Why Not 50?

May 22, 2018

Asking if the Federal Reserve will lift the federal funds rate on June 13 is like asking if Las Vegas Golden Knights goalie Marc-Andre Fleury, who has stopped 94.7% of the shots against him in the 2018 Stanley Cup playoffs, will stop the next one.  It’s a virtual lock.

And everyone knows the rate hike is almost guaranteed to be the very same 25 basis point (bp) increment the Fed has used six times in the current rate hiking cycle, starting in December 2015.  In fact, that’s the same 25 bp increment the Fed used consistently between June 2004 and June 2006, totaling seventeen drip-drip-drip rate hikes in all.  That campaign lifted rate 425 bps total, every one of which was telegraphed.  Rates moved from a starting point of 1% to a peak of 5.25%.

We need to go all the way back to May 2000 to find a meeting at which the Fed raised rates by 50 bps – the final rate hike of that cycle – after a series of 25 bp hikes that started in mid-1999.  In other words, the Fed has become comfortable and predictable with 25 bp moves, which seems to be all about not getting blamed for any kind of short-term market turmoil.

So why not raise by 50 bps?

Everyone knows the Fed will lift rates by at least another 50 bps this cycle.  The federal funds futures market puts the odds of the Fed raising rates by less than 50 bps this year at 6.6%.  We’re sure the odds would be even lower if we included 2019.  That’s as close to a sure thing a Marc-Andre Fleury.

So, if the Fed is going there anyhow, why not get there sooner?  Why not get to a neutral monetary policy more quickly?  Why be so predictable?

Raising rates by 50 bps this early in the cycle isn’t going to make monetary policy tight.  Right now, nominal GDP (real GDP growth plus inflation) is up 4.8% in the past year and up at a 4.4% annual rate in the past two years, well above the current federal funds target of 1.625%.  The 10-year Treasury yield is about 145 bps above the funds rate.  Meanwhile, the banking system is chock full of excess reserves and a record amount of capital.  Congress and executive agencies are moving to undo some of the excess regulations on the banking system, there are no major bubbles in the financial system, and corporate balance sheets are in fantastic shape.

Add in an unemployment rate of 3.9%, well below the Fed’s consensus view that its long-term average will be 4.5%.  Plus, the PCE deflator, the Fed’s favorite inflation measure, is already up 2% from a year ago and, given the recent rise in oil prices, should hover persistently above 2% for the rest of the year.

One of the key problems with “forward guidance” and gradually lifting interest rates on a predictable schedule is that it’s too predictable.  It’s like clockwork.  At present, everyone thinks they can predict the movement of future short-term rates with little to no risk.  Which is exactly what happened in the previous decade.  By telegraphing every move, the financial system could use simple spreadsheets to build a strategy for taking advantage of 25 bp moves at every meeting.  This led to a complacency and a willingness by many players to take on excessive risk.  In many ways, this is the same thing President Trump complained about with our military – always telling the world exactly what we would do and when we would do it.

To be precise, we’d like to see the Fed raise rates by 50 bps in June.  Then, using its dot plot and press conference, the Fed could signal more rate hikes to come while also, by going 50 bps at this meeting, signal that timing is always on the table.    In other words, the Fed would probably raise rates by a total of 100 bp this year, but the average level of short-term rates in 2018 would be slightly higher than if it moved only 25 bps at a time.  This would move long-term rates higher sooner as well.

Surprising the market would not be the end of the world.  Back in September, the Bank of Canada surprised with a rate hike and lived to tell the tale.  Canadian equities are up since then.  And the Canadian dollar is up, as well.

Once again: we’re not holding our breath waiting for the Fed to surprise the market.  The most likely outcome on June 13 is yet another 25 bp rate hike.  But if the Fed really wants to prevent the kinds of imbalances that built up before the last recession, it should consider introducing some upside uncertainty into the path of short term rates.

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist

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Labor Market Strength

May 15, 2018

The US labor market has rarely been stronger.

