November 2013

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 - Stronger growth just around the corner blue bar

  • Paraphrasing a well-recognized refrain from a 1932 song, I still believe that stronger growth is "just around the corner." Indeed, my confidence that real growth will finally accelerate to a more comfortable pace of 3.0 percent next year has increased since the last report.

  • Assuming that the government shutdown slowed the economy somewhat in the current quarter, real gross domestic product (GDP) still is expected to grow 2.2 percent for all of 2013, which would be slightly better than in the previous Laufenberg Quarterly (LQ) forecast of 2.0 percent but shy of what was expected a year ago. More importantly, real GDP growth for all of 2014 is expected to accelerate, despite the postponement of fiscal policy deadlines into early next year. I believe that any drag on economic growth from fiscal policy uncertainty in 2014 will be small and very temporary.

  • Reported at 2.8 percent annualized, third-quarter real GDP growth was markedly better than expected. However, this upward surprise could be temporary, given that all of it was due to more inventories. In the third quarter, real final sales grew 2.0 percent which was slightly less than the 2.2 percent pace shown in the previous report.

  • Inventory accumulation cannot continue to add to growth like it did in the third quarter. At some point, real final sales growth must accelerate to fill the void. Although real final sales growth should improve in the fourth quarter, it is unclear that it will be enough to offset completely the likely slowdown in inventory building. As a result, the average GDP growth rate in the second half likely will be little changed from the previous forecast, as the third and fourth quarter growth rates from last time simply are flip-flopped this time.

  • Over the four quarters of 2014, real final sales are expected to grow nearly twice as fast as expected over the four quarters of 2013. A solid improvement in consumer spending should lead the way, with help from more private fixed investment, both nonresidential and residential.

  • Short-term interest rates, which have been at or near historically low levels for nearly five years now, do not seem to be working as well as many had hoped. According to conventional wisdom, lower interest rates boost bank lending to promote final demand. Although bank lending has improved, this channel of monetary policy has been disappointingly sluggish compared to past recoveries.

blue barForecast at a glance blue bar

chzrt 1 - 4

Forecast details blue bar

Forecast Details

blue barStronger growth just around the cornerblue bar

A year ago, the Laufenberg Quarterly (LQ) forecast for real gross domestic product (GDP) growth over the four quarters of 2013 was 2.4 percent, following a gain of 2.0 percent over the four quarters of 2012.1 Of course, the 2.0 percent growth rate for all of 2012 at the time was based on an assumption about real growth in the fourth quarter of that year that turned out to be too optimistic. Nevertheless, more recent benchmark revisions raised the first-quarter growth rate for 2012 such that real GDP did indeed grow 2.0 percent over the four quarters of last year. Assuming that the current-quarter real GDP will grow 2.2 percent, which is higher than the consensus forecast at the moment, real GDP growth for all of 2013 would come in at 2.2 percent as well. While this would be shy of the LQ forecast of a year ago, it still would represent a slight acceleration in real GDP growth from a year earlier.

Recall that in the previous LQ forecast I lowered U.S. real GDP growth for all of 2013, owing in large part to the Bureau of Economic Analysis' (BEA's) sizable downward revision to its estimate of first-quarter growth but also to my slightly less robust forecast for the second half. At first blush, that downgrade to the second-half forecast looks a bit suspect given the upside surprise in the BEA's advance estimate of third-quarter real GDP growth of 2.8 percent. At such a pace and if it is not revised away, GDP growth in the third quarter was markedly better than the downward revised gain of 2.1 percent in the previous forecast.

But beware! Much of the upside surprise was due to more inventory building than anticipated earlier and not from better-than-expected final sales. The change in inventories was expected to detract 0.1 percentage point from real GDP growth in the third quarter. Instead, inventories added 0.8 percentage point to growth. Needless to say, real final sales, which grew 2.0 percent at an annual rate in the third quarter, were actually slightly less than the 2.2 percent pace I expected. Obviously, the change in business inventories cannot sustain an expansion; that is, eventually final sales growth must improve. I expect some of this to occur in the fourth quarter, but not enough of an improvement in final sales to offset all of the expected weakness in inventory accumulation. As a result, the average GDP growth rate in the second half likely will be little changed, but the third and fourth quarter growth rates likely flip-flopped from the previous forecast.

