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Since my last post (6/28), 10-yr Treasury yields have jumped 36 bps, while 1-yr yields rose by only 8 bps. This was driven by some stronger-than-expected economic news that caused the market to postpone its estimate for when the Fed will begin to cut rates. The market now expects the Fed to increase rates once or maybe twice by year-end, followed by an initial cut in rates sometime around March of next year. I remain convinced that no further rate hikes are needed. Why? Because although the economy has proved more resilient than the market expected, the inflation fundamentals have not changed: money demand has strengthened due to higher rates, "excess" money supply has declined, commodity prices are weak, inflation expectations remain low (~2.2%), and shelter costs are declining. I've explained all this in posts over the past several months.
What follows are some updated charts which fill in the story:
Chart #1
Chart #1 shows the three major components of the Personal Consumption Expenditures Deflator. On a 6-month annualized basis, the increase in the overall deflator has dropped from a high of 8% last June to 3.4% as of May '23. Two of its components—durable and non-durable goods—have not increased at all since last June (witness the flatness of the blue and purple lines). This means that the only source of inflation of late has been the service sector, and a major component of that is shelter costs, which are measured with a significant lag and which will almost certainly be subtracting from the official inflation statistics in coming months. See this post for more details.
Chart #2
Chart #2 shows that almost 85% of the service sector firms surveyed by the ISM reported paying higher prices early last year, but only 54% are reporting that now—that's very significant. This information is more timely than that picked up by the PCE deflator, and adds strong support for my belief that overall inflation is almost certain to decline significantly in the months to come. The Fed cannot ignore this for much longer.
Meanwhile, commodity prices have weakened considerably since the Fed began raising rates in March '22. The CRB Raw Industrials index is down 19%, non-energy commodity prices are down 21%, and oil prices are down fully 39%. If you live in the world of commodities, you've been experiencing painful deflation for the past 15 months.
Chart #3
Chart #3 shows a monthly measure of the number of announced corporate layoffs. Here we see a spike beginning in November of last year that has now all but ceased. The source of that spike was almost exclusively the high-tech sector, followed by more recently by the financial sector. Layoff activity has subsequently subsided to levels that are relatively normal. This was not a precursor of a recession, as many speculated. These are more commonly referred to as "rolling recessions," which hit only parts of the economy, not the whole.
Chart #4
Chart #4 compares the number of job openings in the country to the number of persons who are looking for work. Job openings remain extraordinarily high, and thus indicative of the fact that the fundamentals of the US economy remain healthy. Moreover, swap and credit spreads—key and leading indicators of economic health—remain low.
Chart #5
There is nothing in the stats to support widespread claims that the economy is "running hot." Nothing to suggest that inflation will do anything but decline. Nothing that would justify yet another increase in short-term rates. The Fed is done, but they are loathe to admit it: "once burned, twice shy" as the saying goes.
35 comments:
See: Paul Craig Roberts
read://https_www.zerohedge.com/?url=https%3A%2F%2Fwww.zerohedge.com%2Fpolitical%2Ffederal-reserve-has-been-disaster-america
"The incompetent Fed is incapable of realizing that by fighting employment and output, the Fed is reducing supply, thus rising prices."
The economy is being run in reverse.
As Jerome Powell was quick to point out, the only interest rate inversion that didn't produce a recession was back in 1966. Then, the 1966 Interest Rate Adjustment Act lowered commercial bank deposit rates. This activated monetary savings, increasing velocity while decreasing money growth.
Whereas time deposits were 105 percent of demand deposits in July, by the end of the year, the proportion had fallen to 98 percent.
Still: "The Reserve authorities allowed bank credit to expand during 1966 by $19.7 billion, or at an annual rate of approximately 6 per cent."
https://seekingalpha.com/instablog/7143701-salmo-trutta/5265714-1966-interest-rate-adjustment-act
https://seekingalpha.com/instablog/7143701-salmo-trutta/5265717-1966-interest-rate-adjustment-act-ii
”M1 peaked @137.2 on 1/1/1966 and didn’t exceed that # until 9/1/1967. Deposit rates of banks, Reg. Q ceilings, decreased from a high range of 5 1/2 to a low range of 4 % (albeit not enough). A .75% interest rate differential was given to the nonbanks.
And during this period, the unemployment rate and inflation rates fell. And real interest rates rose.
