Viewpoints

The Federal Reserve Bank of Philadelphia’s state coincident indexes in November, showed softness, but on balance no more so, and arguably less, than in October. The indexes in 14 states dropped from October (little more than half the number that had one-month declines in the initial October results), all less than .5 percent. At the three-month horizon 12 states saw their index decline from August to November, but only 4 small-population ones (Vermont, Montana, Maine, and Rhode Island) clocked drops of more than .5 percent. However, large gains were also rare over these three months; a fairly moderate number (10) had gains of more than 1 percent (this group did include New York and Florida), with Hawaii’s 2.62 percent far and away the best. Over the past 12 months, 13 states (including California, New York, and Florida) had increase of at least 5 percent, but this count is also down from the first October results. 4 states (Arizona, Montana, Mississippi, and Oklahoma) had increases under 2 percent.

in November the independently estimated national figures of growth over the last 3 (.78 percent) and 12 (4.29 percent) months do not appear terribly out of line with the state figures.

All states have set new peaks in this series in this expansion. Connecticut had been the last holdout, but the revised dataset shows that the Nutmeg state exceeded the old mark in July.

State real GDP growth ranged from Alaska's 8.7 percent annual rate to Mississippi's -0.7 percent. States in the West grew more rapidly, while softness was more evident in the central part of the nation. In general, energy-producing states like Alaska fared best--Texas's number 2 8.2 percent growth rate was nearly half the result of increased mining output—while farm-oriented states were weaker. The Dakotas are the real exemplars of this effect: ex-mining, North Dakota's 5.2 percent growth rate would have been close to South Dakota-s -0.5 percent rate of decline. ranged widely in 2022: Q2.

Looking at industry contributions, major sources of declines were construction, nondurable goods manufacturing, and wholesale trade (all three down in every state). A large pickup in accommodations and food services was arithmetically responsible for Hawaii being one of the few states with a real GDP increase.

State personal income growth ran the gamut from Colorado's 14.2 percent growth rate to Indiana's 1.9 percent. Maine and New Mexico, along with Colorado, saw astonishing rates of growth in transfer payments, while Indiana was held down by a drop in that income category. “Net earnings” (employee compensation plus proprietors' income) was much evener, with Texas's growth rate of 8.5 percent at the top and Indiana's 3.2 percent the lowest.

Last week the numbers on 2021 nominal and real personal consumption and real personal income by state were issued. The high for real spending growth was Utah's 12.5 percent, while West Virginia's 2.0 percent was the low. Numbers of states in the Rocky Mountains had growth exceeding 10 percent, as did Massachusetts, New Jersey, and Florida. West Virginia and Alaska (3.1 percent) were considerable outliers on the low side: no other state was under 5 percent.

The availability of both nominal and real consumer spending figures allows for the computation of state consumption price deflators and their growth. The range of growth went from Vermont's 0.5 percent to West Virginia's 8.1. Other New England states—Maine, New Hampshire, Massachusetts, and Connecticut—also saw deflator growth under 2 percent., while Arizona Nevada, and New Mexico were also on the low side. Other high growth states included Alaska and South Carolina (North Carolina was also high). Differences in state deflators, and their growth, would largely reflect differences in service costs (as one would expect, Alaska and Hawaii have the largest divergence in good price levels), especially housing, but also utilities. Thus, it isn't surprising that there is some regional theme to divergences.

It is almost December 23rd and that means that Festivus is nearly upon us. (Actually, Festivus is floating holiday that can be observed whenever one chooses to.) It is traditional on Festivus to air one’s grievances. Among the many, one of my grievances this year with the Fed is that it talks too much – talks too much about things of which it does not know. By talking too much, the Fed adds unnecessary volatility to the global financial markets.

