In September 2012, I wrote What If the Fed Has It All Wrong? which John Mauldin used in one of his Outside the Box posts. I questioned the wisdom of the Fed’s QE programs after QE1, arguing that income inequality would work against the desired wealth effect on economic growth.
The problem with Bernanke’s wealth effect thesis lies with the new reality in America. Income and assets have lately been so significantly redistributed that only a tiny few actually feel a wealth effect from rising equity prices. (…)
Keep in mind that it is these wealthy people who run American corporations, keeping them lean and mean and flush with cash. They remember how profits literally disappeared in 18 months in 2007-08. They remember how financial markets totally froze in 2008. They see the humongous budget deficits and the debt piling on, and the not-so-distant day of reckoning. They realize that all the QEs in the world can’t offset inept and irresponsible politicians on either side of the Atlantic. Yet, they are the ones targeted by the so-called wealth effect!
Call that pushing on a golden string.
Meanwhile, the less affluent, the other 80% – some 250 million people – are little concerned by an eventual wealth effect but highly, directly, and immediately impacted by the side effects of all these QEs, namely rising commodity prices and near-zero interest rates on their savings.
Call that pushing on a chafed string.
These extraordinary monetary experiments have had little impact on the real economy. Three-and-a-half trillion dollars were not enough to lift the economy sufficiently to allow the Fed to normalize interest rates six years after. In reality, the U.S. economy never regained any sustained momentum with growth averaging a paltry 2.1% since 2010 or 1.3% per capita, and staying close to recession all the while, forcing the Fed to keep the financial heroin flowing..
And now, after warning us for months that domestic conditions were just about getting right to begin raising rates off their zero floor, Mrs. Yellen spent the better part of her press conference last week talking about “global economic and financial developments” and the damage these could do to U.S. growth and inflation.
This “data dependant” group has decided to stand pat in spite of all these positive developments since the FOMC meeting of July 28-29:
- The number of job openings rose 21.7% YoY in July to 5.753 million.
- The average job gain over the past three months was 221,000, a slowdown from the July three-month average of 250,000, but still a healthy pace.The latest number includes August’s 173,000 new jobs but everybody knows that August data are often revised upwards. Over the past five years, revisions have added an average 79,000 jobs to the initial August readings.
- Full-time employment is up by 1 million in the past 2 months.
- The unemployment rate declined to 5.1% in August from 5.3%, the lowest level since 2008. It troughed at lower levels during the last two bubble cycles but it had troughed at 5.8% in 1979 and 5.2% in 1989.
- New jobless claims are at a 40-year cyclical low. Adjusted for the diminished labor force, claims are at a record low, suggesting very limited immediate labor slack.
- Average weekly hours for all private employees at 34.6 are back at their 2007 peak level.
- Average hourly earnings of private employees rose 0.4% MoM in August following +0.3% in July, a 4.3% annualized growth rate. They are up 2.4% YoY after averaging +1.9% during the first 7 months.
- Given the growth in hours, wages and employment, the income proxy for August is in the +4.5-5.0% range.
- Nominal personal disposable income rose 0.5% MoM in July, bettering the previous 3 consecutive 0.4% gains. The annualized rate since March is +5.2%, +3.0% in real terms (+3.6% in the last two months).
- Nominal expenditures are also up 5.2% annualized since March while real expenditures are up 2.7% annualized.
- “Core” retail sales rose 0.4% in August and are up at a 5.3% annualized rate in the last 3 months.
- Car sales reached an annualized pace of 17.8 million in August, back to their previous cyclical peaks. Sales of light trucks and SUVs now substantially exceed autos sales.
- Housing starts were up 15.9% in August and their last 3-month average is 16.5% above the 2014 average.
- Existing home sales are up 10.3% YoY and reached pre-recession levels in July.
- U.S. construction spending is up 13.9% YoY in July and at a 15.6% annualized rate in the last 3 months. Private construction is even stronger: +17.5% YoY and +15.5% annualized.
- Orders for non-defense capital goods ex-aircraft jumped 2.2% MoM in July after +1.4% in June.
In brief, the consumer side of the U.S. economy, which is nearly 70% of GDP, is strong and strengthening on solid fundamentals. Economic drivers such as autos, housing, construction and capex are also contributing. While QEs boosted asset values for the wealthiest Americans, lower commodity prices and a strong U.S. dollar are boosting the purchasing power of ordinary people. And being true Americans, they are now spending the windfall.
Yes, U.S. manufacturing is weak as U.S. exports are impacted by the strong dollar and domestic manufacturers struggle against import competition and price deflation. But there’s nothing new there, is there?
