First Trust Economics Blog – The Antidote to Conventional Wisdom

Still No Recession

To many investors, this week’s GDP report is more important than usual.  The reason is that real GDP declined in the first quarter and might have declined again in Q2.  If so, this could mean two straight quarters of negative growth, which is the rule of thumb definition many use for a recession.

We think these investors are paying too much attention to the GDP numbers; the US is not in a recession, at least not yet.  Industrial production rose at a 4.8% annual rate in the first quarter and at a 6.2% rate in Q2.  Unemployment is lower now than at the end of 2021.  Payrolls grew at a monthly rate of 539,000 in the first quarter and 375,000 in Q2.  If we were already in a recession, none of this would have happened.  That’s why the National Bureau of Economic Research, the “official” arbiter of recessions, uses a wide range of data when assessing whether the economy is shrinking.

In addition, it’s important to recognize that once a year the government goes back and revises all the GDP data for the past several years.  That happens in July, including with the report arriving this Thursday.  Given the strength in jobs and industrial production, it wouldn’t surprise us at all if Q1 is eventually revised positive.

In the meantime, we are forecasting growth at a +0.5% annual rate in Q2.  Here’s how we get there.  

Consumption:  “Real” (inflation-adjusted) retail sales outside the auto sector grew at a 2.2% annual rate, and it looks like real services spending should be up at a solid pace, as well. However, car and light truck sales fell at a 19.7% rate.  Putting it all together, we estimate real consumer spending on goods and services, combined, increased at a modest 1.2% rate, adding 0.8 points to the real GDP growth rate (1.2 times the consumption share of GDP, which is 68%, equals 0.8).

Business Investment:  We estimate a 5.5% annual growth rate for business equipment investment, a 7.5% gain in intellectual property, but a 4.0% decline in commercial construction.  Combined, business investment looks like it grew at a 4.4% rate, which would add 0.6 points to real GDP growth.  (4.4 times the 14% business investment share of GDP equals 0.6).

Home Building:  Residential construction looks like it contracted at a 4.0% annual rate.  Mortgage rates should eventually become a headwind, but, for now, it looks like an increase in spending on construction was more than accounted for by inflation in construction costs.   A decline at a 4.0% rate would subtract 0.2 points from real GDP growth.  (-4.0 times the 5% residential construction share of GDP equals -0.2).

Government:  Remember, only direct government purchases of goods and services (and not transfer payments like unemployment insurance) count when calculating GDP.  We estimate these purchases – which represents a 17% share of GDP – were roughly unchanged, which means zero effect on real GDP. 

Trade:  Exports have surged through May while imports, after spiking late in the first quarter, have remained roughly flat so far in Q2.  That means a smaller trade deficit.  At present, we’re projecting net exports will add 1.0 point to real GDP growth, although a report on the trade deficit in June, which arrives on July 27, may alter that forecast.  

Inventories:  Inventories look like they grew at a slower pace in the second quarter than they did in Q1, suggesting a drag of about 1.7 points on the growth rate of real GDP.  However, just like with trade, a report out July 27 may alter this forecast.  

Add it all up, and we get 0.5% annual real GDP growth for the second quarter.  Monetary policy will eventually tighten enough to cause a recession, but that recession hasn’t started yet.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist 

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Monday, July 25, 2022 @ 10:49 AM

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Recovery Tracker 7/22/2022

The table and charts in the Recovery Tracker track high frequency data, which are published either weekly or daily. With states reopening their economies and widespread distribution of COVID-19 vaccines, these indicators show continued improvement in economic activity. It won’t improve in a straight line, but the trend should remain positive over the coming months and quarters. The charts in the Recovery Tracker highlight where the high frequency data indicators were from 2019 to 2022.