With regard to the outlook, I think it can be summarized by paraphrasing a refrain from a popular song from the Great Depression era that stronger growth is "just around the corner."2 Indeed, my confidence that real growth will finally accelerate to a more comfortable pace of 3.0 percent next year has increased since my last report. This seems at odds with the consensus, which has lowered its forecast recently in response to the postponement of fiscal policy deadlines into early next year. I believe that any drag on economic growth from fiscal policy uncertainty in 2014 will be very temporary.

The inflation outlook for the next year or so also remains little changed from the previous report. As expected, the consumer price index rose 2.6 percent at an annual rate in the third quarter, owing in large part to the jump in energy prices. This follows no change in the consumer price index in the second quarter. More recently, lower energy prices will help constrain overall inflation in the fourth quarter but less so than many seem to expect. Next year, the LQ forecast continues to show consumer price inflation edging higher, as energy prices start to drift higher again and service price inflation starts to intensify. This latter item includes higher out of pocket expenses for health care, as well as higher rents for housing services across the board.

The unemployment rate so far in 2013 has been on track with the LQ forecast of a year ago. The average of 7.3 percent for the third quarter equals the average level forecasted late last year. I expect the unemployment rate to continue to drift lower over the next year at least, owing to more jobs and continued departures from the labor force. By the way, there is more than one reason to leave the labor force—return to school, give up looking for a job, or retire. I contend that boomers are retiring and as such are having a much bigger impact on the labor force than many economists are willing to acknowledge.

Interest rates continue to be influenced dramatically by the Federal Reserve's accommodative policies, across all maturities. The rate on the three-month Treasury bill has averaged 6 basis points for the first ten months of the year, thanks to the near zero federal funds rate policy of the Fed. Moreover, the yield on the 10-year Treasury note has averaged 226 basis points over the first ten months of the year, which is actually up from the 183 basis points over the first ten months of 2012. The backup in the 10-year yield earlier this year most likely reflected the expectation that the Fed was about to slow its monthly purchases of longer-term obligations. Although that expectation turned out to be premature, the 10-year Treasury note yield still remains at a more elevated level than it was a year ago. The LQ outlook for longer-term yields in 2014 is that they continue to drift higher as the Fed starts to taper its monthly purchases. I actually think that the Fed ends quantitative easing (QE) much sooner than the consensus. Indeed, Ben Bernanke's departure could provide the Fed a chance to start tapering before Janet Yellen takes charge, providing her an opportunity to reverse course if she feels it necessary. Recall that when Ben Bernanke took over as Fed chair in February 2006, he continued the tightening policy that he inherited from Alan Greenspan, raising the Fed's federal funds rate target from 4.5 percent to 5.25 percent by July of that year. The federal funds rate target was held at 5.25 percent until July 2007. For the next year and a half, the Fed reduced its target to near zero and has held it there ever since. Hence, even if the tapering of QE starts sooner, the federal funds rate target likely will remain low at least until QE has ended.

S&P 500 operating earnings per share are on track to be $107 for all of 2013 owing to still solid margins amid okay revenue growth. In 2014, earnings per share are expected to increase again, but at a much slower pace owing to less generous profit margins. Unit labor costs are expected to register a larger gain over the four quarters of 2014 than they likely will register this year, as compensation rises faster than productivity. And with only moderate pricing power, companies will have a difficult time in 2014 passing all of these costs through to their customers.

Final sales need more lift

In the third quarter, real final sales of domestic product increased 2.0 percent at an annual rate, only slightly less than the 2.2 percent pace in the previous LQ forecast. Recall that the definition of real final sales of domestic product is real GDP less the change in business inventories. Essentially, real final sales measures the total final demand for U.S. produced goods and services. For the most part in the third quarter, the contribution to final sales growth from consumer spending and business fixed investment was below expectations, while the contribution from net exports was above expectations.

Another aggregate measure often mentioned by economists is real final sales to domestic purchasers, which is defined as real final sales of domestic product less net exports. This measure of sales represents only final domestic demand regardless of where the goods are produced. It also may best represent the underlying strength of final demand in the U.S.

In order for real GDP growth to sustain a higher pace, real final sales must sustain such an improvement as well.  As shown in Chart 1, the levels of real GDP and of real final sales of domestic product have tracked rather well over time.  The implication is that changes in business inventories are not very important to real growth in the long run.  Also in Chart 1, the level of real final sales to domestic purchasers have tracked above real GDP and real final sales of domestic product because of the long-standing international trade deficit; that is, over the last several decades, we consistently have imported more than we have exported, suggesting that U.S. final demand exceeds U.S. output.

