Charles Steindel

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State labor markets were generally sound in February, prior to the onset of the pandemic. Texas led the way, with a 50,400 (.4%) rise in payrolls—tops in the absolute gain and trailing only Alaska in percentage change. Michigan and Massachusetts also had statistically meaningful increases. Eleven states reported minor declines in payrolls; the rest reported small gains.

Over the twelve months ending in January job growth was weaker in the mid-section of the nation than elsewhere, with six states in that zone seeing a loss of jobs (only West Virginia’s drop was statistically significant). Vermont also experienced a statistically insignificant job drop. Once again, job growth tended to be faster in West, with Utah’s 2.9% increase being the largest.

In the household numbers, Alaska’s unemployment rate moved down to 5.8% (North Dakota’s 2.2% was the lowest in the nation), so in February there was no state with an unemployment rate of 6% or higher. At this juncture, one can only speculate when that might again occur.

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State labor markets were generally sound in February, prior to the onset of the pandemic. Texas led the way, with a 50,400 (.4%) rise in payrolls—tops in the absolute gain and trailing only Alaska in percentage change. Michigan and [...]

State Labor Markets in February

Joseph G. Carson

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Government restrictions to contain coronavirus have caused tremendous economic damage compelling some to question is it worth "destroying the economy by trying to save it"?

This is not the first time government restrictions triggered a severe slump in the economy. In 1980 government imposed credit restrictions to kill the "inflation" virus. That policy literally tanked the economy within weeks, ultimately forcing Washington to relent.

The 1980 experience clearly shows easing government restrictions on people's mobility and businesses will trigger a substantial rebound in the economy. But will it be sustainable without addressing the core (coronavirus) issue? In 1980 it was not.

Economic Fallout &amp; Political Ramifications 

Since the publication of my article, "Investors Should Brace For A Record Decline in GDP" on March 13, analysts' forecasts the scale of the economic slump have gotten direr day by day. Forecasts of the possible slump in Q2 GDP quickly jumped to -10%, then -20%, and -30%.

It's quite possible that we have now seen the peak of the most pessimistic forecasts. Federal Reserve Bank of St. Louis President James Bullard stated that Q2 GDP could decline as much as 50%, sending the unemployment rate to 30% in the process. Based on the civilian labor force an unemployment rate of 30% would mean a loss of 45 million jobs, pushing the number of unemployed to 50 million.

Now that the severity of the economic slump caused by government restrictions has scared everyone a potential fissure has opened between government health officials and the nation's economic advisors and politicians.

On one side, health officials argue sustained social distancing is necessary to successfully beat coronavirus. On the other side, economic advisors and politicians argue that the economic and financial costs have become too great and a different approach is needed

America had a similar debate four decades ago when the economy faced a different enemy, uncontrollable inflation. At that time, Federal Reserve Chairman Paul Volcker argued, "Inflation was Public Enemy Number One".

The Federal Reserve, following the recommendation of the White House, placed restrictions of the use of credit in order to kill inflation. Initially brushed off as largely symbolic the government restrictions triggered the sharpest decline in consumer spending in the post war period. It was reported that some people felt it "almost unpatriotic to buy items on credit".

In a relatively short period of time the government restrictions were viewed as "overkill" and Washington was forced to undo its credit policy.

Washington is confronting a health and economic crisis today. Undoing or relaxing restrictions on people's mobility and businesses could very well lessen the severity of the economic contraction. But the ability to implement it in a piecemeal way will be most difficult, while never fully eliminating coronavirus.

In 1980, government restrictions on consumer credit were an all-inclusive policy, impacting everyone up and down the income ladder and in every city and state in the US. The decision to impose and remove credit restrictions impacted everyone simultaneously.

Decision on where to relax standards and where not will bring health care and economics together in away never seen before. Allowing some cities and states, or even parts of a state, to recover before others based on a bell-shaped health curve will prove to be unworkable, forcing federal and state governments to adopt a blanket policy approach.

Drawing on the 1980, investors should welcome the government to relax these restrictions on travel, work life and non-essential businesses since it trigger an economic rebound---maybe a V-shaped. Yet, would easing these restrictions give a false sense of security to the American people? Can the medical industry contain this virus and ultimately find a permanent cure? In 1980 recurrence of inflation one year later proved even more difficult to defeat triggering a deeper and more protracted recession.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.
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Government restrictions to contain coronavirus have caused tremendous economic damage compelling some to question is it worth "destroying the economy by trying to save it"? This is not the first time government restrictions triggered [...]

