Monday, June 1, 2015

Those Were the Days, My Friend

June 1, 2015

“Those Were the Days, My Friend
We Thought They’d Never End”
                                      Gene Raskin

As shown in Chart 1, 23 quarters after the 2009:Q2 business-cycle trough, real GDP growth has been the weakest of any 23-quarter post-cycle trough starting with that of 1961:Q2. Although I believe that the nature of the cause of the last recession, a financial crisis, is the principal factor accounting for the relative weakness of the current economic expansion, I also believe that the trend rate of growth of U.S. real GDP in the decades to come will be less than that in the preceding decades. The primary reason for this is related to demographics. A secondary reason is that the credit excesses that preceded the last recession will not be allowed to occur again for some time.
Chart 1


Let’s look at some of the excesses that existed before the onset of the last recession. By the way, these excesses were observable in the years leading up to the recession and financial crisis if anyone was curious enough to look at them. But, those were the days, my friend, and some thought they would never end (Alan?). First, note what was happening to household nominal spending on newly-produced goods/services and residential structures compared to household after-tax income. This is shown in Chart 2.

Chart 2
In 2004, for the first time in the post-WWII era, the sum of nominal personal consumption expenditures and residential investment (new home construction, home improvements and real estate brokerage commissions) reached 100% of disposable personal income. In 2005 and 2006, this measure of total household spending exceeded household after-tax income. Again, this post-war anomaly was clearly observable at the time it was occurring.

There are only two ways households can spend more than they earn – liquidate assets and/or borrow. Households chose to fund their “excess” spending by borrowing, as shown in Chart 3. From 1952 through 2002, the change in household liabilities (household borrowing) relative to disposable personal income had a median value of 5.9% and registered a maximum value of 10.8% in 1985. But starting in 2003 and continuing through 2006, household borrowing relative to after-income exceeded 12%.










Chart 3

In the post-war era, households have relied on home mortgages as their principal source of borrowed funds. In the years leading up to the last recession and financial crisis, households increased their reliance on home mortgages, including home-equity lines of credit, to fund their “excess” spending.
Chart 4

Enquiring minds might have wanted to know how housing values in the years leading up to the financial crisis could be maintained or continue to rise given their relationship to household income. After all, housing was the collateral backing a large part of the surge in loans to households. But those were the days, my friend and some thought they would never end. Chart 5 shows the market value of residential real estate relative to disposable personal income. From 1952 through 1989, the value of residential real estate never exceeded 1.7 times that of household after-tax income. In 2004, 2005 and 2006, it exceeded 2.0 times household after-tax income.
Chart 5
In sum, I would characterize the previous economic expansion as better living through credit, to paraphrase DuPont’s slogan. So, the strength of the previous economic expansion that some yearn to return to was partially due to a financial system that had the capital to support a lot of lending, a Fed that was more than willing to aid and abet financial institution excess lending and lax credit-underwriting standards. Those were the days, my friend. You may have thought that they'd never end, but they have. Yes, after the onset of the last financial crisis, the Fed went on a credit-creation binge, which now has ended. But the increase in the Fed’s contribution to credit was offset by a pullback in private financial institutions’ provision of credit. Although some private financial institutions might desire to relax their credit-underwriting standards more aggressively, their regulators will not allow it.

Now, let’s look at the demographic factor that will retard U.S. growth in real GDP for decades to come. The trend growth rate of output for any economy is a function of the trend growth rate in the economy’s working-age population and the trend growth rate in the economy’s productivity and technological advance. Forecasting productivity growth and technological advance is difficult. Projecting population cohorts is much less difficult. Chart 6 contains Department of Census actual and projected 10-year compound annual growth rates (CAGR) of the U.S. 16- to 64-year old population from 1970 through 2060. In 1980, the 10-year CAGR of the U.S. working-age population was 1.8%, in 2000, it was 1.3% and in 2020, it is projected to be 0.4%. You get the picture – growth in the U.S. working-age population is projected to slow significantly in the decades ahead. Barring some offsetting surge in productivity growth and/or technological advance, this projected slowdown in the growth of the U.S. potential labor force implies slower growth in U.S. real GDP than what we have experienced in previous decades.
Chart 6

