May 2011invisible

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.

Executive summary

  • According to the advance estimate from the Bureau of Economic Analysis, real gross domestic product (real GDP) grew at a very anemic 1.8 percent annualized in the first quarter of 2011, with real final sales up a mere 0.8 percent. This was much slower than expected a few months ago and even less than expected just prior to the release of the data.

  • Despite the disappointing pace of the expansion in the first quarter, the outlook for the remainder of 2011 remains roughly intact. Indeed, many of the factors that contributed to slower-than expect economic growth in the first quarter are not expected to persist in the second quarter. Some of the output lost in the first quarter will be recovered but unfortunately not all of it. For that reason, real GDP over the four quarters of 2011 is now expected to increase 3.3 percent, which is still solid but lower than the 3.9 percent gain shown in the February forecast.

  • In fact, the bulk of the shortfall in real GDP growth in the first quarter relative to expectations came from a much larger than anticipated decline in government spending, especially federal government spending. Any further improvement in government budget deficits are likely to come from lower transfer payments or higher taxes rather than further cuts in discretionary spending. Another disappointment in the first quarter was residential investment, which registered a small decline rather than an anticipated improvement.

  • Business fixed investment also was light of expectations, owing to a steep decline in spending on structures. Structures most likely have hit bottom for this cycle. More importantly, spending on equipment and software was in line with expectations. Also, net exports in the first quarter actually were slightly less of a drag on growth than expected.

  • Higher energy prices may have damped consumer spending somewhat in the first quarter and possibly again to a lesser degree in the current quarter, but they are not expected to remain a drag for long. In the first quarter, energy prices climbed 32 percent at an annual rate, while consumer prices excluding energy rose only 2.2 percent annualized. More importantly, consumers have responded to higher relative energy prices as expected; that is, they seem to be driving less, switching to more energy efficient vehicles, or using other means of transportation.

  • That being said, real consumer spending held up reasonably well last quarter. Real personal consumption expenditures increased 2.7 percent at an annual rate, led by a 4.8 percent jump in spending on consumer goods. An improving labor market, and the income that comes with it, will be the catalyst to further strong gains in consumer spending this year and next.

  • As noted in the February report, the change in business inventories, which detracted nearly 4.0 percentage points from real GDP growth in the fourth quarter of 2010, was not expected to be repeated in early 2011. It was not in the first quarter, but parts shortages from Japan may slow inventory accumulation considerably in the second quarter.

  • At this stage of the business cycle, I continue to favor an overweight in equities. In large part, this is because credit risk may be less of a concern than interest rate risk for now.

Forecast details

Forecast Details

A first-quarter hiccup

The U.S. economic expansion continued in the first quarter of 2011 but at a disappointingly slow pace. According to the advance estimate from the Bureau of Economic Analysis (BEA), first-quarter real gross domestic product (real GDP) grew a mere 1.8 percent at an annual rate, as real final sales registered only a 0.8 percent gain. This performance was much slower than expected a few months ago. Of course, first-quarter real GDP is subject to revisions over the next couple of months and my guess, based on data released more recently, is that it will be revised higher. This data includes a better-than-expected report on new construction in March, as well as upward revisions to retail sales and payroll jobs in February and March reported in the April releases. Nevertheless, even if the BEA’s estimate of first-quarter real final sales is revised higher, it still is likely to be far short of earlier expectations.

In February’s Laufenberg Economic Quarterly (Quarterly) forecast, real final sales in the first quarter were expected to grow at a 3.3 percent annual rate, led by solid gains in consumer spending and fixed investment. Indeed, the only drag on final sales growth was expected to be international trade, with imports climbing faster than exports. Government spending was expected to be roughly neutral, as a decline in state and local spending would be offset by a gain in federal spending. As it turned out, real consumer spending in the first quarter increased 2.7 percent, which was not as robust as the 3.6 percent advance expected in February but still better than expected just prior to the release of the data. Unfortunately the same could not be said about the other components of final sales.

