Tuesday, August 9, 2016

Who Are You Going to Believe -- the Commerce Dept. or ISM, Autodata & the BLS?


August 9, 2016

Who Are You Going to Believe -- the Commerce Dept. or ISM, Autodata & the BLS?

This past July 29, the Commerce Department surprised the economic cognoscenti by reporting that its advance estimate of second quarter real GDP annualized growth was a paltry 1.2%. The consensus estimate of Street economists was north of 2%. Oh my, with growth this anemic, the Fed certainly would not entertain raising its policy interest rates at its upcoming September 20-21 meeting, would it? Yes, it might. And here’s why.

Firstly, the advance estimate of GDP is called that because it is made in advance of the Commerce Department having all of the data that goes into the GDP calculation. For example, Commerce does not have complete inventory, trade and construction data. So Commerce makes educated guesses as to what the missing data might turn out to be. Moreover, some of the “hard” data Commerce has is actually “soft” and will be revised in the coming months. As previously incomplete data are available and revisions to previously available data are made, Commerce releases a revised estimate of GDP a month after the release of its advance estimate. And then a “final” estimate of GDP is released by Commerce a month following the release of the revised estimate. But the final estimate is not really final inasmuch as Commerce keeps revising a given quarter’s GDP years after the release of the not-so-final estimate. To illustrate this revision process, I pulled out of the air (thin air? drink) estimates of the annualized change in real GDP for the first quarter of 2014. The advance estimate was 0.1%. Two months later, the “final” estimate was minus 2.9%. As of July 29, 2016, the estimate of the annualized change in Q1:2014 real GDP was minus 1.2%. So you can see that there is many slip twixt the cup and the lip when it comes to advance estimates of GDP and later estimates.

Secondly, even if we made the heroic assumption that the advance estimate of Q2:2016 real GDP growth at 1.2% were close to being accurate, it understates underlying demand for U.S. goods and services. If the guessed-at inventories component of GDP are stripped out, real final demand for U.S. produced goods and services grew at an annualized 2.4%. This compares with annualized growth in real final demand of 1.2% and 1.3% in Q4:2015 and Q1:2016, respectively. So, if the Fed were inclined to believe the advance national income and product data for Q2:2016, then it might be impressed by the acceleration in real final demand growth.

To get a fix on the current performance of the U.S. economy, I prefer to look at some indicators that have been reliable in the past, are more timely than Commerce Department GDP estimates and do not get revised nearly as much as GDP. Those indicators are the ISM new orders index, monthly new car/truck sales and monthly number of unemployment insurance recipients. The last 12-month behavior of these indicators is shown in Charts 1, 2 and 3.



Chart 1
Chart 2
Chart 3


Chart 1 shows the monthly levels of the weighted-average index of new orders for manufacturing and nonmanufacturing businesses surveyed by the Institute for Supply Managers. The weights are derived from the value-added data of manufacturing and nonmanufacturing firms contained in the national income and product accounts. After dipping in May, business new orders picked up in June and July. Chart 2 shows that car and truck sales accelerated to an annualized pace of 17.9 million units in July after braking in June. Chart 3 shows that the number of people receiving unemployment insurance has been trending lower since blipping up in May. Except for new seasonal adjustment factors and/or changes in the relative value added of manufacturing and nonmanufacturing firms, the ISM new orders data will not be revised.  Except for new seasonal adjustment factors, the car and truck sales data will not be revised. The unemployment insurance data will be lightly revised in the next four weeks, but that’s it.
These three indicators show that the U.S. economy was doing just fine last month. They could reverse course between now and September 20-21. But given strong growth in bank credit, I doubt they will. Don’t count out a policy interest rate increase at the upcoming September FOMC meeting.

