Thursday, May 10, 2018

Laffer Curve strikes again: lower tax rates produced more revenue

The results of last year's Trump tax cut are starting to roll in, and they should not be surprising to students of the Laffer Curve or readers of this blog. As I noted last October, not cutting taxes rates is boosting the deficit:
Since early last year (February 2016, to be exact), when talk of tax cuts began to spread and politicians on both sides of the aisle began to agree that our corporate tax rate—the highest in the developing world—should be cut, revenues from corporate and individual income taxes have flatlined, despite the fact that personal incomes have increased by almost 5%, trailing earnings per share have increased 8%, and the stock market has jumped some 30%.
Indeed, there was zero growth in federal revenues beginning in February 2016 through the end of last year. Further, as I predicted back then, "if the tax code is reformed, and marginal tax rates on incomes, capital gains, and corporate profits are reduced, Treasury will see an almost immediate surge in revenue." And it is happening.

Today's April Treasury report showed that April tax receipts not only set an all-time record, but were fully 12% higher than last April's receipts. People and corporations had been postponing income and accelerating deductions for the 22 months leading up to last December's landmark tax reform, and now they are beginning to realize that income and stop postponing deductions. Tax receipts are once again growing, and there is every reason to expect more of this for the foreseeable future.

Chart #1

As Chart #1 shows, individual income tax receipts have jumped this year, led by very strong receipts in April. Corporate income tax receipts are still soft, but that's not too surprising considering the huge reduction in the corporate tax rate. In any event, individual income tax receipts account for the lion's share of federal income, and they have once again turned up in decisive fashion. 

Chart #2

As Chart #2 shows, spending has been rising at a fairly constant rate (about 4% per year) since 2015. On a rolling 12-mo. basis, federal revenue has risen at a 3.4% rate over what it was a year ago, and it could easily be recording 5-6% rates of growth going forward. With just the tiniest bit of spending restraint, we could see the budget deficit hold steady or decline between now and year end.

Chart #3

As Chart #3 shows, the federal government's finances are very dependent on the health of the economy. They always deteriorate during and after recessions, and they almost always improve during periods of growth. The recent increase in the budget deficit is anomalous in that regard. But when seen through the lens of the Laffer Curve, it is understandable and thus likely temporary.

The Laffer Curve can be summed up as follows: people respond to incentives, especially changes in tax rates. When there is talk of a future reduction in tax rates, it is reasonable to expect tax revenues to decline in anticipation, then subsequently rise once the rates have been cut. Business investment was weak in anticipation of a reduced business tax rate, and now it should be stronger, with the result being more jobs, more income, more profits, and more revenues to Treasury.

The one thing to worry about is the spending side. Spending discipline unfortunately is lacking in today's Congress, and the unchecked growth of entitlements promises to wreak havoc with federal finances in coming years.

Tuesday, May 8, 2018

Jobs nirvana

The economy isn't booming, but labor market fundamentals have never been so good.

Chart #1

The BLS today reported that April job openings were the highest ever recorded (see Chart #1). The current business cycle expansion has added 10 million net new private sector jobs to the economy since late 2007, yet businesses are looking to hire another 6.55 million. Impressive.

Chart #2

The unemployment rate has fallen to a mere 3.9%, and there are only 6.4 million people actively looking for work, according to the BLS. If there is a problem it is the apparent inability of those looking for work to qualify for or accept the jobs being offered. (see Chart #2) Geographical mismatches are one overlooked but likely culprit: the WSJ noted the other day that a growing number of cities around the country are paying people to relocate there because they have a shortage of able-bodied workers. And with businesses enjoying peak earnings these days, it would not be surprising for many to sweeten their salary offerings in order to fill jobs. What's not to like?

Chart #3

As a percent of the workforce, layoffs are now down to their lowest level ever, as shown in Chart #3. Never before has job security been so solid.

Chart #4

Small businesses are where by far the most new jobs are created, and the owners of those businesses have rarely been so optimistic about the future, as Chart #4 shows.

