Tuesday, May 17, 2016

Core inflation is a solid 2%

According to the Ex-Energy version of the Consumer Price Index, inflation has been averaging about 2% per year for well over a decade. Of course, when you add back in energy prices—which have experienced gigantic swings from a low of $10/bbl in 1999 to a high of $150/bbl in 2008, to the current $50/bbl—inflation has been quite volatile. But if ever there were a time to ignore the impact of energy prices on inflation, now is the time. In real terms, oil prices today are only about 10% less than what they have averaged since 1970. So focusing on ex-energy inflation is justified and appropriate, since energy prices have increased by almost the same as all other prices, on average, for the past 45 years. Energy is not noticeably cheap nor expensive relative to other prices these days.

The chart above plots the Ex-Energy version of the CPI on a semi-log scale. It shows that inflation has had a strong tendency to average 2% per year. The only thing unusual about the behavior of inflation was in the 2006-2008 period, when core inflation reached almost 3% and ex-energy inflation slightly exceeded 3%. Since then, and despite massive increases in bank reserves, inflation has been remarkably stable and relatively low.

The chart above draws our attention to the current episode of a major decline in oil prices, and the decline of similar magnitude which occurred in 1986. Both times oil prices plunged, only to later rebound. In 1986 the headline inflation rate collapsed, then returned to the prevailing level of core and ex-energy inflation about a year after oil prices started to rebound. This time should be no different. Today we learned that the CPI increased by 0.4% in April, lifting the year over year rate to 1.1%. If the monthly increases in the CPI are only 0.2% per month for the rest of this year, inflation for 2016 would be 2.0%. That's not difficult to imagine at all.

The Fed is well aware of this dynamic, which is why they haven't panicked over the low rates of headline inflation we have seen over the past year or so. What worries them is that the economy remains sluggish and they know that the market is very nervous about the potential for higher rates to weaken the economy further. I don't think another 25 bps hike in short-term rates would do much harm to the economy, but it's hard to make a compelling argument for doing so. After all, inflation is running right around the Fed's target, and the economy is unlikely to soon defy the myriad headwinds which have been holding it back for the past seven years.

The real action these days is in the election dynamics. The future course of fiscal policy could make a world of difference to the economic outlook in coming years. But for the moment the outcome of the November elections is a jump ball. We'll just have to wait and see how things progress in the months to come. I suspect the Fed will reach the same conclusion and stand pat at the June FOMC meeting four weeks from now.

Thursday, May 12, 2016

The end of declining deficits

On a rolling 12-month basis, the federal budget deficit hit a peak of almost $1.5 trillion in February 2010. From that dizzying height of just over 10% of GDP it fell steadily for six years, hitting a low of $402 billion last February, a mere 2.3% of GDP. It's unlikely to get any lower than that, unfortunately, unless and until we see stronger economic growth and/or significant reform to entitlement programs. For the foreseeable future, the budget deficit is likely to get bigger; it's already jumped to just over $500 billion as of last month. There are several culprits: weaker economic growth, weaker tax collections, and a pickup in spending. 

The chart above shows the nominal level of federal spending and revenues on a rolling 12-month basis. Note that spending was flat from mid-2009 through last year, but is now on a clear uptrend. At the same time, it appears that the strong uptrend in tax revenues, from early 2010 through early last year, is fizzling out. Two virtuous trends have reversed. 

The chart above shows the level of federal spending and revenues as a percent of GDP. Note how both have been trendless over long periods.

It's time for policymakers to revisit Hauser's Law: there is a limit to how much tax revenue can be extracted from the private sector, and we are now approaching that limit. Tax rates have risen in the past year or so, but tax collections have weakened. Raising taxes—as both Clinton and Sanders are proposing—will almost surely fail to close our current and projected budget gap, because higher rates will discourage work and investment, while encouraging more tax evasion. 

As the chart above shows, the weakness in tax collections is concentrated in individual and corporate income tax collections—both of which are driven by weaker profits—while payroll tax collections are rising at a 4% rate that is commensurate with the ongoing rise in payrolls and wages. 

The first of the two charts above shows the nominal level of federal budget surpluses and deficits, while the second shows the level as a % of GDP. There's nothing necessarily scary here, since it will be awhile before the deficit rises meaningfully relative to GDP. The larger message is that the budget deficit is going to be returning to the headlines before too long, and politicians who fail to understand Hauser's Law will mistakenly call for a fix in the form of higher tax rates. The correct fix, of course, would be to reduce tax rates, simplify the tax code, and reform entitlement programs in order to keep spending under control.

Friday, May 6, 2016

April jobs report: more of the same

The April jobs report was weaker than expected (160K vs. 200K), but from a big-picture perspective it was no different than what we've been seeing for the past several years. Private sector jobs—the ones that count—have been growing a little more than 2% per year since mid-2011. Add some meager productivity to that number, and it's reasonable to assume that the economy is still growing at a 2 - 2 ½% annual pace. In other words, the weakest recovery in modern times continues.

As the charts above show, April's "weak" jobs growth was par for the course. The jobs number is naturally volatile from month to month. So it's best to look at the change over several months or even a year. On a year over year basis, private sector jobs rose 2.2%; over the past six months, they are up at a 2.1% rate, which is about what they have averaged since mid-2011. Nothing much has changed.

What has changed is the growth of the labor force, which has picked up of late. That explains why the unemployment rate has stopped declining: on the margin, more people are deciding they want to work. This is a positive development.

It's also encouraging that the growth of public sector jobs has on balance been zero for almost 10 years. The physical size of the public sector has been shrinking relative to the private sector, and that makes it easier for private initiative to take root.

In any event, what this means is that the weak GDP growth numbers of the past two quarters are an anomaly that should be reversed via higher numbers over the remainder of this year.