"Déjŕ Vu"--"Destroying the Economy By Trying to Save It"

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BEA has released the first estimates of state personal income for the fourth quarter of 2019 and for 2019 as a whole. Right now interest in these figures may be mostly antiquarian. For 2019 as a whole, the fastest-growing states were in the West, with Colorado's 6.1 percent increase the nation's largest. South Carolina was the only state in the eastern half of the nation to be in the top 10 for growth—and it was 10th. The Great Lakes was the slowest-growing region, with Wisconsin's 4.0% gain (29th in the nation) noticeably under the nation's 4.4% pace. West Virginia's 2.8% growth was the nation's lowest (West Virginia is classified as a Southeastern state).

In the fourth quarter, much of the West was still strong, with the Southwest seeing the highest growth rate of any region. The Great Lakes states did experience a marked rebound, most likely reflecting the end of the GM strike (Michigan's 4.7 percent rate of growth was the nation's highest). North Dakota, after seeing income grow at an 11.1 percent rate in the third quarter, was last in the fourth quarter, with a 1.1 percent rate of growth.

Of course, the first quarter is likely to see very different results, with outright declines possible. It may be that small energy-producing states will be unusually hard-hit, as will, of course, the states now largely sheltering in place. Presumably, the new legislation will greatly expand federal transfer payments, but those effects will not be seen until the second quarter. Some may be looking at the state income figures to get a sense of the vulnerability of revenues to the virus event, but the potential for major federal aid is arguably the key element in assessing public finances.

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BEA has released the first estimates of state personal income for the fourth quarter of 2019 and for 2019 as a whole. Right now interest in these figures may be mostly antiquarian. For 2019 as a whole, the fastest-growing states were [...]

State Personal Income

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Economic recession is an infrequent occurrence, but in a fundamental sense recessions are the economy's way of cleansing the "rot" out the system that have been built up over time. This emanates from bad investments, bad loans, bad policies, excessive risk and speculation.

Recessions expose the vulnerabilities of the economy and the financial system. Even though the proximate cause could come from an outside shock it's the weaknesses and imbalances that are the underlying cause. So when the "right" shock comes along the fragile structure would collapse. Recessions fundamentally change behavior and policies and post recession business and finance will be materially different.

Economic Recession 

Since 1960 the US economy has experienced eight recessions; each economic downturn has been different along with the duration and depth. For example, some recessions were triggered by an exogenous shock (e.g. the oil shocks and now the coronavirus could be considered); some caused by tight money (to combat inflationary imbalances) and/or credit crunch. Meanwhile, others were started by an abrupt and sharp collapse in real and financial asset prices (financial imbalances).

In the post war period, the shortest recession has been six months and the longest eighteen. The average peak to trough decline in real GDP was around 1.7%, but the range is wide from 0.5% to 4.0%.

Economic recession acts like a forest fire, such that it doesn't discriminate between the "deadwood" and the "good" in the economy. In the process, it destroys jobs and people's lives, but also forces small companies (sometimes mid-sized to big) to close or downsize that were not previously vulnerable. It's the sheer force of an abrupt drop in spending, the curtailment of lending and the scramble for liquidity where few escape.

Some of the industries largely affected today include airlines, restaurants, hotel accommodations, and recreation (sports centers, parks, concerts, theaters, etc.). According to the data in the GDP report, the annual spending by consumers for these services and activities amounts to about $2 trillion - businesses probably spend similarly.

In other words, if there were a cessation of all of these activities for an 8-week period the impact to the US economy would be over $650 billion, equal to 3% of GDP (this is just from the aforementioned service industries). Only the consumer aspect of the spending decline would directly affect GDP, but these industries would feel the full impact of this spending collapse.

Spending in these service industries is not going to "zero", but in some cases it will. There are no professional sports of any kind scheduled for the time being or foreseeable future. These companies are enormously affected since they have to reimburse paid customers for travel and events cancellations.

It's impossible to predict confidently how severe the economic slump will be or the duration. Nothing on this scale has hit the US economy in the post-war period. This disruption goes far beyond work and finance because it also encompasses people's mobility, health care, education, all forms of entertainment and recreation, and confidence in our government.

Fast monetary and fiscal policy responses are helpful, but they do not fill all of the "holes" being opened in finance and the economy. Abrupt and sharp declines in asset prices have amplified distress, contributing to the downdraft in the economy. It is very hard to see how monetary policy can act as a shock absorber since the Fed's policy of low rates contributed to the financial imbalances that now exist.

Recoveries from the last three recessions were painfully slow. They were slowed by debt deleveraging cycle; commercial real estate and banking (early 1990s), non-financial companies (early 2000s); and residential real estate (starting in 2009). Odds are high that another debt deleveraging cycle will arise soon since US non-financial companies started 2020 with record levels of debt relative to GDP and cash flow.

