Thursday, March 8, 2018

The Fed: Rooting for Higher Inflation

While the financial markets have started to worry about a reflation scenario, Fed officials continue to hope that inflation will rise in 2018 to hit their target of 2.0% for the core PCED rate. It was 1.5% last year on a December-to-December basis.

The minutes of the January 30-31 meeting of the FOMC were released on February 21. The word “inflation” was mentioned 129 times. The word “unemployment” was mentioned just 13 times. However, that doesn’t mean that Fed officials are worrying about higher inflation. Rather, they seemed to spend most of their time on the subject trying to convince one another that it should rise back up to 2.0% this year now that the economy is at full employment.

In my new book, Predicting the Markets: A Professional Autobiography, I note that the FOMC has a tradition of starting the year with a “Statement on Long-Run Goals and Monetary Policy Strategy.” They’ve been doing that since January 25, 2012. They’ve invariably expressed the following view that was repeated in the latest minutes:

“The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee reaffirms its judgment that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate.”

In fact, inflation, based on the core PCED, has been below 2.0% most of the time since 2008, even as monetary policy turned ultra-easy. The FOMC’s confidence in the notion that inflation is mostly a monetary phenomenon in the long run begs the question: “Are we there yet?” Nope! If not, then why not? The answer could be that inflation isn’t just a monetary phenomenon. There are powerful structural forces keeping it down, including competition unleashed by globalization, deflationary technological innovations, and aging demographics, as I thoroughly discuss in my book.

The latest FOMC minutes note that the Fed’s staff presented “three briefings on inflation analysis and forecasting.” Here are a few excerpts from the minutes rendition and my reaction:

(1) Inflation models are error prone. “The presentations reviewed a number of commonly used structural and reduced-form models. These included structural models in which the rate of inflation is linked importantly to measures of resource slack and a measure of expected inflation relevant for wage and price setting—so-called Phillips curve specifications—as well as statistical models in which inflation is primarily determined by a time-varying inflation trend or longer-run inflation expectations.”

And how well have those models been working? “Overall, for the set of models presented, the prediction errors in recent years were larger than those observed during the 2001–07 period but were consistent with historical norms and, in most models, did not appear to be biased.” I think that means: The models have worked terribly since 2007, but that’s normal.

(2) Resource utilization is hard to measure. Monetary policy presumably “influences” inflation by affecting resource utilization. “The briefings highlighted a number of other challenges associated with estimating the strength and timing of the linkage between resource utilization and inflation, including the reliability of and changes over time in estimates of the natural rate of unemployment and potential output and the ability to adequately account for supply shocks.” In other words, the macro inflation models depend on variables that really can’t be observed and measured.

(3) Inflationary expectations are also hard to measure. The Fed also presumably can influence long-term inflationary expectations, which should drive actual inflation. “Moreover, although survey-based measures of longer-run inflation expectations tended to move in parallel with estimated inflation trends, the empirical research provided no clear guidance on how to construct a measure of inflation expectations that would be the most useful for inflation forecasting.”

(4) Insanity is using the same flawed models knowing they are flawed. No comment is necessary on the following: “Following the staff presentations, participants discussed how the inflation frameworks reviewed in the briefings informed their views on inflation and monetary policy. Almost all participants who commented agreed that a Phillips curve–type of inflation framework remained useful as one of their tools for understanding inflation dynamics and informing their decisions on monetary policy.”

And what about long-term inflationary expectations? The minutes noted: “They [FOMC participants] commented that various proxies for inflation expectations—readings from household and business surveys or from economic forecasters, estimates derived from market prices, or estimated trends—were imperfect measures of actual inflation expectations, which are unobservable. That said, participants emphasized the critical need for the FOMC to maintain a credible longer-run inflation objective and to clearly communicate the Committee’s commitment to achieving that objective.”

Groupthink continues to flourish at the Fed. While the Fed staff are conceding that their macro inflation models aren’t working, Fed officials continue relying on them.

(5) Tapering the balance sheet. Meanwhile, the Fed started to taper its balance sheet last October at an announced pace that will reduce its holdings of US Treasury securities and mortgage-backed securities (MBS) by $300 billion over the current fiscal year (through September 2018) and then by $600 billion during the following fiscal years. At this pace, the Fed’s balance sheet will be back down to where it was in August 2008 by June 2024. Over the 2018 and 2019 fiscal years, the Fed is scheduled to reduce its holdings of Treasuries by $540 billion and MBS by $360 billion.

