Viewpoints: March 2022

State real GDP growth continued to be in a wide range in 2021:Q4. Nine states grew at rates equal to or exceeding 8 percent, led by Texas's 10.1 percent. However, 3 states (North Dakota, Nebraska, and Iowa) registered declines in output. Again, as was the case in the third quarter, marked declines in agriculture held down the Plains states. Sharp gains in accommodations and food services contributed markedly to growth in Hawaii and Nevada, and a few other states, none of which stand out immediately as major travel destinations (Connecticut, New Hampshire, Vermont, Tennessee, and New Mexico). New York, which has had difficulties reviving tourism, saw that sector decline in the fourth quarter.

The broad contours of growth in the fourth quarter were comparable to those for 2021 as a whole. In general—though there are some exceptions on both sides—state in the middle of the nation (the Middle West, Plains, and South Central) have been growing more slowly than those to the East and West. The Western states have been (again generally) the fastest growing, the South Atlantic is nearly as fast. The Northeast is mixed, with some states noticeably stronger than others (New York is a notable laggard).

The GfK look-ahead consumer confidence metric for Germany is expected to plunge in April, swinging from a reading of -8.5 in March to a -15.5 reading in April. The April reading resides in the lower 1.2% of the historic queue of observations for the GfK headline This is the second lowest GfK reading since the series began in January 2002. The lowest reading on record is -23.1. The monthly drop in the headline is the third largest one-month drop on record over this same period.

The GfK metric chronicles a sudden shock as well as a deeply negative reading for German consumer confidence in April. We should view it as a sort of bellwether for Europe.

The German condition Germany has been torn and twisted by upheavals over EMU/EU policies various, episodes with the virus, political change, and muti-decade haranguing with the U.S. over its modest contributions to NATO, and its dependency on oil from Russia. As the U.S. (Obama, then Trump) urged Germany to contribute more to NATO, the Germans insisted on dragging their feet before upping their NATO contribution to 2% of GDP, a contribution they were loath to make because they were doing so much business with Russia. Germans bought Russian gas and sold other goods. Germans did not see any reason to contribute a huge chuck of GDP to defend themselves against a business partner…until the grim reality set in. Germany has been paying down debt rather than contributing more to NATO. Trump incredibly was treated as a 'bad ally' when he threatened to pull some troops back (and did) because Germany refused to pay more for its own defense (opting to shore up its financial condition instead). Trump may have been ham-handed about it, but he was right. And Germany must have had an inkling of its true need since it really did want the U.S. presence to remain, but it did not want to pay for it. Perhaps some day we can talk about that without blood pressures rising. But German attitudes toward Russia also held-back the U.S. response to Russia as it amassed troops on Ukraine's border since, until Russia invaded Ukraine, Germany was not on board for anything but the most milquetoast of sanctions.

Post invasion…never mind In the event, Russia steamrolled Ukraine, surprised Germans opened their eyes and the world changed before our eyes in a blink. All of this has shocked the German public and we see that in the smackdown of the GfK index in April. All those things that came before the Russian attack are now water under the bridge. Germany is looking to wean itself off Russian energy. Current energy contracts are still honored by both sides (although there have been attempted modifications as Russia has tried to get energy paid for in rubles). Germany is actively looking to arrange for LNG shipments- something the U.S. urged years ago – more water under the bridge.

Metrics for the sucker-punched German consumer The detailed metrics for the GfK system are up-to-date through March not April. But they all are weak. Economic expectations read -8.9 in March; a drop from 24.1 in February. Income expectations are at a reading of -22.1; down from 3.9 in February. The propensity to buy index fell to -2.1 in March from 1.4 in February; this is the smallest monthly drop of the lot. Economic expectations have a 21.9 percentile standing in their historic queue of ordered responses, income expectations have a 0.4 percentile standing, and the buying climate has a 28.1 percentile standing. In terms of monthly drops, the declines are large with the economy measure falling more month-to-month only 13.6 percent of the time, income expectations fall by more month-to-month 13.6% of the time as well and buying plans slip by more in one-month about one-third of the time.

Policymakers are trying to achieve a benign economic outcome, a soft landing similar to 1995. But unfortunately, history shows that soft landings are rare. Since 1960, there have been three soft landings but nine recessions. Soft landings happen when the Fed acts early and often, and recessions occur when the Fed acts late. Unfortunately, the Fed is late, very late today.

