Introducing

Joseph G. Carson

Joseph G. Carson, Former Director of Global Economic Research, Alliance Bernstein.   Joseph G. Carson joined Alliance Bernstein in 2001. He oversaw the Economic Analysis team for Alliance Bernstein Fixed Income and has primary responsibility for the economic and interest-rate analysis of the US. Previously, Carson was chief economist of the Americas for UBS Warburg, where he was primarily responsible for forecasting the US economy and interest rates. From 1996 to 1999, he was chief US economist at Deutsche Bank. While there, Carson was named to the Institutional Investor All-Star Team for Fixed Income and ranked as one of Best Analysts and Economists by The Global Investor Fixed Income Survey. He began his professional career in 1977 as a staff economist for the chief economist’s office in the US Department of Commerce, where he was designated the department’s representative at the Council on Wage and Price Stability during President Carter’s voluntary wage and price guidelines program. In 1979, Carson joined General Motors as an analyst. He held a variety of roles at GM, including chief forecaster for North America and chief analyst in charge of production recommendations for the Truck Group. From 1981 to 1986, Carson served as vice president and senior economist for the Capital Markets Economics Group at Merrill Lynch. In 1986, he joined Chemical Bank; he later became its chief economist. From 1992 to 1996, Carson served as chief economist at Dean Witter, where he sat on the investment-policy and stock-selection committees.   He received his BA and MA from Youngstown State University and did his PhD coursework at George Washington University. Honorary Doctorate Degree, Business Administration Youngstown State University 2016. Location: New York.

Publications by Joseph G. Carson

• USA| May 01 2023

  Rebound in Cyclical Sectors and Profit Data Run Counter to Recession Forecasts

  In Q1, the combined output of the cyclically sensitive motor vehicles and residential housing sectors expanded by 1.3% annualized, slightly better than the 1.1% growth for the overall economy and the first quarterly gain since late 2021. Also, the Q1 data shows that operating profits gained sequentially quarter over quarter and year over year. The rebound in cyclically sensitive sectors and profit data run counter to the recession forecasts. All economic recessions have standard features; declines in cyclically-sensitive sectors and drops in operating profits. Those features are missing at this time.

  S&P purchasing managers manufacturing index rose over one percentage point to 50.2 in April. That’s the highest level in six months, driven by new orders, production, and employment gains. Thus, the rebound in cyclically sensitive sectors has continued into Q2.

  Recessions forecasts are linked primarily to the inverted yield curve and the decline in the leading indicators. Questions over the accuracy of the signal from the inverted curve stem from the Fed's new policy tool, quantitative easing (QE). Since the Fed now actively purchases substantial quantities of long-duration fixed assets to keep a lid, or even depressing, on long-term interest rates, how can the yield curve signal be as reliable as in prior periods?

  History shows that lower long-term borrowing costs often lead to faster growth in cyclically-sensitive sectors. The yield on the 10-year Treasury has declined 75 basis points in the past six months, and cyclically sensitive sectors have rebounded. Is that a coincidence, or are they interrelated? If the latter, the recessionary signal from the inverted yield curve is wrong. It’s the latter.

  The leading economic index, which has declined sharply over the past year, triggering fears of recession, includes the yield curve. Yield curve inversion has been a significant factor in the decline of the aggregate index over the past year. Yet, is the yield curve still a reliable leading indicator with the creation of QE?

  It’s common for the index composition to change from one cycle to the next because economic, financial, or policy changes make some indicators less reliable or obsolete. Broad money failed as an indicator before the Great Financial Recession. A new credit series replaced it in 2012. It will not be surprising if the leading index includes a QE series and removes the yield curve indicator at some point.

  It’s worth noting the 2020 recession was unique from the standpoint non-economic factors triggered it. Yet, the monetary and fiscal policymakers viewed it as a vast economic disaster, rightly so, and responded with the most significant monetary and fiscal stimulus ever seen. Doubling the Fed's balance sheet from $4 trillion to over $8 trillion in 18 months was never done before, and we still need to learn all the economic and financial consequences. At the very least, the aggregate stimulus and new ways of interjecting liquidity in the system raise questions over long-trusted indicators such as the yield curve and broad money.