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Friday, July 22, 2022 @ 2:58 PM

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Existing Home Sales Declined 5.4% in June

Implications:  Existing home sales fell for the fifth month in a row in June, posting the longest streak of declines since 2013.  Recent volatility shows that the housing market is struggling to find its footing so far in 2022, with falling affordability playing a major role.  The prime culprit recently has been 30-year mortgage rates, which have already risen more than 200 basis points since December and are now hovering just below 6%, the highest level since 2008.  Even more notable than the decline in sales in today’s report is that despite surging mortgage rates median prices are still climbing, posting a fifth consecutive monthly gain in June. Part of this is just seasonality (prices typically rise heading into the summer buying season), and median price growth in the past year has slowed to 13.4% from a peak of 25.2% in May 2021, but the “reverse wealth effect” the Federal Reserve has been looking for has yet to show up in the housing market. Assuming a 20% down payment, the rise in mortgage rates and home prices since December amount to a 56% increase in monthly payments on a new 30-year mortgage for the median existing home. No wonder sales have slowed down!  One piece of good news in today’s report is that the inventory of existing homes on the market has begun to rise relatively rapidly, and is now up 2.4% from a year ago, the best way to look at the data given the seasonality of the housing market. Notably, this is the first annual increase we have seen in housing inventory since May of 2019. Meanwhile the months’ supply of existing homes for sale (how long it would take to sell today’s inventory at the current sales pace) rose to 3.0 months in June, the highest level in nearly two years.  While this represents much needed progress, it’s important to note that inventory still remains low from a historical perspective. What is really impressive is that despite the lack of options demand remains strong, with buyer urgency so high in June that 88% of existing homes sold were on the market for less than a month.  While sales are clearly under pressure, this is not a repeat of 2007-09. We do not foresee a widespread collapse in home sales even with higher mortgage rates, though it is likely that existing home sales wind up lower in 2022 than 2021.  More inventory is finally becoming available, which will help price gains moderate further.

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Wednesday, July 20, 2022 @ 10:39 AM

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Housing Starts Declined 2.0% in June

Implications:  Housing starts fell for a second consecutive month in June as builders continued to navigate a challenging housing market with the highest mortgage rates since 2008, labor shortages, and ongoing supply-chain issues.  That said, today’s 2.0% headline decline was the result of May’s reading on construction being revised up. Without that upward revision, June housing starts would have posted a modest gain of 0.6%.  Looking at the details, single-family construction fell 8.1% in June, driving the drop in overall starts versus the revised May level.  Meanwhile, multi-unit starts rose 10.3%.  It is clear developers are becoming more cautious about future demand for new single-family projects with 30-year mortgage rates hovering just below 6% and are continuing to focus resources on apartment buildings. However, it also makes sense to slow down the pace of starts given how many projects are currently sitting in the pipeline. The number of homes already under construction is at the highest level on record back to 1970.  Moreover, the gap between the number of units under construction and the number of completions remains at record high levels back to 1970s, as well. These figures illustrate a slower construction process due to a lack of workers and other supply-chain difficulties. In this context, it’s not surprising to see new building permits fall 0.6% in June.  The backlog of projects that have been authorized but not yet started is currently sitting just below the record high since the series began back in 1999. With plenty of future building activity waiting to get underway as other projects are finished, and given that residential investment is counted in GDP when units are completed, new housing construction can continue to be a small tailwind for economic growth even with a slowdown in the headline pace of housing starts. How long this lasts is open to question, however, as homebuilder sentiment, as measured by the NAHB Housing Index, is clearly deteriorating. The index posted the largest monthly decline since the early days of the pandemic in July, falling to 55 from a reading of 67 in June. Builders’ prime concern continues to be higher mortgage rates, which are having a negative impact on potential sales as certain buyers are at least temporarily priced out of the market.

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Tuesday, July 19, 2022 @ 10:38 AM

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Refocusing the Fed

If you follow the financial press, the conventional wisdom has come to the simple conclusion that the way to fight inflation is raising interest rates.  Unfortunately, this is just not true.  Yes, raising rates may slow the economy, but that alone won’t fix inflation.

Starting in 2009, for seven years the Federal Reserve held the federal funds rate at zero and yet inflation never accelerated.  So, if seven years of zero percent interest rates didn’t cause inflation, why would the last two years do it?  Even though everyone talks about interest rates, it is really money supply growth that matters.  We follow M2 because that is what Milton Friedman told us to follow.  M2 is currency in circulation plus all deposits in all banks (checking, saving, money markets, CDs).