Chart 1

What will improve real final sales growth? For the most part, we probably cannot rely on net exports, so we should turn our attention to real final sales of domestic purchasers. That is, final demand for goods and services in the U.S. regardless of where they are made, although an increasing share seems to be made in the U.S.. Look for several factors to drive demand higher, all of which are somewhat related.

First, I expect consumer spending growth actually to improve slightly in the current quarter and continue to show improvement all of next year. More meaningful employment gains, a rebound in personal income, a much improved household balance sheet and ongoing low inflation should go a long way to boost consumer spending next year, especially on services. There may be a pause in spending early next year because of the renewed concern of a federal debt crisis, but I doubt that it will amount to much. Indeed, the introduction of the new federally mandated health insurance program most likely will boost the level of spending on health care and health care insurance for a start. Although the higher taxes assessed by the Affordable Care Act on both ordinary income and capital gains of high-income households in 2013 may cause some high-income individuals to hesitate a bit about spending early next year, I would guess that the bulk of that impact has been highly anticipated.3 As such, any adjustments to spending probably have already occurred.

Second, business fixed investment should follow consumer spending gains, as companies strive to boost production to keep up with increased demand for their products. With the cost of capital at historically low levels, businesses are encouraged to make more capital intensive investments than they might otherwise. The implication is that job growth, even though I expect it to be okay, will have a difficult time improving dramatically with the cost of capital so low. The LQ forecast now shows nonresidential fixed investment, which includes business equipment, structures and intellectual properties, to increase over the four quarters of 2014 at a pace nearly three times faster than over the four quarters of this year.

Third, residential investment is expected to accelerate again in 2014, as home ownership stabilizes amid higher house prices and still low interest rates. Here again there may be some hesitation to buy early next year, but I doubt it will be prolonged enough to be meaningful. Indeed, even with the more moderate job gains anticipated in the LQ forecast, housing starts are expected to increase to 1.2 million units in 2014. This is roughly a 20 percent gain from 2013, but is still at least 300 thousand units below what I consider the long-run equilibrium pace based on demographics.

Finally, direct government spending, especially at the state and local level, should stop being a drag on final sales growth in 2014. Budgets in many states are now in the black, as tax revenues continue to improve. As such, there is little need for states to cut spending further. Indeed, some of the cuts implemented during the crisis are now being reinstated, allowing the state and local government sector to actually contribute 0.2 percentage point to real GDP growth in the previous quarter. On average, the LQ forecast expects this sector to continue to contribute to real growth through 2014, more than offsetting any further declines in spending at the federal level. But even here, cuts in discretionary spending have gone about as far as they are likely to go. I do not expect a grand bargain before the next fiscal policy deadline, but I do expect reason to play a more substantial role in budget discussions in a mid-term election year.

Fiscal policy uncertainty postponed temporarily

After several months of political haggling, Congress and the White House agreed to allow the U.S. Treasury to issue as much debt as necessary through February 7, 2014 and continue to fund government operations—at sequestered levels—through January 15, 2014. Of course, speculation has already started that even without additional borrowing authority beyond February 7th the U.S. Treasury would be able to use "extraordinary measures" to pay all obligations for a while. Indeed, the more effective deadline has been whispered by most to be mid-April. Such speculation seems to anticipating another round of highly contentious budget and debt negotiations, which could result in another government shutdown or worse. Although the LQ forecast for next year minimizes it, this uncertainty about fiscal policy could pose a threat to real growth in the first half of 2014.

Concern about too much government debt is not new. In keeping with the title of this report, it seems appropriate to include something Herbert Hoover did say: "Blessed are the young, for they shall inherit the national debt."4 At the time he said this, the total federal debt was $33 billion. Today, the federal debt totals $17 trillion and still growing. Unless we have another baby boom, which seems unlikely, the cost of servicing this debt will be inherited by an increasingly smaller segment of the population. In particular, more than half of the voting-age population in the U.S. is 45 or older, which means that this segment of the population will have a substantial political advantage. In particular, they will continue to favor budget deficit reduction as long as the budget cuts do not reduce major government entitlement programs for the elderly, which essentially are programs to transfer income from one group to another.5 And since a large part of the current budget deficit is structural, there is no chance of us growing our way out it. As a consequence, eventually we must realize that it is imprudent to make income transfer payments with borrowed money. Unfortunately, that is exactly what we have been doing by running huge budget deficits, while simultaneously expanding entitlement programs. This puts Congress in a very precarious position. If they want to get reelected, they need to protect entitlements. But to protect entitlements, they will need to raise taxes.