Recent figures from the Labor Department show US businesses had a total of 6.550 million job openings in March versus 6.585 million people who were unemployed.  That’s a gap of only 35,000 workers.  By contrast, this gap never fell below 2 million in the previous economic expansion that ended in 2007, and stood at 638,000 in January 2001, at the end of the expansion that started in mid-1991 and ran through early 2001.

Of course, these figures have to be put in context.  The measure of unemployed workers doesn’t include “discouraged” workers, for example, nor does it include part-time workers who say they want full-time jobs.  And it’s not like all the unemployed have the skill sets needed for the job openings that are available.

Still, the negligible gap between the number of job openings and the number of unemployed who are pursuing work shows that the demand for labor is intense.

Reports on jobless claims show companies are clinging to their workers.  In the past four weeks, the average pace of initial jobless claims has been the lowest since 1969; meanwhile, continuing claims have averaged the lowest since 1973.

And new jobs continue to be created.  In the past year, nonfarm payrolls are up an average of 190,000 per month, matching the pace of the year ending in April 2017.  As a result of this continued job creation, the jobless rate has dropped to 3.9% in April, the lowest since the peak of the internet boom in 2000.

Assuming a real GDP growth rate of 3.0% this year and next, we think the jobless rate will finish 2018 at 3.7%.  That would be the lowest rate since 1969.

Then, in 2019, the jobless rate should drop to 3.2%, the lowest since 1953.  Beyond that, continued solid growth could realistically push the jobless rate below 3.0%.

Maybe it’s optimism about the labor market that’s behind President Trump’s recent tick upwards in popularity and the GOP’s better performance in the “generic” ballot, which measures whether potential voters are inclined to support Republicans or Democrats in House races this November.  Either way, it doesn’t seem like an environment that favors a tidal wave of change for the Democrats this fall.  The odds of the GOP keeping the House are rising, and the GOP looks more likely to gain Senate seats than lose them.

Although some still bemoan slow growth in wages, April average hourly earnings were up a respectable 2.6% in the past year.  And that doesn’t include the kinds of one-time bonuses that have become more widespread since the tax cut was enacted in late 2017.

The biggest blemish on the labor market is that the participation rate – the share of adults who are either working or actively looking for work – is still low by the standards of the last forty years.  After peaking at 67.3% in early 2000, the participation rate has declined to the current reading of 62.8% in April.

This drop is mainly due to three factors: the aging of the Baby Boom generation into retirement years, overly generous student aid (which has reduced the willingness of young Americans to work), and disability benefits that are too easily available.  Hopefully, the coming years will see policymakers find ways to tighten rules on disability while limiting student aid to truly needy students who are taking economically useful coursework.

But even if these changes don’t happen, look for more good news – and an even stronger labor market – in the year ahead.

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist

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Don’t Compare Stocks to GDP

May 7, 2018

The bull market in U.S. stocks, which started on March 9, 2009, gets little respect.  Those who have been bullish, and right, are mocked as “perma-bulls,” while “perma-bears,” who have been repeatedly wrong, are quoted endlessly.

We don’t have enough fingers and toes to count the number of times a recession has been predicted.  Brexit, Grexit, adjustable rate mortgages, student loans, the election of Donald Trump, tapering, rate hikes, a 3% ten-year Treasury yield, Hindenberg Omens, Death Crosses, and two fiscal cliffs are just a few of the seemingly endless list of things that were going to end the bull market.  (And the pouting pundits of pessimism are never held accountable for erroneously spreading fear.)

One staple of the bearish argument, and the one we want to discuss today, is that corporate profits have grown faster than GDP.  This, the bears have claimed for years, can’t last.  The argument is that there will be a reversion to the mean, profit growth will slow sharply and an overvalued market will be exposed.  A close cousin to this argument is that stock market capitalization has climbed above GDP, signaling over-valuation.