Waller, Williams, and Logan seem to agree. They “believe the Fed can keep unloading bonds even when officials cut interest rates at some future date.”
As Scott Grannis said:
Link: September 25, 2018: “An Emerging And Important Secular Trend”
Link: MAY 18, 2020 “Demand for money; what went up will soon come down”
I've always tracked:
Percentage of time (savings-investment type deposits) to transaction type deposits:
1939 ,,,,, 0.42
1949 ,,,,, 0.43
1959 ,,,,, 1.30
1969 ,,,,, 2.31
1979 ,,,,, 3.83
1989 ,,,,, 3.84
1999 ,,,,, 5.21
2009 ,,,,, 8.92
2018 ,,,,, 4.87 (declining mid-2016 with the increase in Vt)
This is corroborated by Dr. Philip George's: "The Riddle of Money Finally Solved"
"For nearly a century the progress of macroeconomics has been stalled by a single error, an error so silly that generations to come will scarcely believe that it could have persisted for as long as it has done."
There's been an 18% drop in the demand for money as measured by the ratio of transaction's deposits to gated deposits.
In Alfred Marshall’s “Cash Balances Approach” (the demand for money), K = “the length of the period over whose transactions purchasing power in the form of money is held”. K is related to Vt; it is the reciprocal.
The history of banking has been perverse:
https://www.rstreet.org/commentary/bigger-fewer-riskier-the-evolution-of-u-s-banking-since-1950/
Link Richard Werner:
Prof. Werner brilliantly explains how the banking system and financial sector really work. – YouTube
"Savings banks in German-speaking countries are called Sparkasse (pl: Sparkassen). They work as commercial banks in a decentralized structure. Each savings bank is independent, locally managed and concentrates its business activities on customers in the region in which it is situated. In general, savings banks are not profit oriented. Shareholders of the savings banks are usually single cities or numerous cities in an administrative district. As banks under public law Sparkassen have a public mandate which requires that they serve their local stakeholders and local communities."
Dr. Leland James Pritchard, Ph.D. Economics, Chicago 1933, M.S. Statistics, Syracuse (Phi Beta Kappa), pontificated 1961: "the growth of time deposits shrinks aggregate demand and therefore produces adverse effects on gDp." An increase in bank CDs adds nothing to GDP.
George Selgin July 20, 2017: "This is nonsense, Spencer. It amounts to saying that there is no such things as 'financial intermediation,' for what you claim never happens is precisely what that expression refers to."
Never are the commercial banks intermediaries in the savings->investment process.
Albert Einstein in his 1919 essay “Induction and Deduction in Physics”:
"The truly great advances in our understanding of nature originated in a way almost diametrically opposed to induction"..."The intuitive grasp of the essentials of a large complex of facts leads the scientist to the postulation of a hypothetical basic law or laws From these laws, he derives his conclusions".
Einstein: "The deeper we penetrate and the more extensive our theories become the less empirical knowledge is needed to determine those theories."
"Ask yourself why it takes $3.70 in credit today to generate $1 of GDP, but it took only 26¢ in credit to generate $1 of GDP before fiat money."
read://https_nationalinterest.org/?url=https%3A%2F%2Fnationalinterest.org%2Ffeature%2Fwho-really-killed-the-gold-standard-12435
As Dr. Pritchard’s economic 1963 syllogism posits:
#1) “Savings require prompt utilization if the circuit flow of funds is to be maintained and deflationary effects avoided”…
#2) ”The growth of commercial bank-held time “savings” deposits shrinks aggregate demand (destroys money velocity) and therefore produces adverse effects on gDp”…
#3) ”The stoppage in the flow of funds, which is an inexorable part of time-deposit banking, would tend to have a longer-term debilitating effect on demands, particularly the demands for capital goods.” Circa 1959
Nice wrap up, as always.
Yes, the Fed should pause a while, and see what happens. Moderate inflation is not the end of the world.
I wonder why the Fed believes it has to shrink its balance sheet, and dump trillions of dollars of debt back onto taxpayer backs--and suck trillions of capital out of capital markets (so it cannot be invested).
Hi Scott,
I have been reading your thoughts for a long time. I also agree with your inflation analysis.
