Monday, February 5, 2024

It's a moderate-growth, disinflationary world

In my economic slowdown post a month ago I was generally upbeat, but I worried about the slowdown in job creation. Those worries faded with a strong January jobs number. The US economy is ok: credit spreads are still quite low, liquidity is still abundant, the dollar is still strong, inflation is still declining, and there are only a few indicators that suggest caution. Meanwhile, the Fed seems unduly concerned about the economy's strength (they now say they will have to wait at least several months before cutting rates), but that is nothing new. Keeping rates higher than necessary for a few months more than is necessary is not exactly a death knell for the economy. In the end, the Fed should know better: more people working means more demand for a money supply that is flat, and that is disinflationary.

Chart #1

Chart #1 shows that for decades the bond market has expected the Fed to deliver 2 - 2½ % inflation, and today is no exception. What stands out here is the dramatic rise in both real and nominal yields which began in early 2022 when the Fed belatedly realized that inflation was entrenched. As is usual, the Fed was late to the inflation party, but they reacted decisively by boosting real interest rates (the ones that really count) by over 400 bps in just one year. 

Chart #2

While the Fed's response was unprecedented in the magnitude and speed of rate hikes, it was also unprecedented given the utter lack of any restrictions on the supply of liquidity to the banking system. This shows up in the level of bank reserves (Chart #2), which has been in super-abundant territory ever since late 2008, when the Fed decided it would raise short-term interest rates directly and pay interest on bank reserves, which they then supplied generously. This had the effect of making bank reserves functionally equivalent to 3-mo. T-bills, while also boosting the quality of banks' balance sheets. Liquidity has been abundant ever since, in contrast to prior tightening episodes which invariably led to liquidity squeezes, bankruptcies, and financial panics. 

Chart #3

Chart #3 focuses on the all-important shape of the real yield curve (again: real (i.e., inflation-adjusted interest rates are the ones that really matter). As has been repeated ad nauseam by the financial press, inverted yield curves (when short rates are higher than long-term rates) typically precede recessions but that rule has long been broken, to the dismay of forecasters, most of whom neglected to focus on real interest rates. Chart #3 tells us that only now has the real yield curve inverted: the real Fed funds rate (which is an overnight rate) today is almost 3% (5.5% funds rate less 2.5% inflation), whereas the 5-yr real Treasury yield is almost 2%. As the chart shows, the blue line reliably has exceeded the red line prior to the last two significant recessions, as it has now. 

An inverted real yield curve is much more meaningful than an inverted nominal curve. Owning short-term risk-free assets today has become a very attractive proposition thanks to relatively high real rates. This is how monetary policy tightening works: it makes holding onto money (which includes short-term interest-bearing and highly liquid assets) more attractive than spending it. Better to have money than to hold commodities; better to have money than to borrow money. There's still loads of money out there, but high real rates are persuading people to hold on to that cash rather than spend it or borrow more. Just ask anyone with a floating interest rate loan these days and they will tell you that they can't believe how much their interest rate is re-setting this year. And the longer the Fed keeps the funds rate at 5.5%, the more floating rate loans are going to reset and the more painful all loans will become for borrowers.

So although no recession looms, neither does a boom. High real rates simply point to more disinflation.

Chart #4

Chart #4 shows the level of announced corporate layoffs according to the tally of Challenger, Gray & Christmas. It's a little on the high side today, but well short of being recessionary. The message here is that firms still have to fight to stay competitive, to cut costs, and to grow. That's healthy. 

Chart #5

Compare Chart #5 above to Chart #2 in my "Economic slowdown" post a month ago. Thanks to recent revisions to the jobs numbers, the recent pace of job growth has improved somewhat, but there is no denying that the pace of growth has been declining significantly for the past two years. While it's true that the pace of overall job growth looks better, that's because there has been a surge in the number of public sector jobs. My charts only refer to private sector jobs, which, like real interest rates, are the ones that really count. But they are only growing at a 1.8% annual pace, and that is a long way from fueling a boom.