Manufacturing employs but 8.9% of all American non-farm workers against 86% for the Services sector. New manufacturing jobs total 28,000 so far in 2015. New service-providing jobs amount to 1.65 million. Goods-producing industries contributed 0.5% to GDP growth in 2013-14, less than one-third the 1.6% contribution from services-producing industries. Hourly earnings in services have increased at an annualized rate of 2.9% so far in 2015, reaching $24.75/hour in August. Manufacturing wages have also risen at a 2.9% rate this year and are now $25.33, only 2.3% higher than services wages (+7.7% in 2006).
THE DYNAMICS OF COMMODITY DEFLATION
So when Mrs. Yellen spends the better part of her press conference talking about external risks to the U.S. economy, her focus is dangerously misplaced. Furthermore, she and her fellow FOMC members fail to grab the dynamics of commodity deflation.
During the last 20 months, there have been extraordinary declines in prices of a large variety of commodities. To wit:
- Oil (Nymex): –63% since June 2014
- Copper: –33% since December 2013
- Aluminum: –29% since August 2014
- Iron Ore: –60% since December 2013
- Nickel: –48% since March 2014
- Corn: –29% since April 2014
- Coffee: –45% since October 2014
- Wheat: –30% since April 2014
- Soybeans: –40% since April 2014
- Sugar: –32% since May 2014
Cotton: –30% since February 2014
Such widespread and significant price declines cannot be only the result of a general supply glut. This is not only China slowing given the large number of food commodities in sharp declines. It is also not simply a USD reaction since the dollar really began to spike late in 2014. Rather, it is symptomatic of a sustained, general slowdown in global demand.
World Bank data show that global GDP growth slowed from the 4% range before the financial crisis to 2.3% on average between 2011 and 2014 and is expected to be less than 2.8% in 2015.
Developing countries are facing two transitions, as they adjust to prospects of low commodity prices over the medium-term and tighter financial conditions ahead. Oil prices appear to have found some support, upon evidence of a sharp decrease in unconventional oil production capacity in the United States, but are likely to remain low. Other commodity prices continue to be soft, on weak demand as well as ample supplies. As a result, in commodity exporting countries, especially those with limited reserve and fiscal buffers, activity has slowed more than anticipated, currencies have weakened, and domestic and external vulnerabilities have grown. (…)
Compared with 2014, growth in developing countries is expected to slow to 4.4 percent in 2015, 0.4 percentage point less than anticipated in January, before rising to 5.3 percent in 2016–17. Growth prospects for low-income countries (LICs) remain robust, above 6 percent in 2015–17.
In a second transition, developing countries will be at heightened risk of depreciation amid a gradual tightening of financial conditions, albeit from very accommodative levels, and moderating capital flows.
The World Bank is normally sanguine in its forecasts. The reality is that the widespread collapse in commodity prices coupled with the strong USD is crippling most developing countries without a commensurate and simultaneous offsetting stimulation of demand in developed countries.
On Aug. 26, we learned that
Household spending on consumption fell more than 4% year-over-year in the three months ended June in Indonesia and Malaysia, two of Southeast Asia’s linchpin economies, according to statistics compiled by CEIC Data. In Thailand, growth in consumer spending slowed to 1.3% year-over-year in the second quarter from 4% in the first.
High-frequency data show retail sales in Indonesia fell 5.3% year-over-year. Sales fell more than 13% in Singapore, a typically volatile market, its fourth straight month of contraction.
Meanwhile, farmers in Asia have been particularly hard hit by falling commodities prices and have less purchasing power as a result. (WSJ)
On August 31, we also learned that Thailand’s private consumption index fell 2.1% from a year earlier in July, widening from a revised 0.1% on-year drop in June.
On the other side of the globe, the same week, we learned that
U.S. net farm income will drop to $58.3 billion from $91.1 billion in 2014, marking the largest percentage decline since 1983, including when figures are adjusted for inflation. The projected decrease would mark the second consecutive drop after incomes reached nominal record highs in 2013, according to the USDA.
Global food deflation adds to the impact that low oil prices are having on state producers from Russia, to Brazil, to Canada’s Alberta and to the U.S. producing states where some 33% of the American population is directly impacted by falling commodity prices.
In real life, commodity producers are quick to retrench as soon as they see lower prices in futures markets. Anticipating the inevitable drop in their revenues, they adapt their consumption patterns well before their revenues actually decline.
On the other hand, commodity consumers do not adjust their consumption so rapidly. For starters, it often takes a while before lower commodity prices find their way to the final products. Secondly, people will often wait and see if the lower prices have some permanency before actually taking full advantage of their newly found purchasing power.
