In her monetary policy testimony to Congress, Federal Reserve Chair Janet Yellen offered no new clues regarding when the central bank will begin raising short-term interest rates. The Fed has been criticized for being “behind the curve” on inflation and for fueling bubbles. Neither criticism is right.
Inflation figures have picked up in recent months. The Consumer Price Index rose at a 2.6% annual rate in the first five months of 2014, a 2.3% pace ex-food & energy. The Fed's official gauge, the PCE Price Index, rose at a 1.9% annual rate, a 1.7% pace ex-food & energy (vs. the Fed’s official goal of 2%).
In the depth of the recession, when the Fed began its extraordinary policy measures, a number of critics said that inflation would soon take off and some even suggested that hyperinflation was “just around the corner.” More sober commentators noted that the huge amount of slack in the economy, especially in the labor market, would keep inflation in check. Nearly six years later, higher inflation has yet to arrive. In her testimony to the Joint Economic Committee last month, Janet Yellen dismissed the recent pickup in the CPI as “noise” and there's good reason to believe that's the case. The Producer Price Report (recently expanded to include services) suggests no significant pipeline pressures. Import price figures show no pressure in raw materials or in finished goods. Wage pressures remain relatively contained.
The inflation mongers dismiss low inflation readings as meaningless the government either isn't measuring inflation correctly or is purposely distorting the figures. There are a number of empirical issues in how inflation is measured, but the Bureau of Labor Statistics does a remarkably good job. Consider MIT's Billion Price Project, which tracks online retail prices and shows inflation relatively close to the official figures. Note that one's personal inflation rate will vary, depending on what goods and services the individual purchases.
At some point, of course, the Fed will need to begin to normalize monetary policy, but there’s nothing to suggest that the Fed is currently behind the curve on inflation.
The other main criticism of monetary policy is that the Fed is fueling bubbles. From the Monetary Policy Report to Congress:
“With regard to asset valuations, house prices have continued to increase, but, for the most part, these increases have left aggregate price-to-rent ratios within historical norms. Moreover, growth in residential mortgage debt has remained anemic, suggesting that the recent increases are not fueled by excessively aggressive lending conditions. More broadly, aggregate measures of the household debt burden appear reasonable despite recent rapid growth in auto lending and student loans, which has strained some borrowers, particularly those in the lower half of the income distribution.”
“However, signs of risk-taking have increased in some asset classes. Equity valuations of smaller firms as well as social media and biotechnology firms appear to be stretched, with ratios of prices to forward earnings remaining high relative to historical norms. Beyond equities, risk spreads for corporate bonds have narrowed and yields have reached all-time lows. Issuance of speculative-grade corporate bonds and leveraged loans has been very robust, and underwriting standards have loosened. For example, average debt-to-earnings multiples have risen, and the share rated B or below has moved up further for leveraged loans. The Federal Reserve continues to closely monitor developments in the leveraged lending market and, in conjunction with other federal agencies, is working to enhance compliance with previous guidance on issuance, pricing, and underwriting standards.”
So, the Fed definitely sees signs of excess in some areas, but this is not a widespread problem for the financial sector as a whole. Yellen promised that the Fed will continue to monitor the situation closely. Earlier this month, she indicated that the Fed would not use monetary policy as the first line of defense against bubbles, but would instead rely primarily on supervision. Yet, she noted that the Fed's regulatory powers, while having increased since the financial crisis, are not where they need to be. Hence, she didn't rule out a tightening of monetary policy as a tool to restrain financial bubbles if need be. Of course, the track record on this is not very good. Tightening to address a bubble, the Fed risks weakening the economy. The financial crisis demonstrates the problem of not tightening soon enough.
One regularly hears that stock prices are artificially inflated due to the Fed's actions and that the market is bound to correct once the Fed begins to raise short-term rates. Let's consider the logic here. Broadly speaking, there are two ways to value stocks. One is to think of the price as a risk-adjusted discounted stream of future earnings. A lower interest rate means that future earnings are discounted less hence, a higher stock price (all else equal). As the economy improves, earnings should increase, but higher interest rates mean greater discounting of those earnings. It may not be clear whether the increase in earnings will offset the greater discounting, but risk and uncertainty should decrease as the economy improves. However, note that the shape of the yield curve implies an expected path of interest rates, which should be incorporated into the discounting of future earnings. So, stock market valuations should therefore depend not on whether interest rates rise, but on whether they rise faster or slower than the market currently expects. That's the key question.
The other way to value stocks is the same as the way one values art. That is, what’s the next person willing to pay? Technical analysis, the study of chart patterns, is one way to measure market sentiment. That's beyond my ken, but interest rates are probably right about where they should be.
The strong pace of growth in nonfarm payrolls suggests much more than a rebound from bad weather. While recent economic figures have been generally mixed, the job market is clearly improving, led by increased hiring at small and medium-sized firms. The hope is that good news will feed on itself, lifting the pace of growth in the second half of the year. However, there are a few concerns in the outlook.
