March 2014

Laufenberg Economic Quarterly

Daniel E. Laufenberg, Ph.D. Economist

The views expressed here reflect the views of Daniel Laufenberg as of the date referenced. These views may change as economic fundamentals and market conditions change. This commentary is provided as a general source of information only and is not intended to provide investment advice for individual investor circumstances. Past performance does not guarantee future results.

blue barExecutive Summary - Weather versus fundamentals blue bar

  • The softness in recent economic data likely has been due to the unusually harsh winter weather rather than a deterioration in the economyís fundamentals, which if the case would point to a snap back in economic activity once the weather simply returns to normal.

  • I contend that, on balance, the economic fundamentals, including jobs, income, wealth, inflation and interest rates, are better now than at any time during the current expansion. As such, it is just a matter of time before households regain confidence about their finances, which in turn will promote stronger spending growth on a more sustained basis.

  • As such, the pace of the U.S. economic expansion is expected to accelerate somewhat in 2014 and remain elevated through most of 2015. That being said, even this elevated pace of the expansion still may be considered disappointing by historical standards, causing some to question whether the U.S. economy will ever return to full employment. For that reason, it is important to assess the current potential growth rate for the U.S. economy, which very likely has slipped considerably in recent years.

  • The implication is that real growth need not be as strong as it was historically to push the unemployment rate lower. After all, so far during the current expansion, real output has grown at an average annual rate of only 2.4 percent, yet the unemployment rate has fallen to 6.6 percent in January 2014 from its cyclical high of 10.0 percent in November 2010.

  • Those who dismiss this development contend that the decline has been due to a drop in the labor force participation rather than to the cyclical preference of more jobs. However, it may be that the changing demographics in the U.S. dictate that there are just fewer people looking for work and that this may be a secular trend rather than a cyclical phenomenon.

  • Hence, it would not be surprising to me if inflationary pressures start developing later this year. Such a development would be much sooner than most expect. Short-term interest rates, which have been at or near historically low levels for nearly five years, may start to drift higher as well. This too would be sooner than suggested by the Fedís guidance on the matter.

  • This forecast includes our first look at 2015, which could prove to be an important transition year for the U.S. economy in terms of interest rates and inflation, as the economy moves into the next phase of the current business cycle.

blue barForecast at a glance chzrt 1 - 4blue bar

 

Forecast details blue bar

Forecast Details

blue bar Weather versus fundamentalsblue bar

Do not be misled by the soft economic data reported in recent months. It most likely was the unusually harsh winter weather, which means any slowdown in economic activity will be temporary and will snap back in the spring. Of course, the likelihood of the economy snapping back still begs the question of whether the economic fundamentals of the U.S. economy warrant such an outcome. The Laufenberg Quarterly (LQ) forecast suggests that they do. But it is not just whether the economy will expand but also whether the pace of the expansion will be fast enough for the U.S. economy to return to full employment. The latter issue seems to be the more interesting one at the moment, given the debate about the Federal Reserve’s recent decision to taper its quantitative easing program.

Despite unanticipated bad-weather effects in the first quarter, the LQ forecast for all of 2014 is little changed from November 2013. Change is good as long as it is driven by need and guided by wisdom. In this case, it is neither necessary nor wise to make any major changes. Over the four quarters of 2014, the LQ still expects real growth to accelerate, inflation to remain subdued albeit a tad higher than last year, the unemployment rate to continue its downward trajectory, and interest rates across all maturities to be higher at the end of this year than they were at the end of last year. Both monetary and fiscal policies are expected to change course this year; that is, monetary policy will become less accommodative and government revenues will improve dramatically. Corporate profits, as measured by S&P 500 operating earnings per share, are expected to rise at a mid-single digit pace for all of 2014, following an estimated 11.3 percent gain for all of 2013.

Key elements of the LQ forecast will depend on two factors—the economic fundamentals and the potential growth rate for the U.S. economy. The fundamentals include such things as jobs, wealth, and interest rates. Debatably the fundamentals are better now than at any other time during the current expansion. But the potential growth rate for the U.S. economy may be lower than it has been since World War II. The implication is that real growth need not be as robust as it was in past expansions for the economy to move closer to full employment and for inflationary pressures to develop.

