Wednesday, August 2, 2017

Consumer Spending – I’ll Bet that Q3 Real GDP Growth Will Be Closer to Q1’s than Q2’s

August 1, 2017

Consumer Spending – I’ll Bet that Q3 Real GDP Growth Will Be Closer to Q1’s than Q2’s

It’s too hot to go sailing today, so I thought I’d “unpack”, as the kids on cable news say, second quarter real GDP and real personal consumption growth (PCE). I will argue that the quarter-to-quarter acceleration in the growth of both second quarter real GDP and real PCE was due more to arithmetic than a fundamental acceleration in the growth of aggregate demand. To refresh your memory, real GDP annualized growth in the second quarter was 2.6% versus 1.2% in the first quarter. Real PCE growth annualized growth in the second quarter was 2.8% versus 1.9% in the first quarter.

Let’s take a look at the month-to-month annualized real PCE growth over the first six months of 2017 (see Chart 1). The median month-to-month annualized real PCE growth during this time period was a paltry 0.6%. The outlier during this period was March, when annualized real PCE growth was a whopping 9.2%. The annualized growth rate of real PCE in April, May and June were 0.20%, 2.20% and 0.45%, respectively. The three-month average of the annualized growth rates of real PCE for April, May and June was 1.15%, a far cry from the 2.8% annualized growth in the quarterly average level of real PCE.
Chart 1
It was the surge in real PCE growth at the end of the first quarter that boosted second-quarter real PCE growth. Plotted in Chart 2 are the monthly levels of seasonally-adjusted at annual rates of real PCE along with their three-month averages for the first six months of 2017. Let’s concentrate on the data points for March and June. The three-month averages of the PCE levels for March and June also are the first and second quarterly averages, respectively, of the levels of real PCE. If you do the arithmetic you will find the March level of real PCE was 0.49% higher than the average level of real PCE for the three months ended March or the first-quarter average level of real PCE. If the level of real PCE had simply remained at its March level in April, May and June, the second-quarter average level of real PCE would have been equal to that of the March level. In this case, annualized growth in second-quarter real PCE would have been 1.97% (1.0049 raised to the fourth power and so on and so forth). Because the March level of real PCE was so far above the first-quarter average, this biased upward the second-quarter average level of real PCE and thus, second-quarter annualized growth in real PCE. But what March giveth, June taketh away. The June level of real PCE was only 0.085% above the average level of real PCE for the three months ended June, or the second-quarter average. If the level of real PCE were to remain at the June level in July, August and September, then annualized growth in real PCE in the third quarter would be only 0.3%! So, while second-quarter annualized growth in real PCE started the quarter with a strong tailwind, third-quarter growth is starting with hardly any wind at its back. In order for annualized growth in third-quarter real PCE to match the second quarter’s 2.8% growth, the month-to-month annualized changes in real PCE would have to be about 1.2%, double that of the median month-to-month annualized percentage changes in the second quarter.
Chart 2
Real PCE contributed 1.9 percentage points to the second quarter’s 2.6% annualized growth in real GDP. If growth in real PCE slows in the third quarter, which quarterly-averaging arithmetic suggests it will, then growth in third-quarter real GDP is likely to slow, too. But there also is a fundamental reason why third-quarter real PCE growth is likely to slow – you guessed it, sluggish growth in thin-air credit. Plotted in Chart 3 are monthly observations of the behavior of the sum of bank credit and the monetary base. The bars are the year-over-year percent changes in monthly thin-air credit. The line traces the month-to-month annualized percent changes in thin-air credit. In June, the year-over-year percent change in thin-air credit was 2.6%, the slowest growth in 12 months. In June, thin-air credit contracted at an annualized rate of 0.4% versus May. Sluggish growth in thin-air credit is not the stuff of robust growth in consumer spending.
Chart 3
If the Fed does, in fact, begin paring its outright holdings of securities in September, then it had better start engaging in repurchase agreements. Otherwise the monetary base will shrink and, all else the same, there will be upward pressure on the federal funds rate. If the monetary base shrinks, thin-air credit growth will slow further unless there is an offsetting increase in bank credit. If thin-air credit growth slows further in the months ahead, investment-grade bond yields will fall more from their already-low levels – barring a Treasury default emanating from a failure to raise the federal government debt ceiling.

