Tuesday, December 22, 2015

The 2015 Festivus Airing of Grievances

Embargoed until 5 PM CST, December 23, 2015

The 2015 Festivus Airing of Grievances

Well, it’s that time of the year again for the airing of grievances.  And, although I don’t have a lot of problems with you people this year, rest assured, I have a few. The first one has to do with the continued misconception that the purpose and measure of effectiveness of central bank quantitative easing (QE) is related to a decline in bond yields. If falling bond yields are an indicator of an easing monetary policy, then how would one explain the contractions in industrial production almost month after month from October 1929 through June 1931 in the face of declining bond yields (see Chart 1)?
Chart 1
Let’s fast forward to recent years when the Fed was engaged in three separate rounds of QE. As shown in Chart 2, generally, as the Fed stepped up its purchases of securities in the open market, bond yields tended to move higher. Conversely, as the Fed backed off its securities purchases, bond yields tended to move lower. So according to conventional wisdom (?), the Fed’s QE was a failure because the level of  bond yields was positively correlated with the amounts of securities purchased rather than negatively correlated, as the cognoscenti hypothesized.
Chart 2

Okay, when the Fed stepped up its securities purchases, the level of bond yields tended to rise. Does this imply that QE was a failed policy with regard to its ultimate purpose – to stimulate the growth in domestic aggregate demand? On the contrary, QE was successful in stimulating nominal aggregate demand (and real aggregate demand, too). QE provided thin-air credit to the economy, augmenting that provided by private depository institutions. (Alright, you may drink from your Festivus wassail cup now that I have mentioned thin-air credit.) Let’s compare the relationship between year-over-year growth in nominal gross domestic purchases with the year-over-year growth in thin-air credit provided by private depository institutions and then thin-air credit growth augmented by Fed securities purchases. These relationships along with correlation coefficients are shown in Charts 3 and 4.
Chart 3
Chart 4
When Fed securities purchases are excluded, the correlation between growth in private depository institution thin-air credit, advanced one quarter,  and growth in nominal domestic aggregate demand is 0.25. When Fed securities purchases are added to private depository institution thin-air credit, the correlation between growth in this Fed-augmented thin-air credit, advanced one quarter, and growth in nominal domestic aggregate demand more than doubles to 0.55. So, if the goal of a monetary policy is to push bond yields lower, it would seem that the Fed should sell large quantities of securities. Notice that on December 17 and December 18, 2015, when the Fed began implementing its policy interest rate increase by draining reserves (thin-air credit), Treasury bond yields fell. If the goal of a monetary policy is to stimulate nominal domestic aggregate demand, then it would seem that the Fed should purchase large quantities of securities.

Another problem I have with you people (i.e., mainstream economists) is your proclivity to strip out telling elements of an economic report. What I have in mind here is the monthly retail sales report. First, you strip out new car and truck sales because the Commerce Department uses a separate unit sales report when it calculates the contribution of car and truck sales to personal consumption expenditures. Fair enough. Then why don’t you add back into nominal retail sales excluding autos your estimate of motor vehicle sales from the unit sales report that had been released previously?  I mean if I am interested in the behavior of total household spending on goods, leaving out spending on motor vehicles provides only a partial picture. By the way, the correlation between month-to-month percent changes in nominal retail sales of new cars and trucks and unit sales of new cars and trucks is pretty high, at 0.90, as shown in Chart 5.
Chart 5
And then there is the convention to exclude from retail sales those for building materials and garden equipment. The rationale is that this category gets captured in the residential investment (housing) component of GDP. Alright. But expenditures on building materials are part of total spending in the economy. If you are stripping these expenditures out of retail sales, please tell me by how much they raise or lower your residential investment estimate. Enquiring minds want to know (as in National Enquirer, you twit who scolded me for not spelling it “inquiring”).

But what really steams me is the exclusion of gasoline sales from retail sales. Yes, gasoline sales are volatile month-to-month because of volatile gasoline prices. The short-run demand for the physical volume of gasoline is relatively insensitive to variations in its price. I need X gallons of gasoline to get to and from work each week. So, a 10 cents or 20 cents change in the price of a gallon of gasoline in a month is not going to change that much the number of gallons I purchase that month.

But, assume that the price of gasoline is trending lower over a number of months. All else the same, would I not use the income previously spent on gasoline purchases to increase my purchases of more discretionary items? Alternatively, observing a more persistent decline in gasoline prices, I might increase my discretionary driving, which would entail an increase in the volume of gasoline I purchase. Either way, on a longer-term basis, growth in my nominal retail expenditures should not be negatively affected by lower trending gasoline prices. I use the “savings” from lower gasoline prices to step up my nominal and real spending on more discretionary items. But if gasoline sales are stripped out of total retail sales, this information is lost.

