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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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