One of the biggest challenges for the Federal Reserve is that it confronts the most significant inflation cycle in decades without any trusted policy gauges. Decades ago, policymakers abandoned the monetary targets, arguing that they no longer provided a consistent and reliable nominal spending and inflation signal. And a few years ago, Fed Chair Powell "retired" the Phillips Curve from a policy gauge, arguing that there was no consistent pattern between labor market slack and up and down movements in inflation for the past two decades.

The Fed's playbook from the 1994 episode should have helped, but policymakers did not follow it. The 1994 transcripts of the Federal Open Market Committee (FOMC) meetings reveal that Fed Chair Alan Greenspan argued, "we are facing a test over whether inflation is a Phillips Curve phenomenon or a monetary phenomenon." He said if it's a Phillips Curve phenomenon, we are on the edge of significant inflation as there was no slack in the industrial markets. However, if inflation is a monetary phenomenon, then the inflation pressures should be a "blip" as "subnormal growth in money and credit" has to mean something.

Even though Greenspan debated with his colleagues, he concluded that "we have to presume the pressures are there." As a result, he felt that the FOMC needed to take more preemptive actions of raising official rates since it was too risky to be wrong. Whether by design or luck, the economy achieved a soft-landing in 1995, and the much-dreaded consumer inflation cycle never took off.

Policymakers need not have the same debate nowadays as Phillips Curve, and monetary inflation features are present. To be sure, broad money growth has topped 40% in the past two years, the fastest ever. And, wage increases have become significant and persistent (average wages up 6.7% in the past year). And wage pressure will continue to be an issue with a relatively low jobless rate of 3.8%.

The inflation cycle of today is also more advanced, markedly different in scale and scope compared with 1994. For example, in 1994, producer prices for crude goods, excluding food and energy, rose 15%, but in 2021, the same prices rose 29%. Greenspan's primary concern in 1994 was the spike in crude prices would work its way up to the pipeline, lifting prices everywhere and in everything. In 1994, that didn't happen. But in 2022, it has.

Producer prices for intermediate materials, excluding food and energy, rose 23% last year. That was nearly 5X times the increase of 1994. Consumer prices have increased 7.9% in the past year, and the peak is not yet. Yet, in 1994, consumer prices showed no acceleration, ending the year at 2.7%, the same rate at the outset.

Policymakers' 2022 playbook is a "wing and prayer" strategy, hoping for a good outcome but unwilling to apply sufficient monetary restraint to get a good result. Current projections show a peak fed funds rate of 2.8% at the end of 2023, or less than half today's inflation rate. Soft landings of 1994 and 1984 came about with policy rates 300 to 600 basis points above inflation.

If lifting nominal interest rates well above inflation helped engineer a soft landing in the past, what are the odds of achieving a soft landing by doing the opposite? Close to zero, in my view. Also, policymakers expect the jobless rate to be even lower at the end of 2023 (3.5%) than today. So how does the Fed expect to break the wage-price cycle (Phillips Curve) without creating slack in the labor markets?

Fed Chair Jerome Powell has often said monetary policy is not on a preset course. Yet, it's on a preset path to fail this time as long as it lets inflation linger and keeps policy rates too low. Investors forewarned.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.

State payrolls were robust in February. 27 states saw statistically significant increases from January, led by California's 138,100 rise. Texas gained 77,800 jobs, and Florida was up 51,000. 19 other states had increases of more than 10,000. Nebraska had the largest percentage gain—1.2—while 4 other states had .8 percent increases. Over the last 12 months 48 states, plus DC, saw statistically significant increases in payroll employment. Unsurprisingly, California had the largest numerical increase (over 1 million) and Nevada the largest percentage increase (9.7).

Virtually all states saw job growth over the last 12 months. California picked up well over 1 million jobs; Nevada saw a 10.3 percent increase. Alabama, Ohio, South Dakota, and Delaware were the only states to report job growth under 2 percent

A whopping 31 states saw statistically significant drops in their unemployment rates in February; New Jersey's .5 percentage point decline was the largest. The range of unemployment rates across the nation continues to narrow. Again, DC was highest, at 6.1 percent. Among the 50 states, Nebraska and Utah continue to have the lowest rates (2.1 percent) and New Mexico the highest (5.6 percent).