  Investors should keep it simple; the economy is growing if companies generate profits and hire.

  by:Joseph G. Carson

  |in:Viewpoints
• USA| Mar 29 2023

  Bank Credit Crunch----Will It Happen or Not? And If It Happens, Will It Be "Transitory"?

  For the week ending March 15, bank lending to commercial, industrial, real estate, and consumers increased by $40 billion, following a slight increase of $10 billion in the prior week. The two-week increase was more than half the cumulative increase over the previous two months, January and February.

  It is far too early to assess the impact of additional changes in lending standards. But the early March lending data reflects the tighter lending standards and the rise in market rates over the past year. And even with those tighter lending and higher rate conditions, the banking system showed a willingness to lend and businesses and consumers an appetite for borrowing.

  A bank-driven credit crunch may eventually happen, and investors are betting something substantial will occur, given the sharp drop in yields. But a few things may mitigate its impact, if not limit, its duration.

  First, all the top commercial banks are well-capitalized and do not face any liquidity constraints. It is hard to see a broad, deep, and enduring credit crunch that does not involve the top banks.

  Second, the Fed's Bank Lending Program should ease mid-tier banks' liquidity issues, and that should limit any pullback in credit due to tighter standards. The program runs for an entire year.

  Third, market interest rates have dropped significantly, which could boost the demand for credit.

  It is instinctive for investors to rush to buy the safest and most liquid assets, even when there is a hint of a banking crisis. That's the playbook investors have used in prior financial crises. Still, a 125 basis points drop in two-year yields over a few weeks is far bigger than during the early months of the 2007-09 financial crisis. The economic and financial data must support that negative narrative on yields for them to stay.

  History has shown that the "price" of credit has been the main rationing factor for credit. And until the "price" of credit gets more expensive through market forces or Fed raising rates, any pullback in credit should prove to be "transitory."

  by:Joseph G. Carson

  |in:Viewpoints
• USA| Mar 08 2023

  The Payback From QE---Fed Hikes Not Lifting Long Term Borrowing Costs To Break Inflation Cycle

  The Fed looks at bond yields as a gauge of long-term inflation expectations and its overall policy stance. Policymakers believe moderate and stable long bond yields are consistent with well-anchored inflation expectations and an appropriately configured policy stance. Yet, questions surround the current signal from long-bond rates after a decade-plus-long program of debt security purchases (quantitative easing, known as QE) by the Federal Reserve.

  Studies have shown that QE has lowered long bond yields by several hundred basis points. But, it needs to be clarified if the anchoring of long-bond interest rates via QE has also changed how the market price of long bonds adjusts to official rate hikes. Whatever the effect is, the Fed is not getting the market response it needs if it believes that higher borrowing costs are the main channel to break the inflation cycle.

  The core inflation and long bond yield picture that Fed faces today is something they have not encountered since the mid-1970s. One has to go back to the mid-1970s to find a similar alignment between long bond yields and inflation. The core inflation rate is approximately 200 basis points over the ten-year Treasuries yield, and that alignment has been in place for more than two years.

  That alignment raises several issues, all pointing to higher official rates.

  First, market rates adjusted for inflation have moved from "super" easy to still easy, indicating that the public's borrowing costs are still not sufficiently high enough to break the inflation cycle. That means the Fed has to hike official rates much more.

  Second, an inverted Treasury yield curve with market borrowing costs below the inflation rate has never occurred before. If borrowing costs matter more, as history has shown, curve inversion does not have the same adverse economic consequences. Consequently, the Fed will need to raise official rates well above market expectations creating an even greater curve inversion to get the inflation slowdown its wants.

