Strong manufacturing report

The March ISM manufacturing indices released today were uniformly strong, pointing to an improving economic outlook in the months to come. In this context, the Fed's recent moves to raise short-term rates do not yet constitute a tightening of monetary policy, nor are they a threat to growth.

The ISM manufacturing index does a pretty good job of tracking quarterly GDP growth, as the chart above suggests. Recent strength in the ISM index is consistent with Q1/17 growth of at least 3-4%, substantially higher than Q4/16 growth of 2.1%.

The strong reading for export orders, shown in the chart above, is particularly encouraging, since it likely reflects improving conditions overseas.

The prices paid index registered its strongest level in many years (first chart above), and that is corroborated by the strength in the industrial commodity prices (second chart). Prices are rising because global demand has proved stronger than commodity producers had anticipated.

Manufacturing firms are becoming more confident about the future, as seen in the chart above which reflects optimistic hiring plans.

It's nice to see that both Europe and the U.S. are experiencing improving manufacturing conditions. Coordinated recoveries can reinforce themselves.

The chart above suggests we are likely to seeing rising revenues per share in the months to come, since the ISM manufacturing index has a strong tendency to lead year over year gains in S&P 500 company's revenues per share.

The chart above shows the inflation-adjusted level of the Fed's short-term interest rate target, using the Fed's preferred measure of inflation, the Core PCE Deflator. This is the true measure of the impact of Fed policy, as the Greenspan Fed made clear in the late 1990s. Short-term rates have been negative in real terms for almost 10 years, and are still quite negative despite three rate hikes since late 2015. Negative real short-term borrowing costs incentivize borrowing (because borrowers can repay their loans with cheaper dollars), thus increasing the supply of money (because banks create money by increasing their lending activity) and reducing the demand for money (because negative real interest rates make holding cash equivalents unattractive). The net result is accommodative monetary policy. If the Fed persists in keeping short-term interest rates negative while economic activity and confidence rise, it risks allowing inflation pressures to rise.

The chart above compares the real Fed funds rate to the level of real yields on 5-yr TIPS. The latter is a proxy for what the market believes the real Fed funds rate will be in 5 years' time. A positive spread between the two indicates an upward-sloping real yield curve, and that in turn reflects the market's expectation that the Fed will likely continue to raise rates in the years to come. The time to worry is when the spread becomes negative (as it did prior to the last two recessions), since that means the market expects the Fed to lower rates in the future because the market senses a significant weakening of economic activity. In short, the chart above tells us that the market is comfortable with the Fed's actions to date.

The chart above shows the level of real and nominal 5-yr Treasury yields and their difference, which is the market's expectation for inflation over the next 5 years. So far we see nothing unusual afoot; the Fed has been managing policy in a manner consistent with relatively low inflation.