But wait. There’s more. And it’s not good. Chart 7 shows the 10-year moving average of the ratio of the U.S. working-age population, the potential “makers”, to the U.S. population too young or too old to work, the potential “takers”. The ratio of potential makers to potential takers just recently peaked at around 1.9 and is projected to fall steadily to about 1.5 in 2040 before leveling off. In other words, in 2010, there were 1.9 potential makers in the U.S. per potential taker. This is projected to drop in 2040 to 1.5 potential makers per potential taker. The implication of the projections in Charts 6 and 7 is that growth in per capita real GDP will be slowing in the decades ahead. Why? Growth in the population producing goods and services will be slowing, which, all else the same, means that growth in total output also will be slowing. At the same time, there is projected to be faster growth in the part of the population too young or too old to work relative to those of working age. This implies future slower growth in output relative to the total population – working age and non-working age .


Chart 7

Perhaps as important, Charts 6 and 7 also might imply future slower growth in real per capita consumption, depending on what happens to the growth of imported goods and services. With growth in per capita real output slowing in the U.S., there would need to be an acceleration in the growth of imports to prevent a slowing in the growth of U.S. per capita consumption.  This could give a whole new meaning to “the hunger games”! My advice is be kind today to your children and grandchildren, the current and future makers, so that they will throw a few crumbs your way in the decades ahead.

Assuming that society will moderate the slowdown in the growth of consumption per taker, an increase in the real equilibrium interest rate is required. If the takers are not going to bear the full brunt of the slowdown in the growth of per capita output, then the makers need to be induced to slow their consumption. This inducement, one way or another, will result in a higher equilibrium real interest rate. Suppose the government provides the takers with funds with which to cushion the slowdown in the growth of their consumption. If the government increases its borrowing to obtain these funds, then, all else the same, the real interest rate will rise. If the government increases its taxes on the makers to obtain these funds, then the makers will cut back on their lending in order  to try to cushion the slowdown in the growth of their consumption, which, all else the same, will drive up the real interest rate.

Now, of course, there could be some mitigating factors to this dark economic scenario. People might delay retirement. This would prevent growth of the makers from falling as much as projected. We could accept more working-age immigrants, again preventing growth of the makers from falling as much. There could be extraordinary increases in productivity and advances in technology, which would offset the slower growth in the working-age population in terms of output growth. And to some degree, these mitigating factors are likely to occur. But just to be prudent, I still would plan on a slower trend rate of growth in U.S. per capita real GDP in the decades ahead.

Paul L. Kasriel
Senior Economic and Investment Adviser
Legacy Private Trust Co. of Neenah, WI
Founder and Chief HR Officer of Econtrarian, LLC
1-920-818-0236


Monday, March 16, 2015

The Fed -- Drunken Coxswain of the SS America

March 16, 2015

The Fed – Drunken Coxswain of the SS America

Back on January 25, I penned a piece entitled “The Fed – Lucky or Smart?”. In that commentary I argued that the Fed was managing the supply of total thin-air credit, i.e., the sum of commercial bank credit and depository institution reserves at the Fed, in a responsible manner such that growth in nominal economic activity would neither be too hot nor too cold. I noted that this Fed management of the supply of thin-air credit in mid January was more likely due to luck than to “smarts” on the part of our central bank. I also implicitly posed the question: What if the Fed’s luck should change for the worse without its “smarts” changing for better? Well, that question now is relevant. After rebounding to a rate approximately equal to its long-run median, growth in total thin-air credit sharply decelerated in February, both on a year-over-year basis as well as a three-month basis (see Chart 1).
Chart 1
In the first nine months of 2014, the year-over-year growth rate of total thin-air credit averaged 8.8% per month. In the final three months of 2014, the average monthly growth rate sank by 300 basis points to 5.8%. Then in January 2015, the year-over-year growth rate of total thin-air credit rebounded to 7.5% only to sink to 4.1% in February. The coxswain is the person in charge of steering a ship. It seems as though the Fed coxswain in charge of steering the U.S. economy should be tested for sobriety because she appears to be steering an erratic course.