  Third, the most significant risk to investors is if remnants of QE have permanently broken the links between long-term market borrowing rates and official rates. That would open the door to official rates moving to levels not seen in several decades. The risk of this scenario is low, but not zero, as the Fed has never faced an inflation cycle with QE in place.

  by:Joseph G. Carson

  |in:Viewpoints
• USA| Feb 21 2023

  QE Is The "Albatross" of Monetary Policy

  Quantitative easing (QE) is the "albatross" of the current stance of monetary policy. Quantitative easing was a monetary tool created during the Great Financial Recession. Operating at the "zero" bound of official rates, the Fed found a new channel (QE) to provide monetary stimulus and liquidity to the economy and financial markets. QE was a new way of making money as the Fed bought bonds directly from the financial markets in exchange for cash, increasing the broad money supply.

  The first quantitative easing program ran from 2009 to 2014. During that period, the Fed's balance sheet exploded to over $4 trillion from about $500 billion before the Great Financial Recession. The Fed started the second QE program when the pandemic hit. That boosted the Fed balance sheet to $8.8 trillion, more than twice the size after the first program.

  Several studies have concluded that the first QE program was the equivalent of several hundred basis points of additional official rate cuts. The second program was as big or bigger in scale, providing monetary stimulus worth several hundred points of Fed easing.

  Since QE never existed before, no one understands how this new tool would impact the effectiveness of monetary policy when policymakers tighten policy. But it should be symmetrical. That means as long as the scale of QE remains exceptionally large (Fed balance sheet still well over $8 trillion), it will probably take much bigger hikes, and to higher levels, in official rates for the stance of monetary policy to be as restrictive as when QE was not in place. (Note: If there are no negative consequences of QE it would then go down as the greatest invention in history)

  How else can anyone explain the exceptional strength of the labor markets and historic low unemployment rate, accelerating bank lending, resilience in the equity and bond markets, and high inflation rates after nearly 500 basis points of official rate hikes, the most significant increase for a single year since the early 1980s without linking it to QE?

  Remnants of QE are preventing the Fed from accomplishing its goal of reversing the inflation cycle. Risk assets should remain well-bid as long as the Fed fails to recognize the problem. But what happens when the Fed says they were wrong again?

  by:Joseph G. Carson

  |in:Viewpoints
• USA| Jan 19 2023

  Consumer Services Inflation Cycle Matters The Most: Fed Tightening Cycle Far From Over

  Last month, although overall headline consume prices fell 0.1%, consumer prices for services rose 0.4%. Since consumer services account for 70% of the overall price index (and 58% excluding energy services), that's the price cycle the Fed needs to crack before it can be confident that overall inflation is slowing to its 2% target.

  Breaking consumer services price cycles take time and significant increases in official rates. Since the mid-1980s, consumer services inflation cycles have reversed after the federal funds rate exceeded the inflation rate, sometimes by substantial amounts. At the end of 2022, the Fed was far from reaching the level of official rates that broke prior inflation cycles.

  That's because consumer services, excluding energy services and core consumer services less shelter, posted year-on-year increases of 7% and 7.4%, respectively, in December. So the current fed fund rate range of 4.25% to 4.5% is still 300 basis points below consumer services inflation.

  The financial markets are betting that the Fed has little more to do to reverse the inflation cycle, while history says there is much more to do. Who's right? I bet the historical pattern between inflation and the fed policy repeats itself; investors, beware.

  by:Joseph G. Carson

  |in:Viewpoints
• USA| Jan 06 2023

  Inverted Yield Curve Not A Sufficient Condition For Recession-Credit Growth & Rate Levels Matter Too

  The inverted Treasury yield curve has raised concern over the risk of recession in 2023, and for a good reason. An inverted yield curve has occurred before the past eight recessions. Yet, something is awry. Banks are not restricting credit as they typically would with an inverted yield curve, and businesses and consumers are borrowing at banks at the fastest rate in fifteen years. What's up?

  The thinking behind the inverted yield curve is that banks slow and eventually stop lending when bank funding costs exceed what banks can earn by lending. Yet, bank credit has been accelerating throughout 2022. The latest data for November shows bank lending to businesses, real estate, and consumers rising 11.8% over the comparable period one year earlier. That's the fastest annual growth since 2007.