It was not always this way. In fact, there was a time when I believe the Fed talked too little. In 1986, I transitioned from being an economist at the Chicago Fed to becoming a so-called Fed-watcher at The Northern Trust Company. Back then, about the only thing the Fed publicly announced about current and future monetary policy was the dates of its Federal Open Market Committee (FOMC) meetings. If the FOMC decided at a meeting to change the desired level of the federal funds rate, it did not reveal this to the public. One of the tasks of a Fed-watcher was to divine whether the FOMC had changed its target federal funds rate. If the federal funds rate were trading somewhat above its pre-FOMC-meeting level in the days following the meeting, how did the New York Fed trading desk respond? Did it execute overnight repurchase agreements, term repurchase agreements, outright open market purchases of securities, do nothing or exercise the “nuclear” option, by executing a matched-sale-purchase agreement (today known as a reverse repurchase agreement). These different open market operations might, or might not, have different implications regarding the FOMC’s federal funds rate decision at its latest meeting. It might take several days for us Fed-watchers to determine the FOMC’s decision. And sometimes we, collectively, got it wrong. Similar to a tree falling in a forest without anyone hearing it, what if the FOMC changed its target level of the federal funds rate and Fed-watchers did not discover it? I always thought that this unnecessary secretiveness on the part of the Fed was a Fed tool to provide full employment for economists. Finally, beginning in 1994, the FOMC began announcing changes in its policy stance, and in 1995 it began to explicitly state its target level for the federal funds rate. Miraculously, many of us Fed-watchers managed to stay employed. We could now devote more of our time to trying to discern the implications of the FOMC’s latest change in the federal funds rate for the behavior of the future behavior of the economy, both in real and nominal terms, of future interest rate levels and of future foreign exchange rates. Even with the extra time available for this, we were not very good at this. But most of us continued to stay employed in our chosen profession!

Now, the chairperson of the Fed holds a press conference immediately after the adjourning of an FOMC meeting. The chairperson talks about all manner of things entering into the FOMC’s policy decision. Not only does the chairperson announce the FOMC’s current target federal funds rate level, but also the FOMC’s expected future path of the federal funds rate. I believe it is a Herculean task to identify the “correct” current level of the federal funds rate, much less the “correct” future level of the federal funds rate. In between FOMC meetings, there can be as many as 19 Fed officials – 7 Fed Board governors and 12 Fed District Bank presidents – commenting on current and expected future monetary policy decisions, not all of whom are singing from the same hymn sheet. The current surfeit of Fedspeak brings to my mind the 1960 pop tune performed and co-written by Joe Jones, “You Talk Too Much” (check it out on YouTube). With apologies to Joe Jones and Reginald Hall, I have substituted my lyrics with Fed references to their song below.

The Fed Talks Too Much Lyrics by Paul Kasriel To the melody of “You Talk Too Much”

You talk too much. You worry markets to death. You talk too much. Why don’t you save your breath?

You just taw-aw-aw-aw-aw-awk, Talk too much!

You talk about a neutral rate That you don’t know. You talk about a soft landing Wherever you go.

You just taw-aw-aw-aw-aw-awk, Talk too much!

You talk about max employment That you can’t define. You talk about a terminal rate That changes all the time.

You just taw-aw-aw-aw-aw-awk, You talk too much.

You talk about transitory inflation And then your views shift. You talk about anchored expectations And then they begin to drift.

You talk too much. You worry markets to death. You talk too much. Why don’t you save your breath?

You just taw-aw-aw-aw-aw-awk, Talk too much!

Well, I have brought the aluminum Festivus pole up from the basement. It is made of aluminum because of its high strength-to-weight ratio. And the clock in the bag is hung on the wall. Why is a clock in a bag hung on a wall? No one really knows. It’s just an ancient Festivus tradition. So, it is time to gather around the pole, lift a glass of single-malt scotch, (Lagavulin, if you are thinking of a present for me) and join in the singing of “O Festivus”. Remember, Festivus is not over until Chairman Powell pins me.

O’ Festivus Lyrics by Katy Kasriel To the melody of O’ Tannenbaum

O’ Festivus, O’ Festivus, This one’s for all the rest of us. The worst of us, the best of us, The shabby and well-dressed of us. We gather ‘round the ‘luminum pole, Air grievances that bare the soul. No slights too small to be expressed, It’s good to get things off our chest. It’s time now for the wrestling tests, Feel free to pin both kin and guests, O’Festivus, O’ Festivus, The holiday for the rest of us.

