Viewpoints

Supply chain bottlenecks, disrupted trade flows and commodity price tension have been key hallmarks of the macroeconomic scene for some months now. But are these factors now moving into reverse? High frequency indicators of shipping costs – such as the Baltic Dry Index – certainly suggest this may be the case (see figure above).

This index has enjoyed a fairly tight correlation with indicators of real economic activity in commodity markets in recent years. And unsurprisingly it has equally enjoyed a tight correlation with global inflation surprises. Indeed its steep decline over the last six months presages a period in coming weeks where inflation outcomes could elicit far fewer positive surprises and even a few negative surprises.

This, in turn, could clearly be of some importance for policymakers and interest rate expectations in the period ahead. Indeed a relationship that may be worth watching closely against this backdrop is the evolution of activity in commodity markets and US Treasury yields (see final figure below).

The inversion of the two-year and ten-year yields creates more problems for the Fed and the financial markets than for the economy. That's because the yield curve inversion has occurred at a relatively low level of interest rates, far too low to slow final demand and squash inflation pressures.

History shows that yield curve inversions offer an accurate negative view of the economy's future path only when accompanied by a level of interest rates that prove prohibitive. In the past, restrictive interest rates were when the federal funds rate and market rates equaled or exceeded the growth in nominal income.

Notably, that is not the case today. On the contrary, it's the exact opposite. A record gap exists between Nominal GDP growth of 10% in the past year and the current fed funds of .5%. There is even a record spread between Nominal GDP and two and ten-year yields of around 2.5%.

Yield curve inversion at low-interest rate levels is a nightmare for the Fed. Past experiences dealing with cyclical inflation pressures tell the Fed that it needs to increase the cost of credit to slow final demand before it can successfully dampen inflation pressures.

Take a look at the current trends in the housing market. Mortgage rates have moved above 4% for the first time since 2019. Yet, borrowing costs for a house purchase still are attractive given that house prices are rising close to 20% a year, people's house prices expectations remain at double-digit levels for the foreseeable future, and wages for most workers are growing close to 7%. In other words, money is still too cheap to slow housing demand and house price inflation.

If the bond market is not responding to high reported inflation by marking up yield levels because it believes the inflation cycle will die or it trusts the Fed to bring it under control, that puts added pressure on the Fed to act more aggressively. And, as the Fed lifts official rates to dampen final demand growth and quell inflation, it will encounter market and political backlash of triggering more curve inversion.

A sustained inversion between fed funds, nominal GDP, and market rates may occur as policymakers attempt to bring inflation to their 2% target. After a decade (2010 to 2020) of a near-zero federal funds rate as policymakers tried to hit its 2% price target, investors will encounter of much different and higher cost of credit landscape. One key takeaway is that high-multiple growth stocks which have outperformed value stocks for the past decade should see a "reversal of fortune" in the next decade.

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

The Federal Reserve Bank of Philadelphia’s state coincident indexes in February continue to show widespread growth across the nation. Over the three months since November 49 states reported growth, with Montana and West Virginia both increasing 3 percent (Alaska edged down marginally). led by a nearly 3 percent rise in Montana. Five other states had increases above 2 percent, and only 3 (other than Alaska) had gains of less than 1 percent. The independently estimated national figure of 1.5 percent growth over this period was consistent with the state numbers.

Over the last 12 months 7 states registered gains higher than 10 percent, led by Nevada’s 16.2 percent (Hawaii was also in this group) and New York and California were again also members. The 6.2 percent national figure seems a bit lower than the individual state reports might have suggested; all of the 4 largest states (California, Texas, New York and Florida) had gains higher than that.

49 states report an increase from January to February, with Alaska again being the exception. Both Maryland and West Virginia were up 1.4 percent.

State real GDP growth continued to be in a wide range in 2021:Q4. Nine states grew at rates equal to or exceeding 8 percent, led by Texas's 10.1 percent. However, 3 states (North Dakota, Nebraska, and Iowa) registered declines in output. Again, as was the case in the third quarter, marked declines in agriculture held down the Plains states. Sharp gains in accommodations and food services contributed markedly to growth in Hawaii and Nevada, and a few other states, none of which stand out immediately as major travel destinations (Connecticut, New Hampshire, Vermont, Tennessee, and New Mexico). New York, which has had difficulties reviving tourism, saw that sector decline in the fourth quarter.