In the November 2013 forecast, when I said that stronger growth was “just around the corner”, it clearly was. At the time, the Bureau of Economic Analysis (BEA) had estimated third-quarter real gross domestic product (GDP) growth at annual rate of 2.8 percent and the consensus forecast for fourth-quarter GDP growth was below 2.0 percent. Just a week or so after the November forecast was published the BEA revised its estimate of third-quarter real GDP growth sharply upward to 4.1 percent. On the other hand, the BEA had initially estimated fourth-quarter real GDP growth at 3.2 percent, but has more recently revised it down to 2.4 percent. Despite the downward adjustment to the fourth quarter, the average annual rate of real GDP growth for the second half of last year is still a solid 3.2 percent and well ahead of the 1.8 percent average annual rate in the first half. But there are a couple of temporary factors that continue to plague the near-term outlook for real growth; that is, the unusually harsh winter weather in several parts of the country and the unsustainably sharp increase in business inventories in the third quarter that unexpectedly was sustained in the fourth quarter.

The implication is that any snap back in real GDP growth in 2014 will require a solid uptick in real final sales growth, something that the LQ forecast discussed in the previous forecast. In this regard, nothing has changed. However, getting there looks more difficult now that real final sales growth in the fourth quarter of 2013 was revised downward to 2.3 percent from the initial estimate of 2.8. As such, fourth-quarter real final sales growth decelerated from the 2.5 percent gain in the third quarter rather than the earlier estimate of acceleration. I contend that the slowdown in real final sales growth late last year was due primarily to a larger harsh weather effect on economic activity in December than initially estimated.

Weather effects are temporary

Data releases so far this year have offered growing evidence that the pace of economic activity has continued to be soft. The question is whether this recent softness has been due to the unusually hard winter weather or whether it was due to fundamental weaknesses in the economy. If it is the weather, then it points to a snap back in the pace of economic activity once the weather improves. On the other hand, if it is deteriorating fundamentals driving the slowdown, then a snap back is far less certain. Indeed, the risk would be that the economy might slow even more.

Based on my assessment of the data, I contend that the slowdown has been weather-induced and as such temporary in nature. Unfortunately, we will not know if this is the correct assessment until the weather improves, which may not be until the spring. In the Twin Cities, we just got another 10 inches of snow with at least a foot of snow already on the ground followed by another extended cold spell with temperatures 15 to 20 degrees below normal. In fact, this will be the coldest winter in Minnesota in 35 years and one of the ten coldest over the last 140 years. This is the kind of weather that discourages new construction and shopping for anything other than groceries, snow throwers, and gasoline to run our winter toys and equipment. By the way, it also favors spending on utilities (services) to heat our homes.

According to recent data, seasonally adjusted housing starts plunged 16.0 percent (not annualized) in January, following a decline of 4.8 percent in December but a 22.5 percent jump in November. Moreover, private nonresidential construction spending declined 0.7 percent in December (the most recent data available) and was down 1.7 percent from a year earlier. Both are consistent with adverse winter weather effects. In addition, harsh weather may have adversely affected other areas of the economy, including most retail sales, some manufacturing, and maybe jobs. According to the Census Bureau, January retail sales slipped 0.4 percent from a month earlier, as declines in sales at motor vehicle dealers, department stores, furniture stores, and restaurants more than offset increases in sales at hardware stores, grocery stores, and gasoline stations. For the most part, this same pattern was in place in December, suggesting once again that it was the weather.

In addition, the Federal Reserve reported that manufactured output dropped 0.8 percent in January, led by declines in automotive products, construction supplies, and materials. On the other hand, the Fed reported that utilities output in January surged 4.1 percent. Also, payroll employment may have been delayed, but more importantly hours worked lost, due to the weather. The labor market data are not conclusive on this point. For example, construction jobs fell in December but improved somewhat in January. If it the weather, one would expect declines in both months. It may be that construction jobs may have been even better in January if it hadn’t been for the weather. Nevertheless, the gains in overall payroll job in December and again in January were disappointing compared to the pace earlier in the year.

