Slow Growth

April 21, 2019

by Steve Stofka

Happy Passover and Happy Easter. Now that tax day is past, let’s raise our heads and look at long-term growth trends of real, or inflation-adjusted, GDP. For the past seventy years real GDP has averaged about 3% annual growth. In the chart below, I’ve charted the annual percent change in a ten-year average of GDP (GDP10, I’ll call it). As you can see on the right side of the graph, growth has been below average for the past decade.

In 2008, growth in the GDP10 crossed below 3%. Was this due to the Financial Crisis (GFC) and the housing bust? No. The GFC barely figured into the computation of the ten-year average. The housing market had been running hot and heavy for four to five years, but this longer-term view now puts the housing boom in a new perspective: it was like lipstick on an ugly pig. Without the housing boom, the economy had been faltering at below average growth since the 1990s tech boom.

The stock market responds to trends – the past – of past output (GDP) and the estimation of future output. Let’s add a series of SP500 prices adjusted to 2012 dollars (Note #1).

For three decades, from the late 1950s to the mid-1980s, the real prices of the SP500 had no net change. The go-go years of the 1960s raised nominal, but not real, prices. Investors shied away from stocks, as high inflation in the 1970s hobbled the ability of companies to make real profit growth that rewarded an investor’s risk exposure. From the 2nd quarter of 1973 to the 2nd quarter of 1975, real private domestic investment lost 27% (Note #2). In less than a decade, investment fell again by a crushing 21% in the years 1979 through 1982.

In the mid-1980s, investors grew more confident that the Federal Reserve understood and could control inflation and interest rates. During the next decade, investors bid up real stock prices until they doubled. In 1996, then Fed chairman Alan Greenspan noted an “irrational exuberance” in stock prices (Note #3). The “land rush” of the dot-com boom was on and, within the next five years, prices would get a lot more exuberant.

The exuberance was well deserved. With the Fed’s steady hand on the tiller of money policy, the ten-year average of GDP growth rose steadily above its century-long average of 3%. A new age of prosperity had begun. In the 1920s, investment dollars flowed into the new radio and advertising industries. In the 1990s, money flowed into the internet industry. Construction workers quit their jobs to day trade stocks. Anything less than 25% revenue growth was the “old” economy. The fledgling Amazon was born in this age and has matured into the powerhouse of many an internet investor’s dream. Thousands of other companies flamed out. Billions of investment dollars were burned.

The peak of growth in the ten-year average of GDP output came in the 1st quarter of 2001. By that time, stock prices had already begun to ease. In the next two years, real stock prices fell almost 50%, but investment fell only 12% because it was shifting to another boom in residential housing. As new homes were built and house prices rose in the 2000s, long-term output growth began to climb again.

From the first quarter of 2006 to the 3rd quarter of 2009, investment fell by a third, the greatest loss of the post-war period. In the first quarter of 2008, growth in the GDP10 fell below 3%. In mid-2009, it fell below 2%. Ten years later, it is still below 2%.

The Federal Reserve has had difficulty hitting its target of 2% inflation with the limited tools of monetary policy. There simply isn’t enough long-term growth to put upward pressure on prices.  Despite the low growth, real stock prices are up 150% since the 2009 lows.  A prudent investor might ask – based on what?

The supply side believers in the Trump administration and Republican Party thought that tax cuts would spur growth. In the first term of the Obama administration, believers in Keynesian counter-cyclical stimulus thought government spending would kick growth into gear. Faced with continued slow growth, each side has doubled down on their position. We need more tax cuts and less regulation, say Republicans. No, we need more infrastructure spending, Democrats counter. Neither side will give up and, in a divided Congress, there is little likelihood of forging a compromise in the next two years. The stock market may be waiting for the cavalry to ride to the rescue but there is no sign of dust on the horizon.

Economists are just as dug in their ideological foxholes. The Phillips curve, the correlation between employment and inflation, has broken down. The correlation between the money supply and inflation has also broken down. High employment but slow output growth and low inflation. Larry Summers has called it secular stagnation, a nice label with only a vague understanding of the underlying mechanism. If an economist tells you they know what’s going on, shake their hand, congratulate them and move to the other side of the room. Economists are still arguing over the underlying causes of the stagflation of the 1970s.

A year ago, I suggested a cautious stance for older investors if they needed to tap their assets for income in the next five years. The Shiller CAPE ratio, a long-term evaluation of stock prices, is at the same level as 1929. At current prices in a low growth environment, stock returns may  struggle to average more than 5-6% annually over the next five years.

