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The U.S. Economy: Far Too Early to Break Out the Champagne

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That markets are wildly optimistic about the U.S. economy is nothing new. What should draw our attention this time around is that such upbeat sentiment has rarely been harder to square with the numbers. For example, contrary to the dominant narrative:

  • The U.S. economy is doing worse than a few months ago, not better. Growth in industrial output is petering out, productivity has moved into negative territory, and employment data point to backsliding.
  • The economy’s ability to cope with higher interest rates simply can’t be taken for granted. Not only has consumer spending yet to pick up, but the real estate market has been derailed by the rise in interest rates since the start of the year.
  • While a change of course by the Federal Reserve may seem long overdue after five years of unconventional monetary policy, it makes no economic sense. This suggests that the Fed is very much in danger of jumping the gun.

What Pocket Change Can Tell Us About Past -and Future- Inflation

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When you get back from an overseas vacation, you’re often left with a bunch of small foreign coins in your pocket. You typically end up stashing them away in a junk drawer as soon as you get home, and this is precisely what I was in the process of doing after a recent trip to the U.S. when a penny dated 1964 caught my eye. I then looked more closely at the dates on my assorted pennies, dimes, nickels, and quarters. I even added my daughter’s coins to the mix. Soon intrigued by this journey back through time, we decided to group the coins by decade. What we found was startling: out of the 107 pennies left from our trip this summer, 3 were from the 1960s, 12 from the 1970s, and 11 from the 1980s. In other words, 24 percent of our lowest denomination coins came from years of double-digit inflation—when the coin mints apparently ran non-stop.

But what about the ensuing decades? Could we see the effects of the subsequent disinflation in our sample, given that our sample is necessarily biased by the lesser erosion in the supply of recently-minted coins? We had 13 coins from the 1990s and 18 from the 2000s. How could we possibly prove that once the time factor is taken into account, this is a much smaller proportion of coins relative to that from the inflationary decades? It seemed a hard circle to square. We were about to give up when we found some coins we had overlooked—our group from 2010 to 2013. There were many more of these, of course: 50 for a period of only 3.5 years—the equivalent of 142 coins per decade!

This shed an entirely new light on our figures. We realized that since we may safely assume the rate of erosion remains pretty much the same from one decade to the next, we can estimate the “erosion-corrected” size of a group of coins from a given decade by “reverse discounting” its actual size by an erosion factor. So we found a pen and did some back-of-the-envelope calculations. First we used an annual erosion rate of 5.5 percent, which was the growth rate of the M1 money supply in the U.S. over the period we were looking at. Next we used an annual erosion rate of 6.7 percent, which was the average annual growth rate of U.S. GDP over the same period. As it turned out, 6.7 percent was closer to what our pocket-change sample suggested.

Theoretically, this gave us a comparable, erosion-corrected total number of coins for each decade. When we restated our results using a base value of 100 for the 1960s batch, we found:

  • The erosion-corrected total peaked in the 1970s, at 234 using the 5.5 percent erosion rate and 209 using the 6.7 percent erosion rate;
  • The total then decreased steadily and hit a low, in the 2000s, of 70 at the 5.5 percent erosion rate and 45 at the 6.7 percent erosion rate;
  • The total rebounded sharply for our very last group of coins, those from 2010–2013, reaching a new high of 318 at the 5.5 percent erosion rate and coming in just below the 1970s value at the 6.7 percent erosion rate.

As you may have guessed, we couldn’t resist plotting our results alongside inflation for the same decades. Unsurprisingly, the curves matched up beautifully.

Pocket Money and Inflation

 

So what’s the moral of the story? Given the pace at which the amount of money in circulation has been growing since 2010, the U.S. appears on track for high inflation once it pulls out of the crisis. And we stand by our prediction even though the process seems to be taking longer than expected. An era of rising prices is already a palpable prospect.

Bright Spots in an Otherwise Lackluster Recovery

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1-Auto Industry    2-Capital Investment in France   3-Consumer Spending in Spain

Although there are still legitimate concerns about the future of the euro area, the recession is definitely over. Like all such episodes, this one comes with a number of pleasant surprises. Here are the three main ones:

• The first and most significant surprise from the investor standpoint is a recovery in Europe’s auto industry, along with improved stock performance for the firms involved.

• The second—and much more surprising—surprise is that the indicators we track on the French economy show a brighter outlook for industrial investment in France

• The third, and possibly most important surprise—given the risks that Spain’s sluggish economy pose for Europe as a whole—is that spending by Spanish consumers is clearly trending upward.

While none of these surprises taken alone has enough weight at this point to convince us to make any major changes to our growth forecasts, they each help restore a modicum of confidence—perhaps even with unexpected repercussions.