If M2 rises by 10%, we would expect a 10% increase in overall spending.  Some of that would be soaked up by real increases in output, but the rest would go to inflation.   

From February 2020 – December of 2021, M2 grew at an 18% annual rate.  No wonder inflation has climbed to 9%.  Raising interest rates, by itself, will not stop this inflation.  The way to stop it is by slowing growth in M2 to a low enough rate, for long enough, to allow the economy to absorb the excess money.

That is exactly what happened in the early 1980s when Paul Volcker altered the focus of the Federal Reserve toward money.  Prior to Volcker, in the 1970s, the Fed would talk about what level of the federal funds rate it was aiming for, and people started to believe it was the level of rates that mattered.  But this was never the case.  The Fed consistently held rates lower than a free market (and the level of inflation) suggested it should, because that’s what politicians wanted.  In order to do that, it would add more money to the system than real growth required, causing inflation.

In the late 1970’s, Paul Volcker turned this approach on its head.  He understood (because of Friedman) that it was money supply growth that mattered.  So, he targeted money growth and let interest rates go wherever they may.  Some people believe he tightened money too much, and with interest rates spiking well above inflation, close to 20%, this may have been the case.

But it is also why inflation fell.  He kept money tight until it was all absorbed and inflation was tamed.  It was slower money supply growth, not higher rates that stopped inflation.  At the same time, Ronald Reagan cut regulations, tax rates and slowed government spending.  This let real economic output accelerate, also helping absorb some of the excess money of the 1970s.

So, if we learned that lesson once, why do we have to learn it again?  Part of the answer is that the Fed shifted from a “scarce reserve” policy to an “abundant reserve” policy in 2008.  This is what Quantitative Easing (QE) was all about.  Under the old “scarce reserve” model the Fed bought bonds from the banking system to increase the money supply and this brought interest rates down.  When it sold bonds to banks, the opposite happened.  The reason this worked so well is that banks had few, if any, excess reserves.  Banks used every dollar created.

Think of it this way.  At the end of 2007, the Fed’s balance sheet (basically bank reserves) totaled roughly $850 billion.  The M2 money supply (all deposits in all banks) equaled roughly $8 trillion.  Banks held roughly $1 in reserves for every $9 in deposits.  The “money multiplier” – how many dollars of M2 circulated relative to reserves held at the Fed – was about 9.

But this all changed in 2008.  With QE 1, 2 & 3, and then more QE during 2020/21 the Fed increased its balance sheet ten-fold.  The Fed’s balance sheet is now roughly $9 trillion, while M2 has grown to $22 trillion.  In other words, banks only have about $2.5 of M2 per $1 of reserves, not $9.  The Money Multiplier has collapsed, while excess reserves have soared.  The Fed has grown tremendously relative to the economy and the banking system. Why?  We could speculate on that…after all, some politicians want to nationalize the banking system.  But the “how” is equally important.

Back in the 1970s, one of the Fed’s tools was to use reserve requirements to manage money.  If the Fed raised reserve requirements it could slow down money creation.  Today, with so many excess reserves in the system ($3.3 trillion at last count), the Fed and other banking regulators have layered regulations on banks, pushing required capital ratios from 4%, to 6%, to 10%, or higher.  “Reserve requirements” have been replaced by direct regulation on how much capital a bank must hold.

This is why the 2008-2014 QE did not create inflation.  The Fed grew its balance sheet, but it also increased capital requirements which kept the banks from multiplying those new reserves.

The pandemic response was different. The Fed monetized Treasury debt (created new money to buy bonds).  At the same time the Treasury and Congress used banks (through PPP loans and direct deposit stimulus checks) to distribute “stimulus” and the Fed eased liquidity rules to allow this to happen.  M2 growth exploded.  In fact, it has grown 41% since February 2020.

So, how does this get reversed?  Once the Fed allows more M2 to be created, it can’t destroy it.  All those deposits are owned by someone – you, me, your employer, or the Treasury.  The Fed can’t take them away – they are private property.