The bulk of the shortfall in first-quarter real final sales relative to expectations was due to a sharp drop in government spending on goods and services, especially federal spending. In the February forecast, we expected a decline in spending by state and local governments to be offset by a gain in federal spending. Although state and local spending fell, so did federal spending, led by a whopping 11.7 percent plunge in defense spending. It is very unlikely that defense spending, based on past performances after a quarterly decline of this magnitude, will decline again in the second quarter. In fact, following the death of Osama bin Laden, federal spending on homeland security and intelligence gathering actually may accelerate over the next few years.

Also, any further efforts to reduce budget deficits are likely to come from lower transfer payments and higher taxes. In large part an improving economy will provide some of this budget relief. After all, a stronger economy means more jobs, which in turn means more tax revenue and less spending on stimulus programs. The problem is that the economy most likely cannot grow fast enough to eliminate all budget deficits, especially the federal budget deficit. According to the Summary Data from the U.S. Treasury, the federal budget deficit for fiscal 2011 is projected to hit an all-time high of $1.65 trillion this fiscal year, exceeding the $1.29 trillion deficit for fiscal 2010. Clearly this is unsustainable, which means that more aggressive steps to reduce the deficit will be needed eventually.

Another minor shortfall in first-quarter real final sales growth relative to expectations came from residential fixed investment. According to the advance estimate from the BEA, residential investment fell 4.3 percent at an annual rate last quarter. In the February forecast, residential investment was expected to climb 14 percent. Clearly this was a huge percentage miss (down 4.3 percent versus up 14 percent), but since residential investment is already at a depressed level, it meant that residential investment detracted a mere 0.1 of a percentage point from growth rather than the anticipated contribution of only 0.3 of a percentage point.

International trade had very little net impact on real final sales growth last quarter, as exports added 0.6 of a percentage point and imports detracted about 0.7 of a percentage point. This follows a quarter when net exports added over 3.25 percentage points to sales growth. I expect net exports to add a bit to growth in the current quarter but detract from growth later in the year. Over the four quarters of 2011, net exports are expected to be a meaningful drag on growth, as imports exceed exports by a considerable margin.

Of course, GDP is defined as final sales of domestic product plus the change in business inventories. In the first quarter, final sales grew 0.8 percent but real GDP grew a somewhat faster 1.8 percent. Apparently, the change in inventories contributed a percentage point to first-quarter real GDP growth. During the recovery phase of the business cycle, the change in inventories tends to add to GDP growth. However, by the time the economy reaches the expansion phase of the business cycle, which is where the U.S. economy now seems to be, inventories have reached their desired level relative to sales and they tend to remain there for some time. In other words, inventory accumulation cannot sustain economic expansions. Final sales growth is the key. Hence, I expect final sales growth to accelerate over the remainder of the year and for inventory accumulation roughly to keep pace.

Another important consideration is the fact that real final sales surged at a 6.7 percent annual rate in the fourth quarter of 2010 and that the first-quarter slowdown in final sales growth may have been in part a payback for the outsized gain in the previous quarter. Indeed, a more realistic perspective of real final sales growth may be the average growth rate of the last two quarters, which is 3.8 percent at an annual rate. I think that this pace of final sales growth is a reasonable expectation at this stage of the expansion. Therefore, it is no coincidence that this rate is also the average growth rate in real final sales expected over the remainder of the year. And since inventories are expected to keep pace, real GDP growth should be about 3.8 percent as well.

A few changes to the forecast

Despite the disappointing pace of the expansion in the first quarter, the general features of the outlook for the remainder of 2011 and all of 2012 remain intact from three months ago. These include solid real GDP growth, relatively benign consumer price inflation and further declines in the unemployment rate. Nevertheless, a few changes to the quantitative details of the forecast were necessary in light of more recent data.