Lastly, my former Northern Trust colleague, Asha Bangalore, has announced her retirement. Her last day at Northern will be August 14. Asha joined me at Northern in 1994. Any success I might have had at Northern was, in large part, due to having Asha as a colleague. She was my “Radar” O’Reilly, knowing what we needed and obtaining it long before I even thought of it. I was always in awe of Asha’s time-management skills. Where as I am a congenital procrastinator, Asha immediately tackles any project regardless of how difficult or boring it might be. I was blessed to have had such a knowledgeable and capable colleague as Asha. Asha, best wishes as you enter this new phase of your life. Who knows, perhaps we can put the team together again if you get bored in retirement?

Paul L. Kasriel
Senior Economic and Investment Advisor
1-920-818-0236

“For most of human history, it made good adaptive sense to be fearful and emphasize the negative; any mistake could be fatal”, Joost Swarte


Sunday, July 16, 2017

Have Bundesbank Agents Infiltrated the Fed?

July 17, 2017

Have Bundesbank Agents Infiltrated the Fed?

Germany’s central bank is the Bundesbank. Prior to the commencement of trading of the euro in January 1999, the Bundesbank conducted Germany’s monetary policy. The Bundesbank has a reputation for pursuing general price-level stability above all else. You might say that the Bundesbank has inflation phobia. The reason for this Bundesbank inflation phobia is the remembrance of the hyperinflation Germany experienced between World Wars I and II. Given the U.S. central bank’s recent actions, it would almost seem that the Fed has developed inflation phobia too.

Although the U.S. does not have general price-level stability, the rate of change of the consumer price index (CPI), no matter how you slice or dice it, is absolutely low. This is illustrated in Chart 1. Plotted in Chart 1 are the 12-month percentages changes in monthly observations of various CPI measures – the CPI including all of its goods/services items, the CPI excluding its energy goods/services items and the Cleveland Fed’s 16% trimmed-mean CPI. The 16% trimmed-mean CPI eliminates components showing extreme monthly price changes. Eight percent of the weighted components with the highest and lowest one-month price changes are eliminated and the mean is calculated from the remaining components, making the 16% trimmed- mean CPI less volatile than either the CPI or the CPI excluding prices for energy goods/services. In the 12 months ended June 2017, the percentage changes in the CPI with all items, the CPI excluding energy items and the 16% trimmed-mean CPI were 1.6%, 1.6% and 1.9%, respectively. Moreover, the 12-month percentage change in the CPI, no matter how you measure it, has been trending lower since the first two months of 2017.

Chart 1
Plotted in Chart 2 are the three-month annualized percentage changes in the same variations of the CPI. In the three months ended June 2017, the annualized percentage changes in the CPI with all items, the CPI excluding energy items and the 16% trimmed-mean CPI were 0.06%, 1.05% and 1.05%, respectively.

Chart 2

Admittedly, this does not represent literal general price-level stability, but these rates of consumer price inflation are low in an historical context and in absolute terms. Of course, just because price inflation currently is quiescent does not mean that it will remain quiescent. According to the late and great economist, Milton Friedman, inflation is always and everywhere a monetary phenomenon. Has the Fed sown the monetary seeds of future higher inflation? To answer this question, consider the data in Chart 3. Plotted in Chart 3 are the year-over-year percent changes in the annual average observations of the sum of depository institution credit and the monetary base (currency plus reserves of depository institutions held at the Fed) along with the year-over-year percent changes in the annual average observations of the Personal Consumption Expenditures chain price index. As regular readers of my irregular commentaries recall, the sum of depository institution credit and the monetary base is what I call “thin-air” credit because both components are created figuratively out of thin air. In Chart 3, observations of thin-air credit growth have been advanced by two years because this results in the highest correlation coefficient, 0.59, between the two series. That is, from 1953 through 2016, the highest correlation between growth in thin-air credit and consumer inflation occurs when growth in thin-air credit leads consumer inflation by two years. So, what is happening to thin-air credit growth today has its maximum effect on consumer inflation two years later. (This has important implications as to how U.S. monetary policy should be conducted, but the discussion of this is for a later commentary.)  Thin-air credit grew 5.7% in 2013, 6.7% in 2014, 4.0% in 2015 and 4.3% in 2016. (As a point of reference, the median year-over-year growth in thin-air credit from 1953 through 2016 was 7.1%.) So, growth in thin-air credit slowed in 2015 and 2016 from its growth in 2013 and 2014, suggesting that consumer inflation should slow in 2017 and 2018 compared with 2015 and 2016.
Chart 3

