Thursday, February 4, 2016

Productivity is the missing ingredient


We've know for years that this recovery is the weakest post-war recovery on record, and the chart above makes the case. If this had been a typical recovery, national income (GDP) would be about $2.8 trillion higher than it is today. That's like saying that average wages and salaries would be 17% higher. For a family earning $60,000, that's over $10,000 more income per year that has failed to materialize despite all their hard efforts.


What's been lacking is productivity (the additional output that each unit of labor produces), because productivity is the key to rising prosperity. We can only earn more if we work and produce more. We've had about the same rate of jobs growth during this recovery as we had in the 2001-2007 recovery, but GDP growth has been much weaker. The reason? Very low productivity growth, as seen in the chart above. I use a 2-yr rolling annualized growth rate to measure productivity, since it is quite volatile on a quarter-to-quarter basis. Over a 2-year period I think the quarterly volatility tends to wash out and a truer picture is revealed. Note that the productivity readings we've had in the past several years have always been associated in the past with recessions. It's no wonder that everyone keeps complaining about the economy. It's as if we've been living in recessionary conditions even though things have been slowly improving. Put another way, we've had to work unusually hard just to enjoy very modest improvements in our standard of living. 


The chart above uses the same data, but instead of a two-year rolling period, it uses a 5-yr rolling period. This, I believe, captures the effect of policies put in place by different presidential administrations. It can take years for policies to be put into effect and then have an impact on the economy, and good policies can have effects that last even after they have been reversed.

The colored bars correspond to different presidential terms, with the red bars reflecting a sustained period of declining productivity growth and the green bars a sustained period of very strong and/or rising productivity growth. I would be quick to note that Republican administrations have yielded three periods of declining productivity (Eisenhower, Nixon, and Bush II), while Democratic administrations have only yielded two periods of declining productivity (Carter and Obama). No political party can lay a claim to implementing policies that consistently lead to sustained rises in prosperity.

One thing that stands out is that the Obama years have seen productivity growth that rivals the malaise that characterized the Carter administration. For the five-year period ending last December, non-farm productivity rose at a miserably slow 0.3% annualized rate. In all of post-war history, only the five-year period ending in mid-1982 was worse (small footnote: Reagan's tax cuts did not take effect for almost two years, so his faulty implementation of tax cuts only served to prolong the declining productivity of the Carter years).

There are many factors that contribute to the slow growth of productivity, such as rising regulatory burdens that increase the cost of economic activity, high marginal tax rates that reduce the incentive to work and invest and take risk, and transfer payments that create a culture of dependency and a reluctance to seek out work.


The charts above show that a significant increase in transfer payments (money the government gives to people for a variety of reasons) beginning in late 2008 corresponded to the beginnings of a significant decline in the labor force participation rate. Many millions of workers have left the workforce, and it could be due at least in part to the fact that the benefits that accrue to those not working (e.g., food stamps, disability payments, welfare, earned income credits, assistance to single-parent families) are greater than the net benefits of working, especially on an after-tax basis. Transfer payments now equal almost 20% of disposable income, and that is a big number that currently totals $2.7 trillion and consumes fully 72.5% of all federal government spending. Yikes! Maybe it's simply the case that our government has grown to the point where it is now suffocating the private sector. Too few people are working and too many are on the receiving end of federal largesse. And for those who are still working, the burden of complying with regulations and the burden of taxes is simply inhibiting their ability to work and invest more.

We are not going to see significant improvement in productivity and living standards unless and until we adopt policies that are more conducive to work, investment, and risk-taking. It's that simple. Unfortunately, the proposals being discussed on the left (e.g., Sanders and Clinton) are only going to exacerbate the current situation. Can the right produce a candidate capable of winning and turning the policy ship around? That is the key question this year.

Tuesday, February 2, 2016

Are commodities bottoming out?

