Viewpoints

India’s economy is rebounding, with the business cycle upswing becoming more pronounced and widespread. Although GDP growth slowed slightly in the second quarter, moderating to 1.1% quarter-on-quarter (QoQ) from 1.3% QoQ, this was largely due to a contraction in government spending, inventories, and exports. Importantly, both consumption and investment spending grew robustly, marking the fastest pace since late 2021 and early 2022, respectively. Leading indicators remain positive, and the economic fundamentals are supportive of continued growth.

The corporate profit cycle is in full swing, with company balance sheets in rude health, positioning businesses to increase investment. Corporate debt-to-equity ratios have declined significantly, and corporate debt as a percentage of GDP is well below global averages. Consequently, the debt service-to-equity ratio is now below the 2007-2023 average, and the interest coverage ratio remains stable—44x for IT, 7.5x for manufacturing, and 1.7x for non-IT services. Infrastructure companies, buoyed by optimism, are increasing their spending, according to the RBI’s Q1 FY24/25 Services and Infrastructure Outlook Survey. Capacity utilisation is tight, and order backlogs are rising. Additionally, monthly data shows upward trends in the capital goods sector and the eight-core industry infrastructure index.

Public sector banks, which dominate the financial sector, have never been stronger. Non-performing loans (NPLs) are at a 12-year low due to a sustained reduction in new NPLs and higher write-offs. Provisioning levels are at their highest since 2007, and asset quality among large borrowers continues to improve. The sector is well-capitalised, with average capital adequacy ratios of 16.8%, comfortably above the RBI’s 11% regulatory minimum. Private credit is growing at double-digit rates, with strong borrowing demand across industries, services, small and medium enterprises, large corporations, mortgages, and big-ticket consumer goods.

Living in a “swing” state, I am bombarded with political television ads. The GOP ads blame the 2021-2022 surge in inflation on Bidenomics and, by association, Harrisomics. A number of the elements of Bidenomics increased the federal budget deficit. But I will argue that federal budgetary deficits do not cause higher inflation. Rather, the actions of the Federal Reserve and the depository institution system cause higher sustained inflation rates by their combined ability to create credit figuratively out of thin air. The Federal Reserve and the depository institution system are, in effect, legal counterfeiters, i.e., they have the unique ability to create credit, figuratively, out of thin air. (Thin-air credit here will be defined as the sum of the Federal Reserve liability items, reserve deposits and vault cash of the depository institution system, currency held by the non-depository institution system, and the sum of depository institution system items, debt securities and loans. (An equivalent definition of thin-air credit is the monetary base, created by the Federal Reserve plus credit created by the depository institution system.) When credit is created out of thin air, the recipients of this credit are able to increase their spending without necessitating any other entity to reduce its spending. With some exceptions, when an entity other than the Fed/depository institution system lends to another, the lender reduces its current spending, transferring spending power to the borrower. This is called saving on the part of the lender.

Let us look at some data relating net federal borrowing as a percent of nominal GDP versus thin-air credit growth to goods/services price inflation. The inflation measure I will use in this analysis is the chain-price index for Gross Domestic Purchases. This inflation measure includes the prices of personal consumption expenditures, business expenditures, residential real estate services expenditures and government expenditures on goods/services. It excludes the prices of US goods/services exports. I have tested lead-lag relationships between net federal borrowing and inflation and thin-air credit growth and inflation. For both variables, the highest correlation coefficients occur when both net federal borrowing and thin-air credit growth lead inflation by two years. So, this year’s inflation rate is most highly correlated with net federal borrowing and/or thin-air credit growth two years prior.

If federal government net borrowing influences inflation, we would expect a negative correlation between the two series. And that is what we observe in Chart 1. The correlation coefficient between the two series is negative 0.14. Although the correlation coefficient has the correct sign, the absolute value of its magnitude, 0.14, is low, suggesting that there is not much association between the two series.

State real GDP growth rates in 2024:2 ranged from Alaska’s -1.1% to Idaho’s 5.9%. There was an odd distribution of agricultural output growth, with pronounced gains in Vermont, Wisconsin, Kansas, Nebraska, New Mexico, and Wyoming, but sharp losses in North Dakota, Arkansas, and Mississippi. Elsewhere, New York’s numbers were swelled substantially by a surge in finance. The industrial Midwest benefitted by increases in durable goods output. As expected, Pennsylvania has become the sixth state with an annual rate of nominal GDP above $1 trillion (with the annual revisions, the Keystone state went above that mark in the first quarter). California’s GDP is now estimated to be higher than $4 trillion, at an annual rate. The five currently above that threshold are California, Texas, New York, Florida, and Illinois; Ohio is the only other state with nominal GDP above $900 billion; New Jersey, Georgia, North Carolina and Washington are above the $800 billion mark.