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Notes:

  1. Adjusted for inflation by the Federal Reserve’s preferred method, the Personal Consumption Expenditures Price Index (FRED series PCEPI). Prices do not include dividends
  2. Real Gross Private Domestic Investment – FRED Series GPDIC1.
  3. A video of the 1996 “irrational exuberance” speech

Inflation Measures

“Everyone is entitled to his own opinion but not to his own facts.” – Sen. Daniel Patrick Moynihan

September 30, 2018

by Steve Stofka

The above quote has been attributed to the former Senate Majority Leader. People repeat the quote when discussing a contentious subject. We are often convinced that we have the facts when our facts may indeed be arbitrary. Let’s take the case of real or inflation-adjusted income. Has the average real wage declined or risen in the past decades? The calculation depends on which measure of inflation we choose.

There are two measures of inflation, the Consumer Price Index (CPI) and the Personal Consumption Expenditure Price Index (PCE). The CPI relies on surveys of what consumers buy. The PCE is based on surveys of what businesses sell (Note #1). The CPI uses a fixed basket of goods, regardless of changes in the prices of items in a basket. If the weekly basket of goods includes two pounds of ground beef, that two pounds never changes in response to lower prices. It is static. The PCE does adjust for price changes. If the price of a pound of ground beef went down thirty cents, the PCE calculates that a family bought a bit more ground beef and a little bit less chicken, for example. It is a dynamic measure.

People drive fewer miles and buy more fuel-efficient cars as the price of gas increases BUT only after a certain dollar amount. Our purchasing patterns are both static and dynamic. Because we are creatures of habit, our buying patterns are resistant to change. Within a certain price range, we will continue to buy the same items. Outside of that range, we do make changes because we want to optimize our choices.

In the past forty years the CPI has calculated an annual rate of inflation that is over ½% higher than the PCE rate. That small difference compounded over forty years amounts to 23%. That large difference tells two very different stories. Using the CPI, the average worker has lost a few percent in inflation adjusted hourly wages. Using the PCE, on the other hand, the average worker has enjoyed real gains of 20% in the past forty years (Note #2).

Our most volatile disagreements are in areas where facts are difficult to observe. The household survey data that underlies the CPI is unreliable because people living busy lives are not accurate journal keepers of their daily purchases. On the other hand, surveys based on business sales are inaccurate because people stock up on items whose prices decline.

Even when facts are readily verifiable, the interpretation of those facts varies with context. In arriving at our version of the meaning of those facts and their context, we subtract a lot of observable data.  We must filter reality because we cannot manage such a large amount of information. Because we filter our perceptions, eyewitness testimony is unreliable. Although our perceptions are inaccurate, we must act on those perceptions and hope that they are accurate enough. That same reasoning guides economists, politicians, and those in the social and physical sciences. We would all have more constructive discussions if we understood the imperfection of our perceptions.

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Notes:

1. The Difference between CPI and PCE {Federal Reserve}

2. Using the average hourly wage for production and non-supervisory employees.

The Reputation of Money

To be respected, authority has got to be respectable. – Tom Robbins

September 9, 2018

by Steve Stofka

Most nations create their own money, a super power of the modern state. The politicians and central bankers of each country have the responsibility to maintain the reputation of its money. Each nation is both the creator and net seller of its money, able to lower but not raise its comparative value. To raise that value, each nation depends on others to be net buyers of its money.

Nations carefully study the behavior of each other’s central banks. Argentina cut interest rates in January 2018 even though the country was experiencing high inflation. This action was the opposite of good central banker behavior, and hurt the reputation of the Argentine peso, which has lost half its value since January. Money traders suspected that the Argentine central bank had become captive to political control. Few trusted a politician with money super powers.

The reputation of a nation’s money rests on the steadiness of its tax revenues. As I have noted before, revenue from the sale of nationalized resources acts as a tax. Those commodity revenues do not build a money’s reputation as much as the tax revenues from the economic production of a nation’s people and businesses.

A nation can print its own money at little cost. A greater supply of anything, given a constant demand, lowers the price of that thing. The real cost of printing money is borne by the nation’s people and businesses who use that money for daily exchange. As a money’s value declines, that loss of value acts as a sales tax on each money unit exchanged. Let’s call that the king’s tax. This undeclared tax revenue does not build a money’s reputation.

A nation supports the reputation of its money by using its super powers with restraint. When a nation receives most of its tax revenues from its own internal production, that is a sign of a healthy economy, with a reasonable monetary and fiscal policy. When the king’s tax (inflation) and commodity resource revenues exceed half of a nation’s revenue, the value of its money becomes like two day old bread.

A nation’s money rises in reputation when it is bought, and there are two reasons for buying a nation’s money: 1) buying goods and services from that nation, and 2) loaning money to the governments and businesses of that nation. In 2017, China, the United States and Germany were the top exporters, putting their currencies in demand (Note #2). Loans to borrowers in emerging markets are often priced in U.S. dollars, the current reserve money of the world. If the money in that nation loses its value against the dollar, the borrowers effectively pay a king’s tax as they make their loan payments (Note #1). Typically, a nation will blame the tax on rapacious money dealers.