It would be a mistake to think business and financial conditions would quickly return to levels prior to coronavirus outbreak. Recession changes consumer and business behavior in ways that are difficult to predict or forecast.

Post-recession, people will rethink travel destinations and the mode of transportation. Social distancing could alter how people choose to experience forms of entertainment and recreation. Businesses might opt for smaller work forces in several locations, versus bunching large groups in one place. They also may restructure existing supply chains or create new ones.

It is obvious government has to invest more in its public health system. Before the crisis is over it may be compelled to offer bailouts to a number of private sector firms at a cost twice of the $700 billion bank bailout in 2008.

Monetary policy will need to fundamentally alter its operating framework. Policymakers cannot avoid all recessions, but it needs to incorporate a better risk management approach in its policy decisions such that it reduces the risks of the "big" ones. Easy money did not cause the downturn, but it did contribute to the severity; it separated finance from the economy, elevated asset prices and encouraged non-financial companies to add record leverage.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.
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Economic recession is an infrequent occurrence, but in a fundamental sense recessions are the economy's way of cleansing the "rot" out the system that have been built up over time. This emanates from bad investments, bad loans, bad [...]

A "Primer" on Recession: Post Recession Business & Finance Will Be Different

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In what now seems like ancient times, state labor market data was strong in January. Twelve states had statistically significant increases in payrolls over the month, led by a 35,700 gain in Florida and 33,500 in New York. Some other Northeastern states, including Massachusetts, New Hampshire, and New Jersey saw percentage point gains as comparable or larger than New York’s .3 percent (New Hampshire was up .7 percent) strongly suggesting that the remarkably mild winter boosted the numbers. Over the 12 months ending in January job growth was, as has been the case for some time, strongest in most of the belt of states from Washington to Texas, and generally weaker in states along the Mississippi River and its tributaries (along with Alaska and Vermont), with a number reporting statistically insignificant drops.

In the household survey, Alaska had yet again the highest unemployment rate, at 6%, while Mississippi stood at 5.5%, Louisiana at 5.3%, DC 5.2% and West Virginia. Among larger states, Pennsylvania’s 4.7% was highest. North Dakota’s 2.3% was the lowest in the nation, and Vermont and South Carolina reported 2.4% rates.

Once again, these are January numbers (they incorporate the annual benchmark and seasonal revisions). Like the soon to be released February figures, they are rather moot at this juncture.

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In what now seems like ancient times, state labor market data was strong in January. Twelve states had statistically significant increases in payrolls over the month, led by a 35,700 gain in Florida and 33,500 in New York. Some other [...]

State Labor Markets in January

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Two of largest quarterly declines in economic activity during the post war period occurred during a financial crisis and a widespread cessation of consumer and business activity triggered by uncertainty (and panic) following the federal government announcement of credit controls. The current environment has some elements of both prior episodes raising the possibility that the decline in economic activity in upcoming quarters could rival the large declines that occurred in 1980 and 2008.

GDP’s Largest Quarterly Declines

In the past 60 years, the US economy experienced two exceptionally large quarterly declines in real GDP. In Q4 2008 real GDP dropped an astounding 8.4% annualized and in Q2 1980 real GDP contracted 8.0%. The forces behind each decline, as well as the composition, were markedly different but both episodes can still provide some guidance on what to expect.

For example, in 1980, the sharp decline in real GDP was driven by the imposition of credit controls by the federal government, and the uncertainty surrounding the actions of the new policy. Consumers interpreted the Fed directive to “stop using credit cards” and a poll showed 58% of consumers used credit less than before, resulting in a record contraction of 8.7% annualized in real consumer spending in Q2 1980.

In Q4 2008, the sharp drop in economic activity occurred during the abrupt and sharp collapse in the financial markets, following the bankruptcy of Lehman Brothers. In Q4, the plunge in real GDP was driven by 20% to 30% annualized quarterly declines in business investment, housing and exports, as the financial crisis became a global crisis, much like the coronavirus. Real consumer spending took a hit as well, but fell only half as much as overall GDP..

The economy in 2020 faces a number of the same issues. To be sure, there is growing uncertainty (and in some cases panic) surrounding the coronavirus. And there is also confusion and fallout following the federal and state governments imposing widespread restrictions on all types of domestic and foreign travel, work-life, as well as social and business gatherings, events and conferences. The coronavirus is also a global crisis, impacting business activity in a number of major trading partners while also disrupting global supply chains. On top of all of that there is sharp drop in the equity markets that has wiped out over $7 trillion in household wealth in a span of a month or more, which will weigh heavily on consumer confidence.