Let’s see what has happened in the past 12 months to gasoline prices, total retail sales and retail sales excluding gasoline sales. The year-over-year percent changes in each of these series are shown in Chart 6.
Chart 6

In the 12 months ended November 2015, the price of a gallon of unleaded regular gasoline has fallen 36.3%. In this same period, total nominal retail sales have increased 1.4%. This compares with an increase of 4.9% in the 12 months ended November 2014. So, growth in total nominal retail sales has slowed sharply in 2015 vs. 2014. With their “savings” from lower gasoline prices, why didn’t households increase their spending on discretionary items? Even if nominal gasoline sales are excluded from nominal retail sales, there still has been slowdown in the growth household spending on goods. In the 12 months ended November 2015, retail sales excluding gasoline sales increased by 3.7%, down from the 5.9% increase in the 12 months ended November 2014.

What’s been going on here? One thing that has been going on is that households have been using some of their gasoline “savings” to build up their liquidity in the form of currency and deposits at banks and other depository institutions. This is implied in Chart 7. In the four quarters ended Q3:2015, household acquisitions of currency and deposits relative to their after-tax income averaged 4.6% vs. 3.9% in the four quarters ended Q3:2014. In economics jargon, this means that the velocity of money has fallen. Falling money velocity implies slower growth in nominal spending.
Chart 7
An explanation of how a decline in the velocity of money results in weaker nominal spending will have to wait for another time. Right now, it’s time to gather around your Festivus poles, preferably made of aluminum because of its high strength-to-weight ratio, and join me in singing the Festivus Carol.

A Festivus Carol
(Lyrics by Katy Kasriel to the melody of O’ Tannenbaum)

O’ Festivus, O’ Festivus,
This one’s for all the rest of us.
The worst of us, the best of us,
The shabby and well-dressed of us.
We gather ‘round the ‘luminum pole,
Air grievances that bare the soul.
No slights too small to be expressed,
It’s good to get things off our chests.
It’s time now for the wrestling tests,
Feel free to pin both kin and guests,
Festivus, O’ Festivus,
The holiday for the rest of us.

Paul L. Kasriel
Econtrarian, LLC, Founder and Head of Values (BBC “W1A”)
Senior Economic and Investment Advisor
Legacy Private Trust Co. of Neenah, WI

Tuesday, December 1, 2015

The December 16th Fed Tightening -- Preemptive to a Fault

December 1, 2015

The Dec. 16th Fed Tightening – Preemptive to a Fault

Barring an outright decline in November nonfarm payrolls, the Fed’s Federal Open Market Committee (FOMC) will raise its policy interest rates by a quarter of a percentage point on December 16. I submit that this tightening will go down in annals of Fed history as one of the most preemptive, if not, the most preemptive. I say this because the December 16th tightening will occur as a U.S. economy, short of full employment, already is losing momentum with no discernible signs of inflationary pressures. Although this quarter-point increase in Fed policy interest rates will not have a significant negative effect on nominal aggregate demand growth, it will have a marginal negative effect. The investment implication of a Fed tightening in this environment is that longer-maturity investment grade bonds and non-cyclically-sensitive equities should outperform other asset classes.

Allow me to present some data to support my case that the pace of U.S. economic activity is weakening at a time of excess unemployment and disinflationary tendencies. Consumer spending accounts for 66% of total nominal domestic spending on goods and services in the U.S economy. As shown in Chart 1, in the third quarter of this year, nominal personal consumption expenditures grew at an annualized rate of 4.3% vs. the second quarter (blue bar). This was down from the second quarter’s annualized growth rate of 5.9%. But notice that on a monthly basis (red bars), annualized growth in personal consumption expenditures has slowed appreciably from 4.0% annualized pace posted in both July and August. In September and October, annualized growth in personal consumption expenditures was only 0.9% and 1.5%, respectively. In order for this year’s fourth –quarter annualized growth in nominal personal consumption expenditures to match the third quarter’s slower rate, expenditures in the two months ended December would need to grow at an annualized pace of 9.8%, something that has not occurred since the two months ended August 2009 (see Chart 2). In the 12 months ended October 2015, the median annualized month-to-month growth in nominal personal expenditures has been 3.6%. If both November and December nominal personal consumption expenditures grow at annualized rates of 3.6%, then fourth-quarter average nominal personal consumption expenditures will have grown at an annualized rate of only 2.3% vs. the third quarter. Excluding the contraction in Q1:2015 nominal personal consumption expenditures due to the unusually-harsh winter conditions, you would have to go back to Q2:2013’s 1.8% annualized growth to find a quarter in which nominal personal consumption expenditures grew by less than 2.3%. It is against this likely backdrop of weakening and weak consumer spending that the Fed is going to raise its policy interest rates.