There are only three ways to limit money supply growth under the “abundant reserve” model.  First, by paying banks interest on their reserves at a high enough rate to keep them from lending.  But this approach means that at a 3.5% rate, the Fed will be paying private banks roughly $120 billion per year.  This may or may not stop them from lending, but it will certainly not make politicians, like Elizabeth Warren, very happy.

Second, the Fed can raise capital requirements, as it is already doing.  Last week, JPMorgan was forced to raise its Tier 1 capital ratio to 12.5% from 11.2%.  Jamie Dimon, the CEO of JPMorgan said these rules were “capricious” and “arbitrary.”  He is correct.  They have nothing to do with the banks themselves and have everything to do with slowing money supply growth.  At some point, however, this becomes ridiculous.  Banks are better capitalized and have more liquidity than they probably ever have.

The third way has little to do with the Fed.  If the Treasury ran a surplus, like it did in April, it could reduce its debt and allow the Fed to let bonds mature.  But this is unlikely to last.  The US has what appears to be a permanent budget deficit and that is unlikely to change under current leadership.

We are not saying that raising interest rates won’t cause a recession.  What we are saying is no country in the world has ever had massive inflation problems under the new “abundant reserve” policy model.  We are in uncharted territory.  Raising rates alone is an untested tool to slow or stop M2 growth.

Some people say that the velocity of money is falling and so we don’t need to worry about M2 as much.  Slower velocity will help get inflation back down and keep it there.  Slower velocity means every dollar boosts economic activity by less than it used to.  But this is a feature of the abundant reserve model, not a bug.  As the Fed grows its balance sheet, bank balance sheets grow as well, but this money is not allowed to circulate because of higher and higher capital requirements.  That’s why velocity has fallen.  Velocity itself has not changed, money has.

The thing that worries us the most is that the Fed will keep growing its balance sheet and government’s power by regulating banks to the point where capital requirements hit ridiculously high levels.

And this brings us back to Paul Volcker and Ronald Reagan.  By slowing the growth of money, Volcker took the Fed out of the business of juicing the economy.  By cutting tax rates and reducing regulations, Reagan revived the private sector.  This ended stagflation and led to a boom in the economy.

How do we end the current trajectory and fix our problems all over again?  Our answer would be to shrink the size of the Fed’s balance sheet by massive amounts.  It is way too big, and it is regulating banks in an extraordinary and unprecedented fashion.  And while we sound like a broken record, shrink the size and scope of the federal government as well!

Putting these two policies together, just like the US did in the early 1980s, will end the stagflation we haven’t seen since the 1970s.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist 

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Monday, July 18, 2022 @ 1:54 PM

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Recovery Tracker 7/15/2022

The table and charts in the Recovery Tracker track high frequency data, which are published either weekly or daily. With states reopening their economies and widespread distribution of COVID-19 vaccines, these indicators show continued improvement in economic activity. It won’t improve in a straight line, but the trend should remain positive over the coming months and quarters. The charts in the Recovery Tracker highlight where the high frequency data indicators were from 2019 to 2022.

Click here to view the report

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Friday, July 15, 2022 @ 11:46 AM

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Retail Sales Rose 1.0% in June

Implications:  Retail sales grew at what would normally be a robust pace in June, but, at least for this particular sector, sales are not keeping pace with inflation.  Retail sales grew 1.0% in June and were revised up for May, with nine of the thirteen major sales categories rising in June, led by gas stations, non-store retailers, and autos.  “Core” sales, which exclude the most volatile categories of autos, building materials, and gas stations, rose 0.8% in June, are up 6.8% from a year ago, and up 26.8% versus February 2020.  But, again, the problem is that one of the key drivers of overall spending is inflation.  Yes, consumers are spending more, but they are not taking home the same amount of goods.  Adjusted for the consumer price index (CPI), retail sales declined 0.3% in June.  Although retail sales are up 8.4% from a year ago, that pace lags inflation, with the CPI up 9.1% over the same period.  Due to very loose monetary policy and the massive increase in government transfer payments in response to COVID, retail sales are still running much hotter than they would have had COVID never happened.  However, loose monetary policy, which helped finance that big increase in government spending, is translating into high inflation, which is why “real” (inflation-adjusted) retail sales are down versus a year ago.  This doesn’t mean overall consumer spending is down, because “real” (inflation-adjusted) spending on services is still rising.  But it does mean overall real consumer spending growth is soft.  What to expect in the months ahead?  Continued gains in retail sales, but gains that struggle to keep pace with inflation.  Meanwhile, look for modest overall gains in consumer spending due to the service sector as consumers continue to shift their preferences back to services.  In other news this morning, import prices rose 0.2% in June while export prices increased 0.7%.  In the past year, import prices are up 10.7%, while export prices are up 18.2%. More signs monetary policy was too loose for way too long.

