December 2012

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 - Fiscal policy facing another self-imposed deadline

  • The major concern at the moment is the year-end deadline facing fiscal policy makers, which in the absence of action on their part would trigger immediate federal spending cuts and substantial tax increases for most taxpayers. As frustrating as it may be to watch, history suggests that Congress often needs a serious deadline to get something done.

  • Although I believe that the immediate spending cuts (sequester) will be avoided, I am far less clear about what will happen to tax policy. If nothing is done with regard to taxes (all the tax changes since 2001 are allowed to expire), the consensus seems to expect something resembling a recession in the first half of next year. But even if a compromise on taxes is reached before year-end, most economists still expect the economy to be rather anemic in the first half of 2013.

  • As you might expect, I am not as pessimistic as the consensus, in part because I doubt the drag from the fiscal cliff will be as severe as many suggest and in part because I think the underlying U.S. economy is stronger than many now assume. That being said, this underlying strength may be challenged temporarily by the drag on the U.S. economy from the drought and Hurricane Sandy.

  • According to the Commerce Department’s revised estimate, the U.S. economy grew 2.7 percent at an annual rate in the third quarter, which is well above the initial estimate of 2.0 percent. Despite the revision to the headline statistic being in line, the details were mildly disappointing, especially the sizable downward revision to personal consumption expenditures. As such, they no longer favor the upward momentum to fourth-quarter economic growth that was evident earlier.

  • In October, the unemployment rate was 7.9 percent, up a tad from 7.8 percent in September but down substantially from 8.9 percent a year earlier. I expect that the unemployment rate will continue to drift lower over the next year, owing to spurts of solid economic growth and the likelihood that the labor force participation rate will remain near its recent low despite an improving labor market.

  • For all of 2013, consumer price inflation will be perceived as relatively benign, but it is expected to trend slightly higher as the year unfolds. Hence, I expect the Fed to raise short-term rates earlier than its latest commitment of 2015, but not as early as shown in the August forecast. My best guess now is late next year.

  • Forecast at a glance

  • chzrt 1 - 4

    Forecast details

    Forecast Details

    Fiscal policy facing another self-imposed deadline

    The making of fiscal policy is often ugly, but it seems uglier than usual at the moment. The reason is that if Congress does not act before year-end, current law would repeal many of the tax cuts and credits implemented since 2001 as well as impose some automatic spending cuts know as sequester. This is just another in a series of self-imposed deadlines that illustrates the deep dysfunction of our federal budget process, the previous one being the debt ceiling debacle in July 2011. According to Washington’s consensus, the most likely outcome from the protracted negotiations going on at the moment is a framework agreement that avoids the sequester in return for spending cuts in the future and some tax increases. Exactly what the tax increases will be is less certain; that is, will it be in the form of higher tax rates, a broader tax base, or both. The hope is that policy makers will come through with a deficit reduction plan like they did in 1990. Recall that on the last day of fiscal year 1990, after months of difficult bipartisan negotiations, the President and leaders of Congress reached an agreement that yielded budget savings and lasting process reforms. Later in that decade, thanks to the basic principles of the 1990 legislation as well as additional legislation in 1993 and 1997, federal budgets were in surplus from 1998 to 2001. Although we can hope that it will happen again, it seems less likely now than then in large part because it was not a lame duck Congress that was asked to reach an agreement in 1990. On the other hand, the new Congress will look a lot like the old Congress, which will give them very little room to blame the other guy if they fail to get a deal done.

    With regard to the forecast, the uncertainty around the upcoming fiscal policy deadline makes my job more complicated than usual, which is one of the key reasons this report was delayed. I agree with the Washington consensus that a compromise will be reached, which means that no one will like it but the majority will vote for it. This is how politicians cover their backside if the plan does not work. As such, the Laufenberg Quarterly (LQ) forecast assumes that the threat of sequester will be removed and that an agreement on taxes will be reached before year-end. I agree with the view that the electorate voted for a deal in the last election. Of course, not everyone agrees. Some contend that since the recent election did not really change the political landscape very much at the federal level, it was an endorsement of the gridlock in Washington. My assessment is a bit different. I think voters wanted the legislators who pushed us to the brink of potential fiscal Armageddon (less a few members who were more likely to resist a compromise) to deal with the situation rather than saddle someone else with the task. In this regard, I doubt voters will give them another chance if they fail.

    But even without the assumption of a compromise, I am not as pessimistic as the consensus, in part because I doubt the drag from the fiscal cliff will be as severe as many suggest and in part because I think the underlying U.S. economy is stronger than many now assume. That being said, this underlying strength may be challenged temporarily by the drag from the Midwest drought and Hurricane Sandy.