First, the outlook for the price of imported oil to refiners shown in the forecast has been bumped up somewhat from the trajectory shown in the February forecast owing to the recent jump in the price of crude oil to over $100 a barrel. The forecast now is that the price of oil remains at or near this elevated level for the remainder of the year, causing the price of imported oil to refiners to average about $99 a barrel in 2011 versus an average of $75.9 for all of 2010. This implies that overall consumer price inflation will be even higher in 2011 than shown in the February forecast; it is now expected to be 2.8 percent versus 2.2 percent over the four quarters of this year. Although overall inflation is higher than expected earlier, it still is not high enough to be a serious problem for consumers. Indeed, the projected acceleration in overall consumer price inflation for all of 2011 for the most part is due to price advances in energy that have already occurred rather than to expectations of further advances later in the year.

One reason for this assessment is that other prices have not advanced as rapidly as the price of energy. For example, in the first quarter, energy prices climbed 32 percent at an annual rate, while consumer prices excluding energy rose only 2.2 percent annualized. Economists call this a relative price hike. More importantly, consumers have responded to this relative price hike as expected; that is, they may be driving less, switching to more energy efficient vehicles, or using other means of transportation, but have not stopped spending. In other words, the higher price of energy, especially the price of gasoline, may slowdown consumers a bit but it alone will not stop them.

Second, the recovery in residential investment now is expected to take longer and to be more gradual than expected earlier. In particular, housing starts now are projected to total 1.2 million units at a seasonally adjusted rate by the end of 2012 rather than the 1.5 million units shown in the February forecast. This should translate into a less robust gain in residential investment both this year and next. Over the four quarters of 2011, real residential investment is projected to climb 13.6 percent, which is still solid but lower than the 20.1 percent surge anticipated in February.

Finally, government spending is now expected to be a mild drag on real GDP growth over the four quarters of 2011, due in large part to the stunning decline in federal defense spending in the first quarter. Although overall government spending is projected to decline again in the second quarter, it should rebound a bit in the second half of the year in response to a host of national security issues following the death of Osama bin Laden, the 10th anniversary of the 9/11 terrorist attack, and the ongoing war on terrorism.

As a result, over the four quarters of 2011, real GDP is now expected to grow 3.3 percent, with real final sales expected to grow 3.2 percent. In February, the expected growth rates were 3.9 percent and 3.8 percent, respectively. In other words, the outlook for growth has been revised downward but it still should be enough to generate solid job growth and an improving unemployment rate.

Jobs recovering as expected--slowly

Although the employment outlook was discussed in detail in the February issue of the Quarterly, the ongoing debate over whether the labor market will improve enough to sustain the expansion, especially in light of the backup in the unemployment rate in April, warrants another look at the issue.1 I will discuss why payroll employment, even though it has improved over the last several months, still looks sluggish by historical standards, and I will discuss why I still expect unemployment to fall in the next few years much faster than the consensus.

As shown in Chart 1, nonfarm payroll jobs were very slow to recover following the recessions of 1990-91 and 2001, and it looks as if jobs will be at least as slow to recover this time. One reason is because the jobs market has so far to climb just to get back to their previous high. Nonfarm payroll jobs fell a whopping 8.7 million from their peak in January 2008 to their trough in February 2010. As such, it is reasonable to expect it to take longer for jobs to recover, especially given that the pace of the last three expansions, the current one included, has been slower than in prior expansions. As such, productivity gains and longer workweeks have accounted for much of the increase in output early in the expansion rather than hiring additional workers.

Moreover, structural shifts in U.S. employment most likely explain why jobs have been so slow to arrive in recent recoveries. First, I believe that the types of jobs being created have changed such that employees laid-off during a downturn are not quickly recalled once the economy starts to recover.2 In particular, many of the jobs available early in the more recent expansions increasingly are jobs that did not exist prior to the downturn. Many jobs eventually become obsolete, but the pace of obsolescence seems to have quickened in recent decades. New jobs now are more often at different firms and industries rather than rehires. As such, adding to payrolls takes longer, in part because taking on new employees to fill redefined or newly-created positions is far more complicated than recalling workers to their old positions.

chart 1

Second, private service jobs, which have steadily increased in importance over the years, represented a whopping 85.5 percent of all private-sector jobs in April. Hence, if private nonfarm payroll jobs are to recover, private service jobs must lead the way. However, unlike manufacturing or construction jobs, new service jobs are less likely to be filled by rehiring former employees, which may slow the process somewhat.