Puerto Rico eked out a modest gain in payrolls in February. With a revision to January, the job count on the island is now over 900,000 for the first time since 2015. Unemployment continues to fall, with February's rate down .3 percentage points to 6.8 percent.

Economic forecasters have been paring back their expectations for households' living standards for several months now. Soaring prices for energy and food combined with a fading impulse from COVID-related fiscal support together - more recently - with higher borrowing costs have severely derailed households' disposable income growth in most major economies. At the start of last year, the Blue Chip consensus of US forecasters was centred on an advance in real household incomes of 1.1% in 2022. In the latest survey from March this year those same forecasters are now expecting real incomes to plunge by 3.5% (see figures 1 and 2 below). Similar arithmetic applies to consensus forecasts elsewhere.

Figure 1: The evolution of consensus forecasts for 2022 for US consumption and real income growth

Saturday Night Live (SNL) held a fireside chat with Former Fed Chairman Paul Volcker and current Fed Chair Jerome Powell. Here's a replay of their conversation.

Fed Powell. It is an honor to be on the same stage with you. I think of you as one of the greatest public servants in the history of the Federal Reserve.

Paul Volcker. Thank you. Those are very kind words. How goes it at the Fed nowadays.

Powell. Well, we have a little inflation problem.

Volcker. How bad is it?

Powell. Consumer prices (CPI) have risen 7.9% in the past year. But at the Fed, we focus on the personal consumption expenditure (PCE) deflator, which has only increased 6.1%.

Volcker. Why does the Fed look at the PCE and not the CPI? The CPI is what people pay for things, and the PCE includes a lot of non-market prices.

Powell. That is true, but increases in the PCE run less than CPI, making it look like inflation is less high and harmful. The Fed is in the game of trying to influence expectations, so we picked the lower number of the two.

Volcker. Selecting a price measure simply because it produces a lower inflation rate is not sound monetary policy. Good policy decisions flow from unbiased and accurate statistical information.

Powell. That is fair. But we are in the business of managing people's expectations so picking an index with a lower number helps.

Volcker. What is this rental equivalence that has replaced house prices in the measures of inflation?

Powell. It is supposed to measure what people can rent their house for if they decide to rent.

Volcker. How is that inflation? The definition of inflation is what people pay for things.

Powell. I know. But rental equivalence makes reported consumer price inflation rise less fast when there is rapid house price inflation, and that makes it appear that the Fed is doing a good job. Remember, it's our job to try to manage people's inflation expectations.

Volcker. But people know inflation when they see it. Nowadays, people have more sources of house prices than they did in the 1970s, so actual inflation or experienced inflation must be much higher. So how much higher would reported inflation be if the CPI were measured similarly to the 1970s?

Powell. Based on press reports, it would be double-digit inflation, equal to the highs of the 1970s.

Volcker. Based on press reports? Doesn't the Fed staff know?

Powell. No. If we don't calculate it, we can overlook it and make it appear that things are always better than they are. Remember, it is our job to try to manage people's inflation expectations.

Volcker. That's a section of monetary policy I never read or learned. So what are the critical drivers or sources of this inflation nowadays?

Powell. Most of the increase in inflation is due to supply shortages and bottlenecks emanating from the pandemic. But in recent months, inflation has broadened.

Volcker. I thought the Fed has consistently argued that inflation is always and everywhere a monetary phenomenon. How fast have monetary aggregates been expanding.?

Powell. We don't look at money nowadays.

Volcker. The Fed is in the business of making money.

Powell. That is true.

Volcker. So how fast?

Powell. Broad money has increased by over 40% in the past two years.

Volcker. How much?

Powell. 40%.

Volcker. Uh-oh! And the Fed is surprised by the surge in inflation?

Powell. We are committed to fighting inflation and plan to front-load official rate increases.

Volcker. Front-load? What do you mean by front-loading?

Powell. Policymakers see the Fed funds rate at 1.9% at the end of 2022 and 2.8% at 2023. So we plan to hit those targets earlier.

Volcker. When I was Fed Chair, front-loading involved lifting official rates before consumer prices surged. It seems to me the Fed is back-loading rate increases, trying to catch up to inflation.