The broad contours of growth in the fourth quarter were comparable to those for 2021 as a whole. In general—though there are some exceptions on both sides—state in the middle of the nation (the Middle West, Plains, and South Central) have been growing more slowly than those to the East and West. The Western states have been (again generally) the fastest growing, the South Atlantic is nearly as fast. The Northeast is mixed, with some states noticeably stronger than others (New York is a notable laggard).

The GfK look-ahead consumer confidence metric for Germany is expected to plunge in April, swinging from a reading of -8.5 in March to a -15.5 reading in April. The April reading resides in the lower 1.2% of the historic queue of observations for the GfK headline This is the second lowest GfK reading since the series began in January 2002. The lowest reading on record is -23.1. The monthly drop in the headline is the third largest one-month drop on record over this same period.

The GfK metric chronicles a sudden shock as well as a deeply negative reading for German consumer confidence in April. We should view it as a sort of bellwether for Europe.

The German condition Germany has been torn and twisted by upheavals over EMU/EU policies various, episodes with the virus, political change, and muti-decade haranguing with the U.S. over its modest contributions to NATO, and its dependency on oil from Russia. As the U.S. (Obama, then Trump) urged Germany to contribute more to NATO, the Germans insisted on dragging their feet before upping their NATO contribution to 2% of GDP, a contribution they were loath to make because they were doing so much business with Russia. Germans bought Russian gas and sold other goods. Germans did not see any reason to contribute a huge chuck of GDP to defend themselves against a business partner…until the grim reality set in. Germany has been paying down debt rather than contributing more to NATO. Trump incredibly was treated as a 'bad ally' when he threatened to pull some troops back (and did) because Germany refused to pay more for its own defense (opting to shore up its financial condition instead). Trump may have been ham-handed about it, but he was right. And Germany must have had an inkling of its true need since it really did want the U.S. presence to remain, but it did not want to pay for it. Perhaps some day we can talk about that without blood pressures rising. But German attitudes toward Russia also held-back the U.S. response to Russia as it amassed troops on Ukraine's border since, until Russia invaded Ukraine, Germany was not on board for anything but the most milquetoast of sanctions.

Post invasion…never mind In the event, Russia steamrolled Ukraine, surprised Germans opened their eyes and the world changed before our eyes in a blink. All of this has shocked the German public and we see that in the smackdown of the GfK index in April. All those things that came before the Russian attack are now water under the bridge. Germany is looking to wean itself off Russian energy. Current energy contracts are still honored by both sides (although there have been attempted modifications as Russia has tried to get energy paid for in rubles). Germany is actively looking to arrange for LNG shipments- something the U.S. urged years ago – more water under the bridge.

Metrics for the sucker-punched German consumer The detailed metrics for the GfK system are up-to-date through March not April. But they all are weak. Economic expectations read -8.9 in March; a drop from 24.1 in February. Income expectations are at a reading of -22.1; down from 3.9 in February. The propensity to buy index fell to -2.1 in March from 1.4 in February; this is the smallest monthly drop of the lot. Economic expectations have a 21.9 percentile standing in their historic queue of ordered responses, income expectations have a 0.4 percentile standing, and the buying climate has a 28.1 percentile standing. In terms of monthly drops, the declines are large with the economy measure falling more month-to-month only 13.6 percent of the time, income expectations fall by more month-to-month 13.6% of the time as well and buying plans slip by more in one-month about one-third of the time.

Policymakers are trying to achieve a benign economic outcome, a soft landing similar to 1995. But unfortunately, history shows that soft landings are rare. Since 1960, there have been three soft landings but nine recessions. Soft landings happen when the Fed acts early and often, and recessions occur when the Fed acts late. Unfortunately, the Fed is late, very late today.

One of the biggest challenges for the Federal Reserve is that it confronts the most significant inflation cycle in decades without any trusted policy gauges. Decades ago, policymakers abandoned the monetary targets, arguing that they no longer provided a consistent and reliable nominal spending and inflation signal. And a few years ago, Fed Chair Powell "retired" the Phillips Curve from a policy gauge, arguing that there was no consistent pattern between labor market slack and up and down movements in inflation for the past two decades.