Both of these arguments make fundamental mistakes:  first, about the relationship between GDP and profits; second, about the correct measurement of GDP.

The economy is a combination of the public sector and the private sector.  Most people think direct government purchases of goods and services, which were 17.2% of GDP last quarter, represents the full impact of government on the economy.  But total Federal, State and Local spending (which adds in entitlement spending, welfare, and government salaries), as well as the cost of complying with government regulations, raises the number to 45% of GDP.  And because the private sector pays for every penny of government spending, resources directed by the government are significantly larger than just purchases.

There is little doubt that the growth rate of productivity in the private sector is much stronger than in the public sector.    In fact, it is probably true that productivity growth in the public sector is negative – directly, and indirectly – through the burden of regulatory costs.  If 55% of the economy (private spending) experiences strong productivity, but 45% of the economy (the public sector) experiences negative productivity, overall GDP and productivity statistics are dragged down. 

In other words, secular stagnation is a figment of the average – government has grown too big and is a drain on the economy.  Yes, private sector growth (and profits) can grow faster than GDP.  It’s not a bubble, it only looks like a bubble when looking up from the hole government has created.

The second important point is that GDP is a flawed measure of economic activity.  It tracks final sales, but not “total” economic activity.  A new car may cost $42,000, but the total amount of economic activity to build and sell that car (the total of all the checks written between businesses and consumers) is significantly more than the final cost of the car.  Much business-to-business activity is not captured directly in GDP.

Mark Skousen has pushed for years for the Bureau of Economic Analysis to publish “Gross Output (GO),” which includes all economic activity.  And in Q4-2017 GO was $34.5 trillion, nearly double the $19.7 trillion reading for GDP.

If you really want to compare the market cap of U.S. corporations to the correct measure of economic output, it is much more logical to compare it to Gross Output, not GDP.  By that measure the market cap of the U.S. stock market is still well below overall economic activity.

The real issue here is that investors should care little about GDP.  No one buys shares of GDP.  Investors buy shares of companies, and profits are proof that productivity is strong in the private sector.  Government distorts the picture, showing both a secular stagnation and “bubble” that don’t really exist.

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist

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3% – Why It Doesn’t Matter

May 1, 2018

Just a few weeks ago, the Pouting Pundits of Pessimism were freaked out over the potential for the yield curve to invert.  They’ve now completely reversed course and are freaked out over a 3% 10-year Treasury note yield.

All this gnashing of teeth is driven by a belief that low interest rates and QE have “distorted” markets, created a “mirage,” a “sugar high” – a “bubble.”

These fears are overblown.  Faster growth and inflation are pushing long-term yields up – a good sign.  And, yes, the Fed is normalizing its extraordinarily easy monetary policy, but that policy never distorted markets as much as many people suspect.  Quantitative Easing created excess reserves in the banking system but never caused a true acceleration in the money supply.  That’s why hyper-inflation never happened and both real GDP and inflation remained subdued.  Profits, not QE, lifted stocks.

And our models show that low interest rates were never priced into equity values, either.  We measure the fair value of equities by using a capitalized profits model.  Simply put, we divide economy-wide corporate profits by the 10-year Treasury yield and compare these “capitalized profits” to stock prices over time.  In other words, we compare profits, interest rates, and equity values and determine fair value given historical relationships.  The lower the 10-year yield, the higher the model pushes the fair value of stocks.

Because the Fed held short-term rates so low, and gave forward guidance that they would stay low, they pulled long-term rates down, too.  As a result, over the past nine years, artificially low 10-year yields have caused our model to show that stocks were, on average, 55% undervalued.

In other words, stocks never priced in artificially low interest rates.  If they had, stock prices would have been significantly higher, and in danger of falling when interest rates went up.

But we have consistently adjusted our model by using a 3.5% 10-year yield.  Using that yield today, along with profits from the fourth quarter, we show the stock market 15% undervalued.  In other words, we’ve anticipated yields rising and still believe stocks are undervalued.  A 3% 10-year yield does not change our belief that stocks can rise further this year, especially with our expectation that profits will rise by 15-20% in 2018.