Chart #5

As Chart #5 shows, real disposable personal income per capita is at an all-time high of $39.5K. That is up 10% from the end of 2007 (i.e., just before the Great Recession hit), and it is just about double what it was 38 years ago, in 1980. Granted, the pace of gains in the past decade has been only about 1% per annum, which is disappointing compared to the 2.1% per annum gains of the 1980-2007 period. But we are making progress and the future looks bright.

Capital today is relatively abundant, thanks to years of growth, rising profits, and lower corporate income taxes. An abundance of capital is an unqualified boon for labor, because when capital is abundant labor sooner or later becomes scarce. This means that the price of labor is bound to rise further, and that should take the form of higher real wages and salaries, plus more job opportunities as businesses seek to ramp up investment. 

UPDATE (5/10/18): First-time claims for unemployment continue to decline. No one ever would have predicted such low levels. The last time they were this low was in 1969, when the total number of jobs was less than half of what it is today:

Chart #6

Monday, May 7, 2018

Argentina just got a $5 billion lesson in the Laffer Curve

Recently, and in the short span of 4 trading days, Argentina's peso suffered a 10% drop, leaving it down 30% vis a vis the dollar over the past year. The Central Bank spent some $5.5 billion of its reserves trying to stem the latest decline, which was arrested only after the central bank hiked short-term rates to a punishing 40% and the government promised to cut spending.

The catalyst for the latest peso decline appears to have been a new 5% income tax on non-residents' holdings of central bank debt (Lebac). This tax, which was part of a comprehensive—and mostly positive—tax reform passed late last year, took effect on April 25th, the very same day that the central bank suddenly was faced with significant outflows of foreign capital. It would seem that foreigners were unhappy paying a tax of 5% of their 30% Lebac coupons. In effect, some $5.5 billion of Lebac was unloaded by foreign investors, converted—thanks to the central bank's sales of its foreign reserves—to dollars, and then shipped out of the country. This was equivalent to the exodus of almost 10% of Argentina's precious foreign reserves. And all because of a 5% tax that might have generated, in the best of cases, about $0.5 billion per year. Ouch. As Art Laffer tells it, "when you tax something more, you should expect to get less of it." Less, in this case, being foreign capital, which Argentina desperately needs to jump-start its economy.

Most observers blame Argentina's ongoing problems on its inability to reign in government spending and tame its 25-30% inflation rate. I think the problem is simpler. As I noted 18 months ago, Argentina has been addicted to money-printing for a long time. Its monetary base has been growing about 30% per year for the past 9 years. Money printing has been and continues to be a major source of financing for the government's deficits. In the U.S., federal deficits are financed almost entirely by the sale of government debt. In Argentina, however, if the government can't finance its deficit by selling debt, then it simply resorts to asking the central bank for money, in exchange for an IOU. The U.S. spends money it borrows from the market, but the Argentine government spends money created out of thin air by its central bank.

Argentina has two ways to proceed if it wants to get things under control. One, reign in government spending in order to reduce the deficit (no more taxes, please!). Two, establish enough credibility with foreign investors so that government deficits can be financed with debt sales. Nothing wrong with doing both, of course, while at the same time eschewing money-printing.

Chart #1

Chart #1 documents Argentina's primary problem: massive money printing. For the past 9 years, the central bank has allowed a 30% annual expansion of the monetary base (two-thirds of which is currency in circulation). Not surprisingly, inflation has been running around 25-30% per year. Inflation, as Milton Friedman famously noted, is a monetary phenomenon. Inflation happens when the supply of money exceeds the demand for it. And in this case, a ten-fold increase in the money supply over 9 years clearly and by far outpaced money demand, so the value of the peso plunged and prices in turn soared.

Chart #2

Another problem that has plagued the country off and on over the years is the government's attempts to manage the peso's exchange rate. If the peso's decline can be slowed, as government bureaucrats typically argue, then that will reduce inflation pressures (thus conveniently shifting the blame from money printing to the foreign exchange market). Notably, the Macri administration, which began in late 2015, wisely abandoned the "official" rate and allowed the peso to float freely (this is shown in Chart #2 where the red and blue lines converged). That restored confidence, and the peso slowed its decline for the next year or so even though money printing continued apace, because demand for pesos improved with improved confidence.