In some ways, this process has already started. And as expected, the steps taken so far have been to raise taxes for so-called high income individuals. I am referring to the 3.8 percent surtax on investment income, including capital gains, of individuals whose investment incomes exceed a certain threshold, as well as a 0.9 percentage point increase in the Medicare tax on all wage and compensation income of individuals whose wage and compensation income exceeds applicable thresholds for their filing status. It seems to me that the revenue generated by these new taxes will not be sufficient to cover the added costs of any new programs, let alone the current shortfall of existing programs.

Unfortunately, if the objective of government is to transfer income from one group to another, the only way that can be done is to tax those with income and give it to those without. Thus, the challenge will be to broaden the tax base to include many who might consider themselves middle class (generally, wealth accumulators) in order to provide benefits to others who might also consider themselves middle class (wealth dispersers). This has made for very interesting politics. I suspect it will get even more interesting.

Monetary policy: The great enabler

Short-term interest rates, which have been at or near historically low levels for nearly five years now, may be overstaying their welcome. Of course, most economists would dismiss this concern as nonsense. According to conventional wisdom, low interest rates encourage borrowing, which in turn promotes spending. However, we seem to be in a very unconventional place with regard to monetary policy and we have been at extremely low levels of interest rates a very long time. Moreover, the only borrowing it seems to have encouraged is that of the federal government and, to a lesser extent, nonfinancial business. Borrowing by households and financial business has actually turned down since 2007. Essentially, low rates have enabled fiscal policymakers to ignore budget deficits. After all, despite extensive new debt in recent years, the cost of servicing the federal debt outstanding as a percent of GDP remains at a level nearly half of what it was in the late 1980s and first half of the 1990s.

As shown in Chart 2, the three-month Treasury bill rate, which is near zero, has been there a long time. However, such a low rate is not unique. In the Great Depression, the three-month bill rate was just as low. Indeed, some have suggested that a lesson could be learned from this earlier period. For example, in an article written for the Economist magazine, Christina Romer noted the similarity of the current situation to the late 1930s. In that article she wrote:

"After several years of relatively loose monetary policy, American banks were holding large quantities of reserves in excess of their legislated requirements. Monetary policymakers feared these excess reserves would make it difficult to tighten if inflation developed or if 'speculative excess' began again on Wall Street. In July 1936 the Fed's board of governors stated that existing excess reserves could 'create an injurious credit expansion' and that it had 'decided to lock up' those excess reserves "as a measure of prevention". The Fed then doubled reserve requirements in a series of steps. Unfortunately it turned out that banks, still nervous after the financial panics of the early 1930s, wanted to hold excess reserves as a cushion. When that excess was legislated away, they scrambled to replace it by reducing lending. According to a classic study of the Depression by Milton Friedman and Anna Schwartz, the resulting monetary contraction was a central cause of the 1937-38 recession." 6

chart 2

Does this sound familiar? It should. This is the same concern expressed by many economists today about the Fed exiting its very accommodative policy stance too soon. However, it is also interesting to note some differences between now and then. One such difference is that for the four years prior to the 1936 move by the Fed, real GDP growth averaged over 9 percent. For the four years ending in the third quarter of this year, real GDP growth has averaged a more subdued 2.3 percent. Based on this comparison, there clearly is little need for the Fed to back away from its current loose monetary policy anytime soon. An overheated economy is probably the last thing the Fed is worried about at the moment. On the other hand, the unemployment rate recently has edged down to 7.3 percent, whereas in 1936 the unemployment was still at 14 percent."7 From this perspective, the U.S. economy seems far closer to full employment now than it did then.