A nation’s money reputation relies on several factors that a nation can control: inflation, tax revenue and the source of that revenue. A nation is judged on its current and historical behavior with money and debt. Its political structure and the independence of its central bank are important factors as well. On an international stage, its money must compete with other nations in all these categories. Call it the daily beauty contest – no swimsuits.

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1. EMB is a basket of emerging market debt priced in USD (http://etfdb.com/etf/EMB/). It is off 5% from its high at the beginning of the year and pays a dividend of 4.6%. Its annual return for the past ten years was 6.5%, the same as a long Treasury ETF like TLT. A broad bond index fund like Vanguard’s BND earned 3.8%.

2. Germany uses the Euro, not its own national currency. In 2017, China exported $2.35 trillion, the U.S. $1.55T and Germany $1.45T. Visual Capitalist picture graph. The site is a picture book for curious minds. Here’s one on the biggest employer in each state. For southern states, the answer is Wal-Mart. Universities and health care systems are prominent employers in many states.

Related: The U.S. owes $6.2 trillion to the rest of the world. China’s share of that debt is $1.8 trillion. The U.S. holds $125 billion in foreign reserves, similar to the amount Turkey holds. As the world’s reserve money, the U.S. holds enough foreign reserves to counter any distortions in currency markets.

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Miscellaneous

In a survey of 5000 workers, Gallup found that only 51% had a single full-time job.  36% were gig workers.

Since 1991, real purchase only house prices have gone up 1.7% annually. FRED series HPIPONM226S / PCEPI, index 3/1991 = 100. Real rents and owner equivalent rent (OER) nationally have gone up 8/10ths percent annually. This is about half the rate of home price growth. Urban residents must pay an extra price. In Denver, rental prices have gone up 1.9% annually since 1991. OER has risen 1.7% annually. No doubt, California cities have even higher annual growth rates than national averages. Owner Equivalent Rent is a BLS-calculated rent that a homeowner pays themselves for use of the residence. This includes mortgage, repair and maintenance costs on the home.

The Hunt, Part 2

July 22, 2018

by Steve Stofka

Last week, I showed the inputs to the credit constrained economy as a percent of GDP. I’ll put that up again here.

CreditGrowthFedSpendPctGDP

This week I’ll add in the drains but first let me review one of the inputs, bank loans. Focus your attention on that period just after 9/11, the left gray recession bar,  and the end of 2006, just to the left of the red box outlining the Great Recession on the right.  For those five years after 9/11, the banks doubled their loans to state and local governments, a surge of $1.4 trillion. The banks increased their household and mortgage lending by $5.3 trillion, or 67%. Why did banks act so foolishly? Former Fed chairman Alan Greenspan couldn’t answer that. We have a partial clue.

For 4-1/2 years after 9/11 and the dot-com bust, there was no growth in credit to businesses, a phenomenon unseen before in the data history since WW2. The banks reached out to households, as well as state and local governments because they needed the $1 trillion in loan business missing on the corporate side (#1 below).

There are four drains in the economic engine – Federal taxes, payments on loans, bad debts and the change in bank capital. State and local government taxes are not a drain because those government entities can not create credit. The change in bank capital reflects the changes in the banks’ loan leverage and their confidence in the economy. During the 1990s and 2010s the sum of the inputs and the drains remained within a tight range of about 1/7th of GDP.

InputLessDrains

The results of bad policy during the 2000s are shown clearly in the graph. In addition to the surge in bank loans, the Federal government went on a spending spree after 9/11. There was too much input and not enough drain. The reduction in taxes in 2001 and 2003 exacerbated the problem. There was less being drained out. Asset prices absorb policy mistakes until they don’t – a life lesson for all investors.

Let’s add in a second line to the graph – inflation. The rise and fall of inflation approximates the flows of this economic engine model with a lag time of several months. I’ve shown the peaks and troughs in each series.

InputLessDrainsVsPCE

Look at that critical period from 2006 through 2007. The Fed kept raising rates in response to rising inflation (the red line), driven primarily by increases in the price of oil.  The Fed Funds rate peaked out at 5-1/4% in the summer of 2006 and stayed at that level for a year. The Fed misread the longer term inflation trend and contributed to the onset of the recession in late 2007. The net flows in the engine model (blue line) indicated that the long term trend of inflation was down, not up.

Where will inflation go next? Using last week’s theme, follow the hounds! Who are the hounds? The banks. The inflow of credit from the banks is the primary driver of inflation. Why has inflation in the past decade been low? Because credit growth has been low. Where will inflation go next? A gentle increase – see the slight incline of the blue line at the right of the graph. Contributing to that increase were last year’s tax cuts. Less money is being drained out of the engine.