Chart #3

But they have reverted to type of late, by selling $5.5 billion of their forex reserves in order to keep the peso from plunging, as seen in Chart #3. Since that didn't work, their only choice was to jack up short-term interest rates in order to bolster demand for the central bank's debt. Higher interest rates can work in the absence of a decline in money printing (note the similarity to the Fed's use of IOER to bolster banks' demand for bank reserves in the presence of an abundance of excess reserves), but that's not a lasting solution nor will it inspire long-term confidence.

In the end, the math is compelling: since mid-2009, the monetary base has expanded ten-fold, and the peso has lost 83% of its value. The culprit is money printing, and it has got to stop. Any other "fixes" will only prove temporary. Short-term interest rates on Lebac are only effective if they offer investors after-tax compensation for the expected depreciation of the peso. With money printing running at 30% and the peso down 30% in the past year, the after-tax coupon on Lebac needs to be well above 30% to avoid further capital outflows. (Thus it's no surprise that with Lebac rates today at 40%, the peso appears to have stabilized.)

Argentine President Mauricio Macri is, like Donald Trump, a successful businessman who has pledged to restore prosperity to his country. Macri has done a lot of good to date, but this recent peso problem is an unfortunate blemish on his record. I'd like to think that he will take the appropriate steps to get things back on track. So far he's made serious inroads on government corruption and red tape, and the economy's fundamentals have improved measurably (in dollar terms, the Argentine stock market is up 33% since Macri took over). It would be a crime if he didn't set a better course for monetary and fiscal policy. Please, Mr. Macri: cut government spending, pledge to honor Argentina's commitments, get rid of unnecessary taxes, and instruct the central bank to reign in the growth of the money supply.

Friday, April 27, 2018

GDP highlights: money demand down, business investment up

First quarter GDP growth modestly exceeded expectations (2.3% vs. 2.0%), but it was hardly impressive. However, some emerging underlying trends are indeed impressive: thanks to increasing confidence and tax reform, money demand is declining and business investment is rising. Both have the potential to power GDP higher and faster for the foreseeable future.

Chart #1

As Chart #1 shows, real GDP growth has been on a downtrend for the past several quarters. I had expected Q1/18 growth to exceed 3%, as it had in previous quarters, but it was not meant to be. A number of observers have noted that first-quarter growth tends to be on the weak side, perhaps due to faulty seasonal adjustments, and that may well be the case.

Chart #2

Nevertheless, as Chart #2 shows, year over year GDP growth (which avoids seasonal adjustment flaws) has been trending significantly higher for the past year or so. At 2.9% currently, it meaningfully exceeds the 2.2% average annual growth rate for the current expansion.

Chart #3

Despite the recent pickup in growth, the big picture is far from impressive. As Chart #3 shows, the big picture is dominated by an ever-widening "gap" between where the economy is and where it might have been had past growth trends continued. By my estimate, the size of the gap is about $3 trillion.

Chart #4

Chart #5

As Charts #4 and #5 show, one of the biggest things that has happened in the past year or so is a sharp rise in business and consumer confidence. Confidence jumped almost immediately following the November 2016 elections.

Chart #6

As I've argued for many years, one of the defining characteristics of the current business cycle expansion has been risk aversion and a lack of confidence. People were so shocked by the near-total collapse of the financial markets and the global economy that they began to stockpile money. Money demand surged, as shown in Chart #6, beyond anything we had seen previously. That is now beginning to reverse; people are beginning to spend down their money balances and to use their cash to finance increased spending and investment.

Chart #7

Chart #7 tracks the two components of money demand shown in Chart #6: M2 money supply and nominal GDP. I calculate that if the relationship that prevailed between M2 and GDP for the decades prior to 1990 were to re-establish itself, this could result in an additional $4 trillion of nominal GDP. In other words, if the stockpiled cash were to be released into the economy, this could support an additional $4 trillion of national income. That's equivalent to an increase in national income of roughly 25%.