Powell. Remember, it is our job to try to manage people's inflation expectations. So far, people and investors still think we are doing a good job.

Volcker. The pendulum of central banking has fundamentally changed, moving away from things it can control and basing policy success on influencing people's expectations. How did the Fed fall into the trap of assigning so much weight to people's expectations and not actual statistics?

Powell. I hope history will show that we are committed to price stability as much as you were. But, remember, we are judged by a different standard---people's expectations (although no one knows how to measure them)--and not actual inflation.

Volcker. I wish someone could give me one shred of neutral evidence that inflation expectations lead to actual inflation and not that persistent inflation leads to higher expectations.

Powell. When facts change, I will retire my views. Thank you.

Note. Paul Volcker passed away on December 8, 2019. So his responses are my words of what I think he would say today.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.

Personal incomes growth varied widely across the states in 2021:Q4, in large part reflecting great differences in the growth of transfer payments, in turn owing to varying effects of the wind-down of pandemic-related federal unemployment insurance benefits. In addition, the growth of net earnings (employee wages and benefits plus proprietors' income) also differed quite substantially. Texas reported the fastest income growth rate: 9.2 percent, compared to the national figure of 2.4 percent. Texas benefited from rapid growth of net earnings (13.4 percent, at an annual rate, which was tops in the nation) and relatively little deterioration of transfers (-3.6 percent, compared to the national -17.5 percent rate of decline). In very sharp contrast, personal income fell as an 8.7 percent rate in North Dakota, as net earnings plunged at a 15.2 percent rate (transfers rose at a 4.6 percent rate in North Dakota). Developments were similar in other Plains States—declines or weak growth in earnings, with farm incomes down substantially, held down overall personal income, while the rate of decline for transfers was less that elsewhere (in some states other than North Dakota, transfers rose). In Texas's Southwest region transfers were relatively strong (or relatively less weak) and net earnings were strong. In the Far West and New England earnings were strong and transfers were weak. Looking more granularly at income generation, once again the recovery in travel led to enormous increases in income generated in leisure and hospitality in Nevada and Hawaii, but in both states large drops in transfer payments meant that overall personal income growth was relatively unimpressive.

The Fed finally admits it has an inflation problem. Yet, what is the bigger inflation problem and potentially more destabilizing to the economy as it unwinds? Is it the 40-year high in consumer price inflation, or is it the surge and record valuations of asset prices? Of course, policymakers would say it's consumer price inflation. However, I would argue its asset prices since easy money has fueled a record surge in equity prices, lifting macro valuations far above the dot.com bubble.

Asset inflation has been a dominant feature of business cycles for the past two decades or more. And, over the past two years, helped by an avalanche of liquidity as the Fed doubled its asset balance sheet to $8.5 trillion, the market valuation of domestic equities to nominal GDP (i.e., the Buffett Indicator) has jumped to levels never thought possible. At the end of 2021, the market value of domestic equities to nominal GDP stood at 2.55.

It is worth noting that before the pandemic, the Buffett Indicator hit a record high at the end of 2019, surpassing the peak level of the dot.com bubble. In other words, the Fed's easy money policies that resulted in an over-valuation of equities at the end of 2019 created a mind-boggling extreme over-valuation at the end of 2021.

To put the equity market's valuation in perspective, if equity prices dropped 25% in 2022, or a decline four times bigger than the decline in the S&P 500 to date, that would only bring the Buffet Indicator back to the peak of the dot.com bubble. And a drop of nearly double that scale to bring it to the average of the past two decades.

Before the last two years, history shows several years of negative returns following periods of extreme overvaluation. Yet, the S&P equity index has jumped nearly 50% over the past two years, while the Nasdaq is up over 80%. So instead of correcting in value, the equity market moved into a new orbit of over-valuation.

If there are laws of gravity in finance, the equity market is in for a big hurt. That's because monetary policy is a blunt instrument. As policymakers use traditional and non-traditional monetary policy tools to kill the consumer price inflation cycle, it will hit asset prices hard. Moreover, given the scale of over-valuation, the potential decline in equity prices could rival the "big" ones of years past. So investors should take note: history sometimes repeats itself in the world of finance.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.