next year's deficit financing! (Note that the key to the profit is the Fed's decision to buy lots of MBS, which yield more than Treasuries of similar maturity.)

A real-world hedge fund attempting to do the same thing would run up against the reality of mark-to-market accounting rules. If interest rates on the bonds it buys rise, the mark-to-market losses on the bonds could easily wipe out the interest it's receiving, threaten margin calls and ultimately result in insolvency. For example, a 1 percentage point rise in the yield on 7-yr Treasuries would result in a 6.7% decline in their price, thereby wiping out over 5 years' worth of coupon payments. Mortgage-backed securities could fall in price by even more. A hedge fund would also be exposed to the risk that its borrowing costs could rise, thus narrowing or even eliminating the net interest spread it's earning.

Happily, Bernanke doesn't have to worry about any of this, since he doesn't have to mark his bonds to market, and he can keep his borrowing costs below the current yield on his portfolio for at least the next 2 or 3 years, given the FOMC's recent guidance (i.e., it won't start tightening until the unemployment rate falls to 6.5%, short-term inflation expectations exceed 2.5%, and/or long-term inflation expectations become unanchored). And of course, the Fed can always make the interest payments on its borrowings because its "bank reserve checkbook" is effectively bottomless.

If this all sounds too good to be true, it is. The Fed may not face the risks that a typical hedge fund does, but that doesn't mean the Fed is not taking on a huge amount of risk at taxpayers' and citizens' expense. Although the Fed need never face insolvency, if mark to market losses got really bad, they could lose their credibility and with that the value of the dollar could be seriously at risk. The Fed's losses might become direct obligations of Treasury, or they might be inflicted on taxpayers and citizens via the sinister "inflation tax." The Fed could eventually repay its borrowings with devalued dollars, leaving the rest of us with deflated balance sheets and deflated incomes. Meanwhile, by allowing Treasury to borrow trillions at no cost, the Fed is acting as an obstacle to badly needed deficit reduction.

Although it may seem paradoxical, the biggest risk we all face as a result of the Fed's unprecedented experiment in quantitative easing is the return of confidence and the decline of risk aversion. If there comes a time when banks no longer want to hold trillions of dollars worth of excess bank reserves for whatever reason (e.g., the interest rate the Fed is paying is no longer attractive, or the banks feel comfortable using their reserves to ramp up lending, or the public no longer wants to keep many of trillions of dollars in bank savings deposits), that is when things will get "interesting."

More confidence would mean less demand for cash and cash equivalents, and that in turn would mean that a virtual flood of money could try to exit banks (e.g., as people withdraw their savings deposits, and/or borrow more from their banks). If the public attempted to shift trillions in cash into housing, stocks, gold, or other currencies, the consequences would likely be seen in sharply rising prices and higher inflation. Moreover, higher inflation would almost certainly lead to higher interest rates, which in turn would exacerbate the Fed’s mark to market problem and possibly accelerate the whole process. And of course, higher interest rates will result in significantly higher borrowing costs to Treasury, although this will be mitigated to some extent by Treasury's efforts to extend the average maturity of its borrowings.

The Fed reasons that it could deal with declining risk aversion by selling bonds (i.e., reducing bank reserves), not reinvesting principal, and by raising the rate it pays on bank reserves. But it’s not hard to see how things could get out of control: higher rates on bank reserves would likely accelerate the rise in market yields and the mark to market losses on the Fed’s bond holdings, at the same time as its spread eroded. In the meantime, the more bank reserves the Fed creates, the harder it will be to avoid an unhappy outcome.

It’s ironic that the Fed is trying, with QE4, to accomplish the very thing that could be its own undoing. Trying, that is, to encourage more confidence, more lending, more borrowing, more investment, and higher prices for risk assets.

It’s no wonder that the market remains so risk-averse, since this is hardly a comforting position we're in. For now, that is probably a good thing. But in the wake of the election results and the Fed's latest decision, I am less optimistic today than I have been for several years.

Tracking the housing recovery

Markets do have the ability to "look across the valley" and anticipate upcoming changes in the economy. Here are three charts which illustrate how that has happened with onset of the housing market bust and its subsequent recovery.




The first of the above three charts shows the price of lumber futures. Note that prices peaked in 2004, almost two years before the housing market peaked. The second shows an index of home builders' stocks, which peaked in 2005, about a year before the housing market peaked. The third chart shows housing starts, which peaked in early 2006.

As for the housing market recovery, note that lumber futures bottomed in early 2009, home builders' stocks bottomed around the same time, and both lumber futures and home builders' stocks were rising well in advance of the eventual recovery in housing starts, which occurred in mid-2011.

Finally, note that all three indicators are at new post-recession highs. The housing recovery is definitely underway.


This last chart is the Radar Logic measure of housing prices (nonseasonally adjusted). According to this index, prices were up 7.6% in the year ending October 15th. Anecdotally, I continue to see many signs that housing prices have bottomed and are now recovering in many areas of the country. Mark Perry has a nice list here.

UPDATE: Two more charts updated with data released today (12/18/12), both showing continued improvement in the housing market.



UPDATE 2: Below is an updated chart of housing starts, which have soared by 60% since early 2011.