And a contentious Festivus 2022 to all.

Note: I asked ChatGPT to write lyrics for “The Fed Talks Too Much” and “O’Festivus”. In my opinion, the results fell short of versions written by lyricists Katy and Paul Kasriel. But why don’t you give ChatGPT it a try and judge for yourself?

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

State labor market results in November continue to show lessened improvement and, in some measures, some softening. Eight states had statistically significant increases in payrolls. West Virginia saw a 1 percent gain, and New Hampshire’s .6 percent was the only other gain higher than ½ percent. Florida saw the largest numerical increase. Its 28,100 is fairly small compared to earlier months, where the leaders generally with state pickups of more than 50,000 Over the last 12 months, every state (and DC) saw a gain in payrolls, but in six cases (as well as in DC) the increases were not seen as statistically significant. Texas’s 5.1 percent gain over this period was the largest.

12 states saw statistically significant increases in their unemployment rates from October to November, but none larger and .3 percentage point. Three states, and DC, had statistically significant declines, none greater than .2 percentage point. Nevada’s 4.9 percent rate was the nation’s highest, with DC and Illinois also posting rates above 4.5 percent; Utah’s 2.2 percent the lowest, with Minnesota and both Dakotas the other ones with rates under 2.5 percent (in October seven states had rates of 2.4 percent or lower).

Puerto Rico's job count rose by more than 4,000, but once again there was insufficient information to compute the (seasonally-adjusted) unemployment rate on the island.

"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.

In the November 25, 2022 edition of Barron’s, Randall Forsyth penned an article entitled “Another Reason a Quick End to the Fed’s Rate Hikes Looks Unlikely (emphasis added). One of the reasons Forsyth advanced for his forecast (?) of future Federal Reserve interest-rate policy is the behavior of commercial bank credit. “…Joseph Carson, former chief economist at AllianceBernstein, points out that bank credit growth is booming. Loans to businesses and consumers, and for real estate, are accelerating at the fastest pace since 2008, he writes in his blog on LinkedIn.” Earlier in his article, Forsyth says “… [g]rowth in the M2 [money] measure, which consists of currency, checking, and other transaction and retail savings accounts, has collapsed to about 2% below the level a year ago. That’s a stunning reversal from the explosion in the money supply from pandemic monetary and fiscal stimulus; year-over-year, M2 expansion peaked at 27% in early 2021.” Forsyth goes on “… the contrast between the sharp slowing in M2 (which went negative, on a month-to-month basis, in September and October) and strong expansion in credit is puzzling. What should be done about this?” Earlier in the Forsyth article he cites Nancy Lazar, the veteran economist who heads macro research at Piper Sandler, “… [t]he slowing in money growth is the good news. The bad news is that M2, at $21.4 trillion, is still very elevated, by about $4 trillion over where she estimates it would be had it stayed on its prepandemic growth track.” This implies that the private sector has a lot of cash in reserve to fund spending even if the rate of growth in cash has slowed. Veteran economist and former chief economist at The Northern Trust Company, yours truly, discussed the implications of the large amount of cash held by the nonbank private sector in two commentaries, “Households’ Extraordinary Cash Holdings Will Thwart Fed Tightening” (March 14, 2022, LinkedIn, or “Viewpoints” section of Haver.com)) and “Households, Corporations and Banks Are in Good Shape as Recession Looms” (October 17, 2022, LinkedIn or “Viewpoints” section of Haver.com). If the nonbank private sector is now so flush with low/no-yielding M2 balances, why are they borrowing from banks at elevated loan rates? Is that a sign of private sector strength?