Let’s home in on the recent monthly behavior of thin-air credit. Plotted in Chart 4 are the 12-month percent changes in the sum of commercial bank credit and the monetary base along with the end-of-month Federal Open Market Committee (FOMC) target levels for the federal funds rate. Note that growth in this subcomponent of thin-air credit has been trending lower in recent years, slowing to 2.6% in the 12 months ended June 2017. Notice also that the federal funds rate has been trending higher. Coincidence? I don’t think so.
Chart 4
In order for the Fed to push the federal funds rate higher, it must reduce the supply of the monetary base relative to the demand for the monetary base. Chart 5 shows that as the target level of the federal funds rate was increased by one full percentage point in the 19 months ended June 2017, the monetary base contracted by $308 billion.
Chart 5

As the federal funds rate moves higher, banks’ loan rates move higher, too. As bank loan rates move higher, the quantity demanded of bank credit decreases. Chart 6 shows that the 12-month growth rate in bank credit has been decelerating as the federal funds rate has been rising, especially so starting in late 2016.
Chart 6
To reiterate, not only is the current rate of consumer inflation low, but the slowing in the growth of thin-air credit suggests that the rate of inflation two years from now will remain low. While the lag between thin-air credit growth and inflation is about two years, the lag between thin-air credit growth and growth in real aggregate demand for goods and services is much shorter. And for those who don’t have their heads in the sand, the evidence of this abounds. Real GDP growth in the 1Q:2017 was a paltry 1.4% annualized. And although second-quarter real GDP growth is likely to be higher than that of the first quarter, it is unlikely to be that much higher. As shown in Chart 7, annualized growth in second-quarter real retail sales was 1.3%, only marginally faster than the first quarter’s 1.1%. Nominal private construction spending contracted at an annualized 4.7% in the two months ended May, as shown in Chart 8. Shipments of manufactured goods have stalled out after their December 2016 surge (see Chart 9). Annualized growth in manufacturing production slowed to 1.4% in the second quarter vs. 2.1% in the first quarter (see Chart 10).
Chart 7
Chart 8
Chart 9

Chart 10

Allegedly, nonfarm payrolls increased by 581 thousand in the three months ended June 2017. There must have been more frequent and longer coffee breaks because the sales and production data do not point to much being produced or sold. Perhaps employers are hiring in anticipation of the big public/private infrastructure program talked about during the last presidential campaign.

Fed officials indicate that there is at least one more hike in the federal funds rate coming in 2017. Why would the Fed want to do this in the face of low inflation and weak economic growth? Fed officials indicate that the Fed will begin paring down its holdings of securities at some point in 2017. All else the same, a decline in Fed securities holdings will reduce the monetary base. All else the same, a reduction in the monetary base will result in an increase in the federal funds rate. Why does the Fed feel the necessity to reduce its holdings of securities in the face of low inflation and weak economic growth?
 Does the Fed have a working monetary policy compass? The chairman of the House Financial Services Committee, Representative Jeb Hensarling of Texas, is in favor of the Fed determining and announcing some rule to guide the FOMC on its monetary policy decisions. President Trump has nominated Randal Quarles for one of the three vacant Fed Board governors’ seats. Although primary remit of Quarles will be regulatory supervision of financial institutions, when (not if) confirmed by the Senate, he will have one vote on the FOMC. According to a Politico article, Quarles is in favor of the Fed using the Taylor Rule as the compass by which monetary policy is navigated. Governor Yellen’s term as chairperson of the Federal Reserve Board ends February 3, 2018. If she is not re-nominated by President Trump, which I believe is a high probability outcome, she would likely resign from the Federal Reserve Board rather than remain as a mere governor. What all of this implies is that President Trump will likely have nominated and the Senate confirmed four of the seven governorships to the Federal Reserve Board by February 2018, one of whom will be the next chairperson. Who knows, one of the nominees might even be John Taylor, the namesake of the Taylor Rule. Regardless, there is going to be increasing pressure on the Fed to adopt some rule to guide its monetary policy decisions, especially with real economic growth disappointing in 2017. Perhaps in my next commentary I will discuss why the Taylor Rule is the wrong rule for the Fed to adopt. Can you guess what might be involved in the rule I would favor?