The world is still obsessed with the prospect of Chinese weakness, Fed tightening, collapsing commodity prices and super-low oil prices, all of which might—or so the thinking goes—tip us into a deflationary downward spiral. When a narrative such as this becomes so widespread, it's easy to miss important clues to the contrary. I note here a few contra-indicators which bear watching:



The first chart above shows a short-term view of the CRB Raw Industrials commodity index, while the second gives you the long-term view of the same index. This index is composed of some pretty mundane commodities (hides, tallow, copper scrap, lead scrap, steel scrap, since, tin, burlap, cotton, print cloth, wool tops, rosin, rubbers), most of which do not have associated futures contracts and are therefore relatively immune to speculative forces and thus more likely to reflect the changing balance between supply and demand. Since late November, the index is up more than 5%—after tumbling more than one-third from its early-2011 high. As the second chart shows, the plunge in recent years is similar—if not greater—in magnitude to other plunges, all of which were followed by reversals to the upside. Maybe the Great Commodity Price Collapse has come to an end?


As the chart above suggests. Commodities have a strong tendency to move inversely to the dollar's value vis a vis other currencies (note that the y-axis for the dollar is inverted). It might be the case that the dollar is topping out here, just as commodity prices bottom out. [Update: the original chart was mislabeled, now corrected with data as of Feb 3]


This index (see chart above) of the dollar's value against a small basket of major currencies shows that the dollar has been flat for almost a year, another indication the dollar is topping out.

What could be the impetus for the dollar to stop rising? Simple: the perception that the U.S. economy is weak and that therefore the Fed is unlikely to raise rates aggressively. Indeed, I think that process is already underway. Since June of last year, March '18 Eurodollar futures (tied to 3-mo. Libor) have fallen from 2.4% to 1.2%. The market was expecting at least four tightenings by the Fed and now it is only expecting two more over the next two years. With the greatly-reduced prospect of higher short-term rates (and less-than-previously-expected Fed tightening), the dollar is losing some of its appeal.

So, whatever it is that is slowing down the U.S. economy is also reducing the appeal of the dollar, and that in turn is helping to put a floor under commodity prices. And the end of declining commodity prices—particularly if this includes oil—should help alleviate fears of a deflationary death spiral. Markets have a way of resolving things if left to their own devices.

This is not a call for shorting the dollar or going long commodities. It should be taken more as a note of caution that the prevailing wisdom may be getting long in the tooth, and changes may be waiting in the wings.

UPDATE (Feb 3): Well, this change seems to be unfolding all of a sudden. The market senses that the economy is weak, and that therefore the Fed is unlikely to raise rates aggressively. That directly undermines the value of the dollar, which had been boosted by the perception that the US economy was doing much better than others, and that the Fed would be boosting rates. A weaker dollar (which  today is on track for its biggest drop in seven years) provides support to commodity prices, and that is showing up in a huge increase (7-8%) in oil prices today. The stock market is breathing a sigh of relief, as the threat of tight money recedes and higher oil prices reduce the risks of widespread bankruptcies in  the oil patch.

Friday, January 29, 2016

The yield curve says "no recession"

Because of the way the Fed conducts monetary policy, the Treasury yield curve can tell us a lot about the market's expectations for economic growth and inflation. Currently, the yield curve is saying that the market expects to see modest economic growth of 1 - 2% for the foreseeable future, with modest inflation as well, in the range of 1.3 – 1.6% per year over the next five to ten years. 

Central banks have only three choices when it comes to policy tools. They can either control the money supply, interest rates (short or long, but not both), or the exchange rate, and only one of those at a time. After choosing one, they must accept the market's verdict on the others. Any attempt to control more than one of these monetary variables will inevitably end in tears, as the central banks of Argentina and many other developing economies can attest.

The Fed long ago decided that it would conduct monetary policy by controlling overnight interest rates (i.e., Fed funds). For many years the FOMC would add or subtract reserves from the banking system in order to keep the Fed funds rate (the rates banks charge each other to borrow reserves) at or near the Fed's target. Beginning in late 2008, the Fed modified this strategy, since it purposefully supplied trillions of excess reserves to the banking system. With a super-abundance of reserves, banks essentially have no need to borrow more, so the traditional Fed funds market no longer exists. The Fed solved that "problem" by deciding to pay interest on excess reserves (IOER), and that rate became the de facto Fed funds rate, enforced recently by allowing non-bank institutions to enter into reverse-repo transactions with the Fed and thus effectively earn the same rate that major banks can by holding excess reserves at the Fed.

The evidence to date is still relatively scant, but it looks like things are proceeding according to the Fed's plan. Libor, the rate that the market demands for lending to banks instead of to the Fed, is trading around 60 bps, which is somewhat higher than the 50 bps that banks earn by lending money to the Fed (i.e., by holding excess reserves at the Fed), and that makes sense. In other words, the Fed appears to have found a way to target the overnight risk-free rate by simply changing the rate it pays on excess reserves. The Fed's primary tool—short-term interest rates—hasn't changed, but the method of implementing it has.


