June 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 - Less delivered but more expected blue bar

  • The bad news is that U.S. real output contracted in the first quarter according to the latest estimate from the Bureau of Economic Analysis, despite a solid gain in consumer spending. But most of the gain in consumption expenditures was in services, with much of it weather related. The unusual mix of first-quarter economic activity—sharply lower inventory accumulation and weaker final sales—tends to validate the notion that the extremely harsh winter was the culprit. Indeed, the weather apparently was even more disruptive than initially estimated by the Bureau of Economic Analysis and far more disruptive than outlined in the previous Laufenberg Quarterly forecast.

  • The good news is that winter is over, even in Minnesota, setting the stage for a weather-related rebound assuming the fundamentals are still okay. In that regard, more recent economic data already point to a sharp rebound in the pace of economic activity in the second quarter.

  • Nevertheless, the first-quarter contraction makes difficult for real gross domestic product (GDP) to recover enough over the remaining three quarters, even with a solid second quarter performance, to deliver the 3.0 percent growth rate for all of 2014 shown in the previous forecast. For that reason, the growth rate over the four quarters of this year has been lowered to 2.8 percent, but is still better than the 2.6 percent gain last year.

  • Despite less real output growth this year than expected earlier, the civilian unemployment rate still is expected to drop below six percent by the end of the year and inflation expectations are expected to edge upward. The implication is that real GDP growth need not be as strong as it has been historically to get us to full employment.

  • The Utilization Index supports this notion, given that it is already at a level that in the past has signal a shift in Federal Reserve policy. More importantly, this index is very likely to move even higher through the end of 2015.

  • If this is the case, then short-term interest rates may start to drift higher sooner than advertised in the Fed’s recent guidance on the matter. After all, the Fed’s policy stance is conditioned on the availability of excess capacity. The Utilization Index suggests less excess capacity than promoted by policymakers.

  • Also, it is important to note that once the Fed shifts course, short-term interest rates tend to rise rather quickly, in small but frequent steps.

blue barForecast at a glance chzrt 1 - 4

Forecast details blue bar

Forecast Details

blue bar Less delivered but more expectedblue bar

The Laufenberg Quarterly (LQ) forecast has changed a bit from that shown in the February report, owing in large part to a much weaker economy in the first quarter than anticipated earlier. According to the revised estimate by the Bureau of Economic Analysis (BEA), the level of final goods and services produced after adjusting for inflation—real gross domestic product (GDP)—in the first quarter fell 1.0 percent at an annual rate from the previous quarter, which was much softer than the 2.0 percent gain shown in the LQ forecast in February and down from the initial estimate from the BEA of a 0.1 percent gain. Most of the blame for this disappointingly weak growth rate seems to fall on the weather, especially given the details of the weakness. After all, it was an unusually harsh winter most everywhere in the U.S., creating problems for housing and manufacturing.

Residential investment includes new construction, remodeling and commissions paid to real estate agents on existing home sales. It does not include the value of existing home sales. For that reason, housing starts are extremely important to the residential investment component of GDP. They are also very sensitive to unusually wet or harsh weather. In this regard, total housing starts plunged a whopping 34 percent at an annual rate in the first quarter, which explains in large part why residential investment declined 5 percent last quarter.

Manufacturing generally is not as sensitive to the weather as housing, except under some very unusual weather conditions. In particular, if the weather prevents factories from conducting normal operations or if it limits the ability of manufacturers to deliver product or receive inputs, then manufacturing output will be adversely affected. The unusually harsh winter provided just such a circumstance. I contend that this was evident in the sharp decline in business inventories despite a very small gain in consumer spending on goods, a moderate decline in business fixed investment and a substantial drop in exports. Usually a setback in final goods sales tends to boost inventories. That was not the case, suggesting that it was a supply problem owing in large part to the weather rather than a lack of demand.

On the other side of the argument is the fact that real consumer spending increased a solid 3.1 percent in the first quarter, a much better performance than expected by most. However, nearly all of the gain was in consumer spending on services, especially housing and medical services—adding 0.8 percentage point and 1.0 percentage point, respectively—to real GDP growth in the first quarter.

In the housing services component, spending on utilities services was a key factor, reflecting the need to heat homes during the winter months. This is reinforced by the industrial production data released by the Federal Reserve Board, which showed utilities output jumping 17.4 percent at a seasonally adjusted annual rate in the first quarter of 2014 following a 19.5 percent surge in the previous quarter. While not all of utilities output goes to household use, such a surge in usage cannot occur without households participating.

The surge in healthcare spending by consumers was probably less weather related and more the result of the new health insurance exchanges and the extension of Medicaid that went into effect at the start of this year under the Affordable Care Act of 2010. Recall that consumer spending on healthcare includes all care provided to individuals regardless of who pays the bill. And about 60 percent of the total healthcare bill is paid for by third parties, such as employers, insurance companies or the government rather than the individual directly.

