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The past several weeks were spent on a family vacation in Maui, and it was wonderful. Maui is definitely back in business—we have never been so warmly received!
So it's time to resume posting. It's been a month, but my outlook hasn't changed. I still think that the Fed has done enough to tame inflation, which, if measured correctly, is running comfortably within the Fed's target range. The economy is growing at an unspectacular pace, with risks slightly skewed to the downside (but no signs of a recession). Most importantly, financial liquidity conditions are strong, and the outlook for corporate profits remains healthy.
Political risks probably outweigh economic risks at this point. Harris and Trump appear to be running neck-to-neck, and both espouse economic policies that are troubling. Trump is fixated on tariffs, while Harris is fixated on price controls, and either one would hamstring the economy. As much as I dislike Trump's current stance, his intelligence and executive experience clearly "trump" Harris', and the political leanings of Harris and Walz are way too far to the left for my taste. In any event, I can't imagine Harris will survive close scrutiny, and she could easily implode as did Biden in his debate with Trump.
Chart #1
As Chart #1 shows, the US economy has been growing at about a 2.2% annual rate since mid-2009. No boom or bust is yet in sight.
Chart #2
Chart #3
Chart #4
Chart #5
I have argued for years now that the behavior of money demand and money supply easily explain the rise in inflation which began in early 2021 and which peaked in mid-2022. The initial surge in money was offset by an equal surge in the demand for money, which is why inflation didn't surge until early 2021. But after that, and as the economy got back on its feet post-Covid, the demand for money (Chart #5) collapsed. The public began spending the money that had been stockpiled during the Covid shutdowns, and it was a classic case of too much money chasing too few goods (which were constrained because of supply-chain shortages). Money demand is now approaching some semblance of normal.
Chart #6
This same dynamic played out with currency in circulation (Chart #6). During the panic of 2020, most people wanted extra cash in their pockets if for no other reason than that it was difficult to spend it. That has completely reversed. The ratio of currency in circulation to nominal GDP is now less than 1% higher than it was prior to the onset of Covid lockdowns.
Chart #7
Chart #7 shows the spread between investment grade and high-yield corporate debt and Treasuries, which is an excellent barometer of the market's expectations for future profits (lower spreads being good). The current level of spreads also suggests that financial market liquidity is abundant, and that in turn reflects confidence in the health of the economy.
Chart #8
Chart #8 shows the level of Bloomberg's financial conditions index, which uses a variety of money market inputs to gauge the overall health of the financial markets. Conditions appear to be substantially normal here as well, with no signs of distress.
Chart #9
Chart #9 shows the level of the Producer Price Index, which measures inflation pressures early in the production pipeline. As should be evident, there has been zero inflation according to this measure since mid-2022. In fact, the price level according to this measure has actually fallen by 0.9% since June '22, when inflation peaked.
Chart #10
The Consumer Price Index rose 2.9% in the year ended July '24, but roughly one-third of that increase came from shelter costs (as I've explained repeatedly over the past year or so). Chart #10 shows the changes in the CPI and the ex-shelter version of the CPI, the latter of which has increased by 1.78% in the past year and only 1.45% annualized over the past two years.
Moreover, the CPI is up at an annualized rate of only 0.4% annualized in the past three months, while the ex shelter version has fallen at an annualized rate of -1.5%!
Chart #11
Chart #11 shows the three major components of the Personal Consumption Deflator, arguably the best measure of inflation at the consumer level. What stands out here is that, since the inflation peak of mid-2022, prices of durable goods have declined, and prices of non-durable goods have risen by a mere 0.9%. Substantially all of the measured inflation in the past two years comes from "services," which are in turn dominated by shelter costs.
Chart #12
Chart #12 compares 5-y Treasury yields to the ex-energy version of the CPI (I use this measure because energy prices have been extraordinarily volatile in the past two decades). Note the blue asterix at the bottom right hand side of the chart, which marks the year over year change in the CPI ex-shelter (1.78%). At this level of inflation, and based on past relationships, a 5-yr Treasury yield of between 2% and 3% would not be unreasonable at all.