The Fed's playbook from the 1994 episode should have helped, but policymakers did not follow it. The 1994 transcripts of the Federal Open Market Committee (FOMC) meetings reveal that Fed Chair Alan Greenspan argued, "we are facing a test over whether inflation is a Phillips Curve phenomenon or a monetary phenomenon." He said if it's a Phillips Curve phenomenon, we are on the edge of significant inflation as there was no slack in the industrial markets. However, if inflation is a monetary phenomenon, then the inflation pressures should be a "blip" as "subnormal growth in money and credit" has to mean something.

Even though Greenspan debated with his colleagues, he concluded that "we have to presume the pressures are there." As a result, he felt that the FOMC needed to take more preemptive actions of raising official rates since it was too risky to be wrong. Whether by design or luck, the economy achieved a soft-landing in 1995, and the much-dreaded consumer inflation cycle never took off.

Policymakers need not have the same debate nowadays as Phillips Curve, and monetary inflation features are present. To be sure, broad money growth has topped 40% in the past two years, the fastest ever. And, wage increases have become significant and persistent (average wages up 6.7% in the past year). And wage pressure will continue to be an issue with a relatively low jobless rate of 3.8%.

The inflation cycle of today is also more advanced, markedly different in scale and scope compared with 1994. For example, in 1994, producer prices for crude goods, excluding food and energy, rose 15%, but in 2021, the same prices rose 29%. Greenspan's primary concern in 1994 was the spike in crude prices would work its way up to the pipeline, lifting prices everywhere and in everything. In 1994, that didn't happen. But in 2022, it has.

Producer prices for intermediate materials, excluding food and energy, rose 23% last year. That was nearly 5X times the increase of 1994. Consumer prices have increased 7.9% in the past year, and the peak is not yet. Yet, in 1994, consumer prices showed no acceleration, ending the year at 2.7%, the same rate at the outset.

Policymakers' 2022 playbook is a "wing and prayer" strategy, hoping for a good outcome but unwilling to apply sufficient monetary restraint to get a good result. Current projections show a peak fed funds rate of 2.8% at the end of 2023, or less than half today's inflation rate. Soft landings of 1994 and 1984 came about with policy rates 300 to 600 basis points above inflation.

If lifting nominal interest rates well above inflation helped engineer a soft landing in the past, what are the odds of achieving a soft landing by doing the opposite? Close to zero, in my view. Also, policymakers expect the jobless rate to be even lower at the end of 2023 (3.5%) than today. So how does the Fed expect to break the wage-price cycle (Phillips Curve) without creating slack in the labor markets?

Fed Chair Jerome Powell has often said monetary policy is not on a preset course. Yet, it's on a preset path to fail this time as long as it lets inflation linger and keeps policy rates too low. Investors forewarned.

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

State payrolls were robust in February. 27 states saw statistically significant increases from January, led by California's 138,100 rise. Texas gained 77,800 jobs, and Florida was up 51,000. 19 other states had increases of more than 10,000. Nebraska had the largest percentage gain—1.2—while 4 other states had .8 percent increases. Over the last 12 months 48 states, plus DC, saw statistically significant increases in payroll employment. Unsurprisingly, California had the largest numerical increase (over 1 million) and Nevada the largest percentage increase (9.7).

Virtually all states saw job growth over the last 12 months. California picked up well over 1 million jobs; Nevada saw a 10.3 percent increase. Alabama, Ohio, South Dakota, and Delaware were the only states to report job growth under 2 percent

A whopping 31 states saw statistically significant drops in their unemployment rates in February; New Jersey's .5 percentage point decline was the largest. The range of unemployment rates across the nation continues to narrow. Again, DC was highest, at 6.1 percent. Among the 50 states, Nebraska and Utah continue to have the lowest rates (2.1 percent) and New Mexico the highest (5.6 percent).

Puerto Rico eked out a modest gain in payrolls in February. With a revision to January, the job count on the island is now over 900,000 for the first time since 2015. Unemployment continues to fall, with February's rate down .3 percentage points to 6.8 percent.

Economic forecasters have been paring back their expectations for households' living standards for several months now. Soaring prices for energy and food combined with a fading impulse from COVID-related fiscal support together - more recently - with higher borrowing costs have severely derailed households' disposable income growth in most major economies. At the start of last year, the Blue Chip consensus of US forecasters was centred on an advance in real household incomes of 1.1% in 2022. In the latest survey from March this year those same forecasters are now expecting real incomes to plunge by 3.5% (see figures 1 and 2 below). Similar arithmetic applies to consensus forecasts elsewhere.

Figure 1: The evolution of consensus forecasts for 2022 for US consumption and real income growth