Friday, April 17, 2015

2% inflation is alive and well

The prevailing inflation meme is that it is dangerously low, and for years central banks have been trying very hard—without much success—to get it to rise. The reality—at least in the U.S.—is that the underlying "core" rate of consumer inflation has been running at close to 2% for over a decade. Energy prices have been the principal cause of variations from this trend. 

The chart above shows the 6-mo. annualized rate of inflation according to the CPI and the Core CPI (ex-food and energy). The experience of the past decade is a great example of why it pays to ignore big swings in food and energy prices. The core rate of inflation has been much more stable, and inflation according to these two indices has been exactly the same since 1986 (2.7% annualized per year). The core CPI is up 1.75% in the past year, and in the past six months it has risen at an annualized rate of 1.77%. It's very likely that the overall CPI will soon be averaging about the same rate.

If we look at the ex-energy rate of consumer price inflation (see charts above), it has averaged very close to 2% per year since 2003. The 10-yr annualized rate of ex-energy inflation currently registers 1.99%, and the year over year rate of ex-energy inflation is 1.84%.

Unsurprisingly, the bond market is very much aware of these underlying trends. As the chart above shows, the expected rate of CPI inflation over the next 5 years (as embedded in 5-yr TIPS and Treasury prices) is currently 1.89%.

The chart above shows the bond market's expected rate of CPI inflation over the next 10 years, which is currently 1.92%.

Inflation is not dangerously low. It is running just below 2%, and that's where it's been for many years and where the bond market expects it to be for at least the next decade. There is no reason for the Fed to be trying to boost inflation. 

Wednesday, April 15, 2015

Why the drop in industrial production is actually good news

Industrial production fell much more than expected in March (-0.6% vs. -0.3%), but the weakness was driven by good news: lower oil prices and better weather.

The chart above compares industrial production in the U.S. and in the Eurozone. The U.S. has registered a staggering amount of growth in recent years, leaving the Eurozone in the dust. One piece of good news is that the Eurozone economy is now beginning to grow again after languishing for the past five years. Production in the U.S. has been soft (down 1%) for the past four months, however. Is this the beginning of another economic downturn? No, and here's why:

The chart above is the oil and gas well drilling subcomponent of the the industrial production index. It's down 40% in the past four months, and the Baker Hughes U.S. rotary rig count is down 50% over the same period. The huge decline in oil and gas drilling activity is directly attributable to the 50% drop in oil prices that began last summer. The world now enjoys a glut of oil and sharply lower oil prices, and that's great news. We can now devote more of our economy's scarce resources to the production of other, more useful things.

The chart above shows the utility subcomponent of the industrial production index. March weather was much better than February's, with the result that the output of the utility industry fell almost 6% in March. That's more good news.

Manufacturing production (which excludes utilities), shown in the chart above, was up in March and is only down 0.7% in the past four months. That could easily be attributable to the west coast port slowdowns, but in any event is in keeping with the normal historical volatility of this index. It's still up 2.4% over the past year.

Business equipment production, shown above, was also up in March and a little soft in recent months, but not by a significant amount. It's still up 3.2% in the past year, which is a bit more than overall GDP growth.

Tuesday, April 14, 2015

Ignore the recent weakness in retail sales

Retail sales in the first quarter of this year were obviously impacted by lower gasoline prices and bad weather. Both of those have faded in importance, however, so it's important to see if there has been any change in the underlying trends. As I see it, nothing much has changed. The economy continues to grow, but at a disappointingly slow pace compared to other recoveries. Many argue that this is the "new normal" and reflects durable demographic changes. I think demographics is only part of the story (they don't change dramatically from one year to the next), and the bigger story is the burden of government (high marginal tax rates, massive income redistribution, egregious regulatory burdens). These latter conditions don't have to be permanent, and can change for the better, so there is reason to hope for stronger growth in coming years. 

The chart above shows nominal retail sales ex-Autos and Gasoline. This series has been growing at about a 4% annual rate since mid-2009. Sales today are almost 15% below where the could have been had the economy recovered back to its long-term trend. This is the measure of our discontent.

Oil prices have been extremely volatile since 1970, but in real terms they are now close to their average for the past 45 years. As the chart above suggests, big declines in the real price of oil have been reliably associated with a growing economy, and big increases in oil prices have almost always been followed by recessions. So it is reasonable to think that the weakness in retail sales in the first quarter will be followed by stronger growth in the current quarter. Money saved as a result of cheaper gasoline is likely to be spent on other things, and lower energy prices in general lower the economic hurdle rate for new economic activity.