So much for the past. What does it mean for the future? First, since the sharp slowdown in inventory accumulation accounted for such a large decline in real GDP in the first quarter, it is unlikely to be a source of weakness again in the second quarter. Indeed, over the longer run, the impact of inventories on real GDP growth tends to be neutral. For this reason, I suspect that the change in business inventories alone could add as much as a percentage point to real GDP growth in the current quarter, after detracting 1.6 percentage points in the first quarter. In other words, most of first-quarter inventory correction is expected to be reversed in the second quarter but not necessarily all of it, which would leave room for an additional contribution to real GDP growth from inventories in the second half of the year.

Second, excluding the change in business inventories from GDP provides an estimate of final sales, which is an excellent proxy for aggregate demand. In the first quarter, real final sales grew a very anemic 0.6 percent at an annual rate, following a 2.7 percent gain in the fourth quarter of 2013. Hence, real final sales growth was not much help in the first quarter. But this too is expected to change in the second quarter, with another solid gain in personal consumption expenditures getting much needed help from the other final sales components, especially fixed private domestic investment. Recall that fixed private domestic investment includes both business fixed investment and residential investment.

As a result, the LQ forecast now expects an even more dramatic rebound in second-quarter real GDP growth than estimated earlier, in large part because the pullback in the first quarter was more pronounced. More importantly, the forecast expects real GDP growth to continue solid over the remainder of this year. Nevertheless, the rebound still will not recapture everything that was lost during the winter, such that over the four quarters of this year, real GDP now is expected to be up 2.8 percent rather than the 3.0 percent gain expected in February.

Capacity utilization looking up

Recently I heard someone say that there still is a lot of excess capacity available in the U.S. economy, which should prevent inflation from becoming a risk to the economy or the Federal Reserve in the near future. Although I would agree that there still is excess capacity available, I contend that it is far less than many suggest and that it most likely will be utilized rather quickly over the next year. Such an upturn in the utilization rate most likely would trigger inflation concerns, especially if short-term interest rates were still near zero. Hence, I would expect the Fed to be ahead of this concern in order to prevent inflation from becoming a problem or to prevent another credit bubble from developing. This would argue that the Fed should be more aggressively unwinding its quantitative easing program now in order to be in a position to start raising short-term interest rates when needed, especially since that need may be sooner rather than later.

To illustrate this point, I brought back an old favorite of mine—the resource utilization index—that I was pushing in the early 1990s as a signal that the Federal Reserve was on the brink of raising its federal funds rate target. It most likely kept me employed for a few years and enhanced my credibility with the management of American Express, but then that is another story for another day. The utilization index is nothing more than the average of the capacity utilization rate in manufacturing and the employment rate (employed as a percent of the labor force). The latest reading of the utilization index was 86.2 percent in April, which is the average of 78.6 percent and 93.7 percent, which are the industrial production capacity utilization rate and the employment rate, respectively.

The utilization index and the federal funds rate are plotted in Chart 1, with the utilization index measured on the left axis and the funds rate measured on the right. There are a couple of items worth noting from this relationship. First, the utilization index has climbed considerably since the end of the previous recession in mid-2009, suggesting that the current excess capacity available in the U.S. economy is far from where it was five years ago.

Chart 1

Second, as can be seen in 2004, the index was at about its current level of 86 percent and rising when the Fed started increasing the federal funds rate from 1.0 percent back then. However, in 1994, the Fed did not start raising rates until the utilization index was nearly 88 percent. The interesting aspect of this relationship is that the utilization index is likely to be approaching 88 percent over the next year or so, especially if the LQ forecast of real growth and employment turns out to be correct. But even if growth and employment fall short of the LQ forecast, the utilization index still will most likely move higher.

The unemployment rate, which has already dropped to 6.3 percent in April (the latest data available) from 6.7 percent in March, is expected to continue its downward drift over the remainder of this and all of next year. By the end of 2014, the civilian unemployment rate is expected to be below 6.0 percent and by the end of 2015, it is expected to be very close to 5.0 percent. If the Fed is focused on the unemployment rate falling below some threshold before it initiates a policy response, then based on the LQ forecast, that threshold most likely will be breached soon. Probably much sooner than most market participants, as well as most policymakers, now embrace.

Overall industrial capacity utilization, which was estimated at 78.6 percent in April by the Federal Reserve Board, most likely will continue its upward trend as well. It is expected to be led by manufacturing more so than utilities or mining, with both durable and nondurable manufacturing utilization rates continuing to drift higher. Over the next year, both are expected to be back above 80 percent, which is all that is needed to push the utilization index to a level consistent with a Fed tightening of monetary policy.

Without Fed action, I contend that the risk of inflation or another debt crisis will pursue. The difference this time is that mortgages will not be the source of the crisis, although once the crisis begins mortgages will not be immune. I believe it will be interest rate risk this time that will be the shocker, triggered by a sudden realization that inflation is not dead after all and that federal budget deficits are not going to disappear. As Bob Kincade reminded me recently, I have always argued that expansions do not die of old age, they are sabotaged. This time I think it will be inflation that will be the saboteur. The more interesting aspect of this is that after an extended period of very low inflation, not much of an acceleration will be needed for it to be problematic.