The yield curve will not invert until the Fed becomes too tight and that won’t happen until the funds rate is above the growth rate of nominal GDP growth.  Stay bullish.

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist

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Modest Growth in Q1

April 25, 2018

From mid-2009 through early 2017, the US economy grew at a real average annual rate of 2.2%.  Not a recession, but not robust growth either, which is why we called it a Plow Horse Economy.

For the first quarter of 2018, we expect growth of 1.9% at an annualized rate, right in-line with a Plow Horse. 

But that doesn’t mean the economy is still a Plow Horse.  It isn’t.  Growth has picked up, even if last quarter doesn’t show it.  Even with a 1.9% growth rate in Q1, real GDP is still up 2.7% from a year ago, and we anticipate an average growth rate of around 3% this year and next year with higher odds of growth exceeding that pace rather than falling short.

Taxes and regulations have been cut and monetary policy remains loose.  Look for a significant acceleration in growth in the quarters ahead. 

Here’s how we get to 1.9% for Q1.  But, keep in mind that we get reports on shipments of capital goods on Thursday as well as early data on trade and inventories, so we could end up tweaking this forecast slightly later this week. 

Consumption:  Automakers reported car and light truck sales fell at a 12.4% annual rate in Q1, in large part due to a return to trend after the surge in sales late last year following Hurricanes Harvey and Irma.  Meanwhile, “real” (inflation-adjusted) retail sales outside the auto sector declined at a 0.8% annual rate.  However most consumer spending is on services, and growth in services was moderate.  Our models suggest  real personal consumption of goods and services, combined, grew at a 1.2% annual rate in Q1, contributing 0.8 points to the real GDP growth rate (1.2 times the consumption share of GDP, which is 69%, equals 0.8).

Business Investment:  It looks like another quarter of solid growth, with investment in equipment growing at about a 5% annual rate, and investment in intellectual property growing at a trend rate of 5%, as well.  Meanwhile, commercial construction looks unchanged.  Combined, it looks like business investment grew at a 4% rate, which should add 0.5 points to real GDP growth.  (4.0 times the 13% business investment share of GDP equals 0.5).

Home Building:  It looks like residential construction grew at a 5% annual rate in Q1, roughly the same pace as the average over the past five years.  This should add 0.2 points to the real GDP growth rate.  (5.0 times the home building share of GDP, which is 4%, equals 0.2).

Government:  Public construction projects were up in Q1, but military spending declined.  Looks like overall real government purchases rose at a 0.6% annual rate in Q1, which would add 0.1 points to the real GDP growth rate.  (0.6 times the government purchase share of GDP, which is 17%, equals 0.1).

Trade:  At this point, we only have trade data through February.  Based on what we’ve seen so far, it looks like net exports should subtract 0.7 points from the real GDP growth rate in Q1. 

Inventories:  Like with trade, we’re also working with incomplete figures on inventories.  But what we do have suggests companies were accumulating inventories more rapidly in the first quarter than at any time in 2017.  This should add a full 1.0 point to the real GDP growth rate.

Add it all up, and we get a 1.9% growth rate.  More data will come, and we could adjust, but hopes of a blow-out quarter have dimmed in recent months.  Nonetheless, the year-over-year growth rate has accelerated, and this slower quarter is just a temporary pause.  Corporate sales, incomes, jobs growth, investments, and construction are all accelerating.  So will GDP.

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist

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Thoughts on Trade

April 18, 2018

When the report on international trade came out earlier this month, protectionists were up in arms.  Through February, the US’ merchandise (goods only, not services) trade deficit with the rest of the world was the largest for any two-month period on record.  “Economic nationalists” from both sides of the political aisle, think this situation is unsustainable. 