We are currently going through the severe demand slowdown in producing regions, awaiting the full effect on demand from commodity consumers.
The hope is that this dislocation between demand from producing (mainly developing) countries and demand from consuming (mainly developed) countries does not last much longer and that consumers in richer developed countries start using their enhanced purchasing power to boost consumption.
CONSUMERS TO THE RESCUE
Real retail sales in the U.S. nosedived 13% during the financial crisis and never really closed the trend gap.
Income growth was certainly restrained in the U.S. since the financial crisis but the main reason for the continued gap between trend lines stems from the jump in savings as consumers took time to restore their balance sheet.
The deleveraging process is likely coming to an end. Declining debt levels combined with low interest rates have brought household debt servicing to an historical low of 10%. Given the sustained growth in employment and rising consumer confidence, we can assume that growth in consumer spending will be more closely aligned with income growth and may, in fact, rise faster in coming years as the savings rate declines to the 4% range from its current 5%.
As lower commodity prices work their way through the manufacturing and distribution processes, we can also expect that goods deflation will continue for a while. The PCE deflator for consumer expenditures is up 0.3% YoY in the first 7 months of 2015, down from +2.0% in Q314 and +1.1% in Q414. Since January, Services inflation has been +1.9% but Goods inflation has been –3.0%, including –2.2% for Durable Goods which are not directly oil-sensitive.
The U.S. PPI for finished goods has been deflating since July 2014 and has been negative YoY since November 2014. Import prices are also deflating on the strength of the USD. Import prices for all commodities ex-petroleum are down 4.0% annualized so far in 2015. Import prices for consumer goods excluding automotives are down 1.2% YoY in August, having declined sequentially in 8 of the last 11 months and at a 1.5% annualized rate since February. Automotive prices have also been deflating in 2015 at a 2.1% a.r..
A similar deflation pattern is visible in most of the consuming OECD countries:
As we enter the all-important stretch from back-to-school to Christmas, the U.S. consumer seems poised to accelerate its spending thanks to its increased purchasing power, a much improved balance sheet and high confidence as employment growth continues. European consumers are also beginning to spend. Real retail sales have been accelerating since October 2014 reaching +2.0% YoY last May until the Greek uncertainty caused a small setback in June-July. July real sales were up 3.5% YoY in Germany (+4.5% a.r. in last 4 months) , 3.3% in Spain (+5.1%) and 1.6% in France (+2.7%).
Given the on-going slowdown in China and the supply excesses engineered by low cost money since 2010, commodity prices are unlikely to stage a sharp rebound anytime soon. Commodity producers are thus likely to endure slow growth for a while, at least until consuming economies really accelerate their consumption.
This is where lies the risk for the Fed and financial markets. Misreading the transition between commodity-producing and commodity-consuming regions can lead to over-reacting to external challenges and under-estimating domestic strength.
U.S. real retail sales were up a seemingly low 2.2% YoY in August. Yet, core retail sales in July-August are up at over a 6% annual rate. We are entering the all important back-to-school to Christmas season with the consumer fired up to spend on discretionary goods and services. Were that to happen, the current inventory glut in the economy would be quickly eliminated, triggering renewed manufacturing production when domestic labor supply is very tight.
The Fed might then find itself well behind the curve and pain to steer, let alone stop, this big ship then going at cruising speed.
In her press conference following the latest FOMC meeting, Mrs. Yellen said:
While we still expect that the downward pressure on inflation from these factors will fade over time, recent global economic and financial developments are likely to put further downward pressure on inflation in the near term.
(…) the Committee anticipates that inflation will remain quite low in the coming months.
Trivia question: What is the annualized U.S. inflation since January 2015:
- Headline CPI: +2.4% (-2.5% in the 6 months previous)
- Core CPI: +2.0% (+1.4%)
- Headline PCE deflator: +2.1% (-0.4%)
- Core PCE deflator: +1.7% (+1.0%)
We are thus nowhere near deflation even with goods deflation. In fact, goods prices are +2.4% annualized since February even though they are –2.7% YoY. If it were not for Energy goods and services which are down –15.7% YoY, headline inflation would be much higher. But energy goods and services prices have been exploding at a 16.2% annualized rate since February!
So the Committee, which “continues to monitor inflation developments closely” must be looking at things differently…
What are the odds that 3-6 months from now we find the U.S. economy expanding north of 3% with accelerating wages and inflation above 2%? The FOMC would put these odds near current Fed fund rates. I would not.