Why then do you think the fed is continuing to be hawkish with its policy and statements? Are they trying to show that they are being tough inflation fighters? or do they just not see the world and future like you do? Love to hear your thoughts...
https://twitter.com/csppappas
Re "Why do you think the fed is continuing to be hawkish with its policy and statements?"
I've been a Fed watcher since 1980, and it strikes me that the Fed repeatedly appears to succumb to discredited Keynesian theories. Keynesian thinking is addictive to politicians and high-ranking bureaucrats because it suggests that government is fundamentally smarter than the market; that government can pull the right levers and turn the right dials in such a way as to make the economy stronger and correct the evils the market makes. Keynes started it all when he argued that government spending could pull the economy out of the Depression. The Fed has always felt that only it could find the "right" level of interest rates.
This dovetails with the problem of the Fed's "dual mandate:" to deliver low and stable inflation and to keep the unemployment rate low. Classical economists know that if you have only one "tool" (e.g., interest rates) you can only hit one "target" (e.g., inflation). It's impossible to determine what is the interest rate that will both deliver low inflation and low unemployment. Yet the Fed keeps trying.
Another problem is that of communication. It's one that I experienced myself when for several years I took on the role of economic PR for the firm. Reporters would call me looking for a quote. They always want something simple. But in reality things are rarely simple. A good answer to a question about the markets or the economy requires more than just a sound bite. But reporters don't want that; they want something simple that reinforces whatever they think is the right answer. Similarly, Fed governors rarely engage in discussions about the money supply. It's easier to talk about how wages create inflation (blame it on wages, not the Fed). As we see of late, the Fed is arguing that the economy needs to weaken in order to bring down inflation. It's not the Fed's fault, it's that there is just too much demand out there. In today's WSJ (page 2) there is a perfect example of this in a column written by Nick Timiraos. He is the paper's mouthpiece for the Fed, and he is trying to explain why the Fed needs to raise rates more in order to cool off the economy. It's amazing to me that people can write thousands of words on the subject of inflation without once mentioning the money supply. Another example: Inflation is caused by a drought in Panama which is causing shipping rate to climb and this will complicate the Fed's efforts to lower inflation. (continued in next comment)
(continued from previous comment)
And then there is the problem of the Fed's lack of credibility. When they insisted for months that the sudden rise in inflation that began early last year was "transitory:" They were clueless back then and they seem clueless again, but by gosh, it's better (they must think) to be too tight now than to be accused again of being too easy.
Finally, the Fed is composed of a bunch of people from different walks of life that have been entrusted with enormous power that many (or most) of them do not rightly deserve. What makes them uniquely smarter than the hundreds of millions of people all over the world whose livelihoods and fortunes depend on taking risks? They try to convince us they are smart by demonstrating how they and their thousands of Fed economists have painstakingly considered hundreds of variables before coming to a conclusion. In the end, they are just as fallible as anyone else. The Fed is a massive exercise in hubris.
This all helps explain why I try to pay attention to market-based indicators of what is going on, like swap and credit spreads, implied volatility, commodity prices, the value of the dollar, gold, in the belief that the market is ultimately the smartest "person" in the world. In addition to watching market-based indicators, I think it is also essential to look at the current and prospective policy environment. Is fiscal policy conducive to growth? Will higher taxes lead to more confidence? If not, will that then increase the demand for money as a hedge against uncertainty? Ultimately, the Fed should be paying much more attention to the interplay between changes in the demand for money and the supply of money. But that is a complicated task and it is not easily communicated to members of the press or the public.
Hi Scott - Great analysis like always. Why do you suspect you and Wesbury are so far apart on your outlooks right now? It's odd to see such a disconnect. Thanks!
Would you recommend buying high duration US treasury bonds then, Scott?
This asset class seems to be fairly low priced now - the current yield of ca. 4,00% is the highest since 2008. With inflation slowing down as you described in your post, this level seems excessive in the long-term...
On the other hand, I am afraid that if FED was to reduce its balance sheet by selling part of its 10+ US government bonds, the yield would be even higher than today.
re: " the Fed should be paying much more attention to the interplay between changes in the demand for money and the supply of money. "
That sums it up. Banks don't lend deposits. Deposits are the result of lending/investing.
Scott, great post and I love your commentary in the comments section about the Fed. It is reckless and foolish for them to raise rates on July 23. How can they be so blind?