So while the Fed is tapping on the monetary brakes, fiscal policy is stepping on the gas with tax cuts and more spending. Fasten your seat belts.

Sunday, March 4, 2018

Smoot-Hawley Triggered the Great Depression

The following is an excerpt from my new book, Predicting the Markets. It seems especially relevant after President Donald Trump raised tariffs on imports of solar panels and washing machines during January, and is planning on raising tariffs on aluminum and steel imports this week:
[T]he 1920s was a period of globalization, with peace, progress, and prosperity. Yet by the early 1930s, the world fell into a depression that was followed by World War II near the end of the decade.

My research led me to conclude that the Great Depression was caused by the Smoot–Hawley Tariff Act of June 1930. During the election of 1928, Republican candidate Herbert Hoover promised US farmers protection from foreign competition to boost depressed farm prices. However, he was appalled by the breadth of the tariff bill that special interest groups had pushed through Congress, denouncing the bill as “vicious, extortionate, and obnoxious.” But he signed it into law under intense political pressure from congressional Republicans.

The tariff triggered a deflationary spiral that had a deadly domino effect. Other countries immediately retaliated by imposing tariffs too. The collapse of world trade pushed commodity prices over a cliff. Exporters and farmers defaulted on their loans, triggering a wave of banking crises. The resulting credit crunch caused industrial production and farm output to plunge and unemployment to soar. In my narrative, the depression caused the stock market crash, not the other way around as is the popular belief. Consider the following grim post-tariff statistics:

(1) Trade. Data compiled by the League of Nations show that imports of 75 countries dropped 55% from June 1930 through March 1933. In the United States, industrial production dropped 41% from June 1930 through March 1933. Historian John Steele Gordon observed that US exports in 1929 were $5.24 billion, whereas by 1933, exports were only $1.68 billion; when inflation is taken into account, the latter amount was less than US exports in 1896. As countries successively raised tariffs, world trade fell by two-thirds from 1929 to 1934. Gordon concludes, “Thus, Smoot–Hawley was one of the prime reasons that a stock market crash and an ordinary recession turned into the calamity of the Great Depression.”

(2) Prices. The producer price index (PPI) for industrial commodity prices plummeted 24% from June 1930 until it bottomed during April 1933. The PPI for grain prices plunged 59% until it bottomed during December 1932. The consumer price index (CPI) fell 25% from June 1930 until it bottomed during the spring of 1933.

(3) Loans and deposits. Commercial bank deposits fell 36% from $43 billion during 1929 to $27 billion during 1933. Deposits frozen at suspended commercial banks rose sharply during the three banking panics from 1930 to 1933.

(4) Unemployment. The unemployment rate for nonfarm employees soared from 5.3% during 1929 to peak at a record high of 37.6% during 1933. Over this same period, it jumped from 3.2% to 25.2% for the civilian labor force, including farm workers.

The Dow Jones Industrial Average (DJIA) plunged 47.9% from its record high of 381 on September 3, 1929 to the year’s low of 199 on November 13. From there, it rebounded 48.0% to 294 on April 17, 1930. It was down only 5.1% on a year-over-year basis, suggesting that the Great Crash wasn’t so great! But the worst was ahead, as the stock market started to anticipate the passage of the tariff bill, despite a letter printed in the May 5, 1930 issue of The New York Times signed by 1,028 economists who opposed the bill. The DJIA proceed to fall by 86.0% from the April 17, 1930 high to the low of 41 on July 8, 1932. That was the Great Crash indeed! (See Appendix 2.1, The Protests of Economists Against the Smoot-Hawley Tariff.)

That’s my explanation of what caused the Great Depression. ... Google search the “Great Depression” and you’ll find more than 20 million links. Narrow the search to “causes of the Great Depression” and you’ll find more than three million links. In my home office, I have three shelves of books that offer lots of explanations for this economic disaster. Few of them give a starring role to the tariff. Excessive speculation in stocks that set the stage for the Great Crash often gets blamed for starting the mess.

Saturday, March 3, 2018

Dr. Ed’s New Book

I started my career on Wall Street in 1978. Ever since then, I have been thinking and writing about the economy and financial markets as both an economist and an investment strategist. While I have a solid academic background to be a Wall Street prognosticator, I learned a great deal on the job. In Predicting the Markets: A Professional Autobiography, I share my insights into forecasting the trends and cycles in the domestic and global economies and financial markets—including stocks, bonds, commodities, and currencies. Please visit the book’s home page to learn more about it.