The good news is that weather effects are temporary. In fact, there still is enough time remaining in the current quarter for some of the weather effects to correct, as they typically do when the weather returns to normal. Once all the weather-related noise plays out, which is likely to be over the next couple of months, the pace of economic activity most likely will be determined again by the fundamentals.

The key economic fundamental—jobs!

In a summary report from the Bloomberg website on the January housing starts data, it was noted that factors other than the weather were still “negative” for the housing sector “including unappealing mortgage rates, high prices, low supply, and a soft jobs market.” Based on various consumer surveys, the reporters at Bloomberg are not alone in their perspective. It seems that many people still believe that the U.S. economy is either on the brink of another recession or is still suffering from the previous one based on the jobs data. In particular, nonfarm payroll employment gains continue to struggle to average 200 thousand a month, with the bulk of the new jobs thought to be low paying. And the civilian unemployment rate is considered high at 6.6 percent and expected to struggle to fall further as the bulging army of discouraged workers created during the last recession decide to return to the work force.

Central to the snap back in economic activity shown in the LQ forecast are solid fundamentals, especially the job market. After all, consumer spending, which not only represents 70 percent of the U.S. economy but is highly influential on the other 30 percent, depends primarily on income. And sustained income depends on jobs. But the question remains just how many new jobs are possible given the changes in the U.S. population.

As shown in Chart 1, the civilian population aged 25 to 54 years, which is the largest segment of the population, was the fastest growing segment of the population until about 2000. At that point, it continued to rise but at a slower pace until 2007. Since then, the number of 25 to 54 year-olds in the U.S. on average has declined. This is not the number of 25 to 54 year-olds that have decided to participate in the labor force but the total number of potential workers in that age group. In contrast, the older age group (55 years and over), which is the second largest age group considered, has continued to increase since 2007. Indeed, the growth rate has accelerated. And with regard to the younger age group (20 to 24 years), which is the smallest group, it too has increased but is just now getting back to its level in the early 1980s.

The problem is that the age groups that are more likely to want jobs have seen very little or no growth, while the age group that has grown since 2007 is less likely to be looking for work. But even that is changing somewhat. As shown in Chart 2, the younger two age groups still have the highest participation rates, but they seem to be trending lower in both cases. It seems that a smaller share of younger people want to participate in the labor force. On the other hand, the participation rate of the older age group has increased, as a larger share has decided to work longer. Nevertheless, even with this increase, the participation rate of the older group is still well below that of either of the two younger groups. It is no wonder that the overall labor force participation rate has fallen in recent years. But more importantly, the expectation of some that it will return to its former high is very unlikely to occur. The demographics just do not support it.

The implication is that not as many jobs will be needed to push the unemployment rate lower. This interpretation is supported by other labor statistics, including the jobs openings and labor turnover report from the Bureau of Labor Statistics.

Chart 1

chart 2

As shown in Chart 3, new hires so far during this expansion have lagged compared to the new hires gain in the previous expansion, creating the impression that the labor market is soft and suggesting that new hires need to accelerate to see any meaningful improvement. The total number of new hires in December 2013 (the latest data available) totaled 4.4 million versus the peak in the previous expansion of 5.5 million in November 2006. What is not reported generally is that total separations so far during the current expansion have lagged compared to the previous expansion as well. In December 2013, job separations totaled 4.1 million, well below the peak of 5.2 million in the previous expansion. In other words, worker turnover is down, which means that firms need not hire as many replacements.

chart 3

But there may be more to this than just the increased reluctance of people to leave their current jobs. Unlike new hires and separations, job openings have improved at a pace more in line with the previous expansion, totaling 4.0 million in December 2013. This total was slightly above where they were in 2005 but still shy of the previous peak of 4.7 million in mid-2007. In other words, jobs are available, just not being filled. The reason is unclear; either there is a shortage of qualified workers or firms are being unusually slow about filling positions.

