Disturbances in the Force, UCLA Anderson Forecast, April 2016

The January to February drop in stock prices, down
13% from early December, sent shivers through the economy
engendering fears that a new recession was at hand. (See
Figure 1) The markets were disturbed by fears of a far bigger
slowdown in China, continued stagnation in Europe
and Japan, a break in oil prices to $10 below the financial
crisis levels of 2009 and that the European banking system
was on the brink of a new crisis. (See Figure 2 which uses
the share price of Deutsche Bank as an example) However,
the markets soon calmed down and wiped out much of
their earlier losses as strong data from the consumer side
of the economy indicated that retail sales were solid and
employment growth remained robust. Simply put, aside

Figure 1 S&P 500, March 2015-March 2016
Sources: Standard & Poor's via BigCharts.com

from modest declines in the industrial sector, there was no
recession in the data.

However, there are more disturbances on the horizon.
In June, the United Kingdom will vote on whether or not it
will stay in the European Union, commonly known as the
“Brexit” referendum. Whether leaving the European Union
is a wise move or not, the transition period will likely be
occasioned by increased market volatility. In the U.S. there
are two major presidential candidates who want to “blow
up” the global trading system as we have known it since the
end of World War II. Economists might not know all that
much, but trade wars usually do not lead to prosperity,
quite to the contrary.

Although we continue to believe the economy remains
on track for moderate growth, we are not as ebullient as
prior forecasts. The inventory correction we were looking
for last quarter is taking longer than we expected and though
the ramp up in single-family housing starts continues, it is
tracing a shallower path than what we previously thought.
(See Figure 3) For example, inventory accumulation added
$78 billion to real GDP in the fourth quarter of 2015; this
sector will only add $25 billion in this year’s third quarter,
a contraction of $53 billion. Thus, instead of looking for
3.3% growth in real GDP for 2016 on a fourth quarter-

Figure 2 Deutsche Bank Stock Price, March 2006-March 2016
Sources: BigCharts.com

fourth quarter basis we are now calling for a more modest
2.7% growth rate. (See Figure 4)

Despite the slower GDP growth rate, the economy
remains on track to create 2.4 million jobs this year and
1.5 million jobs next year as the economy operates at full
employment. (See Figure 5) Similarly, the unemployment
rate which stood at 4.9% in February, is on track to decline
to 4.6% by yearend. (See Figure 6) The rate of decline will
be slower than in the past few years as for the first time the
labor force participation rate is on the rise, a good thing.

Figure 3 Change in Real Inventory
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 4 Real GDP Growth
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 5 Payroll Employment
Sources: U.S. Bureau of Labor Statistics and UCLA Anderson Forecast

Figure 6 Unemployment Rate
Sources: U.S. Bureau of Labor Statistics and UCLA Anderson Forecast

Monetary Policy: From ZIRP to NIRP

While the Federal Reserve left its zero interest rate
policy (ZIRP) behind last December, the European and
Japanese central banks have embarked on a negative interest
rate policy (NIRP) with unknowable consequences. Apparently
the $12.5 trillion of bond buying that the global central
banks embarked upon since 2008 hasn’t been enough to pull
both Europe and Japan out of the quagmire they now find
themselves in. In a negative rate regime instead of paying
interest the borrower receives interest and lender pays interest.
It is truly an “Alice in Wonderland” world. Reflective
of the dour outlook, negative yields are common in many
developed markets. (See Figure 7)

The obvious problem with NIRP is that it will destroy
the business models of life insurance companies and pension
plans and has the potential to do the same for the banking
system. We don’t know how much lower negative interest
rates can go and we don’t know whether it would be legal
for the Federal Reserve to undertake such a policy if it is
deemed necessary.

Meantime, the Fed appears to be ready and willing
to raise interest rates this year. Consistent with the March
Fed statement, we expect two or maybe three increases
in the Fed Funds rate this year with the first one likely
to be in June. (See Figure 8) Thereafter, we expect gradual
increases with the Fed Funds Rate ending 2017 at about 2%.
With much of the world in NIRP territory, policy rates will
be constrained in the U.S. The same holds true for longerterm
rates where we forecast the 10-Year Treasury to end
2016 at about 2.6% and end 2017 at about 3.6% compared
to a mid-March rate of 1.9%.