I see no reason for the Fed to delay a move to lower interest rates substantially.
8 comments:
Agreed.
Inflation is the most destructive force capitalism encounters. Readers should note that calculating inflation on a year-to-year basis minimizes, over time, the rate of inflation — since the rate is being calculated from higher and higher price levels (esp. after C-19). A $ today, using 1967 (a former reference base year), is equivalent to $ 9.42 of consumer purchasing power today. In absolute terms, each year confronts all of us with a higher and higher level of prices with no end in sight.
The next couple of months will reflect lower inflation due to the yearly base effects. That will give the FED false signals.
Thank you Scott, excellent analysis.
I agree with Salmo's point about compounding inflation effects.
From the above, "...the Fed has done enough to tame inflation, which, if measured correctly, is running comfortably within the Fed's target range."
I assume you are right about what the Fed should do and the data supporting that, but government overall is out of control. The consumer doesn't see CPI without the energy component, or without shelter.
The federal government spent 38% more than it collected in FY 2023. Debt burden is growing, making the budget outlook worse. The shrinking private sector shows up in the 2.2% growth rate versus 3.1, and the slowing private sector job growth for the last two years.
Even "target levels" of inflation combined with bad tax policy are harming private investment.
Large players may adapt quickly, even automatically, to changing price levels while smaller businesses can't.
Property taxes on my home have gone up 10-fold since I've owned it - and I don't think I'm that old. Having new rich neighbors hasn't increased my income or affordability. It's a local issue but it is a cost increase that's happening all over.
A dollar at the start of this administration has 79 cents in spending power today if you assume the cumulative price hike is over 20%. I appreciate the forward looking analysis presented here but the damage done should not be understated (IMHO).
Using usinflationcalculator.com, the cumulative rate of inflation since I bought my first rental house (in 1981) is 246%. These small amounts of inflation, 2% here and 9% there, add up and compound over the years, and then people are taxed on the inflation component of a gain at the federal level, and taxed as ordinary income in the states that have an income tax. This means people won't hold assets long term and many long held assets don't get sold, the opposite of a dynamic or vibrant economy. On top of that, an end to 'stepped up value' would mean people can't escape the tax on inflation, even in death. Not being able to pass on an asset destroys the incentive to build it in the first place.
To me, the 2% inflation target is unacceptable, and 3% inflation isn't near the target, it's off by 50%. The compounding effect of inflation is killing us out here.
I agree 100% with Doug. The 2% target is a perpetual tax. The right target is 0%, so the fed is still a long way off. Scott, i think you're a bit too rosy in your projections. Debt will eventually end the nation, ad it did to every other empire in history.
I agree that the right target for inflation should be 0%. Inflation is indeed a tax, and it is paid by those who are least able to afford it. If I were on the board of the Fed I would resolutely argue for zero inflation. But I wouldn’t be too upset if inflation averaged 1% per year.
Do you not subscribe to the idea of using tariffs as a negotiating tool, given that China benefits from still being considered an emerging market, steals intellectual property, and places firewalls on our big tech companies while we still allow TikTok? The relationship doesn't currently feel like "free trade."
The U.S. trade deficit with China reached $28.4 billion in September 2023, the highest since October 2022. This imbalance raises concerns about China's impact on global economic dynamics.
Re: Trade Deficits: Most people are quick to judge trade "deficits" to be a bad thing. But the counterpart to trade deficits is capital surpluses. China has a trade deficit with the US because they purchase fewer goods and services from us than we purchase from them. They money we pay them that is not spent on purchasing US goods and services must necessarily remain in the US in the form of bank deposits, security purchases, or real estate purchase. So a trade deficit necessarily creates a money surplus. Where is the problem? We end up with cheap Chinese goods and services and a good portion of the money we spend stays here.
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