Paul L. Kasriel
Senior Economic and Investment Advisor
Legacy Private Trust Company of Neenah, WI
Founder, Econtrarian, LLC

1-920-818-0236

Friday, July 22, 2016

July 26-27 – The Fed Will Put Us on Notice for a September 20-21 Rate Hike

July 22, 2016

July 26-27 – The Fed Will Put Us on Notice for a September 20-21 Rate Hike

The Fed was cocked and primed to deliver a 25 basis point increase in the federal funds rate on June 15. But on June 3, the BLS announced that nonfarm payrolls increased a paltry 38,000 in May. This monthly random number prompted the Fed to stand down on its interest rate increase. Then on June 23, the UK voters surprised the smart money by voting to have the UK leave the EU. Globally, the prices of risk assets swooned for a couple of days. The FOMC was thanking its lucky stars that the May nonfarm payroll report caused it to hold off on its planned rate increase for June 15.

But my bet is that in the announcement immediately following the July 26-27 FOMC meeting, the Fed will put us on notice that an interest rate hike is on the agenda for the next FOMC meeting, September 20-21. One reason for my Fed policy expectation is that the pace of U.S. economic activity has picked up in recent months. June nonfarm payrolls rebounded by 287,000. Nominal retail sales surged at an annualized rate of 5.9% in the second quarter after having contracted 0.2% annualized in the first quarter. The manufacturing Purchasing Managers Index (PMI) increased in both May and June with the June level of 53.2 being the highest reading since February 2015. Corroborating the behavior of the manufacturing PMI was the 0.4% rebound in the Fed’s measure of manufacturing production for June. At 1.160 million units, average second quarter housing starts were the highest since Q4:2007. Too be sure, the U.S. economy is not hitting on all cylinders. “Compression” is low in business capital spending, in part due to the relatively low energy prices and previously weak consumer demand.  Exports have weakened because of the slowdown in the pace of economic activity in developing economies. But about 80% of the economy is doing reasonably well.

Does the current inflationary environment cry out for a Fed interest rate increase? After all, growth in the Consumer Price Index (with all components accounted for) has accelerated to an annualized rate of 3.4% in the three months ended June (see Chart 1). But data in Chart 1 also suggest that both the prior deceleration as well as the recent acceleration in CPI growth has been influenced by changes in energy prices.
Chart 1

Although energy prices account for only a little bit over 7% of the CPI, in the past 12 months, the median annualized month-to-month absolute-value percentage change in the energy component of the CPI has been almost 18%.  Perhaps energy prices will continue to rise without other prices falling, thus resulting in a still higher rate of CPI inflation. Alternatively, perhaps energy prices will stabilize or even fall, which, depending on the behavior of other CPI components, could result in a decrease in CPI inflation. Perhaps some other CPI component will exhibit large month-to-month price volatility, which translates into extreme CPI inflation volatility. Whether it is a big movement in energy prices this month or some other component next month, there is a lot of “noise” or volatility in the short-term behavior of the CPI when all items are included. This makes the Fed’s policy decisions and our investment decisions more difficult.



One way to moderate some of the noise in the CPI is to exclude some components that historically have been volatile, such as energy and food prices.  This is part of the logic for looking at the so-called “core” CPI – i.e., the CPI excluding its food and energy components. But food prices and/or energy prices are not volatile every month. So, to automatically exclude these components from the CPI each month is arbitrary. A better way would be to “smooth” the short-term behavior of the CPI would be to exclude items that actually are  volatile in a given month rather than arbitrarily picking one or two items that have demonstrated price volatility in the past. This is what the Cleveland Fed does by calculating each month something it calls the 16% trimmed mean CPI. Essentially what the Cleveland Fed research team does each month is trim, or eliminate, 8% of the weighted CPI components with the largest monthly percentage increases and 8% of the weighted CPI components with the smallest monthly percentage increases from the remaining CPI components. Then, a weighted mean, or average, CPI is calculated using the 84% of the least volatile CPI components for that particular month. Energy prices are not automatically excluded from a particular month’s CPI calculation. But if the percentage change in energy prices in a given month is extreme compared to percentages changes in other CPI components, then they will be excluded.