This is the first commentary I have published since early April. I appreciate those of you who have inquired as to my health or whether I have run off to play the bass guitar in a blues band. My health appears to be good. Not so my bass guitar playing. Some of my time was spent putting together presentations for Legacy Private Trust Company, the contents of which I have covered in my previous commentaries. Similar to President Trump, I have been watching too much television. As an antidote to the news, I got hooked on a Netflix comedy series, “Rake”. The series revolves around a rakish (hence, its name) Aussie defense lawyer. In the first episode of Season 1, the lawyer agrees to defend a prominent Australian economist who is charged with murder. Did I mention that the economist is an admitted cannibal? Talk about putting the “dismal” in the dismal science! I took some time out to walk my lovely daughter down the aisle in her marriage to fine young man (who knows his Seinfeld better than I). Lastly, I have been occupied with a 50th anniversary gift from my wife, a beautifully restored 50-year old classic sailboat – a Pearson Commander 26. I will try to be more productive, but sailing season up here in tundraland lasts until early October!

Paul L. Kasriel
Senior Economic and Investment Advisor
1-920-818-0236

“For most of human history, it made good adaptive sense to be fearful and emphasize the negative; any mistake could be fatal”, Joost Swarte


Wednesday, April 5, 2017

Although the Recent Weakness in Bank Credit Growth May Not Be a Concern to Others, It Is to Me

April 6, 2017

Although the Recent Weakness in Bank Credit Growth May Not Be a Concern to Others, It Is to Me

Starting around this past December, growth in commercial bank credit (loans and securities) slowed precipitously (see Chart 1). Annualized 13-week growth in bank credit of late is the slowest since the summer of 2013. This weakening in bank credit growth has been noticed and commented on by at least two economic analysts besides me – University of Oregon economics professor Tim Duy and Goldman Sachs economist Spencer Hill. These two analysts have concentrated on the weakness in one component of bank credit – commercial and industrial(C&I) loans – and concluded that there is nothing to get excited about with respect to the pace in U.S economic activity. I do not share their sanguine view. Notice that the data in Chart 2 show that the growth in bank credit excluding C&I loans also has slowed precipitously since this past December. If history is any guide, this weakening in bank credit growth excluding C&I loans is cause for concern with regard to the pace of economic activity.
Chart 1
Chart 2

Professor Duy, employing sophisticated econometrics techniques, elegantly corroborated what the Conference Board told us decades ago – the behavior of commercial and industrial bank loans is a lagging indicator of economic activity. What Professor Duy did not do was explain in Dick and Jane (Mr. Pero, that was for you) or otherwise why this is the case. As the data in Chart 3 show, percentage changes in business inventories have a relatively high contemporaneous correlation (0.57) with percentage changes in bank C&I loans. So, businesses rely heavily on bank loans to finance their inventories. To understand why bank C&I loans are a lagging indicator of economic activity, we need to understand the behavior of business inventories relative to business sales in the business cycle. As business sales start to slow, inventory growth tends to picks up. This is shown in Chart 4. This increase in inventory growth relative to sales growth typically is involuntary. With slower growth in revenues, businesses rely even more heavily on their banks to finance their higher involuntary inventory builds.
So, a surge in inventories and C&I loans often is associated with a slowdown in the growth of final demand for goods and services. Hence, bank C&I loan growth often tens to lag growth in final demand for goods and services. That is, the behavior of bank C&I loan growth provides more information as to where the overall economy has been rather than where it is headed.
Chart 3
Chart 4
Goldman’s Mr. Hill hypothesized that the recent weakness in bank C&I loan growth was due to the re-opening of the bond markets to oil and gas industry borrowers. According to Mr. Hill, when energy prices fell in 2015 and 2016 (obviously due to the anticipation of a Trump administration that would promote oil/gas exploration and the elimination of environmental regulations), oil and gas producers had to tap their bank lines of credit because bond-market lenders became more wary. According to Mr. Hill, then, the recent weakness in bank C&I loan growth is largely attributable to a more receptive bond market toward oil and gas industry borrowers and does not signal an imminent slowdown in U.S real GDP growth from its blistering Q4:2016 annualized pace of 2.1%.