Meanwhile, some investors ran for the hills when President Trump started announcing tariffs on steel, aluminum, and other goods, thinking this was the reincarnation of the Smoot-Hawley tariffs that were a key ingredient of the Great Depression.      

We think the hyperventilating on both sides needs to stop.

In general, nothing is wrong with running a trade deficit.  Many states run large and persistent trade imbalances with other states and, rightly, no one cares.  We, the authors, run persistent trade deficits with Chipotle and Chick-fil-A, and we’re confident these deficits are never going away.

Running a trade deficit means the US gets to buy more than it produces.  In turn, we have this ability because investors from around the world think the US is a good place to put their savings, leading to a net capital inflow that offsets our trade deficit.  Notably, foreign investors are willing to invest here even when the assets they buy generate a low rate of return.  As a result, this process can continue indefinitely.  

It’s important to recognize that free trade enhances our standard of living even if other countries don’t practice free trade.  Let’s say China invents a cure for cancer and America invents a cure for Alzheimer’s.  If China refuses to give their people access to our cure, are we better off letting our people die of cancer?  Of course not!

Imposing or raising tariffs broadly would not help the US economy.  Nor would imposing tariffs on specific goods, like steel or aluminum.  Giving some industries special favors will only create demand for more special favors from others.  It’ll grow the swamp, not drain it.   

All that said, we understand the frustration policymakers have with China, in particular, which has been levering access to its huge market to essentially steal foreign companies’ trade secrets and intellectual property.  It has a long-term track record of not respecting patents or trademarks.

In theory, letting China into the World Trade Organization was supposed to stop this behavior.  But no company wants to bring a WTO case against China when it thinks China would respond by ending its access to their markets and letting in competitors who are more willing to be exploited.         

In addition – and this is very important – China is unlike any of our other trading partners in that it is a potential major military rival in the future.  There is a national security case to be made – even if one takes a libertarian position on free trade in general – that the US could accept a slightly lower standard of living by limiting trade with China, if the result is a lower standard of living for China as well.          

And China doesn’t have much room to fire back at recent US proposals (none of which have yet to be implemented, by the way).  Last year, China exported $506 billion in goods to the US, while we only sent them $130 billion. 

That gives our policymakers room to raise tariffs on China much more than they can raise them on us.  If so, China would generate fewer earnings to turn into purchases of US Treasury debt.  Yet another reason for fear among bond investors.  However, don’t expect China to outright dump Treasury securities in any large amount.  They own our debt because it helps them back up their currency, not as a favor to the US.            

We’re certainly not advocating a trade war.  But an approach that focuses narrowly on China’s abusive behavior could pay dividends if it moves the world toward freer trade.

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist

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A Generation of Interest Rate Illiterates

April 13, 2018

An entire generation of investors has been misled about interest rates: where they come from, what they mean, how they’re determined. 

Lots of this confusion has to do with the role of central banks.  Many think central banks, like the Fed, control all interest rates.  This isn’t true.  They can only control short-term rates.  It’s true these can have an impact on other rates, but it doesn’t mean they control the entire yield curve.

Ultimately, an interest rate is simply the cost of transferring consumption over time.  If someone wants to save (spend less than they earn today) in order to consume more in the future, they must find someone else who wants to spend more today than they earn, and then repay in the future. 

Savers (lenders) want to be compensated by maintaining – or improving – their future purchasing power, which means they need payment for three things: inflation, credit risk, and taxes.

Lenders deserve compensation for inflation.  Credit risk – the chance a loan will not be repaid – is also part of any interest rate.  And, of course, those who earn interest owe taxes on that income.  After taxes, investors deserve a positive return.  In other words, interest rates that naturally occur in a competitive marketplace should include these three factors.

So, why haven’t they?  In July 2012, the 10-year Treasury yield averaged just 1.53%.  But since then, the consumer price index alone is up 1.5% per year.  An investor who paid a tax rate of 25% would owe roughly 0.375% of the 1.53% yield in taxes.  In other words, after inflation and taxes (and without even thinking about credit risk, which on a Treasury is essentially nil), someone who bought a 10-year bond in July 2012 has lost 0.35% of purchasing power each year, in addition to capital losses as bond prices have declined.