Too much flow into the economic engine or an improper setting of interest rates – these mistakes are absorbed by assets, which are the reservoirs of the engine. Stocks, bonds and homes are the most commonly held assets and most likely to be mispriced. During the early to mid 2000s, the mistakes in input were so drastic that the financial crisis seems inevitable when we look in the rear view mirror. During the past eight years, the inputs and drains have remained steady, but interest rates have been set at an inappropriate level. Again, we can anticipate that asset prices have been absorbing the mistakes in policy.

 

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1. In the last quarter of 2001, loans to non-financial corporate business totaled $2.9 trillion and had averaged 6%+ growth for the past decade. Anticipating that same growth would have implied a credit balance of $3.9 trillion by the end of 2006. The actual balance was $3.1 trillion.

Hunt For Inflation

July 15, 2018

by Steve Stofka

Saddle up your horses, readers, because we are going on the Hunt for Inflation. I promise you’ll be home for afternoon tea. During this recovery, Inflation has been a wily fox, a real dodger. It has not behaved according to a model of fox behavior. Has Inflation evolved a consciousness?

Inflation often behaves quite predictably. The central bank lowers interest rates and pumps money into the economy. Too much money and credit chasing too few goods and Inflation begins running amuck. Tally-ho! Unleash the bloodhounds! The central bank raises interest rates which curbs the lending enthusiasm of its member banks through monetary policy. Inflation is caught, or tamed; the bloodhounds get bored and take a nap.

Not this time. Every time we think we see the tail of Inflation wagging, it turns out to be an illusion. Knowing that Inflation must be out there, the central bank has cautiously bumped up interest rates in the past two years. Every few months another bump, as though unleashing one more bloodhound ready to pounce as soon as Inflation shows itself.

Yes, Inflation has evolved a consciousness – the composite actions of the players in the Hunt. These players come in three varieties. One variety is the private sector – you and me and the business down the street. The second variety is the federal government and its authorized money agent, the Federal Reserve, the country’s central bank. Finally, there is a player who is a hybrid of the two – banks. They are private but have super powers conferred on them by the federal government. The private sector is the economic engine. The federal government and banks have inputs, drains and reservoirs that control the running of the economy.

The three money inputs into the constrained (see end) economy are 1) Federal spending, 2) Credit growth, and 3) net exports. In the graph below, the blue line includes 1, 2, and 3. The red line includes only 1. The graph shows the dramatic collapse of credit growth in this country. Federal spending accounted for all the new money flows into the economy.

CreditNXFedSpendvsFedSpend

Before the financial crisis, money flows into the economy were just over 30% of GDP. In less than a year, those inputs collapsed by almost 25%.

CreditGrowthFedSpendPctGDP

When inflation is lower than target, as it has been for the past decade, too much money flow is being drained out for the amount that is flowing in. In the case of too high or out of control inflation, as in the case of Venezuela, the opposite is true. Too much is being pumped in and not enough is being drained out. That’s the short story that gets you back to the lodge in time for a cup-pa or a pint. Next week – the inputs, drains and reservoirs of the economy.

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  1. Constrained – the private economy, state and local governments who cannot create new credit.
  2. Net exports are the sum of imports (minus) and exports (plus).

Lots of Changes

March 25, 2018

by Steve Stofka

What a week it was. A glance at the headlines would lead someone to believe that it was all about tariffs and an impending trade war between the U.S. and China. On Thursday and Friday, the Dow Jones Industrial Average lost more than 1000 points, or almost 5%. Was that all about tariffs? Hardly.

As expected, the Federal Reserve raised interest rates ¼% on Wednesday.  This put the Fed rate at 1.5% – 1.75%. Half of the members of the interest setting committee (FOMC) indicated that it might be necessary to raise interest rates four times this year. The market has been pricing in three interest rate increases for 2018. Until Thursday, a fourth increase had not been fully priced in.

Further, the Fed is projecting an unemployment rate below 4% by late 2018 and early 2019. The current rate is 4.1%. Many industries are already struggling to find qualified workers. Rarely does the unemployment rate dip below 4%, and each time, inflation has risen and the stock market has fallen – sometimes substantially.

CPIUnemploy

The downturn following the Korean War was short and shallow, but the other two periods of low unemployment were followed by steep corrections in the market.

On Thursday night, the White House tweety bird announced another change in the roster. Out with the old National Security Adviser, General H. R. McMaster. In with the new adviser, John Bolton, an old school war hawk who avoided military service in Vietnam by joining the National Guard. Bolton’s first instinct is war and regime change as a solution to global disputes. In choosing Mike Pompeo as his new Secretary of State and John Bolton as his new National Security Advisor, Trump has assembled a war cabinet. The market has still not priced in the heightened chances of conflict with North Korea or Iran. Nor has it recognized a greater likelihood of armed conflict with China in the South China Sea. That might come in the next few weeks.