  Why are banks lending so much with an inverted yield curve? Banks' total costs of funds are not determined solely by the rate of federal funds. Customer deposits account for half of the funding costs for many big banks. And with customer deposit earning (or costing) less than 70 basis points, the bank's all-in funding costs remain relatively low. So it's still profitable to lend nowadays.

  That raises questions about the recessionary signal from an inverted yield curve because, in previous periods of inverted yield curves, bank lending slowed sharply, often contracting (see chart). Can the inverted yield curve signal be trusted if bank credit is accelerating, not slowing, or contracting as in previous periods? I would think not.

  Also, why are businesses and consumers still borrowing briskly after the Fed substantially raised official rates? Because the federal funds rate is not crushingly high, at least not yet. In the past, the federal funds rate proved restrictive when its level equaled or exceeded the growth in gross income and output (see chart). In other words, to slow domestic demand, the Fed had to raise rates equal to or above the increase in gross income and output.

  At the end of the third quarter of 2022, the growth in GDP exceeded the Fed funds rate by almost 600 basis points. That's huge, indicating the economy is far from one of the conditions in place before prior recessions. Even if the Fed median forecasts of higher official rates and markedly slower nominal growth are on the mark, the GDP-Fed funds' gap will not be closed before mid-year 2023. A recession beginning around mid-year runs counter to the bullish forecasts of a strong half for 2023.

  Many believe an inversion in the market yield curve, or the spread between the yield on three-month Treasury bills and the 10-year treasury, is a robust forecasting tool due to its consistent and reliable track record. Yet, yield curve inversion, by itself, is not a sufficient condition for an economic recession. Slowing or contracting credit growth and official rate levels equal to or exceeding income growth are also necessary conditions. Those conditions are not present, so until they are, the yield-curve recession signal will remain a forecast, not a reality.

  by:Joseph G. Carson

  |in:Viewpoints
• USA| Dec 06 2022

  Record Profit Margins Suggest It's Been A "Pain-Free" Tightening Cycle For Companies

  "It ain't over until it's over," quoting Yogi Berra, but this has been a "painless" tightening cycle for companies. According to the profit data for nonfinancial companies, profit margins (adjusted for inflation) for the first three quarters of 2022 have averaged 15.6%, essentially matching last year's figure, which was the highest in 60 years.

  In previous Fed tightening cycles aimed at slowing and reversing cyclical inflation forces, real profit margins declined, and by a lot. Declines of 200 to 500 basis points in real profit margins occurred during the tightening cycles of 1980, the 1990s, and the 2000s.

  What makes this period different? For one, the rise in official rates, while significant in scale, up 400 basis points from the start of the year, is still far below the 6.3% rate of core inflation for the twelve months ending in October. And the nominal level of federal funds at 4% is still 500 basis points below the 9.2% growth in nominal GDP for the year ending in Q3 2022.

  In short, the price increases have exceeded total unit costs for nonfinancial companies (including labor, materials, and credit borrowing). A 'pain-free" tightening cycle is not how inflation cycles end. In previous tightening cycles, companies felt the "pain" of higher interest rates, resulting in layoffs and cutbacks in spending.

  In comments at the Brookings Institution, Fed Powell said, "my colleagues and I do not want to over-tighten... that's why we're slowing down and going to try to find our way to what is the right level is". As Yogi Berra said, "You've got to be very careful if you don't know where you are going because you might not get there." Since the Fed does not know where they are going, how should investors know? Investors should expect a volatile 2023.

  by:Joseph G. Carson

  |in:Viewpoints
• USA| Nov 29 2022

  The Big Risk in 2023 For the Fed & Investors---Slowdown in Inflation Proves To Be "Transitory"

  Federal Reserve policymakers are considering implementing smaller rate hikes, acknowledging the lagged effects of previous rate hikes and better news on inflation. Investors have been running with this bullish view that the apparent slowdown in core inflation, along with declines in commodity prices, changes the inflation outlook so that policymakers would scale back and possibly end their rate-hiking experiment in early 2023.