I don't know if the Fed (mainly Powell I am guessing) is blind, foolish, or really smart at the moment. I do believe that there has been dangerous speculation ("irrational exuberance"?) since about 1996. That's when value indicators such as equity P/E ratios went into a new, higher regime. By my favorite measures, equity value has spent only about 6 months of the past 25 years in "significantly undervalued" territory.
https://www.advisorperspectives.com/dshort/updates/2023/07/05/is-the-market-still-overvalued
People have forgotten 2018, when the Fed was trying to "normalize" things. They only got a couple of percent higher and ran out of courage.
Powell may be getting ready to retire. I am not sure if he has a "savior complex" or is very smart in trying to get rid of all of the QE and ZIRP excesses. I do think that should be done. He might be smart to "hide" behind the flawed/lagging data, such as employment data, to do what he is doing.
It would seem to require a recession, and maybe a deep one, to "normalize" things. They have been getting this wrong mostly for at least 25 years now.
Re “ Why do you suspect you and Wesbury are so far apart on your outlooks right now?”
This has puzzled me for awhile now. Usually I am in sync with Brian. The reason for our different views can be found in how we interpret the behavior of M2, and the importance we give to money demand. Brian has been calling for a recession for a long time, and he bases his call on the fact that M2 growth has been negative in unprecedented fashion, and past periods of negative M2 growth have tended to precede recessions. I see the same negative M2 growth, but in the context of the fact that up to about a year ago M2 growth was extraordinarily high, and it is still way above its long-term trend growth rate. So I see there is still a lot of “excess” M2 that needs to be worked off—unless of course, money demand strengthens, which is possible but not likely. I see money demand weakening because I see a return of confidence and an absence of any indicators suggesting that money is in short supply (e.g., swap and credit spreads are still quite low).
Re “ Would you recommend buying high duration US treasury bonds?”
The Treasury yield curve is very inverted these days (i.e., long-term bond yields are way below short-term rates). This means the bond market is expecting the Fed to cut short-term rates significantly in the next year or so. The rationale for buying long-duration bonds would be a belief that the Fed will cut rates even more than is currently anticipated, and that the economy will prove weaker than currently anticipated, and/or that inflation will fall below the Fed’s 2% target.
DXY has fallen from 103.13 to 100.2 in the last 5 days. Any further gains in inflation will take years of tight money.
The June CPI and PPI inflation stats reinforce everything I've been saying for months. Inflation is over. The Fed doesn't need to and shouldn't raise rates any more than they already have. In fact, they should be actively considering a reduction in interest rates. In any event, they sure won't tighten given the evidence to date. The stock market is figuring this out, as is the bond market. The risk of a hard landing (i.e., recession) has dropped considerably.
The Fed probably doesn't "need" to raise rates to keep inflation under control.
However, the other part of what they do is jawboning, and I think they have jawboned themselves into at least one more hike. I think they will do this at the next meeting.
Then comes 2024, the election year. They will have to act fast/early in the year to look like they are not political (i.e. reducing rates).
I think they want to take the risk to be "too tight for too long", which very well may be a mistake.
I do think they need to try to "normalize" policy to get out of the market manipulation as much as possible. No ZIRP, no QE!
Financial Markets, Corporate Profits
I have read several studies on this, and a few things keep coming up.
1. More tech firms in the major indices/markets= higher profit margin (very low capital investment, and low expenses - from low physical investments needed)
2. Lower corporate taxes
3. Lower interest rates
https://www.federalreserve.gov/econres/feds/files/2023041pap.pdf
Abstract
I show that the decline in interest rates and corporate tax rates over the past three decades accounts
for the majority of the period’s exceptional stock market performance.
Gotta say it, Scott has been spot on with his inflation analysis. The Fed should listen to Scott Grannis! (but I doubt they will)
It took 4 straight years of zero means-of-payment money growth to cause the GFC. It will take multiple years of negligible money growth to thwart Powell's mistakes.
I'd say, that if the FED was tight, then the U.S. $ would not fall, but rise, aka, QE4 was really QT.
https://ritholtz.com/2023/07/contrarian-inflation/
Not a big Barry fan but #9 spot on
Yes, See: Paul Craig Roberts
read://https_www.zerohedge.com/?url=https%3A%2F%2Fwww.zerohedge.com%2Fpolitical%2Ffederal-reserve-has-been-disaster-america
"The incompetent Fed is incapable of realizing that by fighting employment and output, the Fed is reducing supply, thus rising prices."