    I expect real gross domestic product (GDP), which grew at an upwardly revised 2.7 percent at an annual rate in the third quarter, to continue to expand at an above-consensus, if not always at an above-trend, pace over the next year or so. Needless to say, the consensus forecasts are not very stellar in either case. After all, the high level of uncertainty around this forecast alone will cause some decision makers to hesitate over the next couple of months, which most likely will detract something from fourth-quarter real GDP growth, even if fiscal policymakers reach a compromise. In addition, the near-term pace of economic activity will be distorted by weather effects, including the Midwest drought and Hurricane Sandy. For example, in the third quarter, real farm inventories fell $11.5 billion at an annual rate and detracted 0.4 percentage point from real GDP growth. More of the same is expected in the fourth quarter, but with a major difference. In the fourth quarter, nonfarm inventories most likely will not increase another $36.5 billion, which suggests that the change in business inventories most likely will be a drag on growth. It most definitely will not contribute to growth to the same degree it did in the third quarter.

    The adverse effect on the economy from Hurricane Sandy was already evident in some October data, which means that real growth in the fourth quarter most likely will not be as stellar heralded in the August forecast. One example of this is real personal consumption expenditures (PCE), which declined 0.3 percent in October from a downward revised September level. In other words, any upward momentum that had been in the September data, as well as any hope of further gains in October, were swept away with revisions and Hurricane Sandy. On the other hand, the drag from bad weather generally is temporary, which is highlighted to some extent in light vehicle sales in November, which climbed to an annual rate of 15.5 million units from 14.3 million units sold in October. Reportedly, much of the surge was due to the replacement of vehicles lost in Hurricane Sandy. Hence, as sloppy as real PCE growth was in September and October, it looks as if it will recover enough in November and again in December to sustain real GDP growth of about 2.0 percent in the fourth quarter.

    Nevertheless, looking through the noise in the data due to concern about the well-advertised fiscal cliff and the widely-reported bad weather, I contend that real GDP growth will be strong enough, albeit very uneven, over the next year or so to push the unemployment rate lower. My estimate is that the civilian unemployment rate, which is currently at 7.9 percent, will fall to 6.8 percent by the end of next year. This is not quite as low as shown in the August forecast but still better than the consensus. But then my unemployment rate forecast has been more optimistic than the consensus in each of the first three years of the current recovery and so far I have been proven correct in my optimism.

    Q3 real GDP revision: Disappointing details

    According to the second estimate from the Bureau of Economic Analysis, third-quarter real GDP grew 2.7 percent at an annual rate, up from the initial estimate of 2.0 percent. Although an upward revision was widely expected, it was less than I anticipated. In addition, the details of the revision were less encouraging for real growth in the fourth quarter.

    Although I expected the change in business inventories and net exports to make a larger contribute to real GDP growth in the third quarter than estimated earlier, I did not expect real personal consumption expenditures and, to a lesser extent, business fixed investment to be revised downward as much as they were. In fact, real final sales growth, which was initially estimated to be up 2.1 percent in the third quarter, was revised downward to 1.9 percent; as such, the change in inventories went from detracting 0.2 percentage points from real GDP growth to adding 0.8 percentage points, despite a 0.4 percentage point drag from the change in farm inventories. Needless to say, there was a lot of inventory accumulation on the part of businesses last quarter, suggesting that the change in business inventories in the current quarter is likely to be a drag, albeit a small one. The point is that any growth in real GDP in the current quarter most likely will have to come from real final sales.

    Unfortunately, real final sales growth has been anemic for most of the current economic expansion, which began in July 2009 (see Chart 1). The one exception was the fourth quarter of 2010, when real final sales jumped at a 4.0 percent annual rate. Otherwise, the range has been from a negative 0.6 percent in the fourth quarter of 2009 to a positive 2.4 percent on three different occasions. The average growth of real final sales over the last 13 quarters is a mere 1.6 percent. Real GDP growth has grown only marginally better over the same period, with an average growth rate of 2.2 percent. This reflects the positive impact that inventory accumulation has had on the U.S. economy, which is not that unusual in the early years of recovery.

    chart 1

    Apparently, the numerous headwinds that have plagued the U.S. economy over the last several years—including the severity of the financial debacle in 2008, the European debt crisis, various hurricanes, the Japanese tsunami, the downgrade of U.S. federal debt, debt ceiling politics, and now the threat of substantial fiscal drag and another debt ceiling crisis in the months ahead—have adversely affected aggregate demand. In other words, there have been plenty of reasons for consumers to exercise restraint, business managers to be careful, and for state and local governments to be frugal. And this is unlikely to change in the immediate future.