Something is off.  The bond market has not been compensating investors for saving, it has been punishing them.

Some blame Quantitative Easing.  The theory is that when the Fed buys bonds, yields fall. It’s simply supply and demand.  But this is a mistake.  Bonds aren’t like commodities, where if someone buys up all the steel, the price will move higher.  A bond is a bond, no matter how many exist.  Just because Apple has more bonds outstanding than a small cap company doesn’t mean Apple pays a higher interest rate.

If the Fed bought every 10-year Treasury in existence except for a single $10,000 Note, why would its yield be less than the current yield on the 10-year note (putting aside artificial government rules that goad banks into buying Treasury securities)?  It’s the same issuer, same inflation rate, same tax rate, same credit risk, and the same maturity and coupon.  It should have the same yield.  It didn’t become a collector’s item; it still faces competition from a wide array of other investments.  It’s still the same bond.

The real reason interest rates have remained so low is because many think the Fed will keep holding short-term rates down below fundamental levels well into the future.  If the Fed promises to hold the overnight rate at zero for 2-years then the 2-year Treasury will also be close to zero.  And since the 10-year note is made up of five continuous 2-year notes, then Fed policy can influence (but not control) longer-term yields as well.  The Fed’s zero percent interest rate policy artificially held down longer-term Treasury yields, not Quantitative Easing.  That’s why longer-term yields have risen as the Fed has hiked rates.

And they will continue to rise.  Why?  Because the Fed has held short-term rates too low for too long.  Interest rates are below inflation and well below nominal GDP growth.  The Fed has gotten away with this for quite some time because they over-regulated banks, making it hard to lend and grow.  Those days are ending and low rates now are becoming dangerous.

With inflation and growth rising, and regulation on the decline, interest rates must go higher.  It’s true the Fed is unwinding QE, but that’s not why rates are going up.  They’re going up because the economy is telling savers that they should demand higher rates.

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist

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Ignoring the Invisible Hand

April 4, 2018

One of the most important questions we have about our country’s future is whether prosperity itself will make the American people lose sight of where that prosperity comes from; whether we’ll forget to cultivate the attitudes about freedom, property rights, and hard work that have made not only us great but also all the other places that have followed the same path.

To be clear, this has nothing directly to do with who is president or which party controls Congress.  It has nothing to do with the tax cut passed late last year, or recent tariffs, or increases in federal spending, or red tape being cut or added.  Instead, it runs much deeper than that and will affect all of these issues over the very long term, multiple generations into the future. 

The issue comes to mind for personal reasons, as a couple of us travel around the country with our high school juniors looking at colleges, hither and yon.

We’re not here to shame any particular school, so we’re not going to name any.  But here’s what we notice on our visits:  at some point, the college admissions officers in charge of the meeting will talk about great accomplishments by students or recently-graduated alumni.  Invariably, the accomplishments are volunteer efforts of various sorts that help people in some far-off land or, sometimes, here in the US.

Don’t get us wrong, stories like this deserve to be told.  They’re important and worthy of honor.  But, not once, in all our collective college tours have we ever heard a school bring up someone who, say, grew up in tough circumstances, was maybe the first in their family to go to college, and has since gone on to become a very successful entrepreneur, investor, or key officer at a large company, like a CEO or CFO,…someone who has gone on to create wealth for their own family and others as well.       

Not once. 

Which is odd because we know these colleges must have tons of these stories to tell.  You can tell when you’re taking the tour after the admissions sessions when you walk through the campuses and see the dorms, classrooms, and athletic centers many of which are named after alumni who’ve cut enormous checks.

Maybe stories of business-oriented success are just not on the radar of the kinds of people who run admissions offices.  Or, worse, maybe they think it’s embarrassing or that there should be some sort of shame associated with striving to generate wealth. 