Many of the consumer and business service sectors are likely to feel the brunt of the drop in sales and revenue. Unfortunately, there is no “real time” hard monthly numbers on sales and revenues for the service sector. The Census Bureau quarterly report on service sector revenue is released almost 80 days after the end of quarter, so a full assessment of service sector revenue and sales for Q1 will not be known until June and Q2 data will not be known until the end of September.

Conversation with a senior official at the Bureau of Economic Analysis indicated that government statisticians are discussing how to properly assess the “data” shortfall, and for now will be monitoring many of their “early” indicators, such as jobs. But its important to keep in mind that during downturns sales and revenues per employee fall hard, so the jobs data will not provide a full assessment of the drop off in service sector revenues.

Given the speed and breadth of events investors should brace for a decline in economic activity that’s more than twice consensus estimates, with company sales and profits declines that prove to far larger than what equity analysts currently expect.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.
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Two of largest quarterly declines in economic activity during the post war period occurred during a financial crisis and a widespread cessation of consumer and business activity triggered by uncertainty (and panic) following the [...]

Investors Should Brace For A Record Decline In GDP

Paul L. Kasriel

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The global spread of COVID-19 represents a classic example of a supply shock. In this case, the factor of production affected is labor. Despite the advance of artificial intelligence, global production of goods and services still depends critically on people. If fewer people are available to work, production of goods and services will decline. Monetary policy affects the aggregate demand for goods and services. If the aggregate output of goods and services declines because of an abrupt decline in person-hours of production, an increase in the demand for aggregate goods and services will result primarily in the rise in the aggregate price level of goods and services. That is, the pursuit of a more accommodative monetary policy in the face of a supply shock will result in stagflation. The degree of the stagflation depends on the severity of the supply shock and the degree of monetary policy accommodation.

We do not know how severe the COVID-19 global and US supply shock will be nor do we know its duration. Chinese production appears to have taken a hit as evidenced by the decline in the Chinese manufacturing purchasing managers to 35.7 in February versus 50.0 in January. The decline in Chinese manufacturing output will play havoc, at least temporarily, with global supply chains. I say “temporarily” because a new hospital was built from scratch in China in six days. I doubt if the Chinese rested on the seventh day. The point is that the Chinese are likely to be able to ramp up production quickly.

So far, the direct COVID-19 supply shock on U.S. production has been de minimis. It is not clear if there has been a net negative impact on U.S. aggregate demand. Although Americans may have cut back on travel and movie attendance, they have increased their demand for face masks and hand sanitizer. But if there were to be widespread shutdowns of K-8 schools in the U.S. in reaction to COVID-19, then there would be a significant negative supply shock to U.S. aggregate production of goods and services as parents presumably will need to stay home with their children rather than going to their place of work. (But don't worry about essential services being interrupted. We economists can churn out errant forecasts and faulty analysis from our isolation chambers so long as we have access to a high-speed Internet connection.) But, again, chumming aggregate demand via a more accommodative monetary policy won't increase the supply of goods.

Last week's swoon in the U.S. stock market was due to the realization that there is going to be a negative supply shock from COVID-19 that will adversely affect U.S. corporate profits. When your workers can't work as much or at all, your production will fall. If your production falls, your profits will fall. There is no uncertainty as to whether aggregate corporate profits will be adversely affected by COVID-19. The uncertainty is to the magnitude of the hit to aggregate corporate profits. Fed interest rate cuts, to the degree that they do not result in higher yields on longer-term maturity fixed-income securities, could cushion the downward pressure on equity prices by lowering the factor by which future profits are discounted. Fed interest rate cuts also could result in higher inflation in the face of the reduced supply of goods and services, as mentioned above. This would boost nominal corporate profits, but also would boost bond yields, the discounting factor of future nominal profits.

In sum, COVID-19 is going to have an adverse temporary effect on global aggregate output, including U.S. aggregate output, because of reduction in person-hours of work. There is nothing printing more money can do change this.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.
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The global spread of COVID-19 represents a classic example of a supply shock. In this case, the factor of production affected is labor. Despite the advance of artificial intelligence, global production of goods and services still [...]

COVID-19 – The Fed Can't Cure What Ails You

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Last weeks' sharp decline in the equity market was both historic and unusual. In a span of 5 trading days, the S&P 500 index dropped 11.5%, one of the largest single week declines on record. And what is also unusual about last week's decline was that there was no “hard” evidence of any disruption or decline in the domestic economy.

Yet, the speed and the scale of the decline were also influenced by how far finance had separated from the economy. Here are a few examples.

Finance vs. Economy 

First, operating profits for US companies have not increased for 5 consecutive years, and yet the S&P 500 had climbed over 60% during that period. Also, the market value of domestic companies to nominal GDP----a ratio that is often used to determine if the equity market is undervalued or overvalued relative to a historic average---stood at an estimated 1.85x at the end of 2019, matching the record high of 2000.