Chart 2 shows the month-to-month annualized percentage change in the Cleveland Fed 16% trimmed-mean CPI and the All-Items CPI. Not surprisingly, the month-to-month behavior of the trimmed CPI has exhibited less volatility than that of the All-Items CPI.
Chart 2
The Fed has hinted that its target for annualized consumer inflation is around 2%. The median month-to-month annualized growth in the Cleveland Fed 16% Trimmed-Mean CPI in the past 12 months has been – you guessed it – 2%. Chauncey Gardiner predicted that the economy would grow in the spring, and it has. The Fed has “achieved” its target consumer inflation rate. Why not signal at the July 26-27 FOMC meeting that a federal funds rate increase is penciled in for the September 20-21 FOMC meeting barring extenuating circumstances?

Is it likely that the pace of U.S. economic activity will slump significantly between now and September 21? Not if the behavior of “thin-air” credit has anything to do with it. (Everyone may imbibe now.) Chart 3 shows that growth in the sum of commercial bank credit and the monetary base (currency in circulation and depository institution reserves at the Fed) has grown at an annualized rate of 4.8% in the three months ended June. Although 4.8% is not a blistering pace in an historical context, it does represent a rebound from its growth slump in December-to-February period. The winter growth slump in thin-air credit resulted from the Fed’s December federal funds rate increase. In order to bring about this rate increase, the Fed had to reduce bank reserves relative to their demand. This caused a corresponding slump in the monetary base component of thin-air credit. As also can be seen in Chart 3, growth in the commercial bank component of thin-air credit actually accelerated after the Fed raised the federal funds rate in December.
Chart 3
In sum, I believe that in the policy statement of the July 26-27 FOMC meeting, the Fed will alert us to the high probability of a 25 basis point increase in the federal funds rate occurring at the September 20-21 FOMC meeting. In the event, I believe that this will cause a significant upward revision in market expectations of the level of future short-term interest rates. Because yields on longer-maturity securities are a function of expected future yields on short-maturity securities, bond yields also will rise. Although history might not repeat itself, it does tend to rhyme. Go back and review what happened to the bond market in 1994.

Paul L. Kasriel
Founder, Econtrarian, LLC
Senior Economic & Investment Advisor
Legacy Private Trust Co., Neenah, WI

1-920-818-0236

July 26-27 – The Fed Will Put Us Notice for a September 20-21 Rate Hike

July 22, 2016

July 26-27 – The Fed Will Put Us on Notice for a September 20-21 Rate Hike

The Fed was cocked and primed to deliver a 25 basis point increase in the federal funds rate on June 15. But on June 3, the BLS announced that nonfarm payrolls increased a paltry 38,000 in May. This monthly random number prompted the Fed to stand down on its interest rate increase. Then on June 23, the UK voters surprised the smart money by voting to have the UK leave the EU. Globally, the prices of risk assets swooned for a couple of days. The FOMC was thanking its lucky stars that the May nonfarm payroll report caused it to hold off on its planned rate increase for June 15.

But my bet is that in the announcement immediately following the July 26-27 FOMC meeting, the Fed will put us on notice that an interest rate hike is on the agenda for the next FOMC meeting, September 20-21. One reason for my Fed policy expectation is that the pace of U.S. economic activity has picked up in recent months. June nonfarm payrolls rebounded by 287,000. Nominal retail sales surged at an annualized rate of 5.9% in the second quarter after having contracted 0.2% annualized in the first quarter. The manufacturing Purchasing Managers Index (PMI) increased in both May and June with the June level of 53.2 being the highest reading since February 2015. Corroborating the behavior of the manufacturing PMI was the 0.4% rebound in the Fed’s measure of manufacturing production for June. At 1.160 million units, average second quarter housing starts were the highest since Q4:2007. Too be sure, the U.S. economy is not hitting on all cylinders. “Compression” is low in business capital spending, in part due to the relatively low energy prices and previously weak consumer demand.  Exports have weakened because of the slowdown in the pace of economic activity in developing economies. But about 80% of the economy is doing reasonably well.