Third, since the end of World War II, consumer spending on services has increasingly gained share of overall consumer spending. As shown in Chart 2, the ratio of consumer service expenditures on services to goods rose from 0.63 in the first quarter of 1947 to 2.14 in the first quarter of 2009. Nevertheless, this ratio has seen frequent but usually minor setbacks over that period, until recently. In late 2008 and into the first quarter of 2009, consumer spending plunged, but spending on goods fell more than spending on services, causing the ratio of services to goods to spike. Since then, overall consumer spending has improved, but the gain in goods has outpaced the gain in services. As a result, since the first quarter of 2009, the ratio of consumer expenditures on services to goods has registered the steepest and longest decline since World War II. I do not expect this ratio to continue to fall. If I am right, then the implication is that consumer expenditures on services is about to show a more pronounced improvement than they have so far during the current expansion.

chart 2

Generally, it is not until consumers start spending more on services that domestic jobs increase in a more meaningful way since service jobs represent such a large percentage of all private sector jobs. As shown in Chart 3, real consumer spending held up reasonably well during the 2001 recession, which was the mildest on record in terms of real consumer spending. Hence, the recovery in spending was very quick, albeit still slow. However, real consumer spending during the 2007-2009 recession fell dramatically, especially spending on goods. More importantly for the pace of service job growth, consumers have returned to spending on goods much sooner than they have to spending on services. Since the recession ended in June 2009, real consumer spending on goods has increased at a 5.4 percent annual rate while real spending on services has increased at a 1.1 percent annual rate. The forecast continues to expect that spending on goods will slow somewhat but that spending on services will accelerate substantially. Indeed, over the last year, real spending on services has increased 1.9 percent, suggesting that the acceleration in service spending may be underway and that service jobs will follow. A hint that this may be starting is provided by the increase of 1.2 million in private-sector service jobs over the last year. Needless to say, there is still a long way to go before private service jobs return to their previous high at the end of the last expansion.

chart 3

Despite the slow recovery in nonfarm payroll jobs, I continue to expect the unemployment rate to fall to a level near 8.0 percent by the end of this year and below 7.0 percent by the end of 2012, both of which are much better than the consensus forecast. The primary reason the consensus is less optimistic is because they continue to expect the civilian labor force participation rate, which fell dramatically during the recession, to rebound to its previous high. If people stop looking for employment, they are no longer considered part of the labor force—they are neither employed nor unemployed. However, as the economy improves and jobs increase, more people start looking for jobs again, pushing the participation rate upward. Most economists contend that job growth, although expected to improve, will only slightly exceed the widely advertised surge in labor force growth due to reentrants, causing the unemployment rate to remain elevated.

Although I admit that there is a cyclical component to the participation rate (that it will increase as the economy improves), I contend that part of the historical decline in the participation rate in recent years reflects the aging of the labor force. After all, when someone retires, they leave the labor force but not the general population, causing the participation rate to fall if all else remains the same. The first wave of “Boomers” was eligible for Social Security three years ago, when they started to turn 62. Some took advantage of the opportunity and retired. Now that group is turning 65, which means that an even larger share of the group probably will retire. This is not to say that this age group will retire at the same pace as they did in the past because the stock market debacle a few years ago may have delayed the retirement plans of many. However, because this age group represents a larger and a faster growing segment of the population than ever before, those that can retire will put downward pressure on the labor-force participation rate. For this reason, it may be decades before the participation rate gets back to its previous high, if then.

Of course, a big deal was made of the fact that the unemployment rate edged back up to 9.0 percent in April, following several monthly declines. As shown in Chart 3, the unemployment rate frequently ticked up during the downward trends of the previous two expansions. The jobs recovery in this expansion will be no different. In other words, I expect the unemployment rate to continue to trend lower, albeit not every month, over the next few years.

chart 4

The bottom line is that the labor market is expected to improve. Barring an overly zealous regulatory policy or a counterproductive trade policy in the name of risk containment or job creation, the U.S. economy seems destined to enjoy a solid-paced, self-sustained economic expansion at least for the next couple of years. And associated with this continued expansion should be a meaningful revival in employment and an even more spirited decline in the unemployment rate.