One could challenge my allegation of a drunken Fed coxswain by questioning whether the sharp deceleration in the growth of thin-air credit, save for February’s rebound, has had any effect on economic activity. I submit it has.

Firstly, I want to present exhibits of the recent behavior of the U.S. economy that will either not ever be revised or will be revised only minimally. First up is the ISM Manufacturing Purchasing Managers’ Composite Index (PMI).  As shown in Chart 2, the PMI has declined in each of the past four months ended February 2015.
Chart 2


Unit sales of light motor vehicles have contracted in each of the past three months ended February 2015, as shown in Chart 3.
Chart 3



Continuing state unemployment insurance claims have increased in each of the past four months, as shown in Chart 4.
Chart 4
Because of its history of frequent and often significant revisions, I have less faith in the reliability of recent observations of nominal retail sales. But they paint the same general picture of the more reliable economic indicators cited above – that the economy has hit a “soft patch”.  Total nominal retail sales have contracted in each of the past three months ended February 2015, as shown in Chart 5. Shown also in Chart 5 is that nominal retail sales excluding those of gasoline stations contracted in two of the past three months ended February 2015. It was against my better judgment that I excluded nominal gasoline sales from nominal retail sales. Yes, I know that when gasoline prices fall, nominal sales of gasoline also decline because households do not instantaneously drive more due to the lower gasoline prices. But with less of their nominal income being spent on gasoline, households might increase their nominal expenditures on other more discretionary goods and services by an amount equal to their nominal gasoline expenditure “savings”. This did not happen in each of three months ended February 2015.
Chart 5

One tangential thought regarding the February 2015 retail sales report. The consensus estimate of the change in total nominal February retail sales was an increase of 0.4%. The consensus did not even get the sign of the change correct. The Census Bureau reported that February total retail sales decreased by 0.6%. What was the common excuse for the big miss by the consensus? Blame it on the weather. But, wait a minute. The economic forecasters did not have to forecast the February weather. The actual February weather was a known fact when the forecast of February retail sales was made.  Yes, the winter weather of this past February was unusually severe. But why wasn’t this fact incorporated into economists’ collective forecast of February retail sales?

I know that forecasting monthly economic data accurately is very difficult. I know that if a reporter calls you for a forecast and you tell him/her that you don’t have a clue, that reporter won’t call you again. And if reporters stop calling you, your job could be in jeopardy, because what, after all, is the principal function of a Street economist? Marketing the name of your employer. Why doesn’t some enterprising economics reporter do a study on the accuracy of consensus forecasts of economic data? Perhaps if the media could be weaned off this mugs game, then Street economists could do something more useful, such as conducting research as to what really drives the cyclical behavior of the economy.

But I digress. Back to the drunken Fed coxswain. Why did growth in total thin-air credit take a dive in February 2015 and why was it relatively weak in November and December 2014? Was it because of weak growth in the commercial bank credit component? No. The data plotted in Chart 6 show that commercial bank credit growth, both on a year-over-year basis as well as a three-month annualized basis, has been quite strong.
Chart 6

That leaves but one explanation for the recent weakness in total thin-air credit growth – weakness in the Fed component, i.e., depository institution reserves at the Fed. This is illustrated in Chart 7. Given the strong growth in commercial bank credit in recent months, it is entirely appropriate that Fed credit growth should have slowed from what it was when the QE III policy was being pursued. But the Fed has overdone it. In September 2014, the year-over-year change in Fed reserves was plus 17.3%. In February 2015, it was minus 10.1%. In the three months ended 2014, the annualized change in Fed reserves was plus 16.4%. In the three months ended February 2015, it was minus 29.5%.