Does the current inflationary environment cry out for a Fed interest rate increase? After all, growth in the Consumer Price Index (with all components accounted for) has accelerated to an annualized rate of 3.4% in the three months ended June (see Chart 1). But data in Chart 1 also suggest that both the prior deceleration as well as the recent acceleration in CPI growth has been influenced by changes in energy prices.
Chart 1

Although energy prices account for only a little bit over 7% of the CPI, in the past 12 months, the median annualized month-to-month absolute-value percentage change in the energy component of the CPI has been almost 18%.  Perhaps energy prices will continue to rise without other prices falling, thus resulting in a still higher rate of CPI inflation. Alternatively, perhaps energy prices will stabilize or even fall, which, depending on the behavior of other CPI components, could result in a decrease in CPI inflation. Perhaps some other CPI component will exhibit large month-to-month price volatility, which translates into extreme CPI inflation volatility. Whether it is a big movement in energy prices this month or some other component next month, there is a lot of “noise” or volatility in the short-term behavior of the CPI when all items are included. This makes the Fed’s policy decisions and our investment decisions more difficult.



One way to moderate some of the noise in the CPI is to exclude some components that historically have been volatile, such as energy and food prices.  This is part of the logic for looking at the so-called “core” CPI – i.e., the CPI excluding its food and energy components. But food prices and/or energy prices are not volatile every month. So, to automatically exclude these components from the CPI each month is arbitrary. A better way would be to “smooth” the short-term behavior of the CPI would be to exclude items that actually are  volatile in a given month rather than arbitrarily picking one or two items that have demonstrated price volatility in the past. This is what the Cleveland Fed does by calculating each month something it calls the 16% trimmed mean CPI. Essentially what the Cleveland Fed research team does each month is trim, or eliminate, 8% of the weighted CPI components with the largest monthly percentage increases and 8% of the weighted CPI components with the smallest monthly percentage increases from the remaining CPI components. Then, a weighted mean, or average, CPI is calculated using the 84% of the least volatile CPI components for that particular month. Energy prices are not automatically excluded from a particular month’s CPI calculation. But if the percentage change in energy prices in a given month is extreme compared to percentages changes in other CPI components, then they will be excluded.

Chart 2 shows the month-to-month annualized percentage change in the Cleveland Fed 16% trimmed-mean CPI and the All-Items CPI. Not surprisingly, the month-to-month behavior of the trimmed CPI has exhibited less volatility than that of the All-Items CPI.
Chart 2
The Fed has hinted that its target for annualized consumer inflation is around 2%. The median month-to-month annualized growth in the Cleveland Fed 16% Trimmed-Mean CPI in the past 12 months has been – you guessed it – 2%. Chauncey Gardiner predicted that the economy would grow in the spring, and it has. The Fed has “achieved” its target consumer inflation rate. Why not signal at the July 26-27 FOMC meeting that a federal funds rate increase is penciled in for the September 20-21 FOMC meeting barring extenuating circumstances?

Is it likely that the pace of U.S. economic activity will slump significantly between now and September 21? Not if the behavior of “thin-air” credit has anything to do with it. (Everyone may imbibe now.) Chart 3 shows that growth in the sum of commercial bank credit and the monetary base (currency in circulation and depository institution reserves at the Fed) has grown at an annualized rate of 4.8% in the three months ended June. Although 4.8% is not a blistering pace in an historical context, it does represent a rebound from its growth slump in December-to-February period. The winter growth slump in thin-air credit resulted from the Fed’s December federal funds rate increase. In order to bring about this rate increase, the Fed had to reduce bank reserves relative to their demand. This caused a corresponding slump in the monetary base component of thin-air credit. As also can be seen in Chart 3, growth in the commercial bank component of thin-air credit actually accelerated after the Fed raised the federal funds rate in December.
Chart 3
In sum, I believe that in the policy statement of the July 26-27 FOMC meeting, the Fed will alert us to the high probability of a 25 basis point increase in the federal funds rate occurring at the September 20-21 FOMC meeting. In the event, I believe that this will cause a significant upward revision in market expectations of the level of future short-term interest rates. Because yields on longer-maturity securities are a function of expected future yields on short-maturity securities, bond yields also will rise. Although history might not repeat itself, it does tend to rhyme. Go back and review what happened to the bond market in 1994.