The run-up in equity prices and valuations over the past several years was fueled by easy money, along with the promise of low rates for the foreseeable future. As such, investors viewed stocks as low risks, with many professional investment advisors going as far as arguing that they “didn't see any alternatives to stocks”.

Second, coronavirus puts “risk” back into investing, something that has been absent in recent years as policymakers have responded to every “illness” or setback in the markets with the promise of support. Also, the new “risk” factor (coronavirus) has an uncertain life and unquantifiable consequences, and cannot be “cured” by more easy money.

Third, the fast run-up in equity prices for so many companies, even for those continuing to report operating losses, forced equity analysts to keep raising their price target to stay relevant, or come up with new ideas or ways to justify higher valuations.

One analyst came up with a new idea on how to value Tesla, a manufacturer of electric cars. The analyst offered various scenarios. The base case price target called for nearly a 40% price drop from the stock's current price (“reflecting an unfavorable risk-reward skew”), whereas the bull case price target was 50% higher, based on 2030 volume and operating margin.

Tesla went public in 2010 and has yet to have one profitable year. Nonetheless, in early February Tesla stock price hit a record $969, a fourfold increase since October---just one example of how finance became separated from current economic conditions. At the end of February Tesla's share price stood at $668.

Where Do We Go From Here? 

Missteps in policy decisions created a large gap between finance and the economy. Fed's policies of low rates ended up inflating finance over economy much more so that it had in success of hitting its price stability target. The fact that a market correction occurred was not a surprise, but the catalyst was.

It would be wise for policymakers to let the re-balancing between finance and the economy run its course, and also let the financial system re-price risk in a natural way. Yet, “politics” may force the Fed to play a role not well suited for traditional monetary policy.

Investors must stay focused on the behavior response of consumers and business to the plunge in equity prices and coronavirus. Each of the past two recessions were caused by a sharp plunge in asset prices, so the loss of household wealth and liquidity does raise the odds of a bad outcome. Consumer confidence for now may be shaken more by the speed of the decline than the scale.

Coronavirus has the potential to be even more disruptive. That's because all of the unknowns about the new virus could compel people and business to become idle, and when the flow of business activity slows or stops so does profits (and soon jobs) in a number of industries.

Perhaps the biggest worry nowadays is that businesses are operating with a record debt load. Even though borrowing costs are exceptionally low, businesses still need to generate revenue to pay its debt obligations (as well as its' workers). Small businesses might be the most vulnerable since they don't have financial resources of large firms, and few, if any, could survive a few weeks of little or no sales. More than one-third of small firms are already burdened with high debt according to the Small Business Credit Survey conducted by the Federal Reserve Banks in 2019.

With the global coronavirus situation still fluid investors should be prepared for more disruption to business with the "big" risk that the disruptions spillover to the labor markets, if not lead to a number of corporate debt downgrades and a rise in business bankruptcies at some point.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.
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Last weeks' sharp decline in the equity market was both historic and unusual. In a span of 5 trading days, the S&P 500 index dropped 11.5%, one of the largest single week declines on record. And what is also unusual about last week's [...]

Unstable Balance Between Finance & Economy Contributed to Equity Market Decline

Heavy US manufacturing states underperforming while Sun Belt states outperforming

Rising long-term yields a global phenomenon

US financial market concerns shifting from growth to inflation

Economic activity is picking up in the US but remains lackluster abroad

Policy uncertainty has surged since the US national elections.

Recent turnaround in US economic surprises leading to increases in rate-cut expectations

The outlook has brightened in the US, while it has dimmed for other major economies

Headline US PCE inflation elevated by sticky services prices

US and global equity prices have recently diverged

US leading global upturn in economic surprises

Blue Chip forecasters look for further significant monetary easing apart from Japan

Recent rise in global supply chain pressures could augur a pickup in global inflation pressures

Underperforming German economy generating increased policy uncertainty relative to Europe and the US

Resilient US economy is pushing up longer-term inflation expectations and interest rates

Positive US economic data surprises leading to upward adjustment of interest rate expectations

Recent aggressive policy easing in China has given a massive boost to equity prices

FOMC expects much more easing now than in June

US is clear world leader in business capital spending on artificial intelligence

Blue Chip forecasters expect US to lead aggressive policy rate cuts over coming year—apart from Japan

Ratio of job openings to the number unemployed in the US now below pre-pandemic level

U.S. layoffs not showing as much cooling in labor markets as unemployment rate

While goods prices have moderated, service price inflation remains elevated and sticky

Since Jan 2023, BCEI US outlook has improved, worsened for Japan and the euro area

Persistent negative US economic surprises leading to big rate-cut expectations

Germany is Euro area weakling

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With price stability as a key mandate, the Federal Reserve bears a significant responsibility to guarantee that the targeted price statistics accurately reflect people's experiences and are not influenced by political or statistical manipulation. However, the Fed's price targeting regime has become misleading and unbalanced since the price measure it targets has become less relevant to "actual" inflation. The Fed nowadays lacks a "Greenspan," or an individual who is both an expert in economic statistics and methodology and possesses the political power and influence to challenge the accuracy of published statistics or request their review. The matter of accurate price measurement is not just academic; it has real economic and financial effects.