On Thursday, Trump enacted tariffs on imported steel and aluminum from China as promised. Stronger action against China’s trade policies are overdue, as it has long violated the spirit, if not the letter, of the WTO global agreements. Car manufacturers wanting to set up a plant in China must have a Chinese business partner with a 25% stake and – surprise – access to industrial trade secrets. The national government heavily subsidizes key industries so that they can support their own industries and workers. They avoid labor and environmental regulations, and when caught, pledge to do better. They issue a national change in regulation, but the change is only published and enforced in a few local areas.

The theft of intellectual property is a hallmark of most developing nations like China. In the 18th and 19th century, the U.S. was notorious for copying products made by companies in England and France. Article 1, Section 8 of the Constitution added some promise of patent and copyright protection, but the laws instituted protected only U.S. citizens. A half century later, Charles Dickens was “one of the chief victims of American literary piracy” (Source). A foreign inventor had to establish citizenship or residency in the U.S. for two years to gain any patent protection. In 1887, the U.S. joined a 19th century version of the WTO called the Paris Convention. As China does today, the U.S. skirted international agreements for at least a decade (Patent history).

Older Chinese citizens may have watched patrolling U.S. naval ships from the shores of the Yangtze River. The nation remembers the century of U.S. gunboat diplomacy (Wikipedia article). Despite American free market rhetoric, Chinese leaders understand that mercantilism still retains a strong political influence in the trading policies of many developed countries, including the U.S.

When NAFTA was signed in the early 1990s, subsidies of American corn farmers enabled them to sell cheap corn to Mexico. Unable to compete, many farmers in northern Mexico went out of business. As farming jobs decreased in Mexico, many laborers journeyed north to the U.S. to pick crops so that they could support their families. The U.S. is partially responsible for creating the very environment that led to so much illegal immigration from Mexico.

Around the world, developed countries cry foul when another country subsidizes goods that are exported at a lower cost into their countries. Since 1963, the U.S. has imposed a protectionist tariff of 25% on imported light duty trucks, the so called “chicken tax”. Protected for over fifty years by this tariff, domestic truck manufacturers like Ford and Chevy had made few substantial changes to their work vans in the past few decades. In 2015, Ford finally made a substantial change to its F-150 pickup. Notice those Mercedes tall work vans on the road? They are built in Germany, disassembled to avoid the tariff, shipped to the U.S. and reassembled by U.S. workers. Ford uses the same process with its Transit Connect van.

Boeing imports parts from all over the world to build its Dreamliners. Chinese companies use southeast Asia as a manufacturing supply, then assemble and ship thousands of products to the U.S. and around the world. In the truly global manufacturing economy, a trade war is a threat to the profits of many large businesses. They have tuned their operations to the contradictory rules of international trade.

Business leaders understand the political strut of free trade. Each business wants free trade when it wants to compete in someone else’s market. Each business lobbies for more regulations, tariffs and barriers to protect its competitive position within its own market. Yes, it’s all lies, so it’s important that the rules underlying this game not change too much. Trade wars change the rules and that’s bad for business.

The Puff

February 25, 2018

by Steve Stofka

Each week I’m hunting scat, the data droppings that a society of human beings leaves behind. This week I’m looking for a ghost ship called the Phillips Curve, a relationship between employment an inflation that has had some influence on the Federal Reserve’s monetary policy. The ideas and policies of others, some long dead, have a daily impact on our lives. I’ll finish up with a disturbing chart that may be the result of that policy.

A word on the word “cause” before I continue. As school kids we learned a simplistic version of cause and effect. Gravity caused my ball to fall to the ground. As kids, we like simple. As adults, we long for simple. As we grow up, we learn that cause-effect is a very complex machine indeed. The complexity of cause-effect relationships in our lives are the chief source of our disagreements.

So, “cause” is nothing more than shorthand for “has an important influence on.” The dose-response mechanism is a key component of a causal model in biology. If A causes B, I should be able to give more of A, the dose, and get more of B, the response, or a more frequent response.

Let’s turn to the Phillips Curve, an idea that has influenced the Federal Reserve’s monetary policy since it was proposed sixty years ago by economist A.W. Phillips. Simply stated, the lower the unemployment rate, the higher the inflation rate. There is an inverse relationship between unemployment and inflation.

Inverse relationships are everywhere in our lives. Here’s one. The lower the air temperature, the more clothes I wear. I don’t say that air temperature is the only cause for how many clothes I wear. There is wind, humidity, sex, age and fitness, my activity level, social protocols, etc. While there is a complex mechanism at work, I can say that air temperature has an important effect on how many clothes I wear. If I measure the varying air temperatures throughout the year and weigh the amount of clothes that people have on, I will get a strong correlation. High temps, low clothes.

Now what if the temperature got colder and people still wore the same amount of clothes? I would need to come up with an explanation for this discrepancy. Perhaps there never was much of a relationship between air temperature and clothes? That seems unlikely. Perhaps clothes fabrics have been improved? I would need to look at all the other factors that I mentioned above. If I could find no difference, then I would have to conclude that air temperature had little to do with clothes wearing. Headlines would herald this new discovery. Important areas of our economy would be upended. Retail stores would stop stocking coats or bathing suits a few months in advance of the season. Businesses around the country who depend on warm weather clothing would go out of business.