Paul L. Kasriel
Founder, Econtrarian, LLC
Senior Economic & Investment Advisor
Legacy Private Trust Co., Neenah, WI

1-920-818-0236

Sunday, May 22, 2016

a June Fed Funds Rate Hike Risks a September Economic Stall

May 19, 2016

A June Fed Funds Rate Hike Risks a September Economic Stall


Recent economic data, e.g., retail sales, housing starts and industrial production, suggest that the U.S. economy has awoken from its winter slumber. In addition, growth in consumer prices has accelerated of late (see Chart 1). The consensus of the Federal Open Market Committee (FOMC) is that the federal funds rate will be hiked twice by 25 basis points each time in 2016. Time’s a wastin’.  The behavior of short-term interest rates indicates that investors have been skeptical that the Fed will pull the fed-funds trigger at its June 14-15 FOMC meeting. But about a month ago, comments by Boston Fed President Eric Rosengren, no Johnny-One-Note policy hawk like Richmond Fed President Jeffrey Lacker, were interpreted to imply that financial-market participants were underestimating how soon the Fed might hike the federal funds interest rate.
Chart 1

Despite the recent acceleration in the pace of U.S. economic activity, I believe that the Fed runs the risk of causing the pace of U.S. economic activity to stall out in the late-summer or early-fall of 2016 if it raises the federal funds rate at its June 14-15 FOMC meeting. The reason I believe an economic stall would occur is, you guessed it, because of the negative effect a fed funds rate hike would have on growth in thin-air credit (the sum of the monetary base and depository institution credit).

Allow me to elaborate. The federal funds interest rate is the price of overnight credit in immediately-available funds, or reserves, created by the Fed. This price, like any price, is determined by supply and demand. The demand for reserves is determined by the amount of reserves depository institutions (primarily commercial banks) are required to hold in relation to their deposits. Depository institutions also have a demand for reserves in excess of what they are required to hold. Now that the Fed pays interest on reserves held by depository institutions, this excess demand for reserves is much higher than was the case when no interest was paid by the Fed on reserves. The supply of reserves is determined by the Fed. For example, if the Fed sells securities in the open market, the supply of reserves will decrease, all else the same. If the Fed wants the federal funds rate to rise, it needs to reduce the supply of reserves relative to the demand for reserves. When the Fed raised the federal funds rate in late December of 2015, the monetary base – the sum of reserves and currency in circulation – declined (see Chart 2). And, although the level of the monetary base rose subsequent to its dip coincident to the increase in the fed funds rate, the level of the monetary base has not returned to its level prior to the increase in the fed funds rate.
Chart 2

Now, let’s look at the recent behavior of a variant of thin-air credit, i.e., the sum of the monetary base and commercial bank credit. Chart 3 shows the annualized growth in this variant of thin-air credit on a three-month basis.  In the three months ended October 2015, thin-air credit had grown at an annual rate of 6.7%, close to its long-run median annualized growth rate of about 7%. By the three months ended January 2016, annualized growth in thin-air credit had slowed to just 1.1%. In the three months ended April 2016, annualized growth in thin-air credit had recovered to 3.8%. But that was still well below its long-run median annualized growth of 7%.
Chart 3
Now let’s reproduce the data in Chart 3, the three-month annualized growth in thin-air credit, but also show the three-month annualized growth in its components, commercial bank credit and the monetary base. This is shown in Chart 4. We can see that in March and April 2016, the three-month annualized rate of growth in commercial bank credit has moderated (6.0% in the three-months ended April 2016). Although the monetary base still is contracting, its rate of contraction has become less, only minus 2.5% annualized in the three months ended April 2016. If the Fed raises the federal funds rate in June, the contraction in the monetary base will likely become more severe, as it did after the December 2015 hike in the federal funds rate. Unless growth in commercial bank credit surges for some reason, a June increase in the federal funds rate implies further slowing in the growth to total thin-air credit from an already slow rate of growth. In turn, this would imply future slowing in the pace of nominal economic activity from a none-to-robust current pace.
Chart 4
If the Fed decides to raise the federal funds rate in June, I would expect a rally in the prices of investment-grade U.S. bonds. At the same time, I would expect a decline in the prices of riskier financial assets.

Paul L. Kasriel
Senior Economic and Investment Advisor
Founder and Outplacement Officer of Econtrarian, LLC
1-920-818-0236