Thursday, March 1, 2018

Dow Vigilantes

The Tax Cut and Jobs Act’s (TCJA) cut in the corporate statutory tax rate at the end of 2017 will send earnings hurtling beyond the Earth’s gravitational pull this year into outer space.

They were heading in that direction last year. It’s conceivable that some of last year’s earnings extravaganza was attributable to the Trump administration’s easing of regulatory costs. More likely is that 2017 earnings were boosted by the synchronized global economic expansion that followed the worldwide energy-led global growth recession from 2014 through 2016. I started to see signs of a global recovery during the summer of 2016, which led me to conclude that stock prices were likely to head higher no matter who won the presidential race on November 8, 2016. Trump won on his campaign promise to “Make America Great Again.” Earnings were on course to be great again in any event, and now they will be even greater thanks to the TCJA.

That simple insight led me to conclude that the meltdown in the stock market in early February was a flash-crash correction that would be short-lived given the meltup in actual and expected earnings. We now have the results for S&P 500 earnings during Q4-2017. They were HUGE. Consider the following:

(1) Revenues. S&P 500 revenues rose to a record high of $329.41 per share at the end of last year. Remarkably, revenues per share rose 9.4% y/y, the fastest since Q3-2011. Needless to say, it’s hard to imagine that this fast pace was boosted by anything that can be traced to the White House, especially since almost half of S&P 500 revenues come from abroad. In the US, nominal GDP was up 4.4% y/y during Q4, lagging the 8.5% growth in S&P 500 aggregate revenues.

On the other hand, the trade-weighted dollar fell 7.0% y/y last year, which must have boosted revenues. As I previously observed, the dollar tends to be weak when the global economy is doing well and commodity prices are rising.

I’m not that surprised by the strength in revenues at the end of last year. That’s because it was clearly signaled by the weekly S&P 500 forward revenues series, which is the time-weighted average of industry analysts’ consensus expectations for revenues during the current year and the coming year. It continues to rise in record-high territory.

(2) Earnings. Also, I’m not surprised that S&P 500 operating earnings per share jumped 15.3% y/y during Q4-2017 according to Thomson Reuters. Nevertheless, I am certainly impressed. S&P also compiles operating earnings for the S&P 500 operating earnings using a more conservative approach for one-time nonoperating gains and losses. This measure rose even more impressively, with a 22.3% y/y gain.

Interestingly, S&P 500 reported earnings dropped sharply during Q4-2017, and was basically flat compared to a year ago. Weighing on earnings during the last quarter of 2017 were charges related to the TCJA, such as a substantial drop in the value of deferred tax assets given that the corporate tax rate was cut from 35% to 21%.

Again, I’m not surprised by the strength in earnings. It was clearly signaled by the weekly S&P 500 forward operating earnings. The four-quarter sum of S&P 500 operating earnings per share (based on the Thomson Reuters data) was $133 last year. The forward earnings series suggested in late February that earnings are headed toward $160 per share this year. That would be a 20% jump.

At the end of February, the analysts’ consensus earnings estimate for 2018 was actually $157.92, a 19.1% y/y gain. I am currently forecasting $155.00, a 16.8% increase. In any event, earnings will be up HUGEly this year.

(3) Profit margin. Now let’s take a moment to remember all those growling bears who have been trampled by the stampeding bulls since 2009. I miss them. I would have more confidence in the longevity of the bull market if they were still growling (as they mostly did from 2009-2013) that the bull market was on a sugar high and that earnings would be disappointing, or that the profit margin would soon revert to its mean.

The flash crash a few weeks ago might have given the bears a reason for living, but it was too short-lived. And here’s another disappointing flash for the bears: The operating profit margin of the S&P 500 rose to a new record high during Q4. It was 11.0% based on Thomson Reuters data and 10.4% based on S&P data. It will be higher during Q1-2018 thanks to the TCJA.

The bears could make a comeback if President Donald Trump turns into an outright protectionist. More likely is that he will back off if the market continues to react badly to his protectionist pronouncements. After all, he clearly prefers the Dow Jones Industrial Average as a measure of his popularity rather than opinion polls. Could today’s sharp stock market selloff on news that Trump intends to slap tariffs on steel and aluminum imports be the incipient formation of the Dow Vigilantes?