Figure 7 Government Bond Yields in Selected Countries,
March 18, 2016
Sources: The Wall Street Journal

Figure 8 Federal Funds vs. 10-Year U.S. Treasury Bonds
Sources: Federal Reserve Board and UCLA Anderson Forecast

Figure 9 Consumer Price Index vs. Core CPI
Sources: U.S. Bureau of Labor Statistics and UCLA Anderson Forecast

Nevertheless, the Fed will be under pressure to raise
interest rates because it is about to get the inflation it has
been praying for. Specifically, as of February, the year-over-year
increase in core consumer prices was 2.3% and it is
forecast to approach 3% by 2017. (See Figure 9) Similarly,
with oil prices likely to have bottomed earlier this year, and
with the tightening labor market finally working its way
into employee compensation, headline consumer prices will
be rising at a 3% clip by the end of 2016. (See Figures 10
and 11) We would note that as of mid-March the price of
oil was tracking above our forecast and whether that trend
continues could very well depend upon an OPEC/Russia
meeting scheduled for April 17.


The U.S. Consumer is in Good Shape

Despite issues concerning the distribution of income
and debt burdens, the U.S. consumer remains in good shape
overall. Consumption will continue to be on a 3% growth
path throughout 2016 and it will be accompanied by a saving
rate in excess of 5%. (See Figures 12 and 13) Where
previously we thought that much of the consumer benefits
flowing from lower gasoline prices would be spent, a goodly
portion of it was saved. That being said, the lower gasoline
prices seem to have found their way into generating near
record automobile sales.

Housing starts continue to improve, albeit at a slower
pace than we previously thought. After reaching 1.106
million units in 2015, we forecast starts to increase to 1.24
million units and 1.43 million units in 2016 and 2017, respectively.
(See Figure 14) Our prior forecast for 2016 was
for 1.4 million units, but the forecast for 2017 is much the
same as before. Homebuilders did not ramp up single-family
production as fast as we thought and they concentrated their
activity on the higher end of the market. There is now anecdotal
evidence that the builders are shifting their emphasis
towards starter homes where there is real pent-up demand
coming from increased household formation, modest income
growth and rising rents. Our prior forecast for multi-family
starts of in excess of 400,000 units a year remains on track.

Figure 10 Oil Prices, West Texas Intermediate
Sources: Commodity Research Bureau and UCLA Anderson Forecast

Figure 11 Employee Compensation
Sources: U.S. Bureau of Labor Statistics and UCLA Anderson Forecast

Figure 12 Real Consumption Expenditures
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 13 Savings Rate
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 17 Real Private Gross Domestic Investment in
Commercial Buildings
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 16 Real Gross Private Domestic Investment in
Mines and Wells
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Capital Spending Growth Remains Tepid

With the industrial economy in a shallow recession and
oil exploration capital spending dropping below the nadir
of 2009, we should be thankful for the modest increases in
capital spending we are witnessing. Specifically, we forecast
that equipment capital spending will increase at a 4-5% pace
over the next few years, not great, but certainly not a recession.
(See Figure 15) On the other hand, investment spending
on structures is in the midst of a two-year decline triggered
by the collapse in oil exploration spending. (See Figure 16)
Specifically, real investment in mines and wells will have

Figure 14 Housing Starts
Sources: Bureau of the Census and w Anderson Forecast

Figure 15 Real Gross Private Investment in Equipment
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

declined by 60% from $137 billion in the fourth quarter
of 2014 to a forecast $56 billion in the first quarter of
2016. Most people don’t realize that construction in the oil
exploration and production sector was far larger than the
entire commercial construction sector, no more.

On the other hand, commercial construction is gaining
strength. Improved fundamentals for office and industrial
construction are driving spending in this sector that is being
fueled by an abundance of capital seeking modest yields in
a low-yield world. (See Figure 17) In contrast, spending on
retail structures is now being driven by negative fundamentals brought about by e-commerce. Major malls are seeking
to remain relevant by making huge investments in renovation
on the order of $500-$800 million per mall at the high end.

Exports Remain a Real Risk

With a strong dollar and weak economic growth in
Europe, Japan, Canada, China, Brazil and the Middle East,
the U.S. export sector remains under pressure. We are still
forecasting minimal growth this year, but the real risk is that
we can very easily have a decline. (See Figure 18) If you
want to tell a story about a U.S. recession it would have to
begin in this sector, but even with a modest decline it would
not be enough to put the U.S. into a recession.

Figure 18 Real Exports
Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Government: A Modest Positive

After several years of decline, federal purchases are
once again on the rise. Whether federal spending continues
to rise over the intermediate term will largely be dependent on how this year’s election turns out. (See Figure 19) The
increase this year is due to the temporary lifting of the
sequester that has been in place since 2013. Similarly, the
much larger state and local sector has been growing since
2014, but it will once again face the twin pressures of higher
pension and Medicaid outlays as the decade ends.

