Market to Fed: two rate cuts needed

We're in the midst of a mini-replay of the drama surrounding Fed policy that played out late last year and early this year. Back then the market was telling the Fed that it was mistaken in planning two more rate hikes this year, but it took the Fed a bit too long to figure that out, and that in turn led to a severe equity market selloff. But in the end they did figure it out, and they apologized to boot. Now the bond market is telling the Fed that at least two rate cuts are needed. They are needed to offset the increased uncertainties surrounding Trump's trade/tariff wars, which have now expanded to include Mexico, and the general malaise which has kept economy's growth potential from being fully realized.

Higher tariffs reduce future economic growth expectations and increase general uncertainty (e.g., what if tariff wars escalate further? what if China stumbles and brings down the rest of the world with it?). If the Fed fails to offset the increased demand for money this creates, then deflationary forces will take root and the risk of a recession (though still very low in my estimation) will increase.

Chart #1 

Chart #2 

In Chart #1 we see the significant decline in both nominal and real yields that has occurred since their November '18 peak. 5-yr Treasury yields have fallen over 100 bps, from 3.1% to 1.96%. 5-yr TIPS real yields have fallen by 80 bps, from 1.16% to 0.36%. Inflation expectations are down to 1.6%, but that could be largely due to the recent decline in oil prices, as shown in Chart #2.

Chart #3

Chart #3 compares the current real Fed funds rate (blue line: the difference between the Fed's target funds rate and the year over year change in the PCE Core inflation rate) with the market's expectation of what that real rate will average over the next 5 years (red line: the real yield on 5-yr TIPS). The message here is that the front end of the real yield curve is inverted, and that is a sure sign that monetary policy as it stands today is a bit too tight. Whereas the Fed says it is likely to stand pat for the foreseeable future, the market is saying they need to cut the funds rate target to 2% (vs the current 2.5%), and hold it there for the foreseeable future. The last two recessions were preceded by a similar inversion of the real yield curve (i.e., the blue line exceeding the red line), but the one important difference between now and the last two recessions is that real rates were much higher then than they are now. Red lights are flashing today, but this is not a four-alarm fire; it's more like the need for some modest adjustment to policy.

Chart #4

Chart #4 is the best chart to illustrate the impact of monetary policy on the economy. It combines the real Fed funds rate (blue line: the true "cost" of borrowing money) with the slope of the Treasury yield curve (red line: the difference between 1- and 10-yr Treasury yields). When the yield curve is flat or inverted and real interest rates are high, a recession has always followed. Today the yield curve is flat, but real interest rates are still relatively low. The current situation is problematic, but a recession is not imminent or foreordained. 

Chart #5 

Chart #5 is the classic way to look at the shape of the nominal Treasury yield curve, as measured by the difference between 2- and 10-yr Treasury yields. Here we see that the nominal curve is still somewhat positively-sloped. Again, a recession is not foreordained nor imminent. The market is sending a strong message to the Fed, and the market is betting that the Fed will respond accordingly.

Chart #6

If the Fed were really, really "tight," we would be seeing swap spreads rise, which would be an indication that liquidity conditions were deteriorating. Instead, we see swap spreads falling (see Chart #6). I interpret this to mean that the market is buying swap spreads in addition to Treasuries (pushing both yields down), in an attempt to hedge against the risks posed by Trump's tariff wars. We saw the same action in late 2015, when real GDP growth fell almost to zero. (That was also the time when oil prices collapsed from $100/bbl to $30/bbl, creating shock waves throughout the oil industry that threatened to spread to the rest of the economy.) The Fed is not really "tight" today, since they are not trying to restrict liquidity; they are simply keeping short rates a bit too high. The fundamentals of the economy are still sound, but the market is worried and so the market is paying up for bond-market hedges like swaps and bonds.

Chart #7

Chart #7 tells the same story. Credit Default Swap spreads have moved up a bit, but they are still relatively low. The market is only marginally concerned about the outlook for corporate profits. We're talking about a slowdown in growth, not a recession.

