GDP from 30,000 feet

Quarterly GDP readings are notoriously volatile, and they are subject to substantial revision after the fact, so it doesn't pay to read too much into any one quarter's number. Third quarter GDP, released today, was in line with expectations, but it was disappointingly slow: a mere 1.5% annualized rate. Did the economy really take a nose dive, considering it grew at a 3.9% rate in the second quarter? Most likely not.

Given the vagaries of the quarterly numbers (see the first chart above), I've found it makes more sense to look at the rolling 2-yr annualized rate of growth of GDP, as shown in the second chart. Think of it as looking down on the economy from 30,000 feet, getting the big picture rather than the street-level map. It's clear this is a weak recovery, but notice how the pace of growth has actually picked up somewhat over the past year or so.

I'm not alone in making this observation: the bond market has figured it out too. The real yield on 5-yr TIPS has been trending higher over the past two years, tracking the rising trend in growth. The market senses that the economy is on somewhat firmer footing—even though growth is still sub-par—and thus the market is coming to accept the fact that the Fed is getting ready to raise short-term real interest rates.

In another sign that the economy is on firmer footing, weekly unemployment claims have fallen to their lowest level since 1973, and to the lowest level relative to total jobs on record (which goes back to 1967).

As the chart above suggests, the REAL big picture is one of an economy that has been growing at a sub-par pace (2.15% annualized) since the recovery began in mid-2009). If the economy had bounced back as it always did in the past, real GDP would be about 15% bigger: that translates into $2.6 trillion in "lost" income this year alone. That's arguably the measure of the cost of increased regulatory burdens, marginal tax rates that are too high, and years of Keynesian-inspired "stimulus" spending. This chart should make it painfully obvious that our highest priority should be to bend fiscal, tax, and regulatory policy in a more growth-friendly direction.

Who's afraid of a December rate hike?

Earlier today the FOMC temporarily rattled markets by signaling an increased likelihood that they would raise short-term rates by 25 bps at their next meeting, December 16th.(Bloomberg's implied probability of a rate hike by the December meeting rose from 35% this morning to 48% by the close.

In my view this is good news, if only because it shows that the Fed is somewhat less concerned about the economic outlook. Optimism has been in short supply for a long time now, so it's good to see less pessimism. A more-confident Fed can easily lead to more-confident markets, even if it means higher interest rates. (To be more specific: even if it means that interest rates will be less extremely low.)

In the meantime, the economy continues to grow, albeit relatively slowly, corporate profits continue to be relatively strong, markets continue to enjoy abundant liquidity, and key indicators of systemic risk remain unusually low. Moreover, it's hard (at least for me) to find evidence of irrational exuberance; on the contrary, I see lots of evidence that suggests the market is still cautious.

Arguably, it doesn't matter much whether the December FOMC meeting results in a rate hike or not. Regardless of whether the interest the Fed pays on reserves is 0.25% or 0.5%, short-term rates will be very low and monetary policy will most likely not pose a threat to economic growth for quite some time. The only thing likely to make a big difference to the outlook is the expectation of a pro-growth shift in fiscal policy, and that won't come until we get closer to next year's elections.

The equity market continues to shed its fear and uncertainty, as reflected in the decline in the ratio of the Vix index to the 10-yr Treasury yield. As fears of a China and oil patch meltdown recede, equity prices have risen.

The prices of gold and 5-yr TIPS (here proxied by the inverse of their real yield) have been slowly declining for the past several years. I have interpreted this to mean that pessimism and fear have been slowly replaced by optimism, because both gold and TIPS are assets that protect you from uncertainty. Even at current levels, gold is still trading at a substantial premium to its long-term average price in constant dollars, which I estimate to be around $500-600/oz. At today's 0.28%, real yields on 5-yr TIPS are still very low from an historical perspective, suggesting the market's expectations for real economic growth are still relatively anemic.

The real yield curve is still positively sloped (i.e., the difference between 5-year real yields and real overnight yields, shown here as the blue and red lines, respectively, is positive), which suggests that the market fully expects the Fed to be "tightening" policy in the years to come. This is to be expected in the early and middle stages of an economic expansion. If the market were really worried about a Fed tightening, and if the economy were really vulnerable to higher rates, the real yield curve would be flat or inverted, as happened prior to the past two recessions.