Regardless, it is important to remember that the Fed can only control short-term rates. As three Quantitative Easing episodes from 2008 through 2014 demonstrated, despite the Fed's massive purchases of notes and bonds, 10-yr Treasury yields actually rose (see chart above). This put the lie to the Fed's professed objective of buying notes in order to artificially lower yields and thus "stimulate" the economy. As I've explained many times over the years, the real purpose of QE was NOT to lower bond yields and stimulate the economy—the real purpose was to supply the world with more risk-free monetary assets (aka bank reserves, which, with the addition of IOER, became T-bill substitutes) in order to satisfy the world's intense demand for money and safe assets in the wake of the 2008 financial crisis. The Fed did this by buying notes and bonds and "transmogrifying" them into T-bill equivalents. This was neither stimulative nor inflationary, since the Fed was simply supplying the money that the market wanted to hold.

Since the Fed can only control short-term rates, observing longer-term rates can tell us a lot about the market's expectations for the future of Fed policy. 2-yr Treasury yields, for example, are equivalent to the market's guess as to what the Fed funds rate will average over the next two years. The current 2-yr yield of 0.8% is a function of the market's expectation that the Fed funds rate will rise from 0.5% today to 1% or so two years from now. This expected path of the funds rate is consistent with a forecast of modest economic growth and low inflation. It is not consistent with an expectation of recession.

Market equilibrium tells us that, collectively, investors at any moment in time must be indifferent between earning the prevailing overnight risk-free interest rate for two years or investing their money in a 2-yr risk-free security and holding it for two years. Ditto for 5-year yields. But when it comes to 10-yr yields, the analysis becomes trickier, since the market invariably demands some kind of premium for locking in yields for such a long period. Nevertheless, looking at the difference between 2-yr and 10-yr Treasury yields can tell us a lot about what the market expects from the Fed over the next several years.



The two charts above show the history of 2- and 10-yr Treasury yields and the difference between the two, which is the slope of the yield curve. Note that the slope of the yield curve typically flattens or inverts (becomes negative) in advance of recessions. This is the bond market's way of saying that emerging weakness in the economy is putting a lid on the Fed's ability to raise short-term rates, and that it is increasingly likely that the Fed's next move will be to cut, rather than raise, rates. The current slope of the yield curve is not unusual at all, and is typical of the middle part of a business expansion. The market doesn't believe the economy is going to be weak enough to warrant lower short-term rates for the foreseeable future.


The chart above compares the nominal yield on 5-yr Treasuries with the real yield on 5-yr TIPS, the difference between the two being the market's expected annualized rate of inflation over the next 5 years, currently 1.3%. This is relatively low, but not unprecedented and not of great concern. Indeed, I would be thrilled if inflation were to average 1.3% per year for the foreseeable future. Inflation is pernicious, penalizing savers and rewarding borrowers, and is effectively a backdoor way for the government to avoid the full consequences of its spendthrift ways. The lower the better, in my book.


The chart above compares the real yield on 5-yr TIPS with the 2-yr annualized rate of real GDP growth. These rates tend to track each other, with real yields on TIPS tending to be a point or so less than the economy's growth tendency over the past two years. That makes sense: you can lock in a risk-free rate of return on TIPS, or you can take your chances with the real growth of the economy. Risk-free yields should always be less than riskier returns. As I read this chart, the market is expecting real GDP growth to be between 1 and 2% for the next few years, which is a bit less than the 2.1% annualized growth of the economy in the current business cycle expansion.

There's not much to get excited or worried about here. The market is (not atypically) projecting that recent trends in growth and inflation will persist for the foreseeable future.


Meanwhile, as the chart above suggests, this continues to be the weakest post-war recovery on record. If this had instead been a "normal" recovery, the economy today would be about 15% ($2.8 trillion!) bigger. Rather than worrying about a recession, we should be obsessed with finding ways to get the economy back on its long-term growth path. (Hint: smaller government, reduced regulatory burdens, lower and flatter marginal income tax rates, and much lower corporate tax rates.)

It's the unrealized growth potential of the economy that is the big news, not the risk of recession.