So what does all this mean for nonfarm payroll jobs? It helps explain how the underlying features of the labor market, such as hires and separations, affect net new jobs. This is illustrated by Chart 4, which plots the difference between hires and separations against the change in nonfarm payroll employment. As can be seen, the two track very well, as they should. After all, hires represent the gross number of jobs filled and separations represent the gross number of existing jobs vacated. The difference between the two is by definition the number of net new jobs filled. After all, the change in nonfarm payroll employment is a measure of the net new jobs created in the economy.

Based on the changing demographics of the labor force, the downshift in separations and the cyclical rebound in job openings, the slower net new nonfarm payroll job growth so far during the current expansion still may be fast enough to be consistent with the unemployment rate falling further, which in turn will generate some upward pressure on wages in the process. In other words, the labor market may not be as bad as some claim, but more importantly may be moving to a better place faster than the consensus now expects.

Obviously, if the economy is creating jobs, income gains follow. And it is income growth that drives spending. However, spending also will get an assist from wealth—the so-called wealth effect. This effect is marginal when compared to the income effect but still can be important to spending over short periods of time. At the moment, the household sector’s balance sheet is the strongest it has been since 2000, given the degree of deleveraging that has occurred since 2007 and the increase in the total value of all asset owned by households (see Chart 5). When households feel wealthier, they are more likely to take on debt to boost spending; that is, spend a larger share of their income. For the most part, this is the primary channel through which wealth operates on spending.

chart 4

That being said, the latest observations from the Financial Accounts of the United States data from the Federal Reserve, as well as the Household Debt and Credit report from the New York Fed, show evidence that U.S. consumers indeed took on net new debt in the second half of 2013 after years of contraction. However, the uptick in net mortgage debt was due more so to reduced foreclosures and bank loan write-offs than to increased mortgage production. Also, the increase in consumer debt was driven primarily by student loans provided by the government rather than consumer loans provided by banks. Hence, this should be viewed as the first step toward a more pronounced wealth effect on consumer spending. Of course, ongoing concern of a return to the “bad old days” of high leverage will limit just how much of an effect to expect.

chart 5

Finally, there may be other fundamental drivers of the economy, including inflation and interest rates. For example, low inflation assures the purchasing power of the income earned, which drives real demand and output. The overall consumer price index increased a mere 1.2 percent over the four quarters of 2013, following a 1.9 percent advance in 2012 and 3.3 percent in 2011. As shown in Chart 6, consumer price inflation is very well contained for an economy in the fifth year of an expansion, providing evidence that the economy can continue to expand without risk of inflationary pressures developing in the near term. The debate is just how long this will be the case. For the record, I do not expect such pressures to develop soon but I do expect them to develop sooner than most as the unemployment rate continues to drift lower and capacity becomes a binding constraint on growth.

Finally, low interest rates also have been positive for growth, albeit maybe not as positive as hoped. Low interest rates are effective only if households have the confidence or the ability to borrow. For the most part, such confidence or ability has been lacking until very recently. Although low inflation has helped considerably to keep interest rates low, so too have an unusually transparent and prolonged accommodative monetary policy, as well as financial concerns overseas. The LQ forecast assumes that these factors will not favor the currently low level of interest rates forever. For example, if the economy continues to expand at a 3.0 percent pace, the unemployment rate falls as much as expected, the Federal Reserve continues to taper its quantitative easing program before actually raising the federal funds rate, and the safe-haven effect on Treasury yields from overseas financial crises dissipates, it is very likely that U.S. interest rates will start to rise. At first, most of the increase in interest rates will be at the long end of the maturity structure, resulting in an even steeper yield curve; that is, not too dissimilar to what happened last year. Later in the forecast, the rise in interest rates most likely will be more pronounced at the shorter end of the maturity structure, leading to a much flatter yield curve. My best guess is that the yield curve flattening rise in interest rates does not happen until 2015.

chart 6

Is slow motion fast enough?