Chart 7
The Fed is steering its component of thin-air credit like a drunken coxswain. As a result, total thin-air credit is behaving in a similar fashion. And as a result of these frequent and, most likely, unintentional course changes in thin-air credit growth, my near-term forecasts of the pace of economic activity also have become erratic. The erratic behavior of my economic forecasts is inconsequential. But what is consequential is the effect on the economy and financial markets.  If the Fed continues to “steer” growth in thin-air credit with these seemingly erratic and random course changes, then the economy will behave in a volatile fashion, which will impart volatility to the financial markets. Other than short-term financial-market traders, no one will benefit from this.

There is continued interest in Congress to impose some “rules” on the Fed as to how it should conduct monetary policy. I am sympathetic to the general notion of imposing rules on the Fed – but not Taylor’s [interest rate] Rule. We will have to leave a discussion of new rules on the Fed for another commentary.

Paul L. Kasriel
Founder and Administrative Asst., Econtrarian, LLC
1-920-818-0236
Sr. Economic & Investment Advisor, Legacy Private Trust Co., Neenah, WI




Thursday, February 19, 2015

Yes, There Will Be Growth in the Spring

February 19, 2015

“Yes, There Will Be Growth in the Spring”
                                                                                                                     Chance, the Gardener (Google it)

Looking past the large upward revision to November 2014 nonfarm payrolls, you might have noticed that the U.S. economy has entered, in the words of the Federal Reserve’s version of Chance, the Gardener, Alan Greenspan, a “soft patch”. In recent months, labor conditions have weakened, manufacturing activity has hit a wall, consumer spending has waned and residential real estate demand has sunk. This “soft patch” is illustrated in Charts 1,2,3 and 4, which contain representative data that will not be revised radically, if at all.
Chart 1
                                            
Chart 2

Chart 3
Chart 4

I believe this current weakening in the pace of U.S. economic activity is primarily the result of the past sharp deceleration in the growth of thin-air credit, thin-air credit being defined here as the sum of commercial bank credit and reserves of depository institutions held at the Federal Reserve.  As I have argued ad nauseam, there is a positive correlation between lagged values of thin-air credit growth and the growth of economic activity. Chart 5 shows the behavior of thin-air credit in the 12 months ended January 2015 in terms of its three-month annualized growth and its month over year-ago month percent change. There was a noticeable deceleration in the growth of thin-air credit in October, November and December 2014, followed by a sharp re-acceleration in January 2015.






Chart 5

Chart 6 shows the behavior of the two components of thin-air credit in terms of their three-month annualized percent changes.
Chart 6

With the cessation of Fed QE securities purchases in October 2014, the Federal Reserve component of thin-air credit, depository institution reserves held at the Fed, has entered an outright contractionary phase. But at the same time that the Fed’s contribution to thin-air credit has been diminishing, commercial banks’ contribution has been increasing. The acceleration in commercial bank credit in the three months ended January 2015 has largely been responsible for the re-acceleration in year-over-year and three-month annualized growth in total thin-air credit in January 2015.

Barring a sharp deceleration in commercial bank credit in the next several months, a re-acceleration in total thin-air credit growth should be sufficient to extricate the U.S. economy from its current “soft patch”. So, to paraphrase Chance, the Gardener: “Yes, there will be stronger growth in the U.S. economy in the spring.” The current economic-activity “soft patch” likely has the FOMC leaning toward making no monetary policy changes at its June 16-17 meeting. If the pace of economic activity picks up in the second quarter, as I expect, the lag in the reporting of economic data might still stay the FOMC’s hand in June. If I am right about a spring pick-up in the pace of economic activity, however, look for some overt FOMC tightening action at the July 28-29 meeting.

Paul L. Kasriel
Senior Economic & Investment Advisor
Legacy Private Trust Co. of Neenah, WI
Founder, Econtrarian, LLC
econtrarian@gmail .com
1-920-818-0236