The 1966 Interest Rate Adjustment Act is the precedent (where there was no recession with an interest rate inversion).
https://seekingalpha.com/instablog/7143701-salmo-trutta/5265714-1966-interest-rate-adjustment-act
https://seekingalpha.com/instablog/7143701-salmo-trutta/5265717-1966-interest-rate-adjustment-act-ii
See: “The Case of the Missing Money” STEPHEN M. GOLDFELD Princeton University
See: Velocity: Money’s Second Dimension – By. Bryon Higgins
I.e., TDs are being activated by saver-holders, or M2/GDP.
“Money has a ‘second dimension’’, namely, velocity . . .. ” Arthur F. Burns in Congressional Testimony.
See: “Quantity leads and velocity follows” Cit. Dying of Money -By Jens O. Parsson
See: “Was the 1982 Velocity Decline Unusual?” – by JOHN A. TATOM
See: Why Does Velocity Matter? By Daniel Thornton
Why Does Velocity Matter? (stlouisfed.org)
See: Solving the 1980s’ Velocity Puzzle: A Progress Report By Daniel Thornton
Solving the 1980s' Velocity Puzzle: A Progress Report (stlouisfed.org)
Dr. Daniel Thornton: "Because the concept of velocity stems directly from the theory of the demand for money, anything that affects velocity can be related to some aspect of the demand for money."
https://files.stlouisfed.org/files/htdocs/publications/review/87/08/Solving_Aug_Sep1987.pdf
As Dr. Philip George states: "Changes in velocity have nothing to do with the speed at which money moves from hand to hand but are entirely the result of movements between demand deposits and other kinds of deposits."
Scott,
Real rates are at 2% now, but if we adjust the CPI by lagging rental input, real rates are close to 5%. Also this 1,6 trln usd covid money will be spend soon. So, if the FED stays tight, should we expect some earnings slowdown?
Scott: Any thoughts on the consistent Manufacturing ISM readings below 50? Usually predicts a recession unless we now think that manufacturing is too small a share of US economy. I do see a big decline in CRE deal activity in our law firm due to interest rate uncertainty. Hope we can rebound.
Timing- economy vs Fed Funds tightening- 2006-2008 example
In 2004 the Fed started tightening, and in mid-2006 subprime defaults were starting, and the economy was obviously slowing. It took ~ another 18 months for the recession to be called. They kept Fed Funds rate at the 5.25% high for about 11 months.
So, it would not be unusual to have a recession to start about a year from now, or any time prior to that. ( my original guess last year was that we should be in recession by May of 2023; probably too early).
All deposits are created ex-nihilo by the Reserve and commercial banks. So, all monetary savings, income not spent, originate within the confines of the payment’s system. The source of interest-bearing deposits is non-interest-bearing deposits. DDs are just shifted into TDs within the system.
Unless monetary savings are expeditiously activated by their owners, saver-holders, a dampening economic environment is fostered, i.e., secular stagnation. In the current situation, we have the opposite scenario, where TDs are being activated, e.g., M2/GDP.
https://fred.stlouisfed.org/graph/?g=eTtE
Link: Dr. Daniel L. Thornton, May 12, 2022:
“However, on March 26, 2020, the Board of Governors reduced the reserve requirement on checkable deposits to zero. This action ended the Fed’s ability to control M1.”
I.e., as Dr. Richard Anderson said: “Legal reserves are driven by payments”.
Shadowstats corroborates this: The extraordinary flight to liquidity in “Basic M1” (Currency plus Demand Deposits [checking accounts]) continued in December 2022, at a 52-year high, providing the driving force behind the monetary-based inflation.
In other words, time deposits are being activated, increasing money velocity.
"The GDPNow model estimate for real GDP growth (seasonally adjusted annual rate) in the second quarter of 2023 is 2.3 percent on July 10, up from 2.1 percent on July 6."
Not certain, but I have a thought: I believe balance sheets of companies and consumers are not always demonstrated in M2. M2 is a good Genesis, but the liquidity moving into capital spend and where credit actually is deployed may not just show up at banks. Thus, researching the paper trail, new issuance of corporate debt of mid-sized (<$1B> has slowed dramatically), inventory levels, payroll levels and other factors may be more imperative in the post-M2 bonus. Just thoughts...
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