However, there is one other difference now versus then. The Fed now pays interest to banks for holding cash reserves, both excess and required, at the Federal Reserve. The current rate is 25 basis points, which at first blush seems trivial but may not be. I agree that banks may still be nervous following the financial crisis of 2007-2009 and may prefer to hold more excess reserves as a cushion than they might otherwise, but I doubt the cushion would be as extensive as it is now without the 25 basis points they get from the Fed for holding them. After all, 25 basis points is a lot better than the yield on short-term Treasury bills (5-10 basis points) or federal funds (10 basis points). The conclusion that I reach from this is that if the Fed wants to make its accommodative policy more effective, rather than buy more long-term securities, it might consider lowering or eliminating interest paid on reserves. Such a move probably would not bring excess reserves back to zero, but it may go a long way to provide an incentive to banks to at least partially reduce excess reserves from their current level of $2.3 trillion.

I now believe that with the change in leadership at the Federal Reserve Board from Bernanke to Yellen, the Fed will wait to start tapering its quantitative easing (QE) program. My guess at the moment is that it waits until early next year. However, there has been some discussion that when the Fed does start to taper, it simultaneously announce that its federal funds rate target will stay low longer than they suggested earlier. One way for them to announce that would be to lower the unemployment rate threshold at which it would tighten. Another approach might be for them to lower the interest rate they pay to banks on reserves held at the Fed. My preference is the latter, which is something I thought they should have done a long time ago. Of course, whenever I have mentioned this in the past, most other economists have dismissed my suggestion as nonsense. Nevertheless, I remain unconvinced by their arguement that the current level of excess reserves serves a useful purpose.

For the most part, the concern about changing the direction of monetary policy is always two sided—either they turn too soon or wait too long. I continue to believe that the greater risk currently is that the Fed waits too long. After all, this is the politically easier option. Congress never likes it when the Fed is raising rates, especially in an election year. And 2014 will be an election year. Do not get me wrong. The election year may not stop the Fed from tightening if they feel they should, but it will make it politically more difficult for them to be as aggressive as they might need to be. A strong Chair at the Fed will be essential to get the job done.

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1 See Daniel E. Laufenberg, "Fiscal policy facing another self-imposed deadline," Laufenberg Economic Quarterly, December 2012.

2 Written by Carson Robinson, "Prosperity is Just Around the Corner" was released in 1932. It is amazing how many of the verses in that song echo the sentiments of many today. By the way, former President Herbert Hoover has been credited for this quote in an address he gave to the United States Chamber of Commerce in May 1930. According to Paul F. Boller, Jr. and John George—"They Never Said It: A Book of Fake Quotes, Misquotes, & Misleading Attributions" (1989), p. 48, Mr. Hoover never said it. What he did say was "While the crash only took place six months ago, I am convinced we have now passed the worst and with continued unity of effort we shall rapidly recover. There is one certainty of the future of a people of the resources, intelligence and character of the people of the United States—that is, prosperity."

3 There are two tax provisions included in the Affordable Care Act that might be meaningful for individuals. First is the additional Medicare tax of 0.9 percent for individuals with wages, compensation or selfemployed income in excessive of the statutory threshold amounts based on the individual's filing status. Second is the net investment income tax (NIIT) that applies a Medicare tax of 3.8 percent to certain net investment income of individuals, estates and trusts that have income above the statutory-threshold amounts. In both cases, the threshold for individuals filing jointly is $250,000. By the way, the NIIT applies to most capital gains.

4 Herbert Hoover, Address to the Nebraska Republican Conference, Lincoln, Nebraska, January 16, 1936.

5 See the response from the American Association of Retired People (ARRP) expressing serious concerns with the House Concurrent Resolution on the Budget for Fiscal Year 2014, March 18, 2013. "AARP acknowledges that the nation's long-term debt requires attention and we are committed to lending our support to balanced policies addressing the nation's long term fiscal challenges. We can only do so, however, while also honoring the contributions of our members and the needs of millions of other Americans who rely on Medicare, Medicaid, Social Security and other important programs and services."

6 Christina Romer, "The lessons of 1937," Economist, June 20, 2009. Professor Romer is considered an expert on the Great Depression. At the time she wrote this article, she was Chair of the Council of Economic Advisers for the Obama Administration.

7Ibid

 

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)
February 2010 - LEQ
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August 2010 -LEQ

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February 2011 - LEQ

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August 2011 - LEQ

November 2011 - LEQ

February 2012 - LEQ

May 2012 - LEQ
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December 2012 - LEQ
March 2013 - LEQ
June 2013 - LEQ
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