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Weekly Economic Commentary

Weekly Economic Commentary by Scott J. Brown, Ph.D.

Who’s confused, the Fed or the markets?
September 26 – September 30, 2016

The Federal Reserve provides a lot more information than it used to. The central bank issues policy statements, it makes public its economic projections and policy expectations, and the Fed chair holds regular press conferences to explain things. However, despite this added clarity, financial market participants appear to be more confused than ever. Last week was no exception. It’s really rather simple.

In August, the Fed appeared to be well on its way to a September rate increase. Eight of the 12 Federal Reserve district banks were pushing for higher interest rates in late July. In their public comments, most senior Fed officials seemed open to a move. In her Jackson Hole speech, Chair Yellen said that “the case for an increase in the federal funds rate has strengthened.” It doesn’t get much clearer than that. However, she also left herself an out: “of course, our decisions always depend on the degree to which incoming data continues to confirm the FOMC's outlook.”

The economic data arriving since Yellen’s Jackson Hole speech have been mixed, but generally on the soft side of expectations. These data, as we all know, are fuzzy. Figures are based on statistical samples (with their inherent uncertainty) and seasonal adjustment is hard to get precisely right (especially when seasonal patterns are shifting, which they appear to be doing). Numbers bounce around from month to month and quarter to quarter. This makes it difficult to judge whether there is a change in trend or whether we’re just looking at noise. The Fed does not consider economic data alone, but also relies on anecdotal information from around the country.

So why didn’t the Fed raise rates? Chair Yellen said that “our decision does not reflect a lack of confidence in the economy.” The job market is strengthening, and the Fed expects that to continue – and while inflation is low, policymakers are confident that it will move back to the 2% target (as measured by the PCE Price Index). However, with the slack in the labor market being taken up at a somewhat slower pace, and inflation still trending below target, “we chose to wait for further evidence of continued progress toward our objectives.” Yellen also emphasized the asymmetry of policy errors. With rates already close to zero, “we can more effectively respond to surprisingly strong inflation pressures in the future by raising rates than to a weakening labor market and falling inflation by cutting rates.”

Simply put, the Fed can afford to wait awhile longer. The more interesting outcome from the Fed’s meeting was in the Summary of Economic Projections. At every other Fed policy meeting, senior Fed officials (the five governors and 12 district bank presidents) submit forecasts of growth, unemployment, and inflation. They also submit their expectations of the appropriate year-end level of the federal funds target for each of the next few years (now out to 2019). This is the infamous “dot plot.” The dots in the dot plot were expected to drift lower, much as they have consistently quarter after quarter. However, this time, the shift in the expected glide path of rates was much shallower than anticipated. Fed official remain optimistic about the economy, but they also generally lowered their expectations for future tightening. What gives?

Bear in mind, that the dots in the dot plot are expectations, not an actual plan of action. There is considerable uncertainty surrounding each of the dots. The pace of actual rate increases will almost certainly be faster or slower than expected. This does not mean that the Fed doesn’t know what it is doing. Rather, the outlook for monetary policy reflects the uncertainty in how the economy will evolve in the months and quarters ahead. When the Fed says that future policy decisions will be data-dependent, they mean it. Note that the Fed does not react to the economic data per se. Rather, policymakers react to what the economic data inform them about the future – and the focus remains on the amount of slack in the job market and the likely path of inflation in the months ahead.

The drifting of the dots does reflect a shift in the overall economic outlook. Slower labor force growth (as the job market approaches it long-term equilibrium) combined with a slower trend in productivity growth means that potential GDP growth will be a lot slower (about 2%) than what we grew up with (3.5% or so). That’s simply demographics (two forces propelled GDP growth in the last four decades of the 1900s: the arrival of the baby-boomers and increased female labor force participation).

“I know you think you understand what you thought I said but I'm not sure you realize that what you heard is not what I mean.” – Alan Greenspan


Limited economic upside?
September 19 – September 23, 2016

This being a presidential election year, views on the economy vary widely. The labor market has improved substantially in the last few years, to the point where we are seeing some evidence of wage pressures. On the other hand, growth in inflation-adjusted Gross Domestic Product has been low by historical standards. Many Americans have not participated in the economic recovery, but most are better off than they were a year or two ago. At any particular time, some sectors of the economy will do better than others, and with a slower trend growth in GDP, some are likely to appear weak. This can create uncertainty about where the overall economy is headed.

Real GDP rose 1.2% over the four quarters ending 2Q16. However, growth was restrained by slower (and more recently, declining) inventories. Final Sales (GDP less than change in inventories) rose 1.9%. And if you also exclude net exports and government (Private Domestic Final Purchases, a better measure of underlying demand), growth was 2.3%. Inventory growth is expected to pick up in the second half of the year, providing a short-term boost to overall GDP growth, but we saw little improvement in the data for July.

In late summer, the Census Bureau releases its annual report on income and poverty. The latest figures showed that real median household income rose 5.2% between 2014 and 2015, the first annual increase since 2007 and the largest gain since 1967, when data were first compiled. Gains were widespread across categories (household type, race, age), with the lone exception of those outside metropolitan statistical areas (-2.0% y/y). Real median household income was still below where it was in 2007, before the recession began (also about where it was in 1998). However, it is moving in the right direction.

With a goal of being better able to manage the economy, the government began collecting economic data following the Great Depression. Naturally, these reports focused largely on the manufacturing sector. After WWII, manufacturing accounts form nearly one of three jobs in America. That percentage has drifted lower over time. Currently, manufacturing accounts for 8.5% of nonfarm payrolls (or about one in 12 jobs).