And I agree with Messrs. Duy and Hill that the recent slowdown in bank C&I growth is not alarming with regard to the future course of U.S. economic activity. But I believe bank C&I loan growth is a red herring with regard to the future course of the economy. Instead, I focus on the growth in bank credit excluding the C&I loan component. And as I mentioned at the outset of this commentary, growth in bank credit ex C&I loans also has weakened precipitously starting in December 2016.

I am arguing that thin-air credit growth (you knew it was coming) excluding C&I loans is a better leading indicator of the pace of domestic demand than is thin-air credit growth including C&I loans. I will demonstrate this to you by comparing changes in correlation coefficients when thin-air credit leads and lags growth in domestic demand. Plotted in Chart 5 are year-over-year percent changes in quarterly observations of the sum of depository institution credit (including C&I loans) and the monetary base (the sum of depository institution reserves at the Fed and currency) along with year-over-year percentage changes in quarterly observations of Gross Domestic Purchases. The contemporaneous correlation coefficient between these two series is relatively high 0.61. (Remember, a perfect correlation is 1.00). Plotted in Chart 6 is the same thing except that C&I loans are excluded from the thin-air credit growth aggregate. The contemporaneous correlation coefficient between growth in thin-air credit growth excluding C&I loans and growth in Gross Domestic Purchases is 0.55 – not bad for private-sector analysis, but less than the 0.61 correlation coefficient when C&I loans are included in thin-air credit growth.
Chart 5
Chart 6
Remember, though, I am trying to discern which measure of thin-air credit growth is a better leading indicator of economic activity – thin-air credit growth with C&I loans or excluding C&I loans. So, we need to see what happens to correlation coefficients when thin-air credit growth leads and lags Gross Domestic Purchases growth. Contemporaneous correlation coefficients tell us nothing about leading or lagging characteristics. Does thin-air credit growth “cause” Gross Domestic Purchase growth or vice versa? When thin-air credit growth including C&I loans is advanced by one quarter, implying that today’s thin-air credit growth “causes” tomorrow’s Gross Domestic Purchases growth, the correlation coefficient falls from 0.61 to 0.59. When thin-air credit growth excluding C&I loans is advanced by one quarter, the correlation coefficient rises from 0.55 to 0.57. Now let’s retard thin-air credit growth by one quarter, implying that Gross Domestic Purchase growth “causes” thin-air credit growth. When we do this, we find the correlation coefficient for thin-air credit growth including C&I loans is 0.61, the same as its contemporaneous correlation coefficient and higher than 0.59, its correlation coefficient when thin-air credit growth including C&I loans is advanced by one quarter. These changes in the correlation coefficient suggest that thin-air credit growth including C&I loans is a lagging indicator of economic activity. When thin-air credit growth excluding C&I loans is retarded by one quarter, the correlation coefficient falls to 0.51 compared to its contemporaneous level of 0.55 and its one-quarter-advanced level of 0.57. These changes in correlation coefficients suggest that thin-air credit growth excluding C&I loans is a leading indicator of economic activity.

By the way, in case you think that there might not be much left of depository institution credit once C&I loans are excluded, take a look at Chart 7. From 1952 through 2016, the median percentage of nonfinancial business loans from depository institutions as a percent of total depository institution credit was 14.7. In 2016, C&I loans accounted for 13.9% of total depository institution credit. So, C&I loans, although a significant portion of total depository institution credit, are far from the whole ball of wax.
 