A flatter yield curve in the forecast

Since the utilization index suggests that the Fed is close to shifting its course toward a tighter policy stance, it may be worthwhile to examine what happens when the Fed does make such a shift. One thing that happens is that the yield curve tends to flatten, as short-term interest rates rise faster than long-term interest rates—a so-called, bear flattening of the curve. While this is not likely to happen overnight, it is expected to get started in the next year. Of course, timing Fed policy changes should be a lot easier in this new era of transparency. Unfortunately, what the Fed says it will do and what I think it should be doing sometimes are at odds, which makes forecasting interest rates a lot more difficult for people like me.

At the moment, most market participants are convinced that the Fed will keep interest rates low in order to boost the economy without fear of inflation becoming a problem. My concern is that the Fed has stayed in its current excessively accommodative stance too long already. I contend that my concern is justified by the historical data shown in Chart 2. In particular, it is interesting to note the cyclical nature of interest rates; that is, they tend to reflect the business cycle, rising when the economy is doing better and falling when it is not. I contend that the economy is doing well enough to warrant a far less accommodative monetary policy stance. After all, low interest rates generally encourage borrowing and discourage saving. Unfortunately, the financial crisis of 2008-09 was so disruptive that it apparently alteedr behavior—consumers have been extremely conservative with their investments, while deleveraging their balance sheets in a historically low interest rate environment. I contend that this environment is changing, as individual investors start to stretch for higher return on their investments, see home prices improve, and stop deleveraging their balance sheets.

But if the Fed is about to change course, there is more to the story. First, typically when the Fed decides to raise rates after an extended period of easing, it tends to do more than expected at the time. Gradualism may describe the process of monetary policy tightening in the past, but the total upward move was far from gradual. As recently as 2007, the 3-month Treasury bill rate was at 5.2 percent, which was up from its previous low of 0.9 percent in 2004. Hence, it is not unrealistic to expect that short rates will be bumped up considerably during the next tightening phase of monetary policy. This helps explain the LQ interest rate forecast for 2015. In other words, once the Fed changes course, it may do so gradually each time but more frequently and for longer than generally expected at the start.

chart 2

Second, despite the cyclical element of interest rates, the longer-term trend since 1980 has been downward, with lower highs and lower lows in each cycle over that period. In large part, this reflects the disinflation trend in place during that same time. With consumer price inflation now running at about 1.5-2.0 percent at an annual rate, it makes sense that interest rates reflect the low inflation environment. Of course, the key factor for interest rates is not past inflation but rather expectations of future inflation, since it is an important part of the time value of money. At the moment, inflation expectations remain “well anchored,” but are unlikely to remain that way if the economy improves as much as Federal Reserve Board Chairman Janet Yellen expects over the next year, let alone the more optimistic LQ forecast.1

Third, short-term interest rates have been near zero, the lowest level since the Accord of 1951, for over five years. Holding short-term interest rates this low for this long is an outlier, reflecting some very special concerns about deflation and labor market conditions on the part of policymakers. I contend that those concerns, which probably were exaggerated when they did matter, are no longer valid.

Investment implications

Needless to say, the weather had a huge impact on the U.S. economy in the first quarter, which means that a return to more normal weather most likely will trigger a sharp recovery. Based on more recent data, this seems to be happening. Most models that are used to calculate real GDP in the current quarter show that it is on track with only one month of data to grow nearly 4.0 percent at an annual rate. The LQ forecast is even more optimistic and now expects second-quarter real GDP to grow at 4.5 percent pace owing to a larger contribution from the rebuilding of inventories than expected earlier. Recall that the change in business inventories was revised downward substantially in the first quarter. Although this would still leave the growth rate for the first half below its historical average for this stage of an expansion, it most likely will prove to be fast enough to push the unemployment rate lower and to create some inflation concerns later in the year.

Some market commenters claim that the Treasury bond market is signaling that the economic rebound will not be sustained, while the stock market seems to be more constructive on the outlook. I tend to believe the stock market at the moment because I think it better reflects the economic fundamentals. The bond market is being dominated by technical factors--less supply owing to improving federal budget deficits in conjunction with the gradualism of the Fed's tapering of its quantitative easing policy. Of course, geopolitical risk also makes U.S. Treasury obligations the safe haven for global investors. If the bond market was nervous about the U.S. economy, then credit spreads would widen. Instead, credit spreads as measured in the corporate bond market have narrowed over the last few years, encouraging individual investors to look beyond fixed income for return as they become increasingly more tolerant of risk once again. For this reason, I still favor risk, but expectations of future returns have been adjusted downward.

______________________________

1 Statement by Janet Yellen, Chair, Board of Governors of the Federal Reserve System, before the Joint
Economic Committee, U.S. Congress, Washington, D.C., May 7, 2014, pp. 2-4.

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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