    First, the downward revision to real PCE in the third quarter was the biggest disappointment. After estimating real PCE growth at a 2.0 percent annual rate initially, the BEA revised it downward to a mere 1.4 percent pace. Actually, I was expecting thirdquarter real PCE growth to be revised higher. Indeed, prior to the revision, it looked as if the many headwinds facing the U.S. economy were having less of an adverse effect on consumer spending than on business investment and government spending. Now it looks as if consumers also were more cautious about expenditures than at first blush.

    So what will consumer spending, which represents over 70 percent of GDP, look like in the months ahead? I contend that it will not be as sluggish as the consensus expects but also not as strong as the consensus requires. As shown in Chart 2, the average growth rate for real PCE for the first 13 quarters of the current recovery is 2.1 percent. This compares with 2.9 percent for the first 13 quarters of the previous recovery, which had been the slowest recovery since 1960. Clearly the slow-motion recovery in real PCE this time around is even slower than the previous recovery.

    chart 2

    Finding an explanation for this slowdown in consumer spending is a bit difficult. My initial response is that it is due the aging of the population; that is, the surge in the number of older folks, who are past their peak spending years, and the decline in the number of younger folks, who are just starting to spend for home and family. The net result is that there is less need for real spending to grow as fast in this expansion as it has in past expansions.

    The BEA’s second estimate of third-quarter real business fixed investment in equipment and software also was revised lower, but unlike PCE it was weak to begin with. Rather than being flat in the third quarter, real business spending on equipment and software actually fell 2.3 percent at an annual rate, which detracted 0.2 percentage point from third-quarter real GDP growth. This is not a huge difference, but it begs the question of whether business equipment spending will recover in the current quarter. The good news is that orders of nondefense capital goods less aircraft (in current dollars), which serves as a reasonable proxy for business spending on equipment, jumped 1.7 percent in October to a level that is already 6.0 percent at an annual rate higher than the third-quarter average. Although capital goods orders are very volatile from month-to-month, the October gain may be strong enough (barring a major downward revision) to support an increase in the fourth quarter, despite the uncertainty about future tax policy. The LQ forecast currently shows real business fixed investment increasing at a 2.4 percent pace in the fourth quarter, with all of the gain coming from spending on equipment and software.

    Government spending, which had been a drag on the economy for eight consecutive quarters, actually contributed about 0.7 percentage point to real GDP growth in the third quarter, owing to a spike in defense spending. I expected government spending to be less of a drag in the third quarter but I was surprised by the magnitude of the contribution. More importantly, it is very doubtful that government spending can sustain such a contribution to GDP given the increased likelihood of some budget austerity in the near term. From this perspective, I expect real government spending to revert back to being a drag on the economy in the fourth quarter and into the first half of 2013.

    Identifying the trend rate of growth

    Identifying the trend (potential) growth rate for the U.S. economy is extremely important for the inflation outlook, as well as determining what an acceptable growth rate should be at full employment. Both have important monetary and fiscal policy implications. As shown in Chart 3, the trend rate of growth for real GDP from 1973 to 1990 was about 2.5 percent. Over this same period, the labor force grew at a 1.7 percent pace.

    chart 3

    If we assume that real output growth is the sum of the growth rates of the labor force (hours worked) and productivity (output per hour worked), then productivity growth apparently averaged about 0.8 percent over this period. From 1990 through 2007, the trend rate of growth for real GDP was 3.3 percent, reflecting the combination of 1.2 percent labor force growth and 2.1 percent productivity growth. Since the end of 2007, the average annual growth rate for real GDP has been 0.5 percent. The average annual rate of labor force growth over the same period has been 0.2 percent. This does not bode well for average annual productivity gains over this period.

    So what will be the trend rate of growth over the next decade or so? My expectation is that it is no longer 3.3 percent, which some analysts continue to suggest, but rather something closer to 2.0 percent. First, labor force growth remains slow by historical standards, in large part because “boomers” are retiring. Although the 0.2 percent annual rate of labor force growth since 2007 most likely was influenced somewhat by discouraged workers, it seems that even when these workers reenter the labor force that the trend rate of labor force growth will be less than 1.0 percent.

    Second, labor productivity growth most likely will be better than the 0.8 percent inferred from the trends from 1973-1990, but less than the 2.1 percent average from 1990 to 2008. My best guess is that the average annual rate of growth for productivity going forward will be about 1.0 percent. Although technology will continue to drive labor productivity gains, it is unlikely to be as substantial as it was in the 1990s and the first decade of the 2000s. Innovation will be slower in the wake of the limited risk taking following the financial debacle of 2008 and the increased regulation implemented to prevent it from happening again. Not until the next great technological advance, whatever and whenever that might be, will productivity gains be unleashed again. My best guess is that these advancements will come in either the transportation industry or the health care industry, or both. However, now that the federal government apparently is increasingly more involved in each of these industries, significant innovation will be even slower to come by. History suggests that extensive regulation or government sponsorship does not promote innovation but rather it preserves the status quo. Government regulation is necessary but it should be used with discretion. An unintended consequence of extensive regulation is that it allows businesses to continue operating even if they are no longer economically viable. After all, why would regulators ever shutdown a business if it meant the loss of jobs. This was the primary argument for the “too-big-to-fail” policy exercised during the last financial crisis, where big was measured by the number of employees. I have not yet heard anyone argue in favor of a “too-efficient-to-fail” policy.