Inflation expectations (the blue line in the chart above shows the market's expectation for the average annual increase in the CPI over the next five years) are relatively low, but I think this is mainly the result of the significant decline in oil prices (red line) over the past year, as the chart suggests. As I've argued previously, the core and non-energy versions of the CPI have been running right around 2% for many years, and are likely to continue that pace. Today's low inflation expectations do not necessarily reflect monetary policy that is too tight.

The link between significant changes in real oil prices and inflation expectations holds up over long periods, as the chart above suggests.

2-yr swap spreads, shown in the chart above, are about as low as they get. If the economy and/or financial markets were really in trouble, swap spreads would be much higher. Current levels suggests that liquidity is abundant and systemic risk is very low. This is one of the healthiest indicators to be found anywhere, and it has gone largely unnoticed for years. Swap spreads are not only good coincident indicators, but also good leading indicators, and today they are telling us that economic conditions are likely to improve over the next year or so.

The S&P 500 closed today with a PE ratio of 18.5, according to Bloomberg. From an historical perspective, this is only modestly above average. Considering that corporate profits relative to GDP are at or near record levels (10% now vs. a long-term average of 6.5%), today's slightly-above-average PE ratios reflect a degree of caution and restraint.

I also find caution and restraint in the pricing of AAPL. As the chart above shows, Apple's PE ratio today of 13 is not only much lower than the market's PE, but also near the lower end of its historical range. This, despite the fact that Apple's earnings have surged over 40% in the past year, and the company is sitting on a mountain of cash—which makes its effective PE ratio more like 10. This means that the market is pricing in the expectation that Apple's earnings are likely to be flat or down for the foreseeable future. This is not unusual, since it has happened before: Apple's PE ratio was just above 10 in the first half of 2013, despite years of very strong double-digit earnings growth. That proved prescient, since Apple's earnings were subsequently flat to down for the next year. I would note, however, that while Apple's stock price averaged just over $60 in the first half of 2013, today it closed at nearly twice that.

It's fine to be cautious, but it may be premature to be bearish.

A good approach to growth-oriented policies

John Cochrane (Senior Fellow at Stanford's Hoover Institution) is one of my favorite economists. Not surprisingly, I agree with most of his positions, but more importantly, I like the way he explains why some policies are better than others. He recently wrote an essay on why economic growth is so important and what we could do to foster stronger growth. He recognizes up front that government cannot target growth, but it can pursue policies that create fertile ground for growth. The essay is long, however, with over 10,000 words. Here are some excerpts totaling just over 1,300 words that I think summarize his important points. I hope they pique your interest, and that you go on to read the whole thing.

Sclerotic growth is the overriding economic issue of our time. Looking forward, solving almost all our problems hinges on reestablishing robust economic growth. Over long periods of time, economic growth comes from one source: productivity, the value of goods and services each worker can produce in a unit of time. In turn, productivity comes from new ways of doing things. Higher productivity typically comes from new companies, which displace old companies — and displace the profits of their owners, and the healthy pay and settled lives of their managers and workers. 

More people working, and working longer hours, can improve income a bit, but soon runs in to an upper limit. Saving, investment and capital formation can improve income a bit, but its benefit is limited as well. Only new ideas, new products, new technologies, new organizations, and new skills produce such huge increases in prosperity. 

In this context, the decline of US GDP growth coincides with more worrying changes. Productivity growth is declining. New business formation is sharply down. Mobility of people from job to job has declined. 

Our economy is like a garden, but the garden is choked with weeds. Rather than look for some great new fertilizer to throw on it, why don’t we get down on our knees and pull up the weeds? 

It is tempting to cast the question before us as growth vs. redistribution, or growth vs. inequality, as the rhetoric of redistribution and inequality pervades the arguments from those who want to continue the policies that are strangling growth. 

But giving in to that rhetoric is a mistake. The US, in fact, has one of the most progressive tax systems in the world. And the relatively minor costs of government assistance to truly poor, needy, mentally ill or disabled people are not major impediments to growth. The weeds choking the economy represent cronyist redistribution to wealthy people, well-connected industries, and other powerful groups such as public employee unions, and large transfers among middle income people (social security and medicare).
When the average person (voter) expresses concern over inequality, what they really mean is that they are concerned that average people are not getting ahead economically. If the average person were getting ahead, whether some big shot CEOs fly on private jets or not would make little difference.  

The golden rule of economic policy is: Do not transfer incomes by distorting prices or slowing competition and innovation. 

The purpose of most economic regulation is to transfer money to a specific group of people, companies, or industry. It does so by slowing down new entrants, impeding competition, mandating uneconomic actions or cross-subsidies, slowing innovation, turning off price signals, distorting incentives, and encouraging waste. 