An important aspect of the outlook and how quickly inflation bottlenecks might develop is assessing the “potential growth rate” for the U.S. economy. For this purpose, I try to keep the analysis simple (some economists could rightfully argue that I am being too simple). I contend that economic growth in the long run essentially depends on two factors—the likely number of total hours worked by all available workers and just how much output they produce for each hour worked. One version of this is illustrated in Table 1, which shows the average annual growth rates for the labor force in column (a) and for nonfarm business productivity in column (b) over various time periods since World War II. The first four time periods in Table 1 are determined by changing trends in productivity growth. From 1948 to 1972, output per hour worked (productivity) increased at an annual average rate of 2.8 percent, but slipped to about half that pace (1.5 percent) from 1973 to 1994. There are several factors that have been suggested to explain this slowdown, including the end of the population shift away from self-employment (including farm) to assembly-line jobs, the effects of the 1973-75 and 1980-82 recessions on output growth, the absorption of the baby boomers into the labor force, rising energy prices, and even environmental protection regulations.

table 1

From 1995 to 2006, the trend rate of growth in labor productivity increased again to 2.6 percent, owing in large part to innovations in information technology at the time. But apparently, this resurgence in productivity was short lived with the onset of the 2007-2009 recession because since 2007 labor productivity has increased at an average annual rate of 1.7 percent.

To calculate an estimate of the average annual potential growth for the U.S. economy during each period, I have added the average annual rate of labor force growth— column (a)—and the average annual rate of labor productivity growth—column (b). There are many shortcomings with using such a simple calculation of potential, including the assumptions that the average workweek across these four periods was the same and that labor productivity in the nonfarm business sector is a reasonable measure of labor’s contribution to output. Nevertheless, when compared to actual real output growth for each of the time periods, they tracked reasonably well.

The point is that the potential growth rate for the U.S. economy is probably as low as it has been since World War II. Estimating it may be somewhat imprecise but not enough to alter the story. Indeed, one could argue that the potential growth rate probably is no more than 2.0 percent—about 0.25 percent annual growth in the labor force and about 1.75 percent growth in labor productivity. The implication is that a growth rate above 2.0 percent is above potential, which will cause the unemployment rate to continue to fall. As shown in Table 1, real GDP grew an annual average rate of only 2.4 percent so far during the current expansion, yet the unemployment rate has fallen from 10.0 percent in September 2009 to 6.6 percent in January. In other words, the economy can grow faster than its potential without inflation bottlenecks developing but only as long as it is operating below full employment. Hence, it is important, especially for policymakers, to have a good understanding of what full employment might look like.

I continue to believe that we are moving toward full employment a lot faster than the consensus still admits for two reasons; first, the unemployment rate most likely will drop to a lower level by the end of this year than most now expect and, second, because full employment may occur at a be achieved at a higher unemployment rate than in the recent past due to structural changes in the labor market. These structural changes include the growing disconnect between healthcare insurance and jobs, the aging population, and the apparent growing mismatch of skills and jobs.

A first glance at 2015: A possible transition year

By the middle of 2015, the current expansion will be six years old, long by historical standards. However, as we have noted in the past, expansions do not die of old age, they are killed. Although we see the economy possibly slowing late in 2015, we do not expect a recession—at least, not yet. That being said, I do expect that the bottlenecks that likely will end the current expansion to start to manifest themselves next year. As such, I expect the U.S. economy in 2015 to transition into the final phase of the current business cycle.

Based on an early read of the data, real GDP growth will be solid in the first half led by consumer spending, housing and business fixed investment. But this may prove to be too much of a good thing, creating some bottlenecks over the course of the year. This will result in somewhat higher consumer price inflation, which most likely will force the Federal Reserve to back away from its very accommodative monetary policy. Although the Fed most likely will be gradual at first, any hint that the Fed is behind the curve on fighting inflation will accelerate the policy reversal.

In 2015, the expected combination of deteriorating purchasing power and higher interest rates most likely will constrain real consumer spending growth at some point. My best guess is that this constraint will not be binding on consumers until sometime in the second half. After several years of very low inflation and the expectation that the Federal Reserve can keep it low, an uptick in the rate of inflation need not be very severe to adversely affect purchasing power, given that wage and salary gains probably will not keep pace.

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The views expressed here reflect the views of Daniel Laufenberg as of the date referenced. These views may change as economic fundamentals and market conditions change. This commentary is provided as a general source of information only and is not intended to provide investment advice for individual investor circumstances. Past performance does not guarantee future results.


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