Unlike air temperature and clothes, the relationship between inflation and employment is two-way. The change in one presumably has some influence on the other. During the 1970s, inflation and unemployment both rose. The hypothesis behind the Phillips curve posits that one should go up when the other goes down. Some economists threw the Phillips curve in the trashcan of ideas. Milton Friedman, an economist popular for his lectures and his work on monetary policy, proposed a concept we now call NAIRU. This is a “natural” level of unemployment. If unemployment goes below this level, then inflation rises.

Some economists complained that NAIRU was a statistical figment designed to fit the Phillips curve to existing data. Economic predictions based on the Phillips curve have been consistently wrong. Still, the Congress has mandated that the Federal Reserve maintain “maximum employment, stable prices, and moderate long-term interest rates” (Federal Reserve FAQs). Economists at the Fed must consider both employment and inflation when setting interest rates. The models may not accurately describe the relationship, but many will instinctively feel that the relationship, in some form or another, is valid.

For the past several years, the economy has been at or near maximum employment. In January 2018, the unemployment reading was 4.1%. Whenever that rate has been this low, the country has either been at war or within a year of being in recession. The puzzlement: only lately have there been signs of an awakening inflation.

Because inflation was below the Fed’s 2% benchmark while unemployment declined, the Fed kept its key interest rate near zero for seven years. For its 105 year history, the Fed has never kept interest rates this low for as long as it did. Low interest rates fuel asset bubbles. Such low rates cause people and institutions who depend on income to take inappropriate risks to earn more income. The financial industry develops and markets new products that hide risk and provide that extra measure of income. We can guess that these products are out in the marketplace, waiting to blow up the financial system if a set of circumstances occurs. What set of circumstances? We will only know that in the rear view mirror.

Here’s a chart that tracks price movement of the SP500 ETF SPY for the past twenty years. I’ve shown the tripling in price that has occurred during the past five years.  Notice the long stalk of rising prices. That growth has been nurtured by the Fed’s policy.  Well, maybe this time is different.  Maybe not.

SPYPF20180223

Trump To The Rescue

by Steve Stofka

December 10, 2017

This blog post goes to what may be a dark place for some readers. The election of Donald J. Trump may have stopped a year-long slide into recession. I didn’t start out with that conclusion. I meant to point out some interesting correlations in the velocity of money. Yeh, yawn. By the time I was done, not yawn.

If I mention the change in the velocity of money, do you groan at the prospect of a wonky economics topic? Take heart. Anyone who has slowed down from 65 MPH on a highway to 15 MPH in rush hour traffic is familiar with a change in velocity.

The velocity of money measures the amount of time that money stays in our pockets. It signals the willingness of buyers and sellers to make transactions. When buyers and sellers can’t agree on price, transactions fall and the change in velocity goes negative. In the chart below, the change in the velocity of money (blue line) often has a similar pattern to the change in real GDP (red line).

VelocityVsGDP

Both recent recessions were preceded by declines in GDP growth and the speed of money. Following the financial crisis, the Fed began to inflate the money supply in a series of policies dubbed “QE,” or Quantitative Easing. In 2011, after two rounds of QE, the Fed worried that the recovery might stall out.

Let’s turn to the green square in the chart labelled Operation Twist. Obama and a do-nothing Republican Congress were at odds so there was little chance of Congress enacting any fiscal policy to come to the economic rescue. That task was left – once again – to the Federal Reserve to use its monetary tools.

In Congressional hearings, then Fed Chairman Ben Bernanke advised the Senate Finance Committee that the short term interest rate was already zero and the Fed was out of monetary tools. The Congress should step in with a stimulative fiscal policy. The Committee members somberly hung their heads. We are incompetent, they said, so the Federal Reserve will have to rescue the country.

If it expanded the money supply further, the Fed was concerned that they would spark inflation. In hindsight, that fear was unfounded, but none of us has the luxury of making decisions while looking in the rearview mirror. Economic identities like M*V = P*Q (notes at end) are just that – looking in the rearview mirror.

The Fed resurrected a monetary tool from the 1960s dubbed Operation Twist, after the dance craze the Twist (Fed paper).  Early Boomers will remember Chubby Checker. The Fed began selling the short-term Treasuries they owned and buying long term Treasuries. By increasing the demand for long term Treasuries, the Fed drove down long-term interest rates as an inducement for businesses and consumers to borrow. Despite the low rates, consumers continued to shed debt for another year. How effective was Operation Twist – maybe a little bit (Survey).

As the price of oil declined in late 2014 and the Fed ended yet another round of QE (QE3), there was a real danger of moving into a recession. Notice the decline in GDP growth (red) and money velocity (blue).