The overwhelming cost of regulation is the economic dislocation: companies not started, products not produced, innovations not innovated, people not hired, costs not slashed, prices too high. And growth too slow.

The popular debate is about “more” vs. “less” regulation. Regulation is not more or less, regulation is effective or ineffective, smarter or dumber, full of unintended consequences or well-designed, captured by industry or effective, based on rules or based on regulator whim, accountable or arbitrary, evaluated by rigorous cost benefit standards or by political winds, distorting economic activity or supporting it, and so forth.  

Like much else in America, our government works to cross purposes. It subsidizes debt with tax deductibility, deposit insurance, too big to fail guarantees, regulatory preference for holding short-term assets, liquidity rules, credit guarantees, Fannie and Freddie, the home mortgage interest deduction, community reinvestment act, student loan programs and so forth. And then it tries to regulate against using debt with bank asset regulation, stress tests, consumer financial protection, macro-prudential policy, and so on. 

The central problem of preexisting conditions was an artifact of regulation. In the ideal form of health insurance, you buy cheap catastrophic insurance when young, but the insurance policy can follow you as you age, change jobs, and move from state to state, and does not radially increase premiums if you get sick. Why don’t we have that ideal insurance? Because previous rounds of regulation outlawed it. 

We need to allow simple, portable, largely catastrophic, lifelong, guaranteed-renewable health insurance to emerge. Right now it’s illegal. To the extent that the government wishes to subsidize health insurance — and it should — then it should give straightforward vouchers, which people can use to buy insurance, or to fund health savings accounts. Such vouchers should take the place of Obamacare, Medicaid, and Medicare. 

Environmental policy at a minimum needs a far more frequent application of cost-benefit analysis! 

Practically everyone agrees on the basic structure of a growth-oriented tax reform: Lower marginal rates — the extra amount of taxes you pay on an extra dollar of income determines the disincentive to earning that income. To raise revenue at lower marginal rates, broaden the base, i.e. remove exemptions and loopholes. And massively simplify the code. 

The right corporate tax rate is zero. Corporations never pay taxes. Every dollar of taxes that a corporation pays comes from higher prices of their products, lower wages to their workers, or lower returns to their owners. 

A growth-oriented tax system taxes consumption, not income. When we tax income that is saved, or the investment income that results from past saving, we reduce the incentive to save, invest, start companies and build them, vs. enjoy consumption immediately. 

The estate tax is a particularly distorting tax on saving and investment. One may sympathize with the moral judgment that rich kids don’t “deserve” inherited wealth. But the point is on the incentives of the giver. The tax code should not give strong incentives to middle-age people to stop building their businesses, investing their money, spend their money on round the world cruises and their time with tax lawyers. Nor should it force the breakup of privately held businesses to pay taxes. Maybe the kids don’t deserve it, but if people cannot provide better lives for their children, we remove one of the strongest and oldest human incentives for economic activity. 

When we say broaden the base by removing deductions and credits, we should be serious about that. Thus, even the holy trinity of mortgage interest deduction, charitable donation deduction, and employer provided health insurance deduction should be scrapped. The extra revenue could finance a large reduction in marginal rates. 

Americans remain generous. Even without a tax incentive, Americans will give to worthy causes, as they give now to political campaigns.

A simple code makes its incentives transparent. A simple code vastly reduces compliance costs. And most of all, a simple code is much more clearly fair. Americans now look at the tax code and suspect — often rightly — that rich smart people with clever lawyers are getting away with things. Our voluntary tax code depends vitally on removing this suspicion. 

Zero is zero. If you don’t kill a tax completely, it keeps coming back like zombies in a science fiction movie. If you don’t kill a tax completely, you do nothing to simplification of the tax code. 

Indexing social security to price inflation rather than wage inflation takes care of much of the social security problem. 

Social programs are so expensive because most of them are middle class subsidies, not help for the truly poor and desperate. 

America needs a vast deregulation of its labor market. I want to work for you, you want to pay me? Good enough. 

We can end illegal immigration overnight: Make it legal. The question is, on what terms should we allow legal immigration. The immigration debate is about who is allowed to work in this country, and, later, who is allowed to become a citizen. Our Federal government has a massive program in place to stop people from working. That is immigration law.

Allowing free migration is, by many estimates the single policy change that would raise world GDP the most. If you believe in free trade in goods, and free investment, then you have to believe that free movement of people has the same benefits.