Conclusion

We don’t see a recession this year or next and we do
envision inflation rising above the Fed’s 2% target. As a
result, we are forecasting slow and steady increases in the
Federal Funds rate over the next few years. And although
we have continued growth in 2018, a forecast that far out is a
conjecture. Growth will be driven by increases in consumer
spending and housing along with the end of the inventory
correction we are now going through. The risks we envision
largely come from outside of the U.S. domestic economy
where disturbances in Europe and Asia along with domestic

politics have the potential to cast a pall over the economy.

My Amazon Review of Karl Rove's "The Triumph of William McKinley: Why the Election of 1896 Still Matters"

The Realignment of 1896

My advice to readers of this very fascinating history is to ignore the name of its author. Karl Rove is extraordinary as he is controversial as a political strategist. Nevertheless if a reader checks her political baggage at the door, she will find a very well written biography of William McKinley that focuses on his election to the presidency in 1896.

McKinley a Civil War hero and the last of the Civil War presidents was a highly organized politician and a strategic thinker. Although McKinley is remembered today as an establishment politician he, in fact, ran against the bosses of his day, successfully represented striking workers in Ohio and he opened up the Republican Party to masses of immigrant workers that were flooding into America’s factories.  He practiced the politics of inclusion by having a Rabbi open the 1896 Republican Convention and was very comfortable working with the black politicians who represented the core of the Republican Party in the South. He understood the fundamental truth that political parties grow by addition, not subtraction. Unfortunately all too many of today’s Republicans have failed to heed that lesson.

In Congress McKinley was known as the “Napoleon of Protection”.  Instead of arguing for Capital, he argued that protection set a floor underneath American wages therefore his high tariff policies protected workers as well as factory owners. In 1896 he wanted to run on that issue. Instead the locomotive of history made the “money question” the issue that year. It was the question of the gold standard versus free silver and its champion was William Jennings Bryan.

Rove is especially good at covering the Democratic Convention of that year and he shows step-by-step how Bryan won the nomination. You can almost hear the crowds cheering his “Cross of Gold” speech. The money question split both parties, but in the end it hurt Bryan more than McKinley as the “Gold Democrats” ended up with more heft than the “Silver Republicans”. Further Rove explains how McKinley successfully convinced working class voters that it was against their interests to be paid in a debased silver currency. Simply put, what was good for indebted farmers was not necessarily good for the urban working class.

Along the way Rove introduces us to the master insider Mark Hanna who runs and finances McKinley’s campaign, the 30 year old Charles Dawes who runs McKinley’s Midwestern operation who later becomes a Vice President and authors the Nobel Peace Prize winning reparations plan in 1925 and Theodore Roosevelt who greatly aids McKinley’s efforts in New York.

My quibbles with the book is that Rove spends too much time on inside baseball minutia and leaves out important details as to how McKinley financed his campaign where on a conservative basis he outspent Bryan 10-1. He also credits the rise in crop prices in the fall of 1896, the October surprise of that year, which undercut Bryan’s free silver campaign to bad crops in Australia and India. A closer look would have indicated the gold shortage of the 1890s that was deflating the economy was coming to end with the introduction of the cyanide process that was ramping up South African gold production and the discovery of gold in the Yukon in August of that year which set off the Klondike Gold Rush. With gold no longer scarce, the deflation ended and the need to inflate the currency with the introduction of silver disappeared. Thus what McKinley accomplished laid the basis for Republican dominance over the next 36 years.

The full Amazon URL is:

https://www.amazon.com/review/R2IMOO3Z3E2XIM/ref=pe_1098610_137716200_cm_rv_eml_rv0_rv

Cry Baby Trump

Donald Trump continues to act like the spoiled child that he is. The online edition of this morning's New York Times led with Trump's reversal of his earlier pledge to support the Republican nominee with the following:

Asked at a forum hosted by CNN if he still pledged to support the nominee if someone else wins, Donald J. Trump said, “No, I don’t anymore,” adding that he had not been treated fairly.

Poor baby especially coming from someone who has hardly treated his opponents and several of their spouses fairly. It is beginning to look like that when you strip away Trump's tough guy veneer, there is a frightened child who when he doesn't get his way he picks up his marbles and goes away. If he thinks he is being treated badly by his opponents and the Republican Party establishment, just wait until he gets in the ring with Putin. CNN's Anderson Cooper had it right when he said Trump was acting like a 5 year old.