Let’s do some fact checking before arguing that there is reason to believe that a quick end to the Fed’s rate hikes looks likely based on the recent behavior of bank credit. Plotted in Chart 1 are month-to-month annualized percent changes in both bank credit, which includes loans, leases and securities on the books of commercial banks, and the monetary aggregate, M2. Yes, M2 growth slowed in the waning months of 2021 and M2 has been more or less contracting starting in April 2022. But notice that bank credit growth has slowed since December 2021 and bank credit has contracted in both September and October 2022. So, although the magnitudes of recent month-to-month percent changes in M2 and bank credit have differed, the trends are similar – smaller positives transitioning to negatives. So, from where does the notion of “booming” bank credit come?

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.

The widespread protests witnessed in China’s major cities over the weekend is something that has been brewing [1] for months. It is a cocktail of popular discontents with zero-covid restrictions (despite policy relaxation [2] earlier), constitutional changes [3] to remove the two-term presidential limit and a weaker economy [4], while the block fire [5] in Urumqi, Xinjiang was merely a flashpoint and had fanned the recent anti-government or “A4” [6] movement. The unfolding situation in China will have profound economic and geopolitical implications that will reverberate around the world.

Certainly, this poses one of the most serious challenges to Xi’s rule, especially since he was re-elected as country leader in the recent 20th Party Congress. It will be interesting to see how the Chinese authorities respond to this unprecedented wave of protests - the most concerted and largest since the democratic student movement in 1989.

Amongst the most energetic and idealistic, numerous students and at least 51 universities are again involved in this round of anti-government protests, suggesting that the movement is unlikely to die down easily. If the authorities cannot exert effective controls over the situation in the next couple of days, we should expect a series of policies to be implemented. In the policy toolbox, vaccinating the vulnerable and a further relaxation of Covid restrictions are on the cards, a potential mass arrest of activists and measures to restrict congregations and communications. Curfews may be widely imposed in affected cities, followed by an Iranian style internet shutdown [7] with authorities cutting off mobile internet and social media platforms. If everything fails, the worst-case scenario is a Tiananmen style crack-down, which is still a possibility if the Party is determined to cling on to power. In terms of geopolitics, China might employ a diversionary foreign policy, to divert public’s attention away, instigating disturbances in the South China Sea and Taiwan strait. However remote the possibility, experts might reassess the timeline for the annexation of Taiwan [8].

Overall, the instability witnessed so far will likely linger on well into 2023 if no meaningful measures are implemented to avert the situation. The above-mentioned policies to restrict movement and information flow in major cities that generate a significant portion of the country’s economic output, if put into effect, will dent the economy further, dashing hopes for more job creation [9] which is key in promoting social stability. This truly is a dilemma for the Party. These measures will also have negative impacts on the world’s supply chains [10].

References: [1] https://www.bbc.co.uk/news/world-asia-china-63633109 https://www.washingtonpost.com/world/2022/10/14/china-protest-sitong-bridge-haidian/ https://www.bbc.co.uk/news/world-asia-china-63447755 [2] https://www.bloomberg.com/news/articles/2022-11-11/these-are-the-20-measures-guiding-china-s-covid-easing-efforts [3] https://www.bloomberg.com/news/articles/2022-10-18/anti-xi-slogans-in-rare-beijing-protest-spread-within-china?leadSource=uverify%20wall [4] https://www.imf.org/en/News/Articles/2022/11/21/pr22401-imf-staff-completes-2022-article-iv-mission-to-the-peoples-republic-of-china#:~:text=Following%20the%20impressive%20recovery%20from,percent%20in%202023%20and%202024. [5] https://www.bbc.co.uk/news/world-asia-china-63752407 [6] https://www.independent.co.uk/news/world/protesters-china-blank-paper-white-covid-b2234009.html [7] https://www.forbes.com/sites/emmawoollacott/2022/09/22/iran-shuts-down-whatsapp-and-instagram-as-protests-spread/ [8] https://www.spectator.co.uk/article/a-chinese-invasion-of-taiwan-is-coming/ [9] https://foreignpolicy.com/2022/08/04/xi-china-unemployment-jobs-economy-crisis-youth-mao-great-leap-forward/ [10] https://edition.cnn.com/2022/11/25/tech/apple-foxconn-iphone-supply-china-covid-intl-hnk/index.html