The downward trend barely reversed itself in the 3rd quarter of 2016, just before the election, but not by much.

MoneyGDPGrowth2013-2017

The election of Donald J. Trump and a single party controlling both houses of Congress kindled hope of a looser regulatory environment and tax reform. Only then did the speed of money turn consistently upward. But we are not out of the woods yet. A year later, in late 2017, money velocity is still negative. As I said earlier, buyers and sellers still cannot agree on price. There is a mismatch in confidence and expectations. Until that blue line turns positive, GDP growth will remain tepid or turn negative.

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M*V = P*Q is an identity that equates money supply (M) and demand (V) to inflation (P) and output (Q).

 

 

Phillips Curve

November 12, 2017

For the past 16 decades, there has been a least one recession per decade. Given that this bull market is eight years old without a recession, some investors may be concerned that their portfolio mix is a bit on the risky side. Here’s something that can help investors map the road ahead.

For several decades, the Federal Reserve has used the Phillips Curve to help guide monetary policy. The curve is an inverse relationship between inflation and unemployment. Picture a see saw. When unemployment is low, demand for labor and inflation are high. When unemployment is high, demand for labor and inflation are low (See wonky notes at end).

The monetary economist Milton Friedman said the relationship of the Phillips curve was weak, and economists continue to debate the validity of the curve. As we’ll see, the curve is valid until it’s not. The breakdown of the relationship between employment and inflation signals the onset of a recession.

Let’s compare the annual change in employment, the inverse of unemployment, and inflation. We should see these two series move in lockstep. As these series diverge, the onset of a recession draws near.

In a divergence, one series goes up while one series goes down.  The difference, or spread, between the two grows larger. Spread is a term usually associated with interest rates, so I’ll call this difference the GAP.

In the chart below, I have marked fully developed divergences with an arrow marked “PC”. Each is a recession. I’ll show both series first, so you can see the divergences develop. I’ll show a graph of the GAP at the end.

PhillipsCurveRecession

As you can see to the right of the graph, no divergences have formed since the financial crisis.

Shown in the chart below are the beginnings of divergences, marked with an orange square. I’ve also included a few convergences, when the series move toward each other. These usually precede a drop in the stock market but no recession.

PhillipsCurveDiverge

Here’s a graph of the difference, or GAP, between the two series in the last 11 years.

PhillipsGap

Fundamental economic indicators like this one can help an investor avoid longer term meltdowns. Can investors avoid all the bear markets? No. Financial, not economic, causes lay behind the sharp downturns of the 1987 October meltdown and 1998 Asian financial crisis.

What about the 2008 financial crisis? A year earlier, in October 2007, this indicator had already signaled trouble ahead based on the high and steadily growing GAP.

What about the dot com crash? In February 2001, several months after the market’s height, the growing GAP warned of a rocky road ahead. A recession began a month later. The downturn in the market would last another two years.

Readers who want to check on this indicator themselves can follow this link.

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Wonky Stuff

In Econ101, students become familiar with a graph of this curve. Readers who want to dive deeper can see this article from Dr. Econ at the Federal Reserve. There is also a Khan Academy video .

The Fed Feints

September 18, 2016

This week I’ll cover several topics, most of them concerning personal finances.

Social Security and COLA

 Sometime in mid-October the Social Security Administration (SSA) will announce the cost-of-living adjustment (COLA) for social security benefits in 2017 and it will probably be less than 1% (History of previous COLA adjustments).  The COLA is based on the year-over-year increase in the Consumer Price Index (CPI).  In 1982, Congress specified that the SSA use the CPI version for urban workers, called CPI-W. (Info from SSA).  Each month the BLS releases their estimate of inflation, and this week they published their calculation for August – a yearly increase of just .66%.  September’s inflation number may be slightly different but the reality for the average SS recipient is a monthly increase of less than $10 in the average benefit of $1340.

Gas prices fall

For years senior advocacy groups like AARP have argued that a different CPI measure should be used to calculate the COLA.  The alternative measure, the CPI-E, puts more weight on health care expenses and less weight on gasoline and transportation costs because seniors don’t drive as much. So far, Congress has not adopted any changes to the methodology of calculating inflation for retirees.

In late 2014 gasoline prices began to fall and this had a significant impact on measured inflation in 2015, as we can see in the chart below. Although gas prices remain low, they have stabilized so that they will have less of an impact on yearly inflation growth in the future.

Reaching For Yield

Investors who are reliant on the income from their investments, including giant pension and endowment funds, typically desire fairly safe investments that will give them a decent return while preserving their principle.  These include high grade corporate bonds (Johnson and Johnson, for example), Treasury bonds, CDs and savings accounts. Abnormally low interest rates have made those traditional investment choices less desirable.