Chart 7
Okay, now that I have established (beyond a shadow of doubt?) that thin-air credit excluding C&I loans is the better leading indicator of the two, let’s see how it has been behaving on a year-over-year basis in recent weeks and months. This is shown in Chart 8. Although year-over-year growth in weekly observations of commercial bank credit excluding C&I loans has been slowing since October 2016, there has been some acceleration in the growth of combined bank credit ex C&I loans and the monetary base in recent weeks. Mind you, at 3.4% in the 52 weeks ended March 22, growth in this version of thin-air credit still is weak in an historical context.  If commercial bank credit is not boosting modestly the growth rate of thin-air credit of late, it must be the monetary base. As can be seen in Chart 9, one important factor that has been increasing the monetary base since January is the decline in Treasury deposits at the Fed. All else the same, when these deposits decline, depository institution reserves increase. But as the April 15 tax payment date approaches, Treasury revenues will spike up. To the degree that these revenues are transferred to the Fed, all else the same, the monetary base will decline. In addition, when the Fed raises the federal funds rate, it has to reduce the supply of reserves in order to push up the interest rate. In sum, I would expect that in coming weeks the monetary base will be contracting. Unless there is a resurgence in bank credit growth, total thin-air credit growth will slow from an already tepid pace.


Chart 8
Chart 9

On January 17, I published a commentary entitled “2017 – Shades of 1937”. In the commentary, I wrote: “Based on the recent slowdown in thin-air credit growth, I believe that a significant slowdown in the growth of nominal and real U.S. domestic demand will commence in the first quarter of 2017.” Perhaps “significant” was too strong an adjective, but I hold by my prediction of a slowdown in the growth of real domestic demand. Despite relatively strong employment gains in January and February and hinted at by the March ADP employment guesstimate, real GDP growth in Q1:2017 appears to have come in at an even weaker pace than that of the paltry 2.1% annualized in Q4:2016. (Perhaps the depths of the productivity labor pool are being plumbed, requiring a larger quantity of workers to get a given amount of output produced.) The Federal Reserve Bank of Atlanta’s GDPNow Q1:2017 real GDP annualized growth estimate as of April 4 is 1.2%. Of course, this does not yet incorporate March data. Real personal consumption, which has accounted for about 68% of total real GDP in recent years, is coming in weak based on January and February readings. If the March level of real personal consumption were to be unchanged from the February level, Q1:2017 real personal consumption will have grown at an annualized pace of 0.3% -- not 3.0%, but 0.3%. In order for Q1:2017 real personal consumption expenditures to grow at the 3.5% annualized pace of Q4:2016, March real personal consumption would have to grow at annualized rate of 9.75% vs. February.  How likely is this given that from January 2010 through February 2017 there have been only two month when real consumption expenditures grew by at least 9% annualized month-to-month? The median month-to-month annualized growth in real personal consumption from January 2010 through February 2017 has been 2.3%. If March real personal consumption were to grow at an annualized 2.3%, this would imply Q1:2017 real personal consumption growth of only 1.1%.  What is arguing against a strong reading of Q1:2017 real personal consumption growth is the annualized 17.1% Q1:2017 contraction in unit sales of light motor vehicles, the largest quarterly contraction since the 30.2% contraction in Q4:2009, the quarter after the federal “cash-for-clunkers” program that boosted motor vehicle sales.

In conclusion, with or without C&I loans, thin-air credit growth remains weak. Weak thin-air credit growth implies weak growth in domestic demand. If the Fed does raise its federal funds rate target a couple of more times this year as it has indicated it might, this would weaken thin-air credit growth further and would likely bring on a recession. My bet is after seeing the weakness in Q1:2017 real GDP growth and the lack of rebound in early Q2:2017, the Fed will hold its fire.
Paul L. Kasriel
Senior Economic and Investment Advisor
1-920-818-0236

“For most of human history, it made good adaptive sense to be fearful and emphasize the negative; any mistake could be fatal”, Joost Swarte