Chart #8

Chart #9

The rise in confidence directly coincides with a decline in the growth of M2 and Bank Savings Deposits, as shown in Charts #8 and #9. Bank savings deposits, I have argued, are an excellent measure of money demand, since in the current expansion they have paid little or no interest. People have put trillions of dollars in the bank because they want it to be safe, not because they want the interest. Bank savings deposits were about 50% of M2 prior to the 2008 recession, and they have now grown to be almost two-thirds of M2. From the end of 2008 until the end of 2016, bank savings deposits more than doubled, from $4 trillion to $8 trillion, for an annualized rate of increase of almost 10%. 

Savings deposit growth has now fallen to about 3%, which is similar to the decline in M2 growth to 3-4%. In the past several quarters, M2 growth has been less than nominal GDP growth, with the result that the demand for money (i.e., M2/GDP) has declined. This is potentially just the beginning of something that could continue for years. The Fed no longer needs to force-feed liquidity to the economy; the increased willingness of people to spend what they have accumulated is sufficient to do the trick. 

Chart #10

Chart #10 shows the other important and recent change in the economy: a pickup in investment, which began early last year, coincident with rising confidence and fueled of late by tax reform. Private fixed investment rose by almost 7% in the year ending March 2018. By historical standards, investment is still relatively weak, as Chart #10 shows, but it is increasing at a healthy pace. Increased investment enhances the likelihood that we will see a pickup in productivity and living standards in the years to come. As Chart #10 also shows, there is plenty of upside potential here.

Q1/18 growth may have been a bit disappointing, but a look inside the numbers shows that there is reason to remain optimistic.

Wednesday, April 25, 2018

Who's afraid of 3%?

The all-important 10-yr Treasury yield rose above 3% today, and that naturally leads to all sorts of questions. Is it good, or is it threatening? Is the Fed too tight? Is inflation about to rise? Is the stock market at risk? I argue here that on balance it's a good thing, and the only ones who need to worry are those that are betting against the US economy.

Chart #1

Three years ago I predicted that we were in the early stages of a bond bear market, and Chart #1 is one validation of that claim: the multi-year downtrend in yields has been broken. To be honest, however, I was a bit early in my prediction. The bear market didn't start until 10-yr Treasury yields hit an all-time closing low of 1.36% in July '16. Today, 10-yr Treasury yields are trading with a 3-handle for the first time in almost seven years (with the exception of one day, Dec. 31, 2013, when yields reached briefly exceeded 3%). 

Chart #2

Chart #2 shows the history of 10-yr Treasury yields going back to 1925. The great bond bull market began when 10-yr yields hit an all-time high of almost 16% in September '81, and it lasted almost 35 years. Perhaps not coincidentally, my career as an economist began in early 1981 when I went to work for Claremont Economics Institute (CEI). That was just before CEI found itself in the limelight, the result of having produced the Reagan Administration's "rosy scenario" forecast that bond yields and inflation were going to plunge as the economy picked up speed. It took a few years before our forecast was vindicated, though none of us at the time would have predicted that bond yields would be falling for the next three and a half decades. What a ride!

Chart #3

Chart #4

As I see it, the first leg of the great bond bull market that has now ended was driven mainly by lower inflation, whereas the second leg was a function of slower real growth, coupled with fears that very slow growth would lead to very low inflation. Chart #3 shows how it took almost 20 years—from the early 1980s through the early 2000s—for 10-yr yields to close the gap between interest rates and inflation; as a result, real (ex-post) yields fell from very high levels to long-term average levels (1%-2%). As Chart #4 shows, the very low real yields of the past 7-8 years have tended to track the very slow real GDP growth of the current economic expansion. And very low real yields combined with low inflation expectations gave us very low nominal yields up until a few years ago.