  The rally in equities has been impressive. From the low on September 30, the Dow Jones is up 20%. If the equity market follows the historical pattern between the second and third year of presidential terms, there is much more to go. The average gain in the Dow Jones average from the low in the second year to the high in the third year has been 45%. A Fed pivot could be the catalyst for additional gains into 2023.

  The risk to that optimistic scenario and sustainable equity market gains for 2023 is that the inflation slowdown could be "transitory."

  Suppose that the Fed raises official rates by 50 basis points at the December 13-14 meeting and follows that with another 50 basis points hike in early 2023. That would lift the federal funds rate to 5%. And if core inflation continues to run at 0.3% for the next five months, the twelve-month reading on core inflation in March 2023 would be 5.25%.

  What are the odds of the Fed beating the current inflation cycle and bringing core inflation back to the 2% target with nominal rates below the inflation rate? History would say the odds may not be zero, but they are low. Official rates of 300 to 500 basis points above-reported core inflation broke the inflation cycles of the 1980s and 1990s.

  Here are three reasons why the slowdown in inflation could prove to be "transitory."

  First, individuals are sitting on a cash bundle. At the end of Q2, households had $18.5 trillion in checking accounts, time deposits, and money market funds, equaling approximately 25% of total liquid financial assets, the highest share since the financial crisis. A Fed pivot could easily trigger a big risk-on rally in equity markets ("FOMO," fear of missing out, has not been retired), with spillover effects in the real economy. A rebound in equity prices, lifting consumer wealth, would boost consumer sentiment and trigger more robust consumer spending.

  Second, the Fed rate hikes have hit the housing market hard. Home sales and new construction has slowed a lot in the past year. Yet, the number of existing homes for sale at 1.2 million in October is low and well below the level before the pandemic. The cost of mortgage borrowing, currently around 6% +, might look high nowadays, but that could change quickly in a risk-on environment when people's price expectations for housing starts to rise against a very low inventory backdrop. A more robust housing market would increase demand for commodities and consumer goods, lifting prices. And it has been the recent decline in consumer goods prices that have been responsible for the slowdown in core inflation.

  Third, labor markets remain tight, with an unemployment rate of sub-4% and almost twice as many job openings as the number of unemployed. The jobless rate increased by over 200 basis points and remained relatively high for a few years following the tightening cycles of the late 1980s and 1990s. That helped sustain the slowdown in core inflation. Continued tightness in the labor markets is the biggest hurdle to achieving a sustainable slowdown in inflation as it maintains wage-cost pressures.

  Policymakers will soon face Yogi Berra's "fork in the road." Will policymakers turn left (pause) or right (continuation of rate hikes)? Investors are betting on a left turn, expecting a rally in the short run. A right turn would create more pain in the short run but offer a better path for sustainable long-term gains.

  by:Joseph G. Carson

  |in:Viewpoints
• USA| Nov 03 2022

  We Were All Wrong: The Starting Point Was Zero

  When policymakers started to raise official rates in the spring, the official projections showed an official peak rate of 2.8% at the end of 2023. With inflation running much faster at the time, I argued that the peak rate could be as much as 100 basis points higher than what the Fed was telegraphing. We were all wrong.

  Four consecutive seventy-five basis points increases and three hundred and seventy-five basis points in eight months look like a substantial increase in official rates. But the starting point was zero, and much more is still needed to reverse inflation risks.

  Price increases lead to revenue and profit increases for companies, while wage increases trigger income gains for workers. So when the price cycle broadens and wages increase, it takes more and more rate hikes to break the cycle because higher profits and income offsets the higher borrowing costs.

  In October, core consumer prices were up 6.7% from one year ago, while average wages for non-supervisory workers increased by 5.9%. Price increases are 260 basis points above last year's gain, while wage increases are roughly the same. At 4%, the fed funds rate is still far below the price and wage gains, so there is more ground to cover before the policy is even neutral, let alone restrictive.

  Businesses and consumers do not borrow at the fed funds rate. But the federal funds rate is the benchmark for all borrowing costs, so for market rates to be at levels that restrict borrowing, the Fed needs to lift rates to prohibitive levels. The fed funds moved above price and wage gains in the past three cyclical inflation cycles (the 1980s, 1990s, and 2000s).

