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Industrial production lackluster

May industrial production figures show only lackluster growth, and are consistent with the modest-to-moderate economic growth we have seen for the past several years. What the economy is lacking is an improvement in business confidence, and that is not likely to come unless and until we see reforms that reduce regulatory burdens (especially those associated with Obamacare) and corporate income taxes. I think we will see movement in this direction before the end of the year, but for now things look pretty dull and unexciting.

U.S. industrial production has generally fared much better than Eurozone industrial production over the past decade or so. In fact, Eurozone production hasn't experienced any net increase for the past 13 years (since May 2000). Germany stands out as a relative powerhouse, but production there has been stagnant on balance since mid-2011, mostly as a result of the onset of the PIIGS sovereign debt crisis. It is encouraging to see that German production has enjoyed a sizable pickup in recent months, as this may be a leading indicator of a more widespread improvement in the Eurozone economy after more than two years of declining output. U.S. industrial production growth has been lackluster, rising only 1.6% in the past year.

Abstracting from utility output, which has been roughly flat for the past seven years, manufacturing production was up a bit in May but up only 1.7% over the past year.

Production of business equipment has been doing a little better, posting 3.2% growth in the past year, but growing at only a 1.8% annualized rate in the past six months.

Fears of tapering are misplaced

Recent economic data continue to show no sign of any emerging weakness or unusual strength in the U.S. economy. The economy is likely continuing to grow at about a 2% pace, which is the average pace of the current business cycle expansion. Despite any notable changes in the health of the economy, the market has rather suddenly been gripped by fear that a tapering of the Fed's Quantitative Easing program—not a reversal, just a slower pace of asset purchases—puts the economy at risk. This fear is based on the assumption that the recovery has been primarily driven by QE, an assumption I think is unfounded. I see no logical connection between the Fed's purchases—which amount to swapping T-bill substitutes for notes and bonds—and the creation of new jobs. As I argued months ago, the Fed is not "printing money."

If there is any connection between QE and economic growth, it is that both are unprecedented: we've never seen the Fed purchase assets of such magnitude, and we've never seen such a slow-growing economy after such a deep recession. Indeed, it might make more sense to believe that QE has actually retarded the economy's growth—and that therefore a tapering of QE might actually boost growth—rather than to worry that a slow-growing economy might get even slower if the Fed begins to taper its purchases of notes and bonds.

Some brief notes on today's data releases:

Weekly claims for unemployment continue their downtrend. This suggests the labor market is getting more resilient by the day, as employers have done just about all the cost-cutting they need to.

Relative to the size of the workforce, layoffs have rarely been lower than they are today.

The number of people receiving unemployment insurance is down almost 21% in the past year. This continues to be one of the biggest changes on the margin in the U.S. economy, and it is a positive, since it increases the incentives for people to find and accept employment.

May retail sales were stronger than expected (+0.6% vs. +0.4%). To date there is no sign that the expiration of the payroll tax holiday (which caused withholding taxes to increase beginning in January) has had any significant impact on consumer spending. Real retail sales are up about 3.3% in the past year, and in the past six months they are up at 2.7% annualized pace.

The main problem with the economy has been a failure to thrive. Unemployment remains quite high, and the economy is operating at much less than its capacity. As the chart above suggests, retail sales are a little more than 10% below where they otherwise could have been if this had been a normal recovery. This, combined with the fact that inflation remains relatively low, is hardly evidence that the Fed has artificially pumped up the economy with QE.

Federal finances continue to improve

Federal tax receipts are growing strongly while spending is stagnant, thanks to a deadlocked Congress, a growing tax base, and higher tax rates. The federal deficit as a % of GDP has fallen almost by half in the past 3 1/2 years. This dramatic improvement is likely under-appreciated and almost totally unexpected. At the very least this removes a good deal of uncertainty about the future, at the same time as it removes the need for further tax hikes and increases the odds that tax rates might be lowered in the future.

Federal spending has changed very little in the past four years. In the 12 months ended May 2013, spending actually declined 1.1%. 

Federal tax revenues have been rising steadily for the past several years, and have surged at a 17% annual rate in the six months ended May 2013. Several factors were responsible: jobs and incomes are growing, the payroll tax holiday expired at the end of last year, income was shifted forward at the end of last year as people attempted to avoid an anticipated increase in tax rates, tax rates on top income earners increased, and a stronger stock market generated more capital gains. Federal revenues over the past 12 months reached a new all-time high of $2.7 trillion.