Either way, they seem out of touch with why so many of their students want to go to college in the first place.  “Making the world a better place” is not just about volunteer work; it’s about personal ambition and desire mixing with the invisible hand to raise the standard of living for everyone.        

Capitalism isn’t a dirty word and the long-term success of our civilization means making sure our children know it.

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist

Approved For Public Use

When Volatility is Just Volatility

March 27, 2018

Stock market volatility scares people.  But, volatility itself isn’t necessarily bad.  Only if there are fundamental economic problems, something that could cause a recession, would we think volatility itself is a warning sign.

So, we watch the Four Pillars.  These Pillars – monetary policy, tax policy, spending & regulatory policy, and trade policy – are the real threats to prosperity.  Right now, these Pillars suggest that economic fundamentals remain sound.

Monetary Policy:  We’re astounded some analysts interpreted last Wednesday’s pronouncements from the Federal Reserve as dovish.  The Fed upgraded its forecasts for economic growth, projected a lower unemployment rate through 2020 and also expects inflation to temporarily exceed its long-term inflation target of 2.0% in 2020.

As recently as December, only four of sixteen Fed policymakers projected four or more rate hikes this year; now, seven of fifteen are in the more aggressive camp.  Some analysts dwell on the fact that the “median” policymaker still expects only three hikes in 2018, ignoring the trend toward a more aggressive Fed.

But all of this misses the real point.  Monetary policy will still be loose at the end of 2018, whether the Fed raises rates three or four times this year.  The federal funds rate is about 120 basis points below the yield on the 10-year Treasury (which will rise as the Fed hikes), and is also well below the trend in nominal GDP growth.  Meanwhile, the banking system still holds about $2 trillion in excess reserves.  Monetary policy is a tailwind for growth, not a headwind.            

Taxes:  The tax cut passed last year is the most pro-growth tax cut since the early 1980s, particularly on the corporate side.  Some analysts argue that the money is just going to be used for share buybacks, but we find that hard to believe.  A lower tax rate means companies have more of an incentive to pursue business ideas that they were on the fence about.

And there is a big difference between who cuts a check to the government and who truly bears the burden of a tax, what economists call the “incidence of a tax.”

Cutting the tax rate on Corporate America will lift the demand for labor, meaning workers and managers share the benefits with shareholders.  Yes, some of the tax cut will be used for share buybacks, but that’s OK with us; it means shareholders get money to reinvest in other companies.  Buybacks also move capital away from corporate managers who might otherwise squander the money on “empire building,” pursuing acquisitions for the sake of growth, when returning it to shareholders is more efficient. 

Spending & Regulation:  This pillar is a little shaky.  On regulation, Washington has moved aggressively to reduce red tape rather than expand it.  That’s good.  But, Congress can’t keep a lid on spending.  That’s bad.

Back in June, the Congressional Budget Office was projecting that discretionary spending in Fiscal Year 2018 would be $1.222 trillion.  (Discretionary spending doesn’t include entitlements like Social Security, Medicare, or Medicaid, or net interest on the federal debt.)  Now, the CBO says that’ll reach $1.309 trillion, a gain of 7.1% in just nine months.

Assuming the CBO got it right back in June on entitlements and interest, that would put this year’s federal spending at 20.9% of GDP, a tick higher than last year at 20.8% – despite faster economic growth.  This extra spending represents a shift in resources from the private sector to the government.  The more the government spends, the slower the economy grows.             

Trade:  Trade wars are not good for growth.  And the US move to put tariffs in place creates the potential for a trade war.  We aren’t dismissing this threat, but a “full blown” trade war remains a low probability event.

The bottom line:  taxes, regulation and monetary policy are a plus for growth, spending and new tariffs are threats.  Things aren’t perfect, but, in no way do the fundamentals signal major economic problems ahead.  The current volatility in markets is not a warning, it’s just volatility.

