In Search of Truth and WisdomMay 23, 2023
Another short note as we traverse Europe in search of truth and wisdom. It is harder to come by these days. Many economists persist in calling for a second quarter recession (Bloomberg has an 0.5% average for Q2), though we are half way through and high frequency data, like continuing claims, does not suggest any weakness. The Atlanta Fed’s GDPNow is up to 2.9%. The S&P500 broke above its most recent high, as the stacks of cash on the sidelines leap at every indication that default might be avoided. We were in Dublin with Cleveland Federal Reserve President Loretta Mester, when she indicated that she was not ready to pause – a view reiterated by Dallas Fed President Lorie Logan later in the week. Many Fed speakers were out all week, and their consensus is clearly hold or tighten – not the hold or ease priced into financial markets. Opinions vary, the saying goes, but now they are quite dispersed and many are held with little conviction.
We have to say that after a week of discussions with travelling members of the Global Interdependence Center and the National Business Economic Issues Council (both started by Nobel Prize winner Lawrence Klein in Philadelphia), as well as local experts in Dublin and London, we are feeling more comfortable about several of our main contentions – which, until recently, were somewhat out of consensus. Notably, the benefit of face-to-face discussions, where one can be a bit more unpolitic when defended by Chatham House Rules — or just plain old-fashioned friendship – was extremely refreshing. Discussions over dinner or at breaks between speakers (whose input is often only too well known before they start) revealed a lot about how strongly various analysts believed in the positions they were advocating – and how much was pressure from employers or other institutional forces.
Bottom line, our very strictly monetarist interpretations on how recent drastic monetary policy moves has impacted inflation is more widely accepted in private (Note, we will drop this emphasis as inflation returns to the 2% target). The money drops exploded asset prices, and goods & services reacted with their normal lag. The end of money printing in November 2021 tanked the financial markets (stocks and bonds), and is having an ongoing impact on goods and services now. Since the Fed shows no signs of backing off – may tighten further – and the only direction for fiscal spending is lower (either through default or agreement), we can hold no other view than that inflation will surprise on the downside.
As to real growth, we remain in the camp that there will be no recession in 2023 – but that 2024 is at risk, after a year in which profit margins erode as wages rise faster than prices. The view that profit margins – and specifically the spread between the growth rate in unit labor costs and core prices – is more important than other lead indicators (like the yield curve) was more broadly accepted this round of meetings. Given our view that competition from growing supply will drive down prices – and that providing more supply will hold up wages – we see the coming year narrowing margins and causing the demise of many weaker players as wages rise (just as SVB and Signature collapsed from rising rates).
There is a significant risk to this more above consensus forecast — from the restart of student loans in September – but payments will likely be deferred until October. So, we see a soft holiday season, and then trouble early in 2024 — as making payments depletes any excess savings remaining for the middle-class. We are less concerned about the macroeconomic effect of a default. We expect that if we approach the x-date without a compromise, the financial markets will begin to panic and send a signal to Washington that cannot be refused. It won’t be pretty, but should be short.
Our main take away from the retail sales report (other than that big revisions have become too common in this series) is that nominal spending for retail excluding food and gas (core retail sales) was up at a 5.4% annual rate in the past three months compared to the previous three. Good prices are supposed to be tracking near zero if the headline PCE deflator is going to be 2%. Nominal growth that high means either labor markets are going to tighten further on strong real growth or that prices are still rising far faster than the 2% target. That leaves a data dependent Federal Reserve leaning the wrong way for financial markets that see aggressive easing coming soon. In our view, too many are focused on inflation and real growth like they are two separate phenomenon, rather than just parts of nominal growth. As long- time readers will know, my father’s greatest lesson (learned at MIT) was that part of it plus the rest of it is all of it! (P+R=T)
Meanwhile, the housing data seem to indicate that this sector is no longer a drag on the economy. Activity is at an extremely low level – but it is no longer declining. That seems to be a byproduct of the fixed income market’s conviction that the Fed will start easing soon, so long rates have retreated to roughly 3.5% and mortgage spreads have stabilized near 3% making new mortgages awfully expensive – but still attractive to some, especially those who expect to refinance soon. Housing typically recovers during the recession as rates drop, so there may still be some risk here from an unexpected further FOMC hike – but given the already low level of activity, that won’t hurt aggregate growth much.
This was another week of sideways movement on the banking data for deposits and new loans and leases. That is certainly not good, as it suggests no growth in money supply (which is already down a lot), but it is not a crisis. Even if it were, we heard from officials at the Federal Reserve, Bank of England and ECB that there is a bright line between monetary policy and supervisory issues. At the Bank of England, there are two distinct committees. For the Federal Reserve and ECB, they are viewed as separate functions, unless there is a broad threat to the financial system – which they do not see.
Industrial production in manufacturing was boosted by strong car production – matching the strong unit sales numbers, but not retail sales. It is the factory sales to dealers that are used in calculating GDP. Manufacturing ex-auto was up just up 0.4%, after falling 0.7% last month. The message from a wide swath of business economists this week was that supply chains issues are largely in the rear-view mirror. NFIB data shows that more small firms are now more worried that inventories are too high, rather than too low.
This supports one of our main views on inflationary pressure – that the recent stronger than expected growth in employment is more about supply than demand. Economists have been trained to think of a new job as a new source of income and spending power, rather than about that income being from the production of new supply. Of course, it is both, as supply and demand must balance. However, we argue that recent increases in employment are more likely to be generating new supply, rather than demand. Some positions are from those returning to the workforce because they have depleted excess savings – so their spending is not rising as much as their new income. Moreover, at NBEIC we saw very convincing data that most of the job growth in the past year has been fulfilled by new immigrants – a significant change from the past three years. Immigrants are typically less well paid than domestic workers – and they send income home, which fuels demand in foreign nations. Their supply, however, tends to stay right here – especially in lower pay service sector jobs, agriculture and food production. More supply increases competition and bids down prices (or at least price increases). We see this as a key component of the faster than expected demise of inflation, while our brethren continue to see jobs not only as needed –but a source of sustained inflation.
Bottom line, the US economy is slowing – but not as fast as the consensus thinks it will in reaction to earlier Fed tightening. Rather, that tightening has surprised the consensus by reducing inflation faster than expected, while maintaining decent real growth. We expect the FOMC will keep policy tighter than expected – squeezing inflation out even faster, especially as competition increases as growth slows. Our simple question is what will firms do first? Let go clearly scarce low-level workers or reduce prices or inflation to steal market share? We expect more price wars ahead – and a year long process of margin erosion in general that leads to a recession in 2024.
Still 2024 is a long way off – it is an election year – and current nominal growth still supports real growth above trend, and is above current interest rates. As long as g>r there is room for entrepreneurs and labor to squabble over who gets the earnings not committed to the rentier. As long as some entrepreneurs get a growing share, they will continue to expand demand for credit – likely punishing their competitors with higher rates. If labor gets a bigger share, first spending will increase (as workers have a higher marginal propensity to consume – you know, they spend more of their income), helping some firms, while other falter from margin pressure. Narrowing margins do not crush an economy instantly – it takes a while to identify winners and losers and for losers to deplete savings or lose access to other people’s money. That is where we believe the economy is now – but if there is a surprise, it is more likely to be from real growth staying above consensus, which will leave the FOMC is a tighter than expected position worrying about a wage-price spiral.