Years ago, the Price Statistic Review Committee (PSRC), a group of academics, economists and statisticians, stated that, “If a satisfactory rent index for units comparable to those that are owner-occupied can be developed" then the committee recommends that BLS to use this approach for house prices and related expenses.

The General Accounting Office (GAO), which released a comprehensive report on how housing costs are measured in inflation metrics, made a similar suggestion. The GAO stated, "Most owner-occupied housing units differ significantly from many rental units. To apply rental equivalence in the CPI, a sufficient number of rental units must be identified that are comparable to owner-occupied units in terms of size, location, and quality, allowing the BLS to create a sample that accurately reflects owner-occupied houses."

In 1983, based on recommendations from the PSRC, GAO and others, the Bureau of Labor Statistics introduced the owners' rental equivalence method to estimate housing costs of owner-occupied homes. This estimation procedure continued until 1998, when the BLS announced that it had to discontinue the owner-sample due to an insufficient sample of owner-housing units. Moving forward, they decided to link the rent estimates for owners' rent to the other rent series. Neither the PSRC nor the GAO provided any comments.

The owners-occupied rent series constitutes roughly fifteen percent of the Fed's preferred price target, the personal consumption expenditure deflator (PCE). Combined with the thirty percent of the PCE that individuals do not buy, nearly half of the PCE deflator reflects an inflation rate derived from administered and non-market prices or imputations. How can this be regarded as a reliable or accurate measure of actual inflation people experience?

Price data should represent "actual" inflation, not a statistical distortion. Considering its essential role in shaping both monetary and fiscal policy, it is crucial for the price data to be accurate, relevant, and objective. The general public benefits from "actual" sustainable low inflation. But who gains when inflation might be understated, or its cyclical fluctuations are dampened or eliminated due to a new statistical method?

Over the past sixteen years, from 1998 to 2024, the average S&P 500 P/E ratio was 26.7. In contrast, during the preceding fifteen years, from 1983 to 1998, it averaged 15. Is this just a coincidence, or could the alteration in inflation estimation for housing costs, combined with the Fed's emphasis on an inflation measure representing only half of the actual inflation rate experienced by people, partly explain this shift? This misleading measure of inflation and policy approach has led to maintaining official rates lower than they might have been otherwise, which benefit finance, especially equity investments.

According to history, "Washington" is unlikely to change it frameworks (price and policy) unless another crisis occurs. The financial press could increase public awareness of this issue, but it has not done so yet. As long as the existing price and policy frameworks remain in place, finance benefits while "Joe Six Pack" loses ground to "actual" inflation.

The Fed Must Target "Actual" Inflation

Mickey D. Levy

The persistently stronger growth of the U.S. economy relative to most other advanced nations has been the driving factor that has resulted in a stronger stock market with higher valuations, higher interest rates and a strong US dollar.  A handful of charts highlight the sizable differences in economic and financial market performance across nations.  Nothing is permanent, and things—particularly shifts in economic policies--can initiate sizable changes in trends.  As we assess shifts in economic policies and central bank monetary policies, it’s important to keep in mind the economic fundamentals that drive financial markets.

**Real growth comparisons**.  Chart 1 shows the cumulative percent change in real GDP since 2000 in the U.S., UK, Europe and Japan.  In general, the faster growth in the U.S. reflects a combination of healthier gains in labor force and productivity.  Real GDP growth in the UK matched the U.S.’s pace from 2000-2008, while Europe nearly kept pace, benefiting from the boom in global trade fueled by the China super-cycle.  While the decade following the Great Financial Crisis was lackluster in the U.S., it was markedly slower elsewhere, particularly in Europe, which was hampered with ongoing financial crises during 2010-2014.

Chart 2 shows the same data but indexes real GDP to 2019Q4, which highlights the U.S.’s continued healthy growth following the pandemic-related contraction in the first half of 2020, while growth in Japan, the UK and Europe has been particularly weak.  The persistent outperformance of the U.S. economy is sizable.