My Amazon Review of Nancy Forbes' and Basil Mahon's "Faraday, Maxwell and the Electromagnetic Field: How Two Men Revolutionized Physics"

The Electromagnetic Underpinning of Economic Growth

The world doesn’t need another review of Nancy Forbes’ and Basil Mahon’s wonderful book. However, after thinking about it, I believe that the explosion in economic growth from 1870-1970 discussed by Robert J. Gordon in his “The Rise and Fall of American Growth” would never have happened were it not for Michael Faraday and James Clerk Maxwell. 

http://shulmaven.blogspot.com/2016/02/my-amazon-review-of-robert-j-gordons.html

What Forbes and Mahon describe are the lives of Faraday and Maxwell and how through their experiments they came to discover some of the most fundamental secrets in nature. What Maxwell does in his 1873 “Treatise and Electricity and Magnetism” is to put a mathematical foundation underneath Faraday’s brilliant experiments. The rest is history. The world became electrified, radio and mass communications became of age and only 32 years later, building on their foundations, Einstein publishes his essays on relativity and the photoelectric effect.

The science is so monumental that it offers support for Gordon’s thesis that the economic growth achieved from 1870-1970 was based on a series of one-off events.

For the full Amazon URL see:

https://www.amazon.com/review/R5ZMT2LIUV3T7/ref=pe_1098610_137716200_cm_rv_eml_rv0_rv

The Fed Will Get the Inflation it Wants

Bye bye data dependence. The data were there for the Fed to make
hawkish comments; core inflation is moving up (now 2.3% yoy on core CPI) and the economy is operating at full employment. Nevertheless the Fed chose to punt by cutting back on its outlook for future rate hikes. Why? It looks like the FOMC members want to over-shoot their 2% inflation target and light a fire under wages. They will soon get their wish.

In response materials and energy led the charge on the stock market, the dollar weakened and the yield on the 2-year note collapsed. It would seem to this observer that TIPS make a great deal of sense today.

America Turns Inward

If we didn't need any more evidence the results of yesterday's primaries indicate that the American electorate is turning inward. The rise of Trump and Sanders proves that there is a strong anti-free trade consensus. Although Sanders and Trump voters vote with their pocketbooks in favor of free trade every day at Wal*Mart, at the ballot box they resoundingly vote against it. These facts will be confirmed when the Trans Pacific trade deals goes down to defeat, if it is ever voted on.

Moreover with Trump appearing to be a direct descendant of the isolationist America First movement of the early 1940s and with Sanders firmly believing in the American retreat of his socialist roots, the world will soon become a more dangerous place. We have written many times before that we are in the process of reliving the 1930s and unfortunately the evidence grows with each passing day. We are getting pretty close to gangs of Trump and Sanders supporters fighting it out in the street. Simply put, the political situation is getting very ugly. Soon the markets will reflect it.

My Amazon Review of Scott Sumner's "The Midas Paradox: Financial Markets, Government Policy Shocks and the Great Depression"

He Doesn’t Love Gold

Scott Sumner has written a fascinating book on how interaction between the operation of the gold standard and the labor policies of the New Deal influenced the course of The Great Depression. I only wish he had a better editor who would have tightened up a writing style that tends to wander in a way that mixes up the important from the unimportant.

His critical variable is the gold reserve ratio of the United States individually and the collective gold ratio of the then developed world. He makes a strong case that as the gold ratio rose policy tightened and as it fell policy loosened. Unfortunately aside from a few instances there was very little in the contemporaneous press, which he quotes extensively, that discussed this issue. Thus it seems policy makers were flying blind.

Similar to most economic historians of The Great Depression the seminal event that turned the economy around was Roosevelt’s abandonment of the gold standard in 1933-34 and then revaluing gold from $20.67/oz. to $35.00/oz. It was that action that enabled the Fed to open up the monetary floodgates. In Sumner’s view had the New Deal left well enough alone the economy would have fully recovered by 1935.

However, offsetting the gold policy, the National Industrial Recovery Act of 1933 triggered a 22% increase in wages during the summer of 1933 that completely stalled the industrial recovery that was well underway in the spring of 1933. He then goes on to discuss, in the tradition of Cole and Ohanian the additional wage shocks that came from the Wagner Act of 1935 and the Fair Labor Standards Act of 1938.

He makes a major point in discussing why the monetary ease of early 1932 failed and it was that failure that turned Keynes away from his belief in the efficacy of monetary policy. To Sumner the Fed’s policy was not credible because under the gold standard it was not able to continue its bond buying program. Only after gold was revalued did the Fed have the greenlight to engage in quantitative easing, to use today’s term.

I wish he would have spent more time on the Treasury’s gold sterilization policy of 1935-37 which Douglas Irwin mentions as the leading cause of the 1937-38 collapse. Nevertheless there are many fascinating nuggets in this book such as the role of the Young Plan bonds issued by Germany had on the financial markets of 1931-32. To my mind Sumner has written a very important book on what made the Great Depression great.

For the Amazon URL see:

https://www.amazon.com/review/ROSQFMUB67B5B/ref=pe_1098610_137716200_cm_rv_eml_rv0_rv