Thursday, February 16, 2017

Reflections on the economy and inflation

Despite all the action in the equity market, there's not much going on in the economy that's visible. Concurrent data suggest that the economy continues to plod along at something like a 2% annual growth rate, which has been the norm since mid-2009. Industrial production and business investment continue to be lackluster, while construction expands slowly.

Confidence, however, is definitely up, and the equity market is up some 12% since just before the November elections. This strongly suggests that the market expects business-friendly policies (e.g., tax reform plus regulatory relief) to emerge from the Trump administration this year. Trump's executive orders so far have been impressive, but a lot of good news has been priced in, so further gains likely will require confirmation that policies put in place are indeed of the business friendly variety.

The type and timing of tax reform are crucial issues, however, and they are still in flux. If tax cuts are postponed until next year this could pose a serious risk to the economy this year, since it will give everyone a reason to postpone new investment, realization of gains, and income until next year—in a manner similar to what happened when the initial Reagan tax cuts were (mistakenly) phased in over a number of years and the economy immediately slumped. If Trump is going to cut taxes, he needs to do it ASAP and/or reassure the market and the public that the cuts will be retroactive to the beginning of this year. Alvin Rabushka has some interesting observations along these lines here.

It's disturbing, meanwhile, that Trump seems to be pushing hard for some type of "border adjustable" tax regime. That appeals to him, presumably, since it would allow him to tax imports and incentivize exports, and that in turn would—supposedly—reduce the trade deficit. Unfortunately, that's a dumb thing to want to do; economics teaches us that there is nothing wrong with a trade deficit, since it is always accompanied by a capital surplus (if foreigners want to buy our financial assets instead of our goods and services there is nothing at all wrong with that). Fortunately, it looks like many economists as well as Republican lawmakers are unconvinced that switching to a border-tax regime makes sense, if for no other reason than that it would result in a massive change in the rules of the game for many companies and that could be quite disruptive. Why overhaul the whole tax system when a few simple adjustments to the current one (which admittedly could be improved) could do the trick?

A lot of sensible people I know would much rather see the current system get a few stimulative tweaks, such as reducing marginal tax rates on income, capital gains, and businesses, limiting deductions and subsidies, and slashing regulatory burdens. Those easy-to-implement measures would incentivize work, investment, and capital formation, and that in turn would help everyone, not just exporters. Let's hope simplicity wins out over complexity.

Core inflation has been running around 2% for a long time, but recently we have seen headline inflation move above the 2% level, thus effectively putting a stake through the heart of the deflation demon. With today's January CPI release we now see that underlying inflation pressures are beginning to exceed 2% per year. The headline CPI in January rose by much more than expected (0.6% vs. 0.3%), while both the core and ex-energy CPI rose by 0.3%. Over the past six months, the overall CPI is up at a 3.6% annualized rate, while the core CPI is up 2.5% annualized, and the ex-energy CPI is up 2.1% annualized. This is not enough to warrant a red alert at the Fed (energy still seems to be the major culprit), but it almost certainly means the FOMC will be raising rates sooner rather than later, and by more than the market expects, rather than less. At the very least inflation is set to become a key focus for the market in the months to come. If it looks like the Fed is falling behind the inflation curve (i.e., raising rates by too little, too late), that could be as disruptive to the economy as a failure to implement meaningful tax reform.

I've been featuring the chart above for a long time, and the story hasn't changed: abstracting from volatile energy prices, inflation at the consumer level has been averaging very close to 2% a year for more than a decade.

Over the past year, the CPI is up 2.5%, with energy prices (specifically, a rise in gasoline prices in January that has already been reversed in February) doing most of the work. Taken together, these first two charts aren't very scary. But if recent trends continue, then it will be time to start worrying.

What happened in January wasn't so much that overall prices actually rose, however. What happened was that they didn't stay flat or fall, as is usually the case around October-January. The chart above illustrates that, showing the 3-mo. annualized rise in the non-seasonally-adjusted CPI. The dots highlight the fact that actual inflation is almost always very low around the end of each year. The January report was an outlier; since seasonal adjustments expect price gains to be zero or negative around this time of year, a modest rise in actuality became a big jump after adjustments were applied.