Chart #5

Since 1997, when TIPS were first introduced, we have enjoyed daily, market-based measures of forward-looking inflation expectations, and that's better than comparing today's interest rates to last year's inflation. Chart #5 shows the history of nominal yields on 10-yr Treasuries, real yields on 10-yr TIPS, and the difference between the two, which is the market's expectation for what the CPI is going to average over the next 10 years. It's worth noting that the real yield on 10-yr TIPS today is just over 0.8%, whereas the ex-post real yield on 10-yr Treasuries (subtracting the year over year change in the core CPI) is also just over 0.8%. If anything, this suggests the market is confident that the future will be similar to the past, and that the Fed is on a sustainable path to raise short-term rates in line with improving economic fundamentals. 

Chart #6

If anyone should fear 10-yr Treasuries breaking through the 3% barrier, it's prospective homebuyers. Since 30-yr mortgage rates tend to trade about 1½ points above the yield on 10-yr Treasuries, the rise in 10-yr Treasury yields has produced a commensurate rise in mortgage rates, as Chart #6 shows. 30-yr fixed, conventional mortgage rates have been 4.5% or less for the past six years, but now they are moving higher. This is certainly bad news for homebuyers, but is it a bad thing for the economy?

Chart #7

To date, rising mortgage rates have yet to put a dent in the demand for new mortgages. In fact, as Chart #7 shows, new issuance of mortgages (for purchases, not refis) has risen significantly in recent years despite rising mortgage rates. This should not be surprising, actually, since it is rising demand for loans and a stronger economy which are bidding up the cost of borrowed money. The higher rates of the past year or two are not bad for growth because they are the natural result of stronger growth. Higher rates are only bad when they rise in real terms as a result of tighter monetary policy, but that's not the case today.

Chart #8

Chart #9

Chart #8 compares 2-yr US yields with 2-yr German yields. As Chart #9 shows, US yields have soared relative to their German counterparts, with the spread (blue line) now exceeding 300 bps. And it's not just nominal yields that have diverged: German real yields on 5-yr inflation-indexed bonds are -1.4%, far lower than today's 0.73% real yield on US 5-yr TIPS. Very low real yields in Europe are symptomatic of very weak growth fundamentals. That can be seen in the fact that the US stock market has vastly outperformed the Eurozone stock market since 2009, as shown in Chart #10.

Chart #10

Traditionally, as Chart #9 also shows, a wider spread between US and German yields has corresponded to a stronger dollar (shown here as a weaker Euro), because higher US rates usually reflect a stronger US economy. But since the beginning of the Trump presidency, this has not been the case: in fact, the dollar has weakened despite stronger US growth and higher US interest rates. It's mighty tempting to conclude that whereas Trump's policies have contributed to a strengthening of US economic fundamentals, global investors have steadfastly refused to join the party, perhaps because they can't stand Trump the man.

Chart #11

In similar fashion, as Chart #11 shows, since the beginning of 2017 gold prices have risen even as real yields have risen (and TIPS prices have fallen), contrary to the relationship that prevailed prior to 2017, when gold prices tended to track TIPS prices. The message here? The dollar seems awfully weak and gold seems awfully strong given strong US economic fundamentals. 

Dollar bears and gold bulls are the ones who really need to fear the advent of higher US interest rates. Arguably, they have misinterpreted rising US rates (and Trump) to mean bad news for the economy, when in fact they are good news. 

I'd wager that Larry Kudlow will be cheering the return of King Dollar before too long, and that would be a very good thing.

Thursday, April 12, 2018

Reading the yield curve's message

If you haven't already heard that an inverted Treasury yield curve is a good predictor of recessions, then either you haven't been reading this blog for long or you haven't been reading much in the financial press of late. (For background, see some earlier posts of mine on the subject here and here.) The subject has become the focus of attention in recent months because the yield curve has been flattening, which in turn has sparked concerns that the risk of recession is rising. These concerns are misplaced, as I explain below.