Industrial production has fallen 2.1% since November 2014, but that decline largely reflects the sharp drop in oil and gas well drilling (which fell 76% from December 2014 to May of this year). Energy exploration (which is capital intensive) has stopped falling, which means that the sector should no longer be a drag on business fixed investment and overall GDP growth. Factory output has been mixed, but generally soft, over the last several months, reflecting weak global growth and lower capital spending in the U.S. and abroad. Global growth ought to pick up, but the shifting demographics implies that labor input will grow more slowly than in recent decades.

Foreign trade has played a part. In the 1980s, the U.S. lost about one of ten manufacturing jobs each year – but each job lost was replaced by a new job. For many years, low-end productivity jobs moved overseas and higher-productivity jobs were created to take their place. As Chinese exporting capacity ramped up in the 2000s, many U.S. manufacturing jobs disappeared and were not replaced.

However, there are benefits, as well as costs, to foreign trade. Tearing up trade agreements is likely to be counterproductive. Limiting cheap imports would boost inflation, reducing real incomes and dampening consumer spending growth. Retaliation would restrain U.S. exports, an increasingly important area of the economy.

Short-term bursts of GDP growth are possible. However, unless productivity growth picks up sharply or we substantially increase immigration, slower labor force growth will limit potential GDP growth over the foreseeable future.


The return of fiscal policy?
September 12 – September 16, 2016

The world’s central bankers are tired of having to do all the heavy lifting to support growth. Some have suggested the need for fiscal policy to take a bigger role. Is that a good idea? Is expansionary fiscal policy even feasible at this point?

Fiscal policy refers to using tax cuts or spending increases to spur economic growth. The idea is that if the government builds a road or a bridge, the wages earned will be spent, and that spending is someone else’s income, part of which also gets spent. If well below full employment (as in a recession), the impact of additional government spending will be multiplied. The tricky part is in deciding when that added spending will be pulled back (hopefully, after the economy has fully recovered). Government debt will be higher, but may be paid down gradually once the economy recovers. Tax cuts can also stimulate the economy, but only if seen as permanent (temporary tax cuts in a recession are ineffective, but politicians always seem to include them in stimulus packages).

The American Recovery and Reinvestment Act of 2009 (ARRA), provided support for the economy at a cost of $831 billion, mostly spread between 2009 and 2011. A little over a third of that was in temporary tax cuts (ineffective). ARRA provided $543 billion in additional spending. That sounds like a lot, but it wasn’t compared to the decline in overall economic output (nominal private domestic purchases had fallen by $754 billion from 4Q07 to 2Q09). The federal deficit ballooned to $1.4 trillion (or 10% of GDP) in FY09, but that simply reflected the magnitude of the economic downturn. Revenues dried up. Spending on things like food stamps and unemployment benefits rose sharply. As the economy recovered, revenues improved and the recession-related spending went away. With less than a month remaining in FY16, the deficit is on track for about 2.9% of GDP, up from 2.5% of GDP in FY15.

While there was much hand-wringing over the deficit in 2009 and 2010, the problem has always been in the future. While the deficit has declined as a percentage of GDP, pressures will build as the baby-boom generation continues into retirement. Social Security is not in a terrible situation, but Medicare spending is set to explode, reflecting the ageing of the population and the long-standing trend of high inflation in healthcare. Paying for the healthcare and retirement of the elderly is not an issue unique to the U.S. Every other country faces a similar problem.

While the ARRA did help to limit the economic downturn, it wasn’t large enough to propel the economy to a strong recovery. This recovery also differed from past recoveries in that state and local government did not provide a base level of support. In fact, they made the recovery worse. Most states and cities have balanced budget requirements. So, when the recession hit and revenues dried up, most cut spending (laying off teachers, police, and firemen). Employment in state and local government is still well below the pre-recession level.

No serious economist advocates using fiscal policy to fine-tune the economy and many are divided on whether fiscal policy works well in fighting a recession, but that’s precisely when you’re going to get more bang for your buck. In an economy that is closer to full employment, fiscal policy is going to be less stimultive and may crowd out private activity. Moreover, with budget pressures looming, there’s little political scope for expansionary fiscal policy (but at least we should see the end of counter-productive austerity measures).

And yet, there is a definite need for more infrastructure spending in the U.S. Both presidential candidates have proposed spending more to repair roads and bridges. Even if you don’t believe in global warming, improvements in sewer, drainage, and other systems are clearly needed (as evidenced by the aftermath of Hurricanes Sandy and, more recently, Hermine). The question is who is going to pay for that.


The opinions offered by Dr. Brown should be considered a part of your overall decision-making process. For more information about this report – to discuss how this outlook may affect your personal situation and/or to learn how this insight may be incorporated into your investment strategy – please contact your financial advisor or use the convenient Office Locator to find our office(s) nearest you today.

All expressions of opinion reflect the judgment of the Research Department of Raymond James & Associates (RJA) at this date and are subject to change. Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete. Other departments of RJA may have information which is not available to the Research Department about companies mentioned in this report. RJA or its affiliates may execute transactions in the securities mentioned in this report which may not be consistent with the report's conclusions. RJA may perform investment banking or other services for, or solicit investment banking business from, any company mentioned in this report. For institutional clients of the European Economic Area (EEA): This document (and any attachments or exhibits hereto) is intended only for EEA Institutional Clients or others to whom it may lawfully be submitted. There is no assurance that any of the trends mentioned will continue in the future. Past performance is not indicative of future results.