Chart #8

Chart #8 shows the market's expectation for what the Fed's target funds rate will be by the end of this year (as derived from Fed funds futures). From its high point of 2.93% last November (which implied two tightenings), the market now sees the funds rate target falling to 2% (which implies two easings). If the Fed doesn't get this message and act on it soon, then we might expect problems.

Chart #9

Finally, Chart #9 shows how the equity market is dealing with these issues. Fears (as measured by implied equity option volatility, or the Vix index) are up and growth expectations (as measured by the 10-yr Treasury yield) are down, which adds up to a moderate spike in the Vix/10-yr ratio. Equity prices have responded by falling, as they have during past "worry" episodes. The current episode is not yet of the significant variety, however. The Fed still has some time to react, but they shouldn't delay too long.

Truck tonnage looks quite bullish

I've been tracking truck tonnage for a long time, and it's been a reliable—and generally bullish—indicator of underlying economic activity. It measures the actual tonnage of freight hauled by the nation's carriers, and this physical measure of the economy's size has also tracked the gains of the US equity market. Truck tonnage surged almost 8% in the year ending April '19, and it's up 22% since just before the November 2016 elections.

Chart #1

As Chart #1 shows, there's a pretty close relationship between truck tonnage and equity prices. Today there is a sizable difference between the two, with truck tonnage suggesting the economy is virtually booming, whereas the equity market has been dominated by caution for the past year or so. Estimates by the Atlanta and NY Fed put real GDP growth in the current quarter at a miserable 1- 1.5%. As happened a few months ago (see Chart #11 in this post) the stock market may still be overly cautious about growth. Recall that Q1/19 growth came in substantially higher than expectations.

Chart #2

Chart #3

Charts #2 and #3 show the two major measures of consumer confidence (Conference Board and University of Michigan). Both have surged in the wake of Trump's election, and despite setbacks in late 2018 and early 2019, have rebounded of late. I won't try to minimize all the negatives that are out there (e.g., flat housing starts, flat car sales, tariff wars, very low bond yields, and expectations that the Fed will need to cut rates 2-3 more times to bail out a struggling economy). I'm just suggesting that things might not be as bad as the market thinks. 

Headwinds to progress; how too much government makes life difficult

John Cochrane is one of my favorite economists, and I regularly read his blog. One of his latest posts is on the subject of minimum wages—how they make no economic sense but yet there are plenty of folks who nevertheless try hard to find ways to justify them. Included in his post is a list of other policies that governments have imposed on us that are supposedly designed to make things better but which eventually lead to perverse and unexpected results. I expand on his list here:

• Minimum wages. If the minimum wage that a policymaker sets is higher than the wage which would result from market forces, the eventual result will be an increase in unemployment among those who lack skills. Businesses can't afford to pay a worker more than a worker's value added; that’s a basic economic fact. Moreover, as I mentioned in this post, fewer than 1% of all those who work make minimum wage or less. The minimum wage affects very few people, but those affected are precisely the ones who would be better off without it, especially when it’s set too high. The real crime is that a high minimum wage makes it difficult for those who are just entering the workforce to get the opportunity to work and learn. Almost everyone who works today makes more than minimum wage, and that’s because they have learned skills that are valuable thanks to their first job. Once you get started in the workforce, you inevitably learn and with time you make more money because you can bring more value added to the table.

• Labor laws, regulations, and taxes. By raising the cost of hiring and retaining workers, these policies end up reducing employment, especially among less-skilled workers. If it's difficult and expensive to fire workers who don't live up to expectations, businesses will naturally be less willing to hire in the first place. The goal of public policy should be to make it easy to hire those who are just starting out; not to make sure that those hired earn a “living wage.” That comes later.