Chart 1
Chart 2

Further evidence of a significant slowdown in the pace of U.S. economic activity can be found in the recent behavior of the new orders index in the Institute of Supply Management’s (ISM) manufacturing survey. Chart 3 shows that there has been a relatively high positive correlation (0.66) between quarter-to-quarter annualized percentage changes in real GDP and quarter-to-quarter annualized percentage changes in the quarterly averages of the ISM manufacturing survey new orders index. In November 2015, the new-orders index dropped to a level of 48.9, its lowest reading since August 2012 (see Chart 4). The three-month moving average of the new orders index slipped to a level of 50.6 in November, its lowest reading since January 2013. The behavior of the ISM manufacturing survey new orders index strongly suggests a further slowing in real GDP growth in Q4:2015 from an already slow-growth Q3:2015 real GDP.
Chart 3
Chart 4

Is the U.S. economy near or at labor full employment? The level of the “headline” or U-3 unemployment rate might lead one to suspect so. In October, the U-3 unemployment rate fell to 5.0%, the lowest since January 2008, just as the last recession was commencing. But if the slack in the labor market has been taken up, why are “real” wages not growing faster. The real wage to which I am referring is a worker’s hourly nominal compensation relative to the unit price at which her employer sells the goods and services that she produced. If labor is getting scarce, then one would expect that nominal hourly compensation would be rising relative to selling prices of goods and services. In Q3:2015, when the average U-3 unemployment rate was 5.2%, annualized growth in business-sector hourly compensation minus the annualized growth in the price index of produced goods and services was 2.3%. Thus, real wages grew an annualized 2.3% in Q3:2015. As shown in Chart 5, the most recent 2.3% annualized growth in real wages as the unemployment rate approaches 5% is quite low in an historical context.
Chart 5

Speaking of the U-3 measure of unemployment, if people have dropped out of the labor force due to discouragement over their job prospects, the U-3 unemployment rate can fall, signaling more improvement in labor-market conditions than actually exists. In addition, some workers who are employed are only able to find part-time jobs when full-time positions are sought by them. The BLS provides another measure of the unemployment rate that captures this labor-force dropout/involuntary-part-time-employment-phenomenon, the U-6 unemployment rate. This is shown in Chart 6. In October, this expanded measure of labor underutilization had fallen to a cycle low of 9.8%. Compared with the previous two cycles when the U-6 unemployment rate fell to 6.8% and 7.9%, respectively, there currently appears to be considerable labor-market slack remaining. So, despite the current U-3 unemployment rate of 5.0%, there appears to be considerable labor-market slack remaining.
Chart 6

Yet another way to gauge labor-market slack is to examine the employment-to-population ratio of the prime-working-age cohort – those people 25 to 54 years old. This cohort typically is out of school and is too young to retire. So a large proportion of this age group would presumably be seeking employment.  Chart 7 shows that the ratio of 25 to 54 year olds employed compared to their total population stood at 77.2% in October 2015. This compares with cycle highs of 81.9% and 80.3% in the two previous cycles. Again, despite the current 5.0% U-3 unemployment rate, the employment-to-population ratio for prime-age workers suggests that there currently is considerable slack in the labor market.
Chart 7

Even if the U.S. economy is short of full employment, the Fed’s dual mandate dictates that it must restrain inflation. There currently is little evidence that inflation is at or is trending toward a threatening rate. Let’s start with the Fed’s preferred measure of consumer goods/services prices, the chain-price index of personal consumption expenditures (PCE). Chart 8 shows that the PCE price index was up just 0.2% from October 2014 and had contracted at an annualized rate of 0.1% in the three months ended October 2015. Six years into the current recovery/expansion, consumer inflation appears to have moderated to near zero.
Chart 8
Of course, one category of consumer purchases that has experienced a large price decline in recent months is energy goods and services. So, let’s look at the behavior of the PCE price index when energy goods and services are excluded, as shown in Chart 9. In October 2015, both on a year-over-year and three-month basis, the annualized inflation rate of PCE excluding energy goods and services was 1.3% and has been trending lower in 2015 vs. 2014. The Fed’s presumed target for PCE inflation is 2% annualized. So, with or without the prices of energy goods and services, consumer price inflation is currently well below the Fed’s target and is trending lower.
Chart 9