  So we all were wrong. Fast and broad price and wage gains require higher official rates.

  by:Joseph G. Carson

  |in:Viewpoints
• USA| Oct 19 2022

  Near-Record High Profit Margins Indicate the Fed Is Not Winning the Inflation Battle

  The resiliency of the corporate sector has been one of the surprises in 2022. Despite a volatile and uneven economy and a series of interest rate hikes from the Federal Reserve, the corporate sector has maintained record profitability and near-record profit margins. The high-profit margins may be the biggest surprise as it confirms that cost increases have been passed along and not absorbed. That dynamic makes the Fed's job of slowing inflation much more difficult, as it shows an "acceptance" of price increases.

  In 2021, real operating profit margins for nonfinancial companies stood at 15.7%, the highest level since the mid-1960s. Surprisingly, companies simultaneously passed along the higher costs of materials, supplies, and labor and lifted margins in the process. And the spread of 275 basis points between final prices and total unit costs was the second widest since the 1960s.

  Real operating margins have remained relatively high in the first half of 2022. At 15.5%, real profit margins for nonfinancial companies are still 300 basis points above the levels that were in place before the pandemic.

  Q3 data on profit margins are not yet available. But, the price and wage data suggest margins held up if not expanded. To be sure, core consumer prices of 6.4% annualized and core producer finished goods prices of 7% were 100 to 175 basis points over the increase in wages for non-supervisory private workers. Firms' total unit costs were probably lifted somewhat due to rising finance costs.

  High-profit margins help to explain why job growth has continued to be so strong this year. Companies added over 1 million workers in the third quarter, about the same number as in the prior quarter. That robust pace of hiring is not something that one would expect if companies, in the aggregate, were experiencing intense downward pressure on margins from rising costs.

  Policymakers will never publicly admit this, but the Fed wants an environment where companies cannot pass along cost increases into final prices. That would lead to a decline in margins, a typical outcome during slower growth periods or recessions, eventually forcing cost cuts, including layoffs, less demand, and slower inflation.

  Policymakers place a lot of emphasis on inflation expectations, but that is a "soft-data" measure of what people would like to see or expect versus what they are doing or accepting, as is captured in the "hard data" measure of companies' profit margins. Near-record high-profit margins indicate the Fed's job of fighting inflation is far from over, raising the risk that official rates have to go much higher than is shown in policymakers' dot plots or future prices.

  Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.

  by:Joseph G. Carson

  |in:Viewpoints
• USA| Oct 10 2022

  Investors Should Be Cautious Of A Policy Pivot: Volcker Showed Quick Policy Pivots Don't End Well

  Investors should be cautious of a policy pause or pivot as it might bring short-term gain at the expense of long-term pain. No one is better than Mr. Volcker at knowing that quick pivots or reversals in the fight against inflation don't end well. Mr. Volcker abandoned his inflation fight in early 1980 following the sharp plunge in the economy (at the time, it was the sharpest one-quarter drop in GDP in the post-war period) associated with the imposition of credit controls.

  After lifting official rates by more than 1000 basis points over several months, Volcker dropped them equally fast, only to resume his inflation fight later in the year. Volcker eventually raised official rates to higher highs in the next two years, underscoring the critical point of inflation cycles; that they do not die quickly or easily.

  Nowadays, there is nothing on the horizon that would trigger an economic decline equal to that of the 1980's drop. But that's not the critical point. Killing inflation cycles require a significant reset of economic and financial conditions following a fundamental tightening of monetary policy. The sharp two-day rally in equities this week based on the slightest hint of a policy pause shows investors' risk-taking appetite is alive and well. If that is still alive, so is the economy's growth and inflation appetite.

  Yet, it is hard to deny that things are lining up for Fed Powell to pause at some point. For example, prices paid diffusion indices from the Institute of Supply Management for manufacturing and the service sector provides a snapshot of cost pressures. Both price measures fell to their lowest levels in roughly two years in September.