Chart #1


The top portion of Chart #1 is the standard way to display the status of the Treasury yield curve. It represents the difference between the two lines on the bottom portion: the difference or "spread" between 10-yr and 2-yr Treasury yields. The spread is effectively a measure of the slope of the yield curve, which indeed is relatively flat compared to where it was several years ago. But it's not flat nor is it inverted; it is still positively-sloped, and that means the market believes the Fed is justified in saying it plans to increase rates modestly over the next year or so. The relative flatness of the yield curve is not saying that the Fed is tightening too much or threatening growth, it's best characterized as the market's way of saying that economic growth expectations are neither exciting nor worrisome. I explain this a bit more below.

Chart #2

Chart #2 is another way of looking at the yield curve—a better way, since it gives us some important additional information. The red line in Chart #2 is similar to the blue line in Chart #1, but the blue line in Chart #2 is the important addition: it shows the real, inflation-adjusted Fed funds rate, which is the overnight rate that the Fed targets. The Fed these days has absolute control over the nominal funds rate, while the rest of the nominal yield curve is essentially a projection of what the market thinks the funds rate will average over time. Any yield curve analysis worth its salt should measure not only the slope of the Treasury curve, but also consider the level of the real Fed funds rate.

The Fed doesn't just target the funds rate. What it really targets—but rarely talks about—is the real funds rate. Borrowing money at 5% when inflation is 1% is one thing, but borrowing money at 5% when inflation is 10% is quite another (the former means borrowing is expensive, the latter means borrowing money is a good way to make money). Real borrowing costs are what truly affect behavior. When money is very expensive—when real borrowing costs are high—people are discouraged from borrowing and spending and are encouraged to save money; eventually, if real rates are forced too high, economic activity suffers. That's been the proximate cause of every one of the recessions in the past 60 years.

One thing that stands out in Chart #2 is that the real funds rate has been negative for the past decade. Doomsayers think this means the Fed has been flooding the world with money, and the sky will soon be falling. Monetarists reason that, since we have seen neither a collapse of the dollar nor soaring inflation over the past decade, this can only mean one thing: the demand for short-term financial assets has been incredibly strong for many years (another way of saying that the market has been very risk averse for most of the past decade), and, moreover, the Fed hasn't artificially depressed interest rates, nor has it flooded the market with money no one wanted. The Fed has kept rates low because the demand for money has been strong. See this post (The Fed is not "printing money") from five years ago for more background.

Chart #2 actually has two messages: 1) an inverted yield curve is a good leading indicator of a recession, and 2) very high real short-term interest rates are also a good leading indicator of a recession. When both those conditions hold, that's when you need to worry about a recession. Today we're not even close to having to worry. Despite the Fed having raised its target funds rate six times in the past 18 months (from 0.25% to today's 1.75%), the real funds rate is still in negative territory (-0.18% as of March 31 by my calculations), because inflation over the past year has been almost 2%. The Fed has raised its target for the real funds rate because the market has grown less risk-averse and economic growth expectations have improved somewhat. The Fed hasn't "tightened" in the sense that it is trying to slow things down. The Fed is just following the market.

Chart #3

Chart #3 is important because it gives us information about the slope of the real, inflation-adjusted yield curve. Real yields are just as important, if not more so, than nominal yields. The blue line, the real funds rate, is ground zero for the real yield curve, while the red line, the real yield on 5-yr TIPS, is the market's estimate for what the real Fed funds rate will average over the next 5 years. Today, the front end of the real yield curve is positively sloped (i.e., the spread between the two lines is positive), and it has actually been steepening since last summer. The message: the market agrees with the Fed that short-term interest rates, in real terms, will need to rise in coming years. Not by a whole lot, but by enough to rule out the notion that the market and/or the Fed are nervous about the health of the economy. The time to worry is when the real yield curve becomes negatively-sloped, as happened before each of the past two recessions (i.e., when the blue line exceeds the red line, because that means the Fed has tightened too much).

Another reason the Fed needs to raise real rates is to boost the attractiveness of the $2 trillion of excess bank reserves held by the banking system. Failing to do so would decrease banks' desire to hold excess reserves, and that in turn would lead to excessive lending, too much money, a weaker dollar, and rising inflation.