Investment implications

Since the outlook over the remainder of the year and into 2012 is little changed, the investment implications are little changed as well. I continue to believe that this year will prove to be very challenging for investors. Interest rates across all maturities are expected to be higher on average in 2011 than they were in 2010. This will create some anxiety among bond investors, who have turned to U.S. Treasury obligations as a safe haven. Credit risk will not be as much of an issue, although concern about the credit rating of the U.S. government and some municipal general obligations may surface at times this year. Indeed, because of the fundamental strength of the economy, I favor high-yield corporate bonds and many municipal revenue bonds more so than U.S. Treasuries or municipal general obligations.

Higher interest rates will not be confined to the U.S. As such, I would be cautious about foreign sovereign debt given the increased likelihood of higher interest rates going forward. In fact, some countries have already started to push interest rates higher. Moreover, do not anticipate a weaker U.S. dollar this year to bail out investors in non-dollar denominated sovereign bonds. All of the dollar weakness expected this year is already behind us.

Equities continue to be preferred over bonds in 2011. But even here, be careful not to get overly exuberant about expected returns. Stock prices will be up this year, but they most likely will not deliver stellar returns in an environment where the Fed is expected to start removing the very accommodative monetary policy stance currently in place.

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1. See Daniel E. Laufenberg, “Help Not Wanted?,” Laufenberg Economic Quarterly, February 2011

2. See Erica L. Grosben and Simon Potter, “Has Structural Change Contributed to a Jobless Recovery?,” Current Issues in Economics and Finance, Federal Reserve Bank of New York, Volume 9, Number 8, August 2003, pp. 1-7.

Core inflation: a policy guide more than a policy target

The reference to core consumer price inflation, which excludes food and energy prices, by the Federal Reserve in its policy deliberations has been questioned once again. Opponents of the core measure argue that it overlooks two very important items by excluding food and energy, while proponents argue that core inflation provides a more accurate assessment of underlying inflation pressures. At the risk of sounding like an economist, they are both correct to some extent. Core inflation can be very useful in the short-run as a policy guide to the underlying pace of inflation, but is totally inappropriate as a policy target or as a measure of consumer inflation in the long run. In the long run, the short-run volatility of food and energy prices is less important to the overall inflation picture.

This point is shown in Chart 1, which plots the percent change from a year earlier in the overall consumer price index (CPI) and the core CPI since 1971. Clearly, the overall component is far more volatile than core. And since the difference between the two is that core excludes food and energy, then food and energy prices tend to be very important to the short-run swings in the overall CPI. However, core inflation and overall inflation were more highly correlated in the 1970s than they have been since.

chart 1

For years, I have fielded questions about core inflation and the role it plays in policy decisions. Most of the questions were about the appropriateness of excluding such important items like food and energy from the inflation measure. Economists do not exclude food and energy prices because they consider them unimportant. I contend it is the opposite. Because they are so important to overall inflation, they are excluded because their short-term volatility, which seems to have intensified in recent years, may have considerable influence on overall inflation in the short run, but not necessarily on inflation expectations in the long run. Without a change in inflation expectations, it is nearly impossible to engineer a long-term change in overall inflation.