World Growth Monitor

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Going it alone. The global economic picture is unquestionably looking brighter. Unlike previous recoveries, however, this one is fueled above all by consumer spending. The trend is especially noteworthy in Europe now that austerity policies have been scrapped. But it can also be observed in the United States—since the country has steered clear of the fiscal cliff dangers at the start of the year—and Japan, where the Abe administration’s first moves have lifted the spirits of local consumers. Even in China, sustained consumer spending is what has offset the negative impact of an end to export support. So on the whole, the environment is more encouraging. Yet the missing ingredient here is what proved to be one of the key drivers of global growth in the 1990s—world trade. This has two main implications:

  1. Global growth will be weaker than in the past, and will stay that way for some time.
  2. There will be greater risk for economies that are still too dependent on exports, i.e., the emerging economies in general and more specifically those suffering from structural imbalances—Brazil, India, and South Africa—and increasingly burdened by mounting current account deficits.

The Upcoming Fed Meeting: Playing for Time

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Most pundits agree that the question isn’t if the Fed will taper off its liquidity injections, but by how much. And they hope to find answers in the minutes of the next FOMC meeting a month from now. It’s unlikely the Fed will backtrack from previous guidance; even that was enough to steer markets back in the right direction. Long-term interest rates are returning to more normal levels, and capital is starting to flow back into money-market funds. An about-face by the Fed at this point would be more likely to wreak havoc than anything else. However, a closer look reveals that the economic indicators predicating investors’ newfound optimism don’t actually point to a U.S. recovery (see below). Many of these indicators remain weak, signaling that the world’s largest economy isn’t strong enough yet for a return to regular interest rate levels.

Japan Bull Markets Die of Anemic Demand

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Japan’s reflation campaign looks impressive. Unfortunately, it is unlikely to work.

True, the substantial depreciation of the yen brought about by the BoJ policy of massively injecting liquidity into the system has driven up corporate profits since the start of the year—even way up in some cases. But this competitive surge has had such a depressive effect on other economies in the region that they now offer a shrinking market for Japanese goods. In fact, what Japan is exporting may well be its own deflation, and to a degree at least commensurate with the inflation target set by the government.

So what can be expected of “Abenomics” if it fails to engineer a rebound in exports? Domestic forces certainly won’t generate inflation: population aging has already done serious damage to the country’s growth potential, and encouraging mass immigration—the only policy with a chance of reversing that trend—is simply not on the government agenda today.The other measures announced will therefore be about as effective in boosting potential output as a band-aid on a wooden leg. With its supply-side bias, the Abe administration’s strategy will have no lasting impact on growth unless it succeeds in re-igniting demand.

All this makes it hard to buy into the current stock market enthusiasm. The Nikkei bull run since last December just doesn’t square with the persistently bleak outlook for the Japanese economy. What follows is a new analysis of this issue by Frank Benzimra, one that concludes with the firm recommendation to dump Japanese equities.

The Euro Area on its Own—With Some Heavy Lifting to be Done

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The recession in the euro area is almost officially over, but that doesn’t mean the economy is back to normal—far from it. As long as no structural growth policies are enacted, the outlook for the EMU will remain grim and member states will have as much trouble meeting their fiscal targets as before. This leaves just two options open. Either Europe reverts to austerity—in which case the recovery will collapse and we’ll be in for another slump with highly unpredictable consequences—or the ECB completely overhauls its policy stance. The latest developments in the international arena make this second option increasingly likely.

Bernanke and the Fool’s Gold of Falling Unemployment

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The last time U.S. unemployment fell below the 6.5 percent mark, the country’s GDP was growing at an annual clip of about 3 percent, real household spending was rising at nearly 4 percent a year, monthly job creation was flirting with 300,000, and annual wage growth was just over 2.5 percent. That was back in March 1994, but similar conditions prevailed in March 1987 and in December 1977. Each time around, labor utilization and capacity utilization were close to potential output—making monetary tightening to one degree or another the right choice. And each time around, a cycle of higher interest rates duly ensued. But in 2003 and 2004, the economic climate was entirely different. Not only had the jobless rate been stuck below 6.5 percent for about a decade; there wasn’t a single blip on the radar screen to suggest that the economy might overheat. So it wasn’t until mid-2004, with unemployment hovering at around 5.5 percent, that the Fed initiated a rate-raising campaign. A good many pundits would later criticize this belated adjustment, identifying it as a major inflator of the now-infamous real estate bubble.

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Thus, when it came time a few months ago to provide forward guidance on monetary policy, the Fed understandably selected the 6.5 percent unemployment mark as a key criterion for when and how to taper its quantitative easing program.

Even so, this policy choice raises a whole host of questions. A given jobless rate may in fact reflect a much shakier economy today than it would have during previous, seemingly similar periods.