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist

Approved For Public Use

The Powell Fed: A New Era

March 20, 2018

In the history of the NCAA Basketball Tournament, a 16th seed has never, ever, beaten a one seed…until this year.  But, on Friday, the University of Maryland, Baltimore County (UMBC) beat the University of Virginia – not just a number one seed, but the top ranked team in the USA.

We don’t expect the unexpected, however, when the Federal Reserve finishes its regularly scheduled meeting on Wednesday.  Based on the federal funds futures market, there is a 100% chance that the Fed will boost the federal funds rate by 25 basis points, to a new range of 1.5% to 1.75%.

The markets are even giving a roughly 20% chance that the Fed raises rates 50 basis points.  That’s better odds than UMBC had, but we suspect it’s highly unlikely given that this is Jerome Powell’s first meeting as Fed chief.

The rate hike itself is not worrisome.  It’s expected and, at 1.75%, the federal funds rate is still below inflation and the growth rate for nominal GDP.  There are also still more than $2 trillion in excess bank reserves in the system.  The Fed is a very long way from being tight.

Instead, investors should focus on how the Fed changes its forecast of what’s in store for the economy and the likely path of short-term interest rates over the next few years.

Back in December, the last time the Fed released projections on interest rates and the economy, only some of the policymakers at the Fed had incorporated the tax cuts into their forecasts.  Prior to the tax cut, the median forecast from Fed officials expected real GDP growth of 2.5% in 2018 and 2.1% in 2019.  Now that the tax cut is law, we expect Fed forecasters to move those estimates noticeably higher, to near 3% growth for 2018 and 2019, which should lower unemployment forecasts.

In December, the median Fed forecast was that the jobless rate would reach 3.9% in the last quarter of 2018 and remain there in 2019 before heading back to 4.6% in following years.

We’re forecasting the unemployment rate should get to 3.3% by the end of 2019, which would be the lowest since the early 1950s.  Beyond 2019, it’s even plausible the jobless rate goes below 3.0%, as long as we don’t lurch into a trade war or back off tax cuts or deregulation.

We doubt the new Fed forecast gets that aggressive, but with the jobless rate already at 4.1%, faster economic growth should push Fed forecasts well below 3.9% in spite of faster labor force growth.

For the Fed, lower unemployment rates mean faster wage growth and higher inflation.  This may force a change in the Fed’s “dot plot,” which puts a dot on each member’s expected path of short-term interest rates.

Back in December, the dot plot showed a median forecast of 75 basis points in rate hikes this year – basically, three rate hikes of 25 bps each.  Four Fed officials expected four or more rate hikes in 2018, while twelve expected three or fewer.  This time, we expect the dots to show a much more even split between “three or fewer” and “four or more.”

At present, the futures market is pricing in three rate hikes as the most likely path this year, with a 36% chance of a fourth rate hike (or more).  Look for the market’s odds of that fourth rate hike to go up by Wednesday afternoon, which means longer-term interest rates will also likely move higher.

In addition, the markets will be paying close attention to Jerome Powell’s performance at his first Fed press conference.  With journalists planning “gotcha” questions, some negative headlines could result.  If so, and if equities drop, the smartest investors should treat it as yet another opportunity to buy.

Since 2008, the Fed has embarked on unprecedented monetary ease.  Rather than boosting the actual money circulating in the economy, however, quantitative easing instead boosted excess bank reserves, which represent potential money growth and inflation in the years ahead.

The Fed has decided that it can pay banks to hold those reserves, and not push them into the economy.  Four rate hikes in 2018 mean the Fed will be paying banks 2.5% per year to hold reserves.  Never in history has the Fed tried this.  The jury is out.  The Fed thinks it will work, we’re not so sure.  The odds of rising inflation in the next few years, because of those excess reserves, are greater than the chance of a number 16 seed beating a number one seed.  Granted, that’s not high odds, but we suggest investors, especially in longer-dated fixed income securities, should be worried.  Stay tuned.

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist

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