• Public education. By eliminating competition and choice, too many public schools—especially those in disadvantage neighborhoods where two-parent households are scarce and unable or unwilling to play a role in their children's education—end up being run for the benefit of unionized teachers rather than pupils. Imagine how life would be if we all had to shop at a state-run supermarket. As Milton Friedman once said, public education is more properly termed “state” education. The state is not well-equipped to run anything, because state-employed workers don't face the discipline of market participants. Competition is good for business, and it’s good for schools. We need more Charter Schools, not fewer.

• Criminal justice pathology. Draconian drug laws, life-destroying treatment of innocents, lack of education and training, and laws and rules against hiring people with criminal records are a plague on our society.

• Zoning and building restrictions. These make it difficult for housing to be built and located close to where the jobs are. Which in turn creates the need to commute, which in turn wastes people’s time and money and pollutes the air. These policies also contribute to housing shortages in areas where jobs are abundant, which in turn make homes less affordable, which in turn hurts lower and middle-income folks the most. Silicon Valley is proof. I've heard it said by the folks at Cato that in California, 95% of the population lives on only 5% of the land. No wonder housing is so expensive here.

• Occupational licensing. A thousand hours of training and a big test just to open a nail salon? That’s insane. It’s like death by a thousand cuts: restrictions on low-price, low-income entrepreneurship. 

• Business licenses. Zoning that disallows businesses in residential areas, laws that make it hard to hire people -- all of which send low income people to the illegal economy, which is a poor way to transition to the legal economy.

• Disincentives built into social programs can easily create 100% marginal tax rates for many. Subsidies sound great, but they almost always have a cutoff point, beyond which a person loses the subsidy. Earning just one dollar more might mean losing a benefit that is a significant fraction of one's income. That equates to a very high marginal tax rate, which then becomes a huge disincentive to make more money. See this post of mine from several years ago which expands on the subject.

• Disincentives of "affordable" or other subsidized housing. When my local government mandates that new housing projects include "affordable" homes, I immediately think that mandating subsidies is a very stupid and inefficient way of helping those who really need the help. Who pays for the subsidies? Those who work hard enough to pay for non-subsidized housing. That just makes housing more expensive for everyone. And who decides who qualifies to buy artificially cheap housing? Politicians, of course, who are incentivized to do that which is likely to boost their reelection chances. The lucky few who get cheap housing are incentivized to re-sell it at market prices as soon as they are able. And the people who end up in subsidized housing located in choice areas most likely don't have the means to maintain their properties as normal owners do.

• Social background: Many people grow up in neighborhoods where there are no two-parent families, few adults with permanent jobs, widespread crime, no business. Government actions bear a lot of the blame for these conditions, which in turn result in the deterioration of homes in marginalized areas of the economy.

When you consider the magnitude and the pervasiveness of all these policies, it's a wonder that we are doing as well as we are. If there's a reason to be optimistic it's because there are so many problems all around us that could be fixed for the better without too much difficulty.

U.S. and China play Trade Chicken, and both are likely to win

Global markets are in the midst of another panic attack that appears to be the direct result of an escalating game of trade-war chicken between the US and China. Who's likely to win? I believe the odds are in favor of the U.S. winning, especially since a trade deal with China to Trump's liking is likely to end up being a win-win for all concerned.

The vast majority of economists would agree that the best trade policy is free trade, with no tariffs, barriers to entry, or subsidies. Free markets and global trade have proven to be the best way to promote global prosperity. Tariffs are best viewed as a tax on imports, with the cost being paid by the consumer, not by the producer. Taxes serve only to reduce private consumption in order to fund public consumption, which in the end is less efficient. The country that taxes its imports least is therefore the country that will benefit most from trade. By the same logic, countries that subsidize their exports only hurt themselves while benefiting those who buy their subsidized goods and services. (We should welcome any country's subsidies!)