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Friday, July 15, 2022 @ 11:26 AM

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Industrial Production Declined 0.2% in June

Implications:  Following five straight months of expansion, industrial production took a breather in June. While the headline decline was 0.2%, and data for prior months were revised down, it’s important to note that industrial production still rose at a healthy 6.2% annualized rate in Q2, which strongly suggests we are not in a recession.  Looking at the details, the main culprit behind today’s decline was the manufacturing sector, which posted a second consecutive monthly drop of 0.5%.  Both auto and non-auto manufacturing contributed to the decline. Today’s report also illustrated the ongoing trend of Americans shifting their consumption preferences back towards services and away from goods, which seems to be leading factories to taper back production.  For example, US factory output of consumer goods fell 0.7% for the second consecutive month in June. The utilities sector, which is volatile from month to month and largely dependent on weather, was the other source of weakness in today’s report, falling 1.4%. Meanwhile, the mining sector (think oil rigs in the Gulf) continued to expand production, rising 1.7% in June, though the index remains below pre-pandemic levels.  We expect continued gains from this sector in the months ahead with oil prices currently still hovering around $100 a barrel incentivizing new exploration.  Unfortunately, there is still no sign of the federal government lending a hand on the energy front, even with the political kryptonite of inflation raging.  For example, the Biden Administration continues to blame high prices at the pump on price gouging rather than offering regulatory relief or approving new leases to help spur additional production.  The good news is that capacity continues to come back online despite this, with Baker Hughes reporting that the total number of oil and gas rigs in operation in the US is rapidly approaching pre-pandemic levels.  Overall, despite the shift back towards services, we expect continued gains in industrial production in 2022 as demand continues to outstrip supply.  For example, this report puts industrial production 2.7% above pre-pandemic levels.  Meanwhile, the report out this morning on retail sales showed that even after adjusting for inflation, “real” retail sales are up 13.4% over the same period.  This mismatch between supply and stimulus-boosted demand exemplifies why inflation remains uncomfortably high.  In other manufacturing news this morning, the Empire State Index, a measure of New York factory sentiment, jumped unexpectedly to +11.1 in July from -1.2 in June.

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Friday, July 15, 2022 @ 10:59 AM

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Dollar Remains World Reserve Currency

How many times have you heard that the US dollar will collapse because of Fed and fiscal policy?  According to the pessimists, this will bring the loss of reserve currency status, and possibly the rise of China.

Replace China with Russia, and it sounds like the 1970s.  Inflation is out of control, energy prices have surged, geopolitical tensions are rising, and Presidents (then Nixon, lately Trump) were replaced by widely perceived weak leaders from the opposite side of the aisle.

Though all these pessimistic forecasts are related, there is one very important distinction.  The dollar is not weakening, as it did in the 1970s, the dollar is surging.

Yes, in absolute terms your dollars are worth less every day due to rising prices. However, when comparing the dollar to other major currencies (in other words looking at the relative value of the dollar) the story is the exact opposite. The dollar has soared over the past twelve months and currently sits at a 20-year high according to the Bloomberg US Dollar Index. The Euro just fell below parity with the US dollar for the first time since 2002. Sure, you may not be able to buy baby formula, but at least it’s a good time to start planning that European vacation.

