Wednesday, December 16, 2015

The Fed Moves: At Last

Seven years ago today, in response to a very real financial emergency, the Fed embarked upon its zero interest rate policy. With the emergency long over the Fed finally acted by raising the federal funds rate by 25 basis points. Because the rate rise was accompanied by very dovish comments the stock market rallied smartly and the bond market, which had correctly priced in the move, ended the day substantially unchanged.

There are three points to take note of:
1. Monetary policy remains extraordinarily accommodating. My analogy is that on a 65 mph speed limit highway, instead of going 90 mph the car has slowed down to a still excessive 85 mph. Thus today's move is unlikely to slow the economy and in fact with the Fed signalling that the emergency is over, the economy could very well speedup.
2. Markets are way too complacent about inflation. With the core CPI increasing at a 2% rate yoy it won't take much for the Fed's personal consumption deflator to be there as well. Moreover housing costs, health care and other services are reporting inflation rates well above 2%. Once oil prices stabilize and likely reverse their recent decline most of the ingredients will be in place for an upside surprise in the inflation data. Stay tuned!
3. If you closed your eyes and I told you that core inflation was 2%, the unemployment rate was 5%, GDP growth is above 2%, and the stock market is close to an all time high, what would you guess the fed funds rate to be? It would be quite a bit higher than .25%-.5%. 

Net Net. Interest rates will surprise on the upside.

Saturday, December 5, 2015

My Amazon Review of Eric Rauchway's "The Money Makers: How Roosevelt and Keynes Ended the Depression, Defeated Fascism, and Secured a Prosperous Peace"

Too Partisan to be Real History

UC Davis history professor Eric Rauchway let his rabid partisanship get in the way of some of the real history that is in his book. His cheer-leading is obvious in the subtitle and that should clearly warn less biased readers. It is not so much what Rauchway left in, but rather what he left out and in doing that he did a real disservice to his readers.

What Rauchway leaves out is as follows:
1.     Although he rightly blames the operation of the gold standard as one of the predominant causes of the Great Depression, he fails to discuss how successful it was in spurring growth in the five decades up to World War I.
2.     He fails to emphasize the fact that it was the imbalances caused by the financing of World War I that was the key element in the demise of the gold standard.
3.     He completely ignores the “forgotten depression’ of 1920-21 where recovery was rapid absent most of the Keynesian remedies that came later and he ignores the great prosperity of the 1920s.
4.     He hails President Roosevelt in his “blowing up” of the World Economic Conference in 1933, but fails to mention that far from being an internationalist, Roosevelt was an isolationist. The fascists in Europe took note of America’s withdrawal from the world.
5.     He characterizes the 1936 Tri-Partite Agreement to stabilize the French Franc as the start of an anti-Nazi coalition. Wrong! Although France was lost some gold following the German reoccupation of the Rhineland, the real cause of the Franc’s collapse was the popular front policies of Leon Blum which scared the living daylights out of French Capital.
6.     He completely ignores the fact that after all of the New Deal spending programs and the Federal Reserve money printing, the economy remained mired in depression as late as 1939.
7.     He makes way too a big deal out of the congressional vote to join the IMF. The measure passed both houses of Congress easily.

8.     Although he notes that Assistant Treasury Secretary Harry Dexter White, Keynes' negotiating partner at Bretton Woods, was a Soviet spy, he doesn’t take seriously the Soviet penetration into the highest circles in the New Deal.
9.     In his glorification of managed currencies he fails to note the debacle that came after Nixon closed the gold window in 1971. Further if you want a date to start when the United States economy became “financialized” you can do a lot worse than 1971. Whatever the real problems of the gold standard, it would certainly have acted as a very real constraint on what we call “the shadow banking system”.

For readers who want a better understanding of the Great Depression I would recommend much of the works of Barry Eichengreen, Ben Bernanke and Peter Temin.

For the full Amazon URL see:

Thursday, December 3, 2015

2016: "Full Employment" with Modest Inflation, UCLA Anderson Forecast, December 2015

With the unemployment rate at 5% reported for
October, the economy is operating at or very close to the
traditional definition of full employment. (See Figure 1).
However, because the employment to population ratio of
59.3% is four percentage points below that recorded prior
to the start of the financial crisis in 2006, for more than a
few Americans the economy does not feel anywhere close
to full employment. (See Figure 2). Nevertheless, employment
growth remains healthy with the economy generating
jobs at a 200,000 a month clip that will bring with it further
declines in the unemployment rate to 4.6% (See Figure 3).