The vast majority of economists would also agree that there are second-order effects that stem from tariffs. By making imported goods more expensive, countries that impose tariffs on imported goods give domestic producers a degree of "protection" to the extent domestic producers can charge higher prices and still compete with imports. But this only reinforces the argument that at least part of the cost of tariffs is born by consumers. Protectionists also argue that tariffs save jobs—and to some extent they do, in the "protected" industries—but only at the expense of consumers. Tariffs, in short, benefit a relative few at the expense of the many.

Trump understands this, and said so at the G7 summit meeting last year: "That’s the way it should be, no tariffs, no barriers … and no subsidies. ... that would be the ultimate thing." The only way to understand Trump's apparent love for tariffs today is that they are, as Larry Kudlow noted a few months ago, "a negotiating tool. They are part of his quiver." And tariffs are a policy tool over which Trump has direct control. That makes tariffs irresistible to deal-maker Trump.

A war of escalating tariffs between the US and China would be damaging to both countries. If carried to an extreme, a tariff war with China would most likely endanger the global economy by weakening both the huge U.S. and Chinese economies. Bad! And in that sense Trump is crazy to be engaging in a tariff war with China. Worse, he falsely argues that his tariffs are paid by the Chinese and that the money goes straight to the federal government's coffers. To his credit, Trump's economic advisor (and my good friend) Larry Kudlow yesterday correctly admitted that tariffs are in fact paid by U.S. consumers, not the Chinese. But he also correctly added that higher U.S. tariffs will hurt the Chinese as well. So the question then becomes, Who will suffer the most? Who will likely back off from this game of chicken the first?

Tyler Cowen is a well-respected economist at George Mason University who has a reputation for not having a partisan bias. Today he wrote a column for Bloomberg (which certainly does have a strong liberal bias) in which he argues persuasively that China stands to lose more from a trade war than the U.S. does, even though it is clear that Trump's higher tariffs on Chinese imports impose burdens on U.S. producers and consumers.

Here's Cowen's conclusion (read the whole thing for the important details):

In my numerous visits to China, I’ve found that the Chinese think of themselves as much more vulnerable than Americans to a trade war. I think they are basically correct, mostly because China is a much poorer country with more fragile political institutions.

My argument isn’t about whether Trump’s policy toward China is correct. I am only trying to get the basic economics straight. Next time you hear that the costs of the trade war are simply being borne by Americans, be suspicious. In their zeal to make Trump look completely wrong, on tariffs or other issues, too many commentators pick and choose their arguments. A more fair and complete economic analysis indicates that China is also a big loser from a trade war. Trump’s threats are exerting some very real pressure on the country.

Markets are usually efficient at discounting the future, if only because they reflect the consensus of millions of participants with skin in the game. Right now they are saying that although both the U.S. and Chinese economies are hurting, the Chinese are hurting more.

Chart #1

Chart #1 compares the value of yuan vis a vis the dollar (blue) with the level of China's foreign exchange reserves (red). Here we see that since the beginning of the U.S.-China tariff war (March-April 2018) the yuan has fallen by about 8% vs. the dollar. That means that the amount of yuan that Chinese producers receive for each dollar of sales to the U.S. has fallen by 8%. This chart also shows that China's foreign exchange reserves have been relatively stable for the past 30 months, at just over $3 trillion. China's central bank is apparently targeting a stable level of reserves, and allowing the yuan to fluctuate in value as capital attempts to enter or leave the country (this is a legitimate monetary policy, though one not often used). The weaker yuan thus directly reflects weaker net investment in China and a loss of Chinese purchasing power. Bad!

As Cowen notes in his column, China's lack of "guarantees against espionage, intellectual property theft and unfair legal treatment ... makes investing in China less desirable for many multinationals, not just U.S. ones." If China were to agree to Trump's demands in these regards, its economy would almost certainly benefit from increased investment and a stronger yuan. Good!

