The US economy as seen from 30,000 feet

As the Covid-19 panic fades into the sunset, it's time to climb to 30,000 feet and review some of the economy's macro vital signs.

Despite the destructive impact of economic and social shutdowns which resulted in millions of lost jobs and businesses and untold damage to the physical and mental health of even more millions, and despite the government's efforts to ameliorate the damage by borrowing trillions in order to shovel money from the pockets of some into the pockets of many, the economy has emerged in amazingly good shape. In fact, the private sector is wealthier and more prosperous than ever before—although the benefits have undoubtedly been distributed unequally and often rather crudely. The public sector, on the other hand, has rung up a tab that will take generations to cover.

Lurking in the background of this surprisingly good news, however, is inflation, which is very much alive and well and prospering.

Chart #1

The Federal Reserve today released its estimates of household balance sheets, which are summarized in Chart #1. (Nonprofit organizations are included in these numbers.) Household wealth has blossomed, thanks to strong financial markets, lots of saving, real estate appreciation, and only a modest accumulation of debt.  

Chart #2

Chart #2 converts the net worth numbers in the first chart to real (inflation-adjusted) figures. Note that the y-axis is logarithmic, which renders steady growth rates into a straight line. Note further that the real net worth of the US private sector has risen slightly more than an annualized 3.6% per year over the past 70 years. It's worthwhile comparing this chart to Chart #16 in my previous post. Both paint a similar picture: net worth and equity prices have appreciated on average by a fairly steady rate over the long haul, and the trend lines I have added to each chart do a fairly good job of dividing above- and below-trend years into equal amounts. Both suggest that valuations and net worth today are somewhat above long-term trends, but not by an egregious amount. In short, the current period does not stand out in any extraordinary way from our long-standing experience.

Chart #3

Chart #3 uses the data from Chart #2 and divides it by the population of the US to get real per capita net worth (currently, the average person's share of total wealth is about $410,000). Here again we see a fairly steady rate of growth over time, but a bit more above trend in the past year. The obvious conclusion to be drawn from all of these charts is that further wealth and equity price gains are likely to be a lot less exciting in coming years than they have been in previous years. 

Chart #4

Chart #4 shows the ratio of total household debt to total household assets, which can be likened to the average degree of leverage employed by the private sector. Here we see a rather dramatic and ongoing decline in financial leverage that began back in 2008, in the depths of the Great Recession. That recession, as you might recall, owed quite a bit to the private sector's use of excessive leverage to buy homes in previous years. We've now rolled back the clock on leverage to the levels of the early 1970s. Which, curiously, was just before the great wave of inflation that lifted housing prices. (I daresay that the recent boom in inflation and housing prices are likely two sides of the same coin.)

Chart #5

In this umpteenth appearance of Chart #5, we see that the gains in equity prices in the past year have been accompanied by a decline in the Vix "fear" index. The Vix is still a bit above the levels that seem to prevail in "normal" times, so there may be room for further gains provided we avoid unpleasant surprises.

Chart #6

Chart #6 tracks the rolling 12-month total of federal spending and tax revenues. Covid-19 provided cover for the most dramatic increase in federal spending since WW II. Things are beginning to return to normal, it would seem, thanks to May's avalanche of tax receipts (thanks in turn to the capital gains generated by a strong stock market in late 2020) and a lessening in the pace of growth of spending. Still, the federal budget is for all intents and purposes very nearly out of control. Spending MUST be reined in or there will be hell to pay at some point. The problem is not so much the amount of debt, but rather the fact that enormous levels of spending are hugely wasteful and make for fertile terrain for graft and corruption. No country has ever borrowed and spent its way to prosperity. That we are not in ruins today is testimony to the hard work and prudence of our private sector, as the charts above document. 

The most important reason to cut spending is to improve the health of the economy, since government can never spend taxpayers' money as prudently, wisely, and efficiently as taxpayers can.

Chart #7

Chart #7 shows total federal revenues on a rolling 12-month basis (blue line) and its major components. The recent surge in revenues owes a lot to a surge in individual income tax receipts, which in turn have been boosted by capital gains revenue thanks to the strong stock market. Corporate income taxes have also increased thanks to strong profits growth in the latter half of the year.

Chart #8

Chart #8 makes a repeat appearance using the latest data. It's hard to believe, but true: the burden of the federal debt (measured as total interest payments as a percent of GDP) today is about as low as it has ever been, even though total debt as a percent of GDP is higher than it has ever been (save for the WW II years). The circle is squared by the level of interest rates, which remain very near all-time historic lows. The blue line on this chart is virtually certain to start rising within the next year as market interest rates rise—as they must, given the huge rise in inflation shown in the following charts.

Chart #9

Chart #9 plots the level of the CPI index ex-energy on a log scale. Here we see how inflation by this measure has averaged just about exactly 2% per year over the past two decades. But note how the index jumps in the past several months above trend. The year over year rate has been boosted to a degree due to the dip in the level of the index in April and May of last year (the so-called "base effect"), but that dip was fully reversed by August last year. What we've seen in recent months is a mini-boom in the index above and beyond its long-term trend growth rate. This makes me think that rising inflation is not just transient. But tell that to the Fed, whose members are inordinately afraid to pull the punchbowl this time around, after doing so prematurely too many times in the past.

Chart #10

Chart #10 looks at the 6-mo. annualized change in the CPI (both with and without energy) to get a better idea of what has happened since the very weak CPI data in the first half of last year. By this measure inflation is running at a 4-6% annualized rate. And even higher—prices are up at a 7-8% annualized rate over the past 3 months! All of this is very reminiscent of what happened to inflation in the mid 2000s when it gradually became obvious that the Fed had failed to tighten policy sufficiently. And when they did manage to tighten policy we ended up with the Great Recession which began in 2008. I would further note that the 10-yr Treasury yield rose from 3.5% in 2003 to a high of 5.5% in 2006. We could easily see a repeat of this in the years to come. Beware fixed income bonds.

It's hard to believe, but today the 10-yr Treasury yield is a mere 1.4%, which is way less than the current rate of inflation. Way less. The entire Treasury curve is well below the current rate of inflation, which means that Treasuries are generating losses in real terms that are on the order of $0.5-0.7 trillion per year (and possibly more). Uncle Sam doesn't mind, though, since he is the world's biggest debtor. (The debt holder's loss is the debt issuer's gain.) Uncle Sam is currently benefiting from a "stealth" tax which is otherwise known as an inflation tax, and it's generating a not insignificant amount of money—much more than all corporate income tax receipts.