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The GDP comparison between the U.S. and Canada tells a different story, as shown in Chart 3.  Unlike other advanced nations, Canada’s economy kept pace with the U.S. in the early 2000s, benefiting from its strong growth in its labor force fueled by immigration and the high demand for its exports of natural resources.  Following the GFC, growth in Canada outpaced the U.S’s soft recovery.  Canada’s growth slowed beginning in 2015 with the decline in oil prices and its shift in economic policies that focused on redistribution and social issues and deterred business expansion and economic growth. Canada’s economy has stumbled markedly in the 2020s. To highlight Canada’s weakness and lack of confidence, its business investment as a percent of GDP drifted down prior to the pandemic, plummeted in 2020, and has failed to recover, as shown in Chart 4.

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Calculations of productivity vary for different nations and are not directly comparable. However, the U.S.’s pace of technological innovation and the implementation of new innovations into commerce and society seems significantly more pronounced than in other advanced nations.  These growth and wealth-enhancing characteristics in the U.S. are facilitated and fueled by the structure of its capital markets, along with its higher degree of risk-taking and entrepreneurial spirit. These characteristics in the U.S. attract global innovators and risk-takers. Various nations are encouraging and rewarding innovation and facilitating advances in capital markets, a distinct positive for global grow.  However, at this point, a comparison of pro-growth characteristics in the U.S. and Europe, and Europe’s diminished potential growth, is striking. Note that amid the political turmoil in Europe, its leaders are discussing just about everything except policies that would promote sustainable economic growth.

Labor and employment data are similarly difficult to compare across nations.  The U.S.’s labor force has continued to grow and is very flexible, with significantly higher mobility than in other nations. The U.S.’s policies that influence the supply and demand for labor leave much room for improvement, but in general facilitate labor mobility much more than other nations.  This enhances the efficiency of business production.  The U.S. has also benefited from immigration, and except for Canada, is seemingly more adept than other nations at assimilating immigrants into the workforce and society.  Of note, while Japan now welcomes a large and growing number of foreigners into its workforce that offset the impact of its declining population, many nations in Europe, particularly Germany, have policies that constrain the mobility of labor and reduce economic efficiencies.

**Stock market comparisons**. Charts 5 and 6 show comparisons of the cumulative appreciation of stock markets.  Of note, Chart 5 measures the cumulative percent changes in the stock market indexes since 2000 in local currencies, while Chart 6 measures the percent changes in total stock market returns including dividends, in US$ terms.  Thus, the recent strength in the US dollar compounds the comparative U.S. advantage.

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The outperformance of the U.S. stock market reflects a combination of healthy economic growth, strong profits, growth leaders and high valuations based on favorable expectations.  The higher returns on the U.S. stock market generate expectations that the relative advantage will continue.  In the last decade, the U.S. has benefited significantly from new growth leaders that garner high multiples.  Those stock market leaders have also been the critical drivers of U.S. business investment and growth of the economy.  Certainly, there are periods when other nations’ stock markets outperform, but history shows that those periods are temporary.  Valuations and P/E multiples are higher in U.S. stock markets that in other markets, reflecting favorable expectations of future economic and profit growth.

**Interest rate comparisons.** The U.S.’s economic growth and productivity gains raise expected rates of return on capital, which lifts real interest rates.  Following the sustained period of low real rates that accompanied the GFC and subsequent decade of weak growth, real rates have normalized.  They are now similar to (but still below) the high real interest rates that accompanied the strong productivity-driven growth of the second half of the 1990s.  Except for Japan, inflation in all advanced nations has receded, and central banks have raised their policy interest rates above inflation.  The Bank of Japan is now normalizing interest rates as it strives to lift inflationary expectations to 2%. Bond yields have risen in all advanced nations and except in Japan, exceed inflationary expectations. Charts 7 and 8 show an international comparison of central bank policy rates and bond yields.

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**Exchange rates.** In an international context, capital tends to flow to the highest risk-adjusted expected rate of return.  Accordingly, the higher expected rates of return on US dollar-denominated assets are associated with a stronger US dollar.  Charts 9 and 10 show the trade-weighted dollar for advanced foreign economies and the dollar versus the yen and the Euro. The trade-weighted dollar is at high levels similar to levels of the late 1990s and early 2000s before it depreciated significantly and near all-time highs versus the yen.

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It is always important to assess how economic policies in the U.S. and globally influence economic and financial market performance.  Currently, the potential for shifts in policies is high.

Advantage U.S.:  Its Economy, Stock Market, Interest Rates and the Dollar

Has the traditional business cycle become obsolete? Not entirely, but major substantial changes in monetary policies and in the methods for calculating price measurement statistics, have altered the manner in which business cycles end. Business cycles consist of two components: an economic cycle and a financial cycle. Changes in policy and price measurement have shifted the pressures and excesses of the business cycle from the economy to the financial sector. In other words, high P/E ratios have taken the place of high CPI figures.