This is the opposite of what happened in years leading up to Paul Volcker’s tenure at the Federal Reserve. From the late 1960s to the early 1980s, the dollar was collapsing in international markets, falling roughly 30% peak to trough. The dollar was at risk of losing its reserve currency status.  Why? The US Government decided to use the dollar’s strength to monetize the debt from Vietnam War spending and President Johnson’s huge expansion of the welfare state through the Great Society programs.  (They called it “Guns and Butter”).

These dollars started accumulating abroad, and the Europeans (and others) saw the writing on the wall and asked for gold.  At the time, the global financial system still operated under a gold standard.  This led President Nixon to close the gold window and devalue the dollar.  And, voila, the fiat currency era was standardized. The bottom line is that this was terrible for the dollar’s reputation internationally, precipitating its collapse in foreign exchange markets and creating even more inflation.

Inflation clearly played a role in the Volcker Fed’s decision to send short-term interest rates to a record high of nearly 20% in the early 80s. However, saving the US dollar’s reputation and reserve currency status was also a priority, even if it meant sacrificing the real economy to do it.

Today, while the US is dealing with plenty of economic problems, bailing out the dollar’s reputation thankfully isn’t one of them. Moreover, there is no potential shock like the end of the gold standard that could happen today. You can only go to fiat once.

So, why has the dollar performed so well recently? First, the US economic recovery has been stronger than pretty much anywhere else in the world, owing to the ability of states to manage much of the response to COVID which allowed certain regions to remain relatively open.  Second, the war in Ukraine has caused a flight into US currency. We are the security umbrella for Europe and have the best defense companies in the world, a resource that now seems to be carrying a much bigger priority abroad. The US energy sector also looks set to displace Russia’s market share in Europe as well. Finally, the Federal Reserve is raising rates while our biggest competitors in the currency space, Japan and Europe, continue to be remarkably dovish despite the global nature of the inflation problem.

While there is plenty of negative news to focus on, the collapse of the US dollar thankfully isn’t on that list. If anything, reserve currency status looks stronger than ever.  Once again the US is coming out of a global crisis as the cleanest dirty shirt in the laundry.        

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist 

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Thursday, July 14, 2022 @ 2:18 PM

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The Producer Price Index (PPI) Rose 1.1% in June

Implications:  Bye-bye 75, hello 100?  Consumer prices rose 1.3% in June and today we got news that producer prices rose 1.1%.  Readings from both inflation gauges came in above consensus expectations, and the futures markets are now pricing in that the Federal Reserve is going to raise rates by 100 basis points (bps) when they meet later this month.  Two meetings ago the Fed moved by 50bps and said a 75 point move wasn’t on their radar. Then last meeting they in fact moved by 75bps but played down suggestions that they would move at that rapid a pace into the future.  Now the Fed has little choice but to acknowledge that they 1) have a flawed inflation model focused on the supply chain – rather than the far more important money supply – which has led them to significantly underappreciate the inflation pressures building in the economy, and they 2) remain behind the curve in remedying their prior mistakes.  Producer prices rose 1.1% in June and are now up 11.3% versus a year ago.  It’s true that energy prices (+10.0% in June) were a major contributor to the monthly rise, but even stripping out the volatile food and energy categories shows “core” prices up 0.4% in June and 8.2% in the past year.  Within core prices, pressures were broad-based but led by a jump in costs for trade services (margins received by wholesalers).  And pressures remain elevated further back in the supply chain, as prices for processed and unprocessed goods for intermediate demand are up 22.2% and 58.0%, respectively, in the past year.  In short, inflation continues to run near the highest pace in decades.  This is what happens when you boost the money supply by leaps and bounds faster than you can grow output.  Fed Chair Jerome Powell was right in saying that the Fed needs to act “expeditiously” to address the damaging impacts of inflation, but a focus on raising interest rates and reducing the size of the Fed balance sheet are not enough by themselves.  The Fed needs to focus on controlling the money supply.  Dust off your Milton Friedman books, the lessons from the old sage are coming in handy.  In other news this morning, initial unemployment claims rose 9,000 last week to 244,000. Meanwhile, continuing claims fell 41,000 to 1.331 million. These numbers suggest continued healthy job growth in July.

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Thursday, July 14, 2022 @ 11:00 AM

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