    The bottom line is that the trend rate of growth will be less than expected by many. So far during this expansion, real GDP has grown an average of 2.2 percent, which is considered by most economists as disappointing. Yet, over that period, the unemployment rate has fallen to 7.9 percent in October 2012 from its recent peak of 10.0 percent in October 2010. The inference is that 2.2 percent growth of real GDP must be above the trend rate of growth, otherwise the unemployment rate would not have fallen.

    Inflation expectations remain anchored

    Inflation concerns are premature. Over the twelve month ending in October, the overall consumer price index (CPI) increased 2.2 percent, while the core CPI, which excludes the volatile food and energy components, increased 2.0 percent, according to the Bureau of Labor Statistics. Although this is elevated a bit from the low of 1.4 percent in July, it still is well within the acceptable range for the Federal Reserve. Indeed, Chairman Bernanke suggested that maybe the PCE price index is a more appropriate measure of inflation than the CPI for policy purposes. In this case, the overall PCE price index increased only 1.7 percent over the twelve months ending in October, while the core PCE price index rose 1.6 percent, according to the Bureau of Economic Analysis. The primary difference between the CPI and the PCE price index is that the former does not allow for substitution among goods and services in the near term, while the latter does.

    With regard to the inflation outlook, it depends heavily on expectations. For example, if people expect high inflation, their actions can drive prices higher even faster. This is why the Fed puts so much emphasis on inflation expectations as a guide to policy. In the October statement from the Federal Open Market Committee, it states that “longerterm inflation expectations have remained stable.” This was the view despite the uptick in overall inflation due to higher energy prices in August and September. Of course, more recently, energy prices have come down.

    Although there are numerous ways to measure inflation expectations, they all seem to suggest that long-term inflation expectations are stable. One such measure developed by the Federal Reserve Bank of Cleveland combines data from nominal interest rates, derivatives known as inflation swaps, and two different survey measures of inflation. Inflation expectations over the next ten years derived from this measure is shown in Chart 4. According to the November reading, the ten-year expected inflation is 1.53 percent. This means that the public currently expects the inflation rate to be less than 2 percent on average over the next decade.

    chart 4

    This suggests that the Federal Reserve still has credibility in keeping inflation low and that the massive increase in its balance sheet and the accompanying increase in banking system reserves have not dislodged the public’s expectations of low inflation, at least not yet. An interesting aspect of inflation expectations as plotted in Chart 4 is the steady decline in such expectations since 1982. This would imply that the disinflation trend that was such a key driver to stock and bond returns over this period may still be in play. As credible as the Fed seems to be at the moment, I believe that the disinflation trend is approaching a lower bound that will make further gains in that direction far more difficult. That being said, as always, these developments tend to survive far longer than most expect.

    Investment implications

    Based on the LQ forecast, credit risk is still favored over interest rate risk. This means that investors should overweight equities and underweight bonds. And in bond portfolios, short-duration, high-yield bonds are preferred over long-duration, low-yield bonds. This is a bit of a contrarian view because there are still plenty of reasons for investors to be cautious toward risk. But when most investors are fearful of risk, it is typically a good time to own it. That certainly has been the case for nearly the last four years.

    It is increasingly clear that the Fed is in no hurry to raise short-term interest rates. However, as inflation and inflation expectations start to drift higher, as I expect they will in 2013, bond investors most likely will not wait. I continue to expect the Fed to start backing away from its overly accommodative stance sometime before the end of 2013. Of course, by the time the Fed gets around to doing something, the bond market will be ahead of the game. I find it interesting that everyone is talking about the impact of higher taxes on the stock market, but no one is talking about their impact on the bond market. I expect that in the absence of meaning spending cuts and budget reform, the bond market may not like the budget compromise even if it includes substantially higher taxes for high-income households.

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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.


    ECONOMIC COMMENTARY
    Mid-term updates to the Quarterly Reports

    ARCHIVES OF LAUFENBERG QUARTERLY ECONOMIC REPORTS

    November 2009 - LEQ (PDF)
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    November 2010 - LEQ

    February 2011 - LEQ

    May 2011 - LEQ

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