Although GDP growth stalled in the third quarter at
a tepid 2.1% annual rate, a mini-inventory cycle knocked
0.6% off the reported growth rate. The growth in real inventories
declined from $113.5 billion in the second quarter to
a more normal $90.2 billion in the third quarter. (See Figure
4, revised data not reflected in the chart) With the bulk

Figure 1 Unemployment Rate 2007Q1- 2017Q4F
Sources: U.S. Bureau of Labor Statistics and UCLA Anderson

Figure 2 Employment to Population Ratio, 1948 – Oct 2015, Monthly Data, Percent
Sources: U.S Bureau of Labor Statistics via FRED.

the inventory correction behind us, we anticipate that real
GDP will grow at a 2.9% annual rate in the current quarter
and grow at a 3.1% year-over-year pace in 2016, the highest
since 2005. (See Figure 5). The seemingly high 3.8%
growth we are forecasting in the first quarter of 2016 is due
to the temporary end of the “sequester” just agreed to by
Congress that will trigger a surge in federal spending that
quarter. Our preliminary view for 2017 is that growth will
slow to 2.6% as a result of the tightening labor market and
the move towards interest rate normalization. (See below)

Higher Wages and Inflation

The tightening labor market will bring with it the
long-awaited increase in employee compensation. Instead
of increasing at the 2010-2015 average of 2.1% a year,
compensation is forecast to increase at a 3.5% and 4.2% rate
in 2016 and 2017, respectively. (See Figure 6) Anecdotal
evidence coming from the retail, construction, meat packing
and professional services sectors indicate that wages are
already rising well above what the official data is reporting.

Figure 3 Payroll Employment, 2007Q1 -2017Q4F, SAAR
Sources: U.S. Bureau of Labor Statistics and UCLA Anderson Forecast

Figure 4 Real Change in Inventories, 2007Q1 -2017Q4F
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 5 Real GDP Growth, 2007Q1-2017Q4
Sources: U.S. Department of Commerce and UCLA Anderson Forecast
Figure 6 Employee Compensation per Hour, 2005Q1 -2017Q4F
Bureau of Labor Statistics and UCLA Anderson Forecast

Adding to the cost pressures coming from the labor
market, especially in the broadly defined services sector, it
is our expectation that oil prices will begin to rebound in
2016 as domestic output from the very short-lived fracking
wells is cut by about a million barrels a day and the intense
budget pressures on OPEC and Russia lead to some degree of
output restrictions. (See Figure 7) Further, as we have noted
in the past, housing costs are already rising at a 3% pace
coming from the continued tightness in the rental market.

As a result, inflation as measured by the Consumer
Price Index (CPI) will ramp up to 2.1% in 2016 and 3.4%
in 2017. (See Figure 8) Perhaps more important, the core
CPI, which excludes food and energy is forecast to increase
2.3% and 2.6% in 2016 and 2017, respectively. The Fed is
about to get the inflation it has been waiting for.

The Fed to Start Normalizing Interest Rates

Seven years ago this month, in response to the rapidly
metastasizing financial crisis, the Federal Reserve embarked
upon its zero interest rate policy and later adopted three
massive programs of quantitative easing. With the financial
emergency long over, the unemployment rate indicating
near full-employment and the likelihood that inflation will
soon approach its 2% target, we expect the Fed to begin
normalizing interest rates by increasing the Federal Funds
rate this month. Thereafter, we anticipate that the initial pace
towards the normalization of policy will be gradual, but if
we are correct about our outlook for inflation, the Fed will
begin to speed up the process. Thus, we forecast that by the
end of 2016 the federal funds rate will be about 1.5% and it
will approximate 3.25% at the end of 2017. (See Figure 9)
Figure 7 Oil Price, West Texas Intermediate Crude,
2007Q1 – 2017Q4
Sources: Commodity Research Bureau and UCLA Anderson Forecast

Figure 8 Consumer Price Index vs. Core CPI, 2007Q1 - 2017Q4
Sources: U.S. Bureau of Labor Statistics and UCLA Anderson Forecast

Figure 9 Federal Funds vs. 10-Year U.S. Treasury Bonds,
2007Q1 -2017Q4
Sources: Federal Reserve Board and UCLA Anderson Forecast

The Consumer in the Driver’s Seat

Driven by a strengthening labor market and an improved
balance sheet, the consumer is once again playing
its leading role in the economy. Real consumption spending
is expected to increase by 3.2% this year and again in 2016.
(See Figure 10) Don’t be all that concerned about the negative
headlines affecting such retail stalwarts as Macy’s and
Nordstrom. The fact remains that the retail landscape has
long shifted away from the traditional department stores
to more innovative formats and more importantly, internet