Chart #4

Chart #5

Chart #4 uses real and nominal 5-yr yields to give us information about the market's inflation expectations. Despite the Fed having kept real short rates negative for 10 years, inflation expectations today are no different from what they have been in the past. As Chart #5 shows, the CPI ex-energy has been on a 2% growth path for the past 15 years, and inflation expectations today, based on 5-yr TIPS and Treasury yields, are about 2.1%. That is effectively proof that the Fed has not been printing money or distorting markets. In monetarist parlance, the Fed has managed to keep the supply of money pretty much in line with the demand for money, though not completely, because inflation has averaged about 1.6% per year for the past 10 years.

Chart #6

Chart #6 shows that real yields on TIPS also provide us with information about the market's GDP growth expectations. The level of real yields tends to track the level of real growth, and that is not surprising at all. A stronger economy implies higher real returns, and real yields should therefore rise in a faster-growing economy. Conversely, as economic growth weakens, as it did following 2000, real yields should fall. Currently, real yields of about 0.5% on 5-yr TIPS tell us that the market expects the economy is likely to grow about 2-2.5% per year, according to my reading of the bond market tea leaves.

If last year's tax reform results in a significant increase in economic growth, as I expect it will, then the Fed is going to have to guide real yields significantly higher as well. And that of course means significantly higher nominal yields, assuming inflation expectations remain "contained."

But for the time being, today's yield curve holds no threatening messages for the economy, and I think the market intuitively understands this.

What's worrisome today is not the yield curve, but the threat of a possible trade war with China and the ongoing tensions in the Middle East. The volatility that we are seeing is the result of the turbulence one would expect when headwinds (trade war risk, Middle East tensions) collide with tailwinds (last year's tax reform). For now, the market's judgment is that the two opposing forces effectively neutralize each other, with the result that growth is expected to be unimpressive, while inflation is expected to remain in the neighborhood of 2%.

Friday, April 6, 2018

Despite a weak March, jobs growth still improving

The March private sector employment report was a big miss on the downside (102K vs. 188K), but the trend rate of growth in private sector jobs continues to improve. The monthly jobs numbers are notoriously volatile and subject to significant revision after the fact, so one month's number cannot possibly be significant. For years I've focused on the 6- and 12-month rate of growth in private sector jobs, and by those measures conditions in the labor market continue to improve, after hitting a low last September. Here are the relevant charts:

Chart #1

Chart #2

Charts #1 shows the nominal monthly change in private sector jobs, while Chart #2 shows the 6- and 12-month rate of growth of private sector jobs. Big swings such as we have seen in recent months are pretty much the norm, so any attempt to characterize the underlying dynamics of the jobs market must rely on at least several months. Over the last six months, private sector jobs have increased on average by 213K, which translates into a 2.0% annualized rate of growth. Over the past 12 months, private sector jobs have increased on average by 187K, for a 1.8% rate of growth. This represents a significant improvement since the low point in September of last year, when private sector jobs rose at a 1.6% rate over the previous 6 and 12 months. We're making progress, albeit slowly.

Chart #3

Another bright spot is the recent pickup in the year over year growth of the labor force (the number of people of working age who are employed or looking for work). This hit a low of 0.4% last October and now stands at 1%, which is close to its average in recent decades. Background: over the long haul, the labor force tends to grow by about 1% per year, and productivity tends to average about 2%: the combination of the two, 3%, gives you the long-range average rate of growth of the economy. The current recovery, the weakest on record, has seen annualized growth rate in the labor force of just 0.5% and annualized productivity growth of only 1.0%.

Chart #4


Chart #4 shows the size of the labor force, which for many years increased by a little over 1% per year. If that growth trend had persisted, there would have been another 12 million or so either working or looking for work, and the unemployment rate—currently 4.1%—would currently be a lot higher.