In Chart 2, the percent changes from a year ago in the price indexes for food and energy, as measured in the CPI, are plotted separately along with the percent change from a year ago in the core CPI index since 1971. Clearly, food and energy inflation is far more volatile than the aggregate of other prices. Indeed, if policymakers want to assess the likely direction of future inflation, what happens to food and energy prices seems to be far less important to core inflation now than they were in the 1970s. Hence, from a policy maker’s perspective, it makes sense to focus on core inflation in the short-run as a guide but not a target.

chart 2

It may be helpful to quantify how important the food and energy are to consumers as measured in the CPI. According to the Bureau of Labor Statistics (BLS), food represents about 14 percent of the CPI, while energy represents about 9 percent. At first blush, the two items represent nearly a quarter of all out-of-pocket expenditures of consumers. However, a more detailed look at the data suggests that the prices that people experience more frequently represent a somewhat smaller share of all expenditures. For example, even though food gets a 14 percent weight in the CPI, slightly more than half is food at home and slightly less than half is food away from home. Over the last year, the prices of food at home rose 3.9 percent, while the prices of food away from home increased 2.1 percent. In other words, the changes in food prices that people are more likely to notice increased nearly twice as fast as changes in the food prices less likely to be noticed.

Another aspect of food price inflation as measured by the CPI is that it is based a fixed basket of goods and services. It does not allow for substitution, whereas the price index for personal consumption expenditures (PCE) is a chain-weighted index, which does allow for substitution. It should be no surprise then that over the twelve months ending in April, the food component of the CPI increased 3.2 percent, whereas the food component of the PCE price index increased 2.9 percent. It seems that some consumers did respond to higher food prices by shifting expenditures. Of course, not everyone has the option to shift spending, especially for consumers who are already buying the lower priced items. The only option available to them in the face of higher prices is to buy less food or to forego other nonfood expenditures.

Moreover, energy includes both energy commodities and energy services. Prices of energy services—such as natural gas and electricity, which represent about 40 percent of all energy expenditures, increased a scant 0.1 percent over the year ended in April. On the other hand, prices of energy commodities—such as gasoline and fuel oil, which make up the other 60 percent of the energy price component of the CPI, jumped nearly 33 percent over the last year. In other words, the energy prices that consumers see every day at the pump are also the energy prices that increased the most. However, they represent about 5 percent of all expenditures. The options available to consumers in the wake of higher gasoline prices are driving less, switching to more efficient vehicles, or using public transportation more often. Of course, like the substitution options available in the wake of higher food prices, the energy options are not available to everyone.

The conclusion is that, regardless of how you slice it, higher food and energy prices matter but that they matter far more for some consumers than for others. However, with regard to their overall impact on the economy, they are probably less important today than they were in the past.

The outlook for the CPI in 2011 is not as tame as it was last year, but it is not expected to be a problem either. The Laufenberg forecast now shows the overall CPI increasing 2.8 percent over the four quarters of 2011, which is up from the 1.1 percent advance over the four quarters of 2010 and slightly ahead of the 2.2 percent gain shown for all of 2011 in the February forecast. This may seem troubling, but it is important to remember that most of the acceleration in the CPI for this year probably is behind us already. Moreover, core CPI inflation, which is expected to be up 1.8 percent over the four quarters of 2011, which is three times faster than the advance in core inflation over the four quarters of 2010. This too may seem troubling, but the level of core inflation still would be very low by historical standards. It seems to me that based on the Federal Reserve’s monetary policy stance so far this year, the Fed agrees.

That being said, I do expect inflation to eventually be a problem for the expansion. However, this is unlikely to occur until the expansion has been in place for a few years and the resource utilization rate has improved dramatically. With the unemployment rate still at 9.0 percent, inflationary bottlenecks are not expected anytime soon.

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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.


ARCHIVES OF LAUFENBERG ECONOMIC REPORTS

November 2009 - LEQ (PDF)
February 2010 - LEQ
May 2010 - LEQ

August 2010 -LEQ
November 2010 - LEQ
February 2011 - LEQ


INDEX TO CURRENT EDITION

Executive Summary

Forecast Details

A first-quarter hiccup

Core inflation: a policy guide more than a policy target

~ ~ ~ ~

INDEX TO CURRENT EDITION

Executive Summary

Forecast Details

A first-quarter hiccup

Core inflation: a policy guide more than a policy target

~ ~ ~ ~

 

INDEX TO CURRENT EDITION

Executive Summary

Forecast Details

A first-quarter hiccup

Core inflation: a policy guide more than a policy target

~ ~ ~ ~

 

 

 

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