Chart #2

Chart #2 compares the value of the MSCI China Index (in HK dollars) to the value of the S&P 500. Chinese equities have greatly underperformed their US counterparts since China's "opening" to the world in 1995. Moreover, since the US/China tariff war started last year, Chinese equities have fallen by almost 18% relative to US equities. Equity markets are clearly saying that China will be the biggest loser.

Chart #3

Chart #3 shows that Chinese exports to the US and imports from the US have both fallen since the beginning of Trump's tariff war (in dollar terms). This is the result not only of a reduced volume of trade but also the yuan's reduced value. US/China trade represents a far greater share of China's economy than it does of the US economy: China's exports to the US are roughly 4 times greater than China's imports from the US, while the US economy is roughly half again as large as China's. China thus stands to lose much more from any trade disruptions.

Chart #4

Chart #4 quantifies the market's renewed sense of unease over trade relations. Though not yet as acute as what we saw late last year, it's a similar pattern. Rising fears are driving down the value of equities.

Meanwhile, swap spreads and credit spreads remain relatively low. Liquidity conditions have not deteriorated, the Fed is not too tight, the dollar is not collapsing, and the US economy is likely to continue growing. What we see in the markets today is another panic attack which will likely be assuaged once the Chinese figure out a face-saving way of capitulating to Trump's demands. That shouldn't be too hard, since it ultimately will lead to a positive result for both the US and Chinese economies.

Bye Bye Misery

This post is a paean to progress. The average person living in the U.S. has never had it so good, by any number of measures.

Chart #1

The Misery Index was invented decades ago by Arthur Okum, and it originally consisted of the CPI inflation rate plus the unemployment rate. A low reading means that inflation is low and unemployment is low, and that brings a measure of stability to the life of the average working person. I've made a minor modification to that in Chart #1, substituting the rate of inflation according to the Core Personal Consumption Deflator (which also happens to be the Fed's preferred measure of inflation. But no matter how you calculate it today, the Misery index as low as it has ever been in my lifetime. Both inflation and unemployment are very low, and that is great news for the average person.

Chart #2

Chart #2 is the result of dividing first-time claims for unemployment by the total number of people working. This is akin to the probability that the average worker will find him or herself unemployed in a given month. Currently that probability is less than 0.2%. It's never been so low, by a long shot.

Chart #3

Chart #3 is a picture of the average worker's nirvana: when there are more job openings than there are people looking for work. This, plus the fact that unemployment is very low makes the current environment the best time in many generations to be looking for a job.

Chart #4

When I was 10 years old, over one-quarter of the average person's annual spending went for food and energy, as shown in Chart #4. Today, thanks to drilling advances, modern agriculture and greatly expanded global trade, that figure has come down to just over 10%. Wow.

Chart #5

Despite our materialistic lifestyles and ever-rising consumer debt, the average household's financial burdens today are no higher than they were 40 years ago, as shown in Chart #5.

Chart #6

Chart #6 illustrates the relative behavior of the prices of services, non-durable and durable goods since 1995, which not coincidentally happens to be the year that China started exporting durable goods to the world in earnest. If you consider that services prices are basically driven by wage and salary income, then one hour's worth of labor today buys about three times more durable goods than it did in 1995 (1.84/0.62). I don't know of any measure of material progress in recent years that is more impressive than this. Is there anyone who can't afford a flat-screen TV or a cellphone these days?

Chart #7

But what about the supposedly huge increase in income and wealth disparity? Well, the rich may be getting richer than the poor are getting richer, but they are picking up the lion's share of the $3.3 trillion in taxes collected by our federal government in the past 12 months, as Chart #7 shows. According to the Tax Policy Center (a joint venture of the left-leaning Urban Institute and the Brookings Institution) the top 40% of income earners pay 86% of all federal taxes, while the bottom 40% pay only 14%. If you want to narrow that down to the top 20% and the bottom 20%, the tax disparity is even more dramatic: the rich pay over two-thirds of all federal taxes, while the poor pay less than 1%. Politicians have just about run out of room to increase rich people's "fair share" of the total tax burden, which I suppose should be added to the list of things to be grateful for these days.