Chart #6

I'll bet Biden and his handlers feel pretty good about Chart #6, because it shows a recent surge in consumer confidence. Confidence is still below average, but with a growing economy and plenty of money, it's not necessarily risky for Biden to ask for votes on the basis of how people feel about their current situation. Regardless, the one big problem that is unlikely to go away is the fact that, while inflation has returned to a semblance of normality, the big surge in prices of recent years has not reversed.  The sting of past inflation is still with us in the form of permanently higher prices for almost everything.

Chart #7

A quick check of credit spreads, such as those shown inn Chart #7, tells us that the outlook for corporate profits—and by extension the economy—is healthy. Spreads are quite low. This is very good.

Chart #8

Chart #4 in my last post told us that the inflation embers still burn, but mainly in the service sector, which in turn is dominated by wages. Chart #8 above reaffirms that message: the prices paid component of the ISM service sector survey shows a meaningful increase in the number of firms reporting paying higher prices.

Chart #9

Chart #9 shows that business activity in the service sector is healthy, but by no means robust. 

Chart #10

Chart #10 shows that the Eurozone service sector is obviously weak, while the US service sector is only marginally better.

Chart #11

Last month everyone worried about the huge decline in the ISM service sector employment index. Fortunately that was completely reversed in the February release. Last month was simply a fluke. These things happen, which is why you can't put a lot of trust in one month's numbers.

Chart #12

Chart #12 tells us two things: a) commodity prices tend to move inversely to the value of the dollar (i.e., a strong dollar tends to depress commodity prices and vice versa), and b) commodity prices are still pretty high given how strong the dollar is today. Commodity prices do appear to be in a downward trend, following the stronger dollar, and that will reinforce the disinflationary pressures of the Fed's reluctance to cut rates. (The commodity basket I use here excludes crude oil, because it is by far the most volatile of all commodity prices.)

Things could be worse. When the Fed reacted late to the need to tighten policy in 2001, that fueled inflationary pressures, and inflation is a tough beast to wrestle with. Today the Fed is late to the disinflation party, but the consequences—lower inflation and possibly deflation—are not so troublesome. In fact, a return to lower prices in many areas would be cause for cheer among consumers. And it's always a good thing to have a strong dollar rather than a weak dollar, no? Your assets are primarily priced in dollars, so anything that weakens the dollars destroys some of your net worth. By delaying its decision to cut rates, the Fed is boosting the value of the dollar by making owning it more attractive. I can live with that.


Grechster said...

Chart #3 is the most negative (for equity markets) thing I've seen in quite some time.

Salmo Trutta said...

In the past the federal deficits didn't affect the level of interest rates. The markets have changed.

rsswg said...

I'm confused how recent M2 contraction can be true, but there be plenty of liquidity in the system. Does it have anything to do with M2 rising over 20% previously and the recent contraction being much less?

Dan said...

do you have a chart for individual income?

Downtown Adam Brown said...

@rsswg Bank reserves are not part of M2. We are in an abundant reserves policy era. Liquidity need not be constrained in an effort to decrease money supply.

Scott Grannis said...

Further to the issue of bank reserves, liquidity and M2: Bank reserves are not included in M2, because they are not money that can be spent. Bank reserves exist only on the Fed's balance sheet, and they are the result of the Fed purchasing securities from the banking system and "paying" for them with reserves. Reserves are functionally equivalent to 3-mo. T-bills in the sense that they are default-free, risk-free securities that pay a floating interest rate. Reserves are abundant today, totaling about $3.6 trillion. Because they are abundant, banks have an almost unlimited ability to make new loans, which is why I say that there is plenty of liquidity in the banking system, even though M2 has been flat for the past 27 months and has declined by $800 billion from its July '22 high.

JSK19682 said...

Scott, thank you. In 2011, I discovered your work. Since then I have read every one of your posts. Not only do I continually learn from you (e.g., nominal rates vs real rates and yield curve inversion), but my reading your work continually helps to place breathless financial punditry into perspective.

Unknown said...

Hi Scott.. Clay turned me onto your work and it's much appreciated. Any thoughts on today inflation report?