Like a stream diverted, investors have wandered to riskier assets, bidding up the prices of stocks which are considered more likely to retain their value because they pay dividends.

Dividend ETFs 

 As one example, Vanguard’s VIG is a Dividend Appeciation ETF containing of stocks that  have a consistent record of dividend growth of almost 5% per year.  The growth rate is 5%, not the dividend yield. The companies in this basket are household names: Johnson and Johnson, Microsoft, Pepsi, McDonald’s, and Walgreens, to name a few.  Vanguard has an added benefit: a very low expense ratio.  At the end of August, the Price-Earnings (P/E) ratio on this basket of stocks was 24.5 (see here). In the first two weeks of September, the prospect of an interest rate hike in the next few months has put a small dent in the price, and lowered the PE ratio slightly.  Clearly, investors are willing to pay extra for income, and extra for reliability.  The yield on this basket of reliability is 2.1%, just .4% more than a 10 year Treasury.

DVY

iShares’ DVY is a popular dividend ETF that has a less selective basket of stocks.  This basket also includes oil and energy companies that have a 5 year record of paying dividends but may not have a consistent record of dividend growth because of declining oil prices.  Because the criteria is less restrictive, this ETF is cheaper – it has a higher yield of 3.2% and a lower PE ratio of 20.8.

The Fed

After eight years of near zero interest rates, the Federal Reserve has put itself in a corner. Whatever actions or adjustments it takes must be in small increments to avoid causing a sudden repricing of the very asset prices it has helped lift by maintaining a low interest rate environment.

The financial crisis was so severe that the Fed thought it must lower rates to near zero, which choked income flows from savings.  Such a policy could be justified as an emergency measure. The economy had suffered the equivalent of a heart attack and the Fed need to shock it alive.  However, the recovery that followed was so weak that the Fed thought it must continue to keep rates low.  After eight years of ZIRP (Zero Interest Rate Policy), the Fed finds that it has effectively been picking winners and losers. Debtors win, savers lose. The Fed was forced into the role by the inability of a bitterly divided and ineffective Congress to pass fiscal policy solutions.

To fully grasp the effects of Fed policy, let’s take a trip up into the mountains.  Imagine a high mountain lake reservoir with a dam at one end to contain the water.  On the mountains surrounding the lake falls snow and rain that drains into the reservoir.  The dam is opened enough so that it releases a measured stream of water for users downstream.  The lake is a stock. The release of water is a flow.

Now let’s say that there is a drought for a year or two.  The water level in the reservoir begins to fall.  The dam operators reduce the amount of water released and this has a negative impact on downstream farms and businesses who depend on the water. The price for water rises as farms and businesses bid to get more water, a simple case of supply and demand. Land, another store of value, decreases in value because the lack of adequate water has made the land less productive. Assuming the same demand, prices for produce from the land rises.  This is the flow from the land, So the flow from the land rises while the stock value of the land falls.  Water is a different kind of asset, a consumable.  In the case of water, both the flow and the stock value rise during a drought.

Eventually the rainfall increases and the reservoir refills with water.  Now the dam operators release more water and the price per unit of water naturally declines. Now the stock value and the flow value of the water have declined. A greater supply of produce leads to price declines in the flow of produce from the land, while the price of the land itself, the store of land’s value, increases in anticipation of more productivity from the land.

After the crisis is over, flows from both types of assets declines.  The extra stock value of the water is transferred back to the land. The flow of water from the reservoir has been the catalyst for this transfer of value.

Let’s take this simplified situation and use it as an analogy to understand the Fed.  When the Fed adjusts interest rates, it transfers a store of value from one asset class to another. (It involves a number of asset classes.  I’ll keep it simple.) That’s the transfer of stock value.  But there is also a raising or lowering of the price of the flows from each of those assets.

Now let’s imagine that the Fed raises interest rates by 1%, effectively opening up the dam’s sluice gates a little more.  The flow of income shifts from debtors, who must pay more for borrowed money, to savers, who receive more for their savings.  Debt is a store of value and this is where the transfer of value happens.  New debt competes with old debt and lowers the price of existing debt, both corporate and government, so that old debt can generate the same income flows as new debt. Assets like bonds, which generate income flows at lower interest rates are now worth less.  Why buy a safe bond paying 2% when I can buy a safe bond paying 3%?  Dividend paying stocks are worth less unless they can realistically increase their dividend to compete with higher interest rate expectations. Buyers and sellers of these instruments adjust the prices to reflect the new expectations.

The change in flows acts as a catalyst for the transfer of the stock values between assets.  When we are younger and working, we don’t pay much attention to income flows from our savings.  We look at our portfolio statements, check our 401K or savings balances to see how much of a stock of assets we have built up.  We measure these assets in dollars, not value and may come to think that dollars and value are the same.  Income flows are measured in dollars.  The stock those flows come from are measured in value.  In the future, I hope to explore the ways that we try to convert value to dollars.