The behavior of industrial commodity prices tells the same story – inflation is trending lower. As shown in Chart 10, both energy and industrial metals commodity prices have fallen to their lowest levels since the last recession.
Chart 10
What about the behavior of the historic ultimate inflation hedge, the price of gold? As shown in Chart 11, the average price of gold in the week ended November 27, 2015 was $1068.66 per troy ounce, the lowest since October 23, 2009.
Chart 11
Let us not forget the behavior of the U.S. dollar in the forex market. In the week ended November 20, 2015, the trade-weighted dollar reached its highest level since the spring of 2003 (see Chart 12). A strengthening dollar means lower prices for U.S. imports, all else the same.
Chart 12
Of course, the Fed wants to be preemptive when it comes to containing consumer inflation. So, it might want to look at professional inflation forecasters for help in determining if the inflation genie is about to escape from its bottle. No, I am not talking about Wall Street economists when I refer to professional inflation forecasters. I am talking about bond investors. Bonds are promises to pay fixed nominal amounts in the future. If inflation rises in the future, the real value of these fixed nominal payments declines. So, bond investors have a definite pecuniary incentive to try to accurately forecast goods/services price inflation. The U.S. Treasury issues bonds that promise to pay future nominal amounts. It also issues bonds that promise to pay future inflation-adjusted amounts. This latter type of bond is called a Treasury inflation protected security (TIPS). It can be demonstrated that the yield on a nominal Treasury bond of a particular maturity minus the yield on a TIPS of the same maturity is a proxy for the annualized rate of inflation expected to prevail over that maturity period, expected by the collective wisdom of bond-market investors. I submit for your perusal in Chart 13 a limited history of bond-market participants’ expectations of coming five-year periods of consumer inflation. In the week ended November 27, 2015, the bond market’s expectation of the five-year consumer inflation rate was 1.3%. In the past 72 months, the median five-year inflation-rate expectation has been 1.8%, with a minimum expectation of 1.1% and a maximum expectation of 2.8%. The armchair professional Fed economists with job security may believe that a burst of economically-destructive inflation is imminent, but those people who bet actual money on it do not.
Chart 13

The Fed does not consider asset prices a component of inflation, but I do. So, let’s look at the recent price behavior of two important asset classes, equities and houses, to assess their inflationary danger signals. Chart 14 shows the weekly year-over-year percent changes in the Wilshire 5000 stock price index. In the week ended November 27, 2015, the Wilshire 5000 stock price index was up 0.1% from a year ago. Notice that the growth in this stock price index has been trending lower to about zero in the past two years. Stock price inflation? Nope.
Chart 14
House price inflation? Maybe. Chart 15 shows the year-over-year percent changes and three-month annualized percent changes in the Federal Finance Housing Agency (FHFA) purchase-price index of houses. In September 2015, the year-over-year percent change in the FHFA index was 6.1%. The three-month annualized change was 6.2%. Although these rates of price appreciation are below those of 2013, they are not low in an historical context. For example, the median year-over-year percent change in FHFA price index from January 1991 through December 2006 was 5.9%. Nevertheless, none of the signs of excess in the housing market that were obvious to anyone with curiosity to look in the mid 2000s are present today.
Chart 15

In sum, the Fed is about to raise its policy interest rates by a quarter of a percentage point in the face of a slowdown in U.S. nominal domestic spending, a labor market with still considerable slack,  and a preponderance of  evidence of low and slowing inflation rather than rising inflation. Other major economies are experiencing weak growth and low inflation. This is not an environment in which risk assets would likely be strong performers.

There is one ray of sunshine sneaking through the economic clouds. You guessed it – a pick up in the growth of thin-air credit. (Okay, everyone can knock back a shot of her/his beverage of choice. I mentioned thin-air credit.) As shown in Chart 16, growth in thin-air credit decelerated sharply during this past summer and into the early fall. This likely played a role in the deceleration of growth in nominal domestic demand now being experienced. But starting at the end of October, there has been a reacceleration in the growth of thin-air credit. If this year-over-year growth in the neighborhood of 6-3/4% were to persist, growth in nominal aggregate demand could pick up in the first quarter of 2016.
Chart 16
But, of course, one month does not a trend make. Moreover, The Fed’s imminent interest rate increase, at the margin, will be a negative for thin-air credit growth. Why? Firstly, in order to get the fed funds rate, the interest rate on interbank loans of reserves, to rise, the supply of reserves must fall relative to the demand for reserves. So, all else the same, the Fed needs to reduce the supply of reserves it provides in order to boost the fed funds rate. Reserves are one element of thin-air credit. If the fed funds rate rises, bank loan rates also will rise. At the higher bank loan rate, the quantity of bank loans demanded will fall. Hence, all else the same, bank credit growth, the other element of thin-air credit, will slow.

A quarter-point increase in the fed funds rate will have a negative effect on thin-air credit growth, but not a significant negative effect. Moreover, after the Fed gets the December 16th rate increase out of its system, it is unlikely to raise rates in quick succession thereafter. So a modest acceleration in the pace of economic activity is the more likely outcome in the first half of 2016 than a recession.

Paul L. Kasriel
Founder & Chief HR Officer, Econtrarian, LLC
Senior Economic & Investment Advisor