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Consumer confidence is low, and surveys find that the majority of the US population thinks the economy is getting worse. According to Rasmussen, only 43% approve of the job Trump's doing. Gas prices are high—the other day I paid almost $7/gal—and there are widespread reports of consumers cutting back on non-essential goods and services. Reported inflation has jumped, and the market fully expects the Fed's next move will be to raise rates. Despite this grim backdrop, the stock market is making new highs almost daily (the S&P 500 is up 28% in the past year!), and corporate profits are simply fabulous. I can't remember another time with such a disconnect.
It's time to review some important macro indicators:
Chart #1
Chart #1 shows that the M2 money supply continues to grow at a moderate pace—up just 5.1% in the past year, and in the past two years up a mere 4.3% annualized. Headline inflation has jumped, however, thanks to the complications of the Iran war which have sharply reduced the global supply of oil. If the Fed under new chair Kevin Warsh stands firm, higher prices for energy will not trigger a broad-based rise in prices. Meanwhile, the market has effectively tightened monetary policy by pushing 5-yr real interest rates up by 50 bps since the end of February, and by pricing in the near-certainty of a one quarter point tightening over the course of the next 12 months.
From 1995 through 2019, the M2 measure of the money supply grew at a compound annual rate of 6%, a period characterized by relatively low and stable inflation. The money supply then exploded by some $6 trillion from 2020 through early 2022 as the federal government sent out Covid "stimulus" checks that—at first—sat idle in bank checking and savings accounts. As consumers and businesses regained confidence and the economy emerged from the Covid shock in early 2021, that extra M2 eventually became monetized, and that in turn provided the fuel for a sharp rise in inflation.
Today, M2 is only about 5% ($1.2 trillion) above where it likely would have been in the absence of the great Covid monetary shock. The Covid-related explosive increase in money has been absorbed by higher prices and a growing economy. Monetary policy has been back on track for several years now. This is key to the inflation outlook.
Chart #2
Chart #2 shows real (blue) and nominal (red) 5-yr Treasury yields, and the difference between the two (green) which is effectively the market's expectation for what the CPI will average over the next 5 years. Just before Covid hit in early 2020, inflation expectations were relatively low—about 1.6%. The Covid shutdowns at first caused inflation expectations to plunge to near-zero, then to soar to 3.7%. Today the bond market is priced to inflation averaging 2.54% over the next 5 years—only modestly above levels that the Fed should be prepared to tolerate. People may be worried about rising inflation, but not the bond market.
Chart #3
Capital goods orders (Chart #3) are key to economic growth and prosperity, since new machinery, factories, and computers are what will drive future productivity. In inflation-adjusted terms, capital goods orders have been usually weak since the turn of the 21st century. Is it surprising that the economy has managed only moderate growth in the current business cycle which began in 2009. The recent strength in this series is a welcome breath of fresh air, and a sign that economic growth may continue to improve in the months and years ahead.
Chart #4
Chart #4 breaks down the Personal Consumption Deflator (the Fed's preferred measure of inflation) into its three major components. Things to note: since 1995, when China's economy started opening to the world and unleashing a flood of cheap electronics and appliances, the prices of durable goods have fallen by 30%. Meanwhile, service sector prices have risen by 141%, a direct result of rising real wages and a growing economy. Until the start of Iran hostilities, non-durable goods prices rose a bit less than 1% per year since mid-2022. Bottom line: outside of wages, and prior to the Iran war, inflation was largely confined to service sector prices, which in turn are largely determined by wages. These facts suggest that in the past 35 years, an hour's worth of wages now buys almost three and a half times more durable goods and 30% more nondurable goods. Wow.
Chart #5 is one of my favorite charts. The dotted green line reflects the growth trajectory of the US economy from 1965 through 2007, when the economy grew at a compound annual rate of about 3.1% per year. The dotted red line in the trajectory since the end of the Great Recession in mid-2009, when the growth trend abruptly slowed to 2.3% per year. If our economy had followed the 3.1% growth path, it would be 23% bigger today. The likely causes of this dramatic underperformance? Inefficient green energy subsidies, a huge increase in transfer payments, and increased tax and regulatory burdens figure at the top of my list. The recent strength in capital goods orders is the first indication that the economy may be regaining its former vitality.
Chart #6
Chart #6 shows corporate profits as a percent of nominal GDP. Think of this as a proxy for corporate profit margins: for every dollar of GDP, corporations today capture more than 11 cents of after-tax profits. That's twice as much as during the 1970s and 1980s (as indicated by the dashed green lines). No wonder the stock market is making record highs! Corporate profits have never been so healthy. Wow.
Chart #7
Chart #7 shows the year over year change in the overall Consumer Price Index as compared to its ex-energy version. Energy has always been the most volatile component of the CPI, and today is no exception. The important thing here is that energy prices do not cause inflation. Monetary policy is the chief determinant. And as we have seen in prior charts, there is no sign that monetary policy has become inflationary. The ex-energy version of the CPI is up 2.8% in the past year, and that is only marginally higher than the 2.5% inflation expectations priced into the bond market. Bear in mind that this number continues to be artificially inflated by the flawed measure the BLS uses to calculate shelter costs. Nationwide housing prices are up by a mere 0.7% in the past year; on an inflation-adjusted basis, housing prices are down 3.7% from their peak in mid-2022. These facts have yet to be captured by the BLS, which uses the year over year change in housing prices from 18 months ago to compute shelter costs.
If you focus less on the headlines in the media and more on the underlying statistics, the picture becomes clear: the economy is in good shape and likely to get even better.