Chart #5

The Labor Force Participation Rate has been steady—and quite low—for the past several years, but with a hint of improvement. (This is the labor force—those working and looking for work—divided by the working age population.) This rate is going to have to increase in coming years if the economy is to grow by more than 3%. Which means that a good portion of the 12 million or so that have "dropped out" of the labor force are going to have to decide to get back in the game. There are hints that this improvement has begun, but progress is still slow. What will entice millions of folks to get off the sidelines and back to work? Better-paying jobs. Where will the extra money to pay higher salaries come from? From increased corporate profits, which are baked in the cake thanks to the recent tax reform, and which will increase the nation's capital stock as corporate investment improves. With more capital deployed in the economy, labor will become relatively scarce and thus more valuable—and better-paid.

Chart #6 

Chart #6 is another bright spot, since it shows that there has been zero change in the level of public sector employment since the end of 2007. (Note that the y-axis for both series shows a similar scale increase, namely 20%.) This means the relative size of the public sector workforce has shrunk by almost 10% over the past decade. That is a very good thing, since the private sector is much more productive. 

Monday, April 2, 2018

ISM optimism

The monthly surveys of the Institute for Supply Management are very timely (though not real-time) indicators of the health of the manufacturing and service sector industries, and that's a good reason to pay attention to each release on the first of the month. They aren't perfect, but when they register strong levels it is almost always the case that the economy is doing well. I dedicate this post to today's manufacturing sector release, which was uniformly positive. That's comforting, given the backdrop of tariff wars.

It's obvious that the market is more concerned about the threat of a tariff war, as evidenced by today's renewed decline in stock prices, than it is bolstered by the strong ISM surveys. Trump has mandated tariff hikes targeted to China, and China is now retaliating with its own tariffs on selected US goods. This way lies misery, and the real losers will be consumers in both China and the US, who will be saddled with higher prices for a wide range of products. We can only hope that these are negotiating tactics on both sides, and that in the final analysis trade between the US and China will become more fair and more free. If not, we will have a mess on our hands and Trump's presidency will end in ignominy. Can he really be so stupid as to carry this tariff war to its disastrous conclusion? Thank goodness he has Larry Kudlow at his side to warn him of this danger.

Chart #1

Chart #1 compares the overall ISM manufacturing index to quarterly GDP growth. The two don't track perfectly, but as I look at the chart it strongly suggests that Q1/18 GDP growth is very likely to exceed current estimates, which, according to the current output of the Atlanta and NY Fed's models, is likely to be just under 3%. I'd wager that if the ISM index remains at or near these levels for several more months, we are very likely to see some stronger-than-expected GDP numbers before too long.

Chart #2

Chart #2 tracks export orders. Although the March reading dropped from the very high level of the February reading, this survey still suggests that overseas economies are doing well, and US exporters are enjoying strong demand.

Chart #3

Chart #3 shows that a significant number of ISM respondents are experiencing rising prices. This could be a harbinger of higher inflation ahead, but it could only be a sign of generally strong global conditions.

Chart #4

Chart #4 shows that a meaningful number of manufacturing firms are planning to increase their hiring activity in the months to come. That in turn reflects a decent level of optimism on the part of industry executives.

Chart #5

Chart #5 compares the US manufacturing index to a similar index/survey of Eurozone manufacturing firms. Both have been quite strong of late, but conditions in the Eurozone appear to have softened a bit in recent months. Eurozone stock markets have been underperforming their US counterparts for many years, however, so somewhat weaker conditions in Europe are not "new" news.

UPDATE: Today's release of the ISM Service Sector surveys (4/4/18) adds to the growing list of indicators which point to stronger US GDP growth:

Chart #6

Chart #7 compares the monthly changes in private sector employment as calculated by the Bureau of Labor Statistics and ADP. We are seeing here preliminary signs of an increase in the trend rate of growth in private sector employment. I think there is a decent chance that Friday's jobs report will be somewhat stronger than the market is currently expecting (+190K).

Chart #7

The market is obviously torn between the good news, reflected in part by the above charts, and the bad news, which is a budding tariff war with China. Comparing the two, I'm inclined to say that "a bird in the hand (i.e., stronger US GDP growth) is worth two in the bush (i.e., the possibility of a trade war with China)." Tariffs are for the moment only in the threat stage, still months away from actually being imposed, whereas it is becoming more clear that the US economy is gaining upward momentum.