Evidence of the robustness of consumer demand is
coming from red hot automobile sales where is now appears
that selling rates on the order of 18 million units might be
the new normal. (See Figure 11) Further, as we noted last
quarter, the new housing market is rapidly improving and we
anticipate that housing starts will exceed 1.4 million units in
both 2016 and 2017 compared to an estimated 1.13 million
units this year. (See Figure 12) Indeed the fourth quarter of
this year is forecast to come in at a 1.23 unit million annual
rate. We also expect the housing baton to be passed from
the white hot multi-family sector to the construction of
single-family homes which remains well below prior levels
of activity. If we are wrong here it will not be due to higher
interest rates, but rather to a shortage of construction workers
that is already hampering the delivery of new homes.
Nonresidential Construction: A Tale of
Two Markets
Investment in nonresidential construction stalled in
2015. (See Figure 13) While growing in most categories,
investment in mines and wells, almost all of it related to
oil and gas drilling, collapsed under the weight of the 60%
decline in oil prices. For example, from the 4Q2014 through
Figure 10 Real Consumption Spending, 2007Q1 -2017Q4F
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 11 Light Vehicle Sales, 2007Q1 – 2017Q4,
In Millions of Units
Sources: BEA and UCLA Anderson Forecast

Figure 12 Housing Starts, 2007Q1 -2017Q4
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

the current quarter of this year, real investment in mines and
wells will have declined from $137 billion to $70 billion, a
decline of nearly 50%. (See Figure 14) On a purely arithmetic
basis this decline whacked 0.4% off 2015 real GDP.

In contrast, commercial construction of office buildings,
shopping centers and warehouses is ramping up in
response to growing demand for modern offices and the
need to improve the retail supply chain. This investment is
being funded by the flood of capital reaching for real estate
yields in a yield starved world. Since the low in the 1Q2011
to the third quarter of 2015, real investment in commercial
construction has increased from $63 billion to $108 billion.
(See Figure 15) Further, because this sector is still just ramping
up, we forecast real commercial construction spending
to be $145 billion in 2017, still well below the $191 billion
recorded in the long ago year of 2000.

Exports Remain the Big Risk

Already weak export growth has gotten weaker in
recent quarters. (See Figure 16) American exporters are
facing the twin challenges of weak foreign economies and a
very strong dollar which is up 18% over the past year. (See
Figure 17) Where earlier in the recovery real exports were
growing at a 12% rate, we will now be lucky to achieve 4%
growth. Because we believe that most of the global weakness
is behind us, we anticipate that the foreign exchange
value of the dollar will soon peak and then gradually decline.
We would note that if we are wrong here and the global
economy continues to weaken and the dollar continues to
strengthen, our forecast of 3% growth in 2016 would be
way over optimistic.

There are two other risks with respect to trade. With
the leading contenders for both parties’ presidential nominations
opposed to the proposed Trans Pacific Partnership there
is a very real possibility that the United States will turn down
its first major trade deal since the 1930s. Although turning
down the deal in the short run would not have an immedi-

Figure 13 Real Investment in Nonresidential Construction,
2007Q1 -2017Q4F
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 14 Real Investment in Mines and Wells,
2007Q1 -2017Q4F
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 15 Real Investment in Commercial Structures,
2007Q1 -2017Q4
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

ate impact on real GDP, it could nevertheless negatively
impact the stock market and over the longer run seriously
hamper exports as our Asian trading partners make separate
deals among themselves and with China. Second, the
mass migration crisis facing Europe along with the horrific
acts of terrorism in Paris have the potential to break apart
the Eurozone with unknown consequences for the global
economy. Compared to immigration, the Greek crisis was
a walk in the park for the European elite.

Defense Spending on the Rebound

As we have been arguing for over a year, the five year
decline in real defense spending is over. Congress recently
amended its “sequester” program to allow defense spending
to increase. We have modeled in further increases in defense
spending for 2017 to account for the increasingly dangerous
geopolitical environment. In our view this increase will
not be a one-off event, but rather the start of a major trend.
Meantime, we forecast that real defense purchases will
increase by 2.9% and 2.4% in 2016 and 2017, respectively.
(See Figure 18)


Continued job growth along with wage increases
will power consumption in 2016 leading to the first year
of greater than 3% growth in real GDP since 2005. Higher
wages along with a modest rebound in oil prices and higher
housing costs will push the inflation rate above 2% leading
the Federal Reserve to embark on a gradual tightening cycle
that will begin this month. Strength will be evidenced in
housing and commercial construction along with a booming
automobile market. The collapse in oil-related capital
spending will come to an end next year and defense spending
will be increasing after five years of decline.