UPDATE: For more on how things have improved dramatically over the years, I recommend the Cato-sponsored Human Progress site.

Productivity makes a comeback

Productivity is essential to economic growth and progress, so it's great news that productivity has picked up in the past two years. Productivity happens when an economy produces more from a given level of input, and that in turn usually means that businesses have invested in productivity-enhancing things such as machinery, tools, and computers, all of which allow workers to produce more with a given amount of effort or time. Productivity is also likely to result from a reduction in the costs of running a business, and that in turn usually means less red-tape, and reduced tax and regulatory burdens. Rising confidence can also help, since that helps give people the courage to work harder and take risk. Rising confidence can also make entrepreneurs more inclined to start new businesses and expand existing ones.

Chart #1

Happily, business investment has picked up in recent years, tax and regulatory burdens have declined, and confidence has surged. Even though jobs growth hasn't picked up much, if at all, in recent years, output has (see Chart #1). That's productivity in a nutshell: getting more output from a given amount of input.

Chart #2

Today we learned that first quarter productivity rose at a surprisingly strong 3.6% annual rate. Chart #2 shows the year over year change in productivity, and how the recent pickup coincides with the beginning of the Trump Administration.

Chart #3

However, productivity can be and usually is a volatile statistic on a quarterly and even annual basis, which is why I like to use a 2-yr rolling average (see Chart #3). I've also added recession bars in this chart, since they show how changes in the trend growth of volatility have a lot to do with the business cycle (not surprisingly). Productivity typically picks up after a recession ends, and it usually—but not always—fades as the business cycle matures. The current business cycle got off to a bang with very strong productivity growth in the last three quarters of 2009, but then it quickly faded, only to experience sluggish growth for the next 5+ years. It's picked up meaningfully in the past two years, and we are likely still in the early innings of a great productivity comeback.

Chart #4

Chart #4 reduces the volatility of productivity even more, by using a 5-yr rolling annualized average.  This captures the important growth trends which persist for years. The chart also overlays the many different presidencies we've had in the post-War period. I've color-coded each presidency using red for presidencies that saw productivity fall, and green for those that saw productivity rise. The Reagan and Clinton years stand out for their sustained increases in productivity, while the Bush II and Obama years stand out for their sustained productivity declines. This is very instructive: the pro-growth policies of Reagan and Clinton (mainly in his second term) worked because they incentivized private sector work, investment and risk-taking, and that in turn boosted productivity and living standards. Bush II and Obama policies were anti-growth, characterized by increased tax and regulatory burdens and a more intrusive state.

In Trump's first two years there has been a huge and unprecedented reduction in the number of federal rules with adverse economic impacts put into effect, as documented by the GWU Regulatory Studies Center (see Charts #5, 6, and 7):

Chart #5

Chart #6

Chart #7

Chart #8

As Chart #8 shows, Trump's election marked a sea-change in consumer confidence right around the time that productivity began to turn up. We saw a similar improvement in confidence halfway through Clinton's Administration (1997), and that too saw a big pickup in productivity and economic growth.

Chart #9

As Chart #9 shows, Trump's election coincided with the biggest increase in Small Business Optimism in decades. Small businesses are the biggest source of jobs and innovation.

The productivity stars are aligned: rising confidence and reduced tax and regulatory burdens have created the conditions for a big productivity comeback that could last for years. We're just beginning to see the results, and they are encouraging. This gives the economy plenty of upside potential, which in turn means that living standards for nearly everyone should be improving for the foreseeable future.

Memo to all those would-be socialists eyeing the 2020 elections: income redistribution, higher taxes, increased regulations, mushrooming bureaucracies and handing out freebies (e.g., free college, student loan forgiveness, single-payer healthcare) don't create the conditions for increased productivity and rising living standards. On the contrary, they will only make things worse for everyone.