Small and medium-sized (essentially, newer) firms typically account for more than their fair share of job growth in an expansion. These firms have been restrained in the recovery, but demand appears to have improved to the point where many of them must hire new workers to keep up.
Prior to seasonal adjustment, nonfarm payrolls rose by 582,000 in June (education down 847,000, but up 1.429 million otherwise), up 3.8 million since February. That’s a pretty good spring. Note that unadjusted private-sector payrolls usually trend only gradually higher in the second half of the year.
The unemployment rate fell to 6.1% in June, the lowest since July 2008. The employment/population ratio rose modestly and has been trending only gradually higher over the last year. The aging of the population suggests that we’re unlikely to get back to the pre-recession level on employment/population, but we should be able to make up at least two-third of the ground lost. We still have a large amount of slack in the labor market.
Short-term unemployment has returned to normal levels, but long-term unemployment remains elevated.
There are three concerns in the economic outlook: 1) wage growth has remained low, limiting the potential upside for consumer spending growth; 2) geopolitical tensions could escalate, boosting gasoline prices and increasing the degree of caution in business hiring and capital spending; 3) there is little scope for expansionary fiscal or monetary policy should that be needed. However, strong job growth may be sufficient to boost consumer spending in the near term, which in turn, would lead to even more job growth in the second half of the year.
The greater-than-expected downward revision to first quarter GDP was a shocker (even more of a surprise than Spain, Italy, and Portugal not making it out of group play in the World Cup). However, investors were willing to dismiss the bad first quarter performance. An inventory correction and a wider trade deficit subtracted 3.2 percentage points from 1Q14 GDP growth. Poor weather and a few other anomalies were also factors. Moreover, the 2.9% GDP contraction was at odds with almost every other piece of economic data. The bigger concern is the soft consumer spending data for April and May. Weak growth in real wages and geopolitical worries should lead to doubts about a strong pickup in economic growth in the second half of the year. However, that may not be bad news for the stock market.
Let’s begin with a little GDP arithmetic. Last week, the Fed projection of 2.1% to 2.3% for 2014 GDP was equivalent to a 3.1% to 3.4% average pace of growth for 2Q14 to 4Q14. That was with a -1.0% annual rate in 1Q14. The -2.9% pace in 1Q14 GDP means that we’d have to average nearly a 5.0% annual rate over the final three quarters of 2014 to get to 3.0% for the year as a whole. We’d have to average 4.3% to get to 2.5%. We’d have to average 3.6% just to get to 2%. Still, a big part of the revised arithmetic outlook is the larger inventory correction and wide trade deficit for the first quarter. Leaner inventories suggest the potential for strong production gains. The wider trade deficit is a mixed bag. Higher imports are a sign of strength, but they have a negative sign in the GDP calculation. On the other hand, weak exports are weak exports. Softer growth abroad means weaker growth in U.S. exports and somewhat slower GDP growth. Looking at the data, it’s better to throw out net exports and the change in inventories. Domestic Final Sales rose at a 0.3% annual rate in the first quarter, a 1.6% increase from a year ago. That’s a bit soft, but we should see domestic demand pick up in the 2Q14 data.
This brings us to the May spending data. Adjusted for inflation, consumer spending declined in both April and May. Figures for January, February, and March were revised lower. Consumer spending on durable goods rose sharply in May, not a surprise given the brisk pace of motor vehicle sales, but spending in other areas was weak. These figures are subject to revision. In fact, they will be revised, and revised, and revised. We should take them with a grain of salt. Yet, at face value, they suggest a much slower pace of consumer spending growth than was expected just a month ago (about a 1.4% annual rate, vs. the month-ago expectation of 3% or more).
Worries about weak growth in real wage income have moved to the forefront in recent months. Average wages are struggling to keep pace with inflation. That, in turn, limits the pace of improvement in consumer spending growth (where gains are being driven largely by job growth). Now factor in the possibility of higher gasoline prices and hopes for second half GDP growth of 3.0% to 3.5% begin to look tenuous. Increasing political tensions could also leave some U.S. firms more cautious, and less likely to hire new workers and make capital expenditures.
The UM Consumer Sentiment Index has been little changed in recent months. However, while survey respondents generally reported that their financial situation improved in June, they were less optimistic about the future. In particular, most households expected that their income would not keep pace with inflation. Nearly half expected a lower standard of living.
From the beginning of this year, the main risk to the economic outlook was not that we’d fall into a recession. Rather, it was that we’d end up with “more of the same.” That is, a lackluster-to-moderate pace of growth, but with little mopping up of the slack that was generated in the economic downturn. For the stock market, that may not be bad. The economy continues to recover, but not so much that the Fed removes the punchbowl.
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