The federal deficit in the past six months was $870 billion, down from a high of $1.47 trillion in CY 2009. Relative to GDP, the federal deficit has dropped almost by half, from a high of 10.5% to now only 5.5%. Almost all of the nominal reduction in the deficit has come from increased revenues (since spending has been flat), which in turn is mostly due to ongoing economic growth, and partly due to higher tax rates. Relative to GDP, 3 percentage points of the 5 percentage point reduction in the deficit have come from the decline in the relative size of government spending, while 2 percentage points have come from the rise in tax revenues.

If current trends continue, the budget could end up balanced within 5-6 years.


Note to Keynesians: The massive increase in the deficit that occurred from late 2008 through 2009 was supposed to "jolt" the economy back to life, but instead we got the weakest recovery in history. If anything helped get the recovery started, it was the Fed's first Quantitative Easing program, which supplied the cash and cash equivalents that were so desperately needed in a world that had become suddenly very risk-averse. Similarly, the huge decline in the deficit that began in 2010 would have choked most Keynesian models, leading to a painful contraction of economic activity that never occurred. Massive fiscal stimulus was followed by excruciating fiscal contraction, yet the economy grew at a fairly steady and unimpressive pace of about 2% throughout—with surprisingly little variation, as the chart above shows.

This recovery has been a perfect laboratory test of the predictive powers of Keynesian economic models, and they have failed utterly. It's time to throw Keynesian economics into the dustbin of history.

Soaring real yields are good news

The biggest change on the margin in the financial markets continues to be the rise in real yields, so this update to my earlier post is both timely and important. Higher real yields reflect not only an improving outlook for growth but also a decline in inflation expectations, and that is a sanguine combination.

Real yields on 5-yr TIPS (see chart above) have soared almost 110 bps since the end of March, to their highest level in more than 18 months.

Ditto for real yields on 10-yr TIPS, which are up 100 bps from their December lows.

As the chart above shows, both real and nominal yields are up on the margin, but real yields have increased by more than nominal yields, thus reflecting a moderate decline in inflation expectations. Inflation expectations are still within a "normal" range, however, and do not reflect any serious risk of deflation.

As I've argued before, government-guaranteed real yields that are available for purchase in the TIPS market can tell us a lot about the market's expectations for real economic growth. As the chart above suggests, the negative real yields on TIPS that we saw earlier this likely reflected market fears of very slow GDP growth. Investors were willing to lock in a negative real yield on TIPS because they feared that the real yields on alternative investments would be even worse, the by-product of collapsing real growth. Real yields are now moving back up towards levels that are more consistent with economic growth of 1-2% per year in the years to come. So this is not a market that has suddenly become optimistic; it is a market that has become less pessimistic. That's not unreasonable at all, given the modest to moderate growth signals we see from other indicators.

The recent decline in the price of gold is also consistent with the message of TIPS. Gold had reached exceptionally high levels not too long ago, arguably driven by fears that the Fed's QE policy might lead to a serious increase in inflation, as well as by fears that the economic outlook was fraught with risk stemming from huge increases in government debt in most developed economies. We now see that the U.S. federal deficit has declined significantly, and TIPS are telling us that inflation risk has also declined, and that the Fed is now likely to reverse QE sooner than expected, thus reducing the likelihood of failure. As I've suggested in a prior post, it looks like gold prices are now coming back down to a level more consistent with other commodity prices. That spot commodity prices are still quite elevated relative to where they've been in the past few decades arguably confirms that the outlook for global growth is far from precarious, so there is no sign here that a Fed reversal of QE poses any serious threat to growth.

As the above chart shows, every recession in the past 50 has been preceded by a significant rise in real yields (the result of concerted Fed tightening), but the current rise in real yields still leaves real yields at very low levels. A true Fed tightening involves not only very high real yields (on the order of 4% or more) but also an inversion of the yield curve. Neither of those conditions exist today. The yield curve is still quite steep, and that implies that monetary policy is still expected to be accommodative for the next several years at least.

The recent jump in nominal and real yields does not threaten the health of the economy. Rather, higher yields reflect a market that is adopting a healthier expectation for growth in coming years. Higher rates normally accompany a healthier economy; they only rarely weaken an economy. This is all very good news.