Industrial production has been improving only modestly for the past year. It's encouraging that the Eurozone has been doing somewhat better, but so far it just looks like catch-up to the U.S.

January housing starts were down a bit, but previous months were revised upwards substantially. Given the relatively high level of builder sentiment, the trend of starts over the past year, and the ongoing rise in building permits, it's reasonable to expect residential construction to continue to contribute to growth for the foreseeable future, albeit modestly.

Industrial metals prices are up over 50% since the end of 2015, and that is impressive indeed. As the second chart shows, it is quite unusual for commodity prices to rise while the dollar is also rising (note that the blue line is the inverse of the dollar index). At the very least this suggests that global economic activity has strengthened. It's also possible that rising commodity prices are symptomatic of a rising inflation trend globally. I note that gold prices are up 17% over this same period, and gold is still significantly above its long-term, inflation-adjusted average price, which I calculate to be roughly $500-600 per ounce.

The road ahead looks promising, but there are still significant obstacles to overcome and nasty pitfalls. I think that's obvious to just about anyone, however, so I'm not sure the market is over-extended. For now I'm in the cautiously optimistic camp, mainly because I believe the economy has a tremendous amount of upside potential that is just waiting to be tapped. I think the pessimists are underestimating this, and underestimating the power of supply-side tax and regulatory reforms. I see too many articles arguing that Trump Stimulus is all about goosing spending, financed by bigger deficits—it's not. It's about unshackling the private sector and shrinking the public sector. That hasn't been tried for a long time, and the time to do it is ripe.


Michael Meyers said...

I'll never convince you that long-term a trade deficit is bad...terribly bad. It seems you are set in your ways. But just think what happens long term with more and more financial assets, including stocks in American companies, owned by foreign savers. Are we to rent the whole country from foreign savers????

Scott Grannis said...

Michael: you'll have to convince not just me but the entire economics profession that trade deficits are necessarily bad. There is an entire body of literature, analysis and theory which argues against you. If they were, how do you explain Florida's prosperity, since it obviously imports more from the rest of the country than it produces (because so many people live there who are retired and don't work).

Benjamin Cole said...

The link above is fascinating.

Nations that run large current account deficits tend to have house price bubbles.

Foreign capital flows into financial assets...and property!

But the supply of property regulated through zoning.

So rising demand but fixed supply...

The solution is the elimination of property zoning...or trade deficits.

Trump may be right on this one...for the wrong reasons.

But I give credit to Trump. He is meeting repeatedly with business guys. Good! Airline guys, automakers, retailers.

When was the last time a US president did this?

There is oodles of capital available. The world needs demand.

ronrasch said...

Business is incentivized to maximized short term profits by off shoring our cutting. We need longer term incentives to create supply of products that are better, faster, and cheaper. As Scott maintains we need to control government spending, remove burdensome regulations, and cut business taxes as well as make everyone't taxes simpler.
Scott, thank you for an amazing blog with an incredible track record.

Benjamin Cole said...

PCE core at 1.7% YOY in December. The CPI overstates inflation, and the Fed does to key on that index. They use PCE core.

The Fed says its average PCE core inflation target is 2%. It claims that is not a ceiling, but an average.

The Fed has been below 2% for a long time, I think back to 2008.

I do not know how the 2% target/ceiling became sacred, and I think 2.5% would ease the US economy into more real growth.

Flowthrough said...

I could not agree with you more on your tax comment. Stay simple. Reduce rates, eliminate some credits and deductions. Stay away from border adjustment tax or denying interest deductions. Radical change often hurts existing businesses, which creates a drag on the economy, while the benefits are slower to show up. Think of the 86 reforms. I think it likely made the early 90s recession worse (remember, the law was passed effective in 87 and many of the major changes which hurt real estate where phased in). I think one reason for faster growth of the mid to late 90s were the beneficial effects of the 8 act finally kicked in.