What Causes the Ups and Downs of a Business Cycles?

Some analysts and academics argue that the traditional business cycle characterized by increasing inflation and interest rates that eventually leads to an end of the cycle no longer exists. This perspective is somewhat supported when comparing business cycles before 1990 with those after.

For instance, since 1990, every business cycle has concluded with relatively low headline and core inflation. In contrast, from 1960 to 1990, business cycles ended with inflation rates of at least 5%, sometimes reaching double digits, with official rates significantly exceeding reported inflation.

However, to assess whether the traditional business cycle is now obsolete, it is crucial to first ascertain if the expansion and recession phases are influenced by government fiscal and monetary policies, developments in financial markets, or an exogenous shock. (Note: The business cycle that ended in 2020 was initiated by an unforeseen event, the pandemic, unlike the recessions of 2000 and 2007. However, in all three instances, both headline and core inflation were relatively low).

Essentially, significant technological advancements and globalization from the mid-1990s and beyond have decreased business cycle volatility, limiting or postponing price pressures that previously would have arisen during a typical business cycle. However, there are other factors at work as well.

During the mid-1990s, the approach to conducting monetary policy shifted from focusing on money and credit growth to targeting real interest rates. Most financial market analysts, myself included, did not initially see this shift in monetary policy as a major transformation. However, it turned into one when the BLS altered its method of measuring consumer prices in 1998.

In the late 1990s, the BLS stopped surveying the owner-occupied housing market to estimate owners' equivalent rent and began using data from the primary rental market, despite the fact that these two housing markets are influenced by different factors and frequently exhibit significantly different supply and demand patterns. At the same time, non-housing financing costs were removed from the CPI, continuing the previous exclusion of housing financing costs in the 1980s.

At that time, participants in the financial market did not consider these changes in price measurement to be significant. However, they were extremely important. During the housing bubble of the early 2000s, while housing prices experienced double-digit increases, the CPI indicated housing cost increases of only 2% to 4%. If the BLS had not implemented the measurement changes in the late 1990s, reported inflation would have been easily double what was reported.

(Note: The BLS excluded housing prices from the CPI in 1983, but continued to survey owner-occupied housing to estimate the implied rent for homeowners, maintaining a direct connection between housing inflation and increases in owners' rent. This connection was severed with the measurement changes in 1998).

The removal of non-mortgage interest costs also had a big impact on reported inflation. A joint research project by economists from Harvard and MIT found that the CPI from 2021 to 2023 would have been twice as high if consumer financing costs for were still included in price measurement.

Still, altering the methods for measuring prices had notable economic and financial impacts. Indeed, the revised CPI measure exhibits significantly less cyclicality, leading the Fed to aim for lower nominal and real interest rates than it would have if the BLS had not made these adjustments. This has led to considerably higher P/E ratios since 2000.

Economic downturns can stem from asset markets, as shown by the stock market crashes in 2000 and 2007, followed by recessions. The S&P 500 is trading at 22 times the projected earnings for 2025, and even higher compared to free cash flow projections. Other market indicators, such as the price-to-sales ratio, are also exceptionally high.

Therefore, the equity market is susceptible, particularly to an additional increase in market interest rates. Historically, the risk of recession increases when the yield on the 10-year Treasury surpasses the growth in Nominal GDP. According to current figures, there is merely a positive spread of 20 basis points with GDP outpacing the yield on the 10-year Treasury. However, current yields might still be too high given the lofty levels of the equity market.

However, the primary threat to the equity market and the economy lies in the fiscal strategies of the new administration. With the existing budget approaching $2 trillion, it is not financially viable to make the 2017 tax cuts permanent, as they are estimated to cost $4 trillion over the next decade, along with introducing further federal tax cuts. Even if the new Administration succeeds in reducing federal spending, it will not be significant enough to offset both past and new tax cuts, resulting in a budget deficit as large or larger than the current one.

More than three decades ago, President Bill Clinton shifted from his new economic agenda, which featured a middle-class tax cut, to a deficit-reduction strategy in response to the threat of increasing interest rates. At that time, the US was dealing with projected budget deficits ranging from $300 to $400 billion, compared to today's deficits exceeding $2 trillion.

Should the Trump economic team ignore the lessons from 2000, 2007, or even 1993, there is a genuine risk of a significant increase in interest rates. Market interest rates have previously impacted the fiscal strategies of a new president, and they have the potential to do so again, if not, the risk of financial chaos will increase.

Viewpoints: March 2020

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