  Yet, it is worth noting that diffusion indexes track the breadth of increases (or decreases) and do not distinguish the magnitude of change. So while cost pressures have subsided, they have not disappeared completely. Also, the service sector's price index at 68% remains elevated, which has to do with two things: services use fewer commodities than manufacturing, and labor is a more significant part of their cost. Since the inflation cycle is increasingly becoming a service sector phenomenon, rising labor costs remain the biggest wild card for the inflation cycle.

  The number of job openings stood at 10 million in August, off 1.1 million from July, but still far above pre-pandemic levels. And, with 1.7 job openings for every unemployed worker, companies, especially in the service sector, will need to pay up to attract labor.

  Tightness in the labor markets will not be an obstacle for Fed Powell to pause after the Fed follows through on hiking rates at the next two meetings, as suggested in the latest policymakers' projections. Yet, it does create the risk of a pickup of inflation and higher official rates later. That's because, without sufficient slack in the labor markets, companies would still face the same labor cost conditions as they do today, raising the prospect of an extended inflation cycle.

  Inflation cycles are not linear, nor do they end in a day, week, or month. It takes time to stop and reverse. Policymakers say they must maintain restrictive policy rates for some time to kill inflation. Yet, will politics and investors let them?

  Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.

  by:Joseph G. Carson

  |in:Viewpoints
• USA| Sep 29 2022

  Is Deflation A Risk, Or Are These Prognostications A Spurious Call For A Fed Pivot?

  Consumer price inflation is at its highest rate in decades, yet some equity managers are screaming that deflation is the most significant risk. Is deflation a credible risk, or are these prognostications a spurious call for a Fed pivot? It's the latter.

  First, the US has never recorded one year of deflation in core consumer prices in the sixty-plus years that the Bureau of Labor Statistics has collected data. Think about that. There have been several years of high unemployment, with the jobless rate exceeding 8% and a few at 10%-plus. Also, the US experienced record wealth losses following sharp drops in equity and real estate prices, abrupt drops in commodity prices, and near-collapse in the banking system in 2008-09, and not one year of a decline in consumer prices. That does not mean the future risk is zero. Still, going from high to negative inflation in months has to be exceptionally low. Also, economic and financial conditions would have to get significantly worse, above and beyond what has happened in the past, for a prolonged period before deflation risks would be the dominant worry.

  Second, many equity managers form their opinion on inflation/deflation risks based on changes in commodity prices, especially energy. But, commodity prices are inputs into the production process and have a small weight in the overall cost of operations. Also, the US uses more commodities than it produces, so a fall in commodity prices is usually bullish for growth as it frees up cash flow and increases demand (and prices) in other areas.

  Third, it is surprising that some equity managers view deflation as bullish for equities. Price is what companies get for their goods and services. A broad decline in final goods and service prices equates to less revenue and slimmer margins for many companies as firms can't cover or offset the cost of labor and other things. Some of the lowest operating profit margins on record occurred during low consumer price readings. Those periods happened against relatively high unemployment, which is not the case nowadays. So it's hard to see how deflation is bullish for equities, especially in the current environment of job openings exceeding the number of jobless by a factor of two, pushing up the cost of labor.

  Fourth, the primary motivation of portfolio managers' deflation calls appears to be a campaign to pressure the fed to stop and eventually reverse the rise in official and market interest rates. Higher interest rates are a double whammy for equities as they hit growth and earnings and reduce the market multiple, or what people will be willing to pay for future profits.

  Suppose the Fed keeps on the current path of raising official rates to get consumer price inflation back to 2%. In that case, equity PMs might eventually get the policy reversal they are presenting with their spurious calls about deflation risks. But that path will be rocky, with sharp declines in operating earnings, corporate bankruptcies, and a rise in credit default rates. The risk of the latter occurring is much higher than the risk of deflation, which is not a friendly environment for risk assets.

  Deflation is not the magic wand to turn the equity market fortunes around, but that doesn't mean some PMs won't stop talking about it.

  Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.

  by:Joseph G. Carson

  |in:Viewpoints