Idaho also led in personal income growth, with an 8.3% rate of increase. North Dakota was last at 2.1%. The above-noted distribution of agricultural output growth also appeared in the income numbers, with the indicated high farm output growth states seeing important growth in farm income, and the others unusually large declines in income from that sector. Transfer income growth was, as usual, dispersed, but probably less so than has usually been the cast; a drop in Massachusetts, virtually no change in Texas, and double-digit growth rates in Iowa, South Dakota, and California being of some note.

The Federal Reserve Bank of Philadelphia’s state coincident indexes in August were again soft. Connecticut continued to be on top, but its relatively modest .6 percent increase was the only state’s above .5 percent. 24 states saw declines, with Massachusetts and South Carolina down by more than .5 percent. Over the 3 months ending in July, 15 states were down, with Massachusetts dropping 2.1 percent, while South Carolina and Michigan were also down more than 1 percent. Repeating the odd New England pattern, Connecticut was on top with an increase of 2.4 percent, while Alabama and Oregon rose more than 1 percent. Over the last 12 months, 5 states were down, and another 8 saw increases of less than 1 percent. Rhode Island’s index was down 1.6 percent. Arizona had a 4.8 percent increase, and Texas, Idaho, Utah and Connecticut had gains of more than 3 percent (and Nevada was up 2.99 percent).

The independently estimated national estimate of growth over the last 3 months (.6 percent) and 12 months result (2.7 percent) both appear to be roughly in line with the state numbers.

State labor markets were again soft in August. Texas, Indiana, Minnesota, and Wisconsin were the four states, while South Dakota saw a .7 percent decline. Numbers of other states had statistically insignificant drops. An interesting sidelight was that the original report that New York government employment had increased by an incredible 40,600 in July was revised to now show a 4,600 drop that month!

Six states, and DC, had statistically significant increases in their unemployment rates in August and one (again Connecticut) showed a decline. South Carolina’s rate increased by .4 percentage point. The highest unemployment rates were in DC (5.7%), Nevada (5.5%), California (5.3%), and Illinois (5.3%). No other state had rates as much as a point higher than the national 4.2%. Alabama, Hawaii, Iowa, Maine, Maryland, Mississippi, Nebraska, New Hampshire, North Dakota, South Dakota, Vermont, Virginia, and Wisconsin had rates of 3.0% or lower, with South Dakota at 2.0%.

Puerto Rico’s unemployment rate was again unchanged at 5.8%, while the island’s job count grew by 3,100.

The Fed raised official rates by 500 basis points from 2022 to 2023, the most significant increase over forty years, and there was no recession. The Treasury yield curve inverted for almost two years, and there was no recession. Is it time to rethink what constitutes tight financial conditions? Merely measuring financial conditions based on interest rate levels is insufficient nowadays when monetary and fiscal policies add trillions to the economy via asset purchases and budget deficits.

The traditional perspective on stringent financial conditions involves official rates higher than reported inflation, an economy expanding below its capacity, an unemployment rate significantly exceeding estimated full employment, and stagnant real and financial asset values, with the possibility of notable declines in either or both.

Yet today's economic and financial picture is the exact opposite—the economy is growing above trend, the unemployment rate is close to the full employment mark, and asset prices are at record levels.

Given these economic and financial outcomes, it becomes clear that a reassessment of our monetary and fiscal policies is necessary to better understand and explain tight financial conditions. This could explain why the current economic and financial situation differs significantly from past years.

Firstly, it's crucial to note that the Federal Reserve's balance sheet remains substantial, at close to $7 trillion. This is approximately $4 trillion higher than its level four years ago. While the Fed's balance sheet is no longer expanding and is gradually shrinking, its impact on financial markets should not be underestimated. The additional $4 trillion of Fed security holdings equates to $4 trillion of liquidity for private investors seeking other investment opportunities.

Second, the US budget deficit is running at about $1.9 trillion. Not every dollar of government spending shows up in GDP, but what does not goes into the hands of people and businesses, and their spending does show up. Also, when the government runs a deficit, it means that people and businesses are not being taxed to an equal amount for the level of government spending. So, the bottom line is that budget deficits enable people's and businesses' cash flow to be higher than otherwise would be the case.

The Fed's balance sheet and the Federal government deficit together amount to over 30% of nominal GDP, which is enormous. The only times it was larger were during the pandemic years.

Using interest rate levels as the traditional method to gauge tight financial conditions is no longer relevant. The current unprecedented stimulus from monetary policy, achieved through asset purchases, and from fiscal policy, due to a relatively large budget deficit, makes it difficult to determine what defines tight financial conditions. It is challenging to ascertain if financial conditions are tight until the combined stimulus falls below pre-pandemic levels (or well below 20% of Nominal GDP).

The Yale Environmental Performance Index (EPI) 2024 Report states that there is a positive correlation between a country’s living standards and its progress toward achieving environmental goals. We wanted to explore that relationship in hopes of both shedding light on paths to making further progress toward environmental sustainability and highlighting any roadblocks. As Brookings noted in its commentary, “Developing Countries are Key to Climate Action,” it is imperative that any solutions for global climate change take into consideration the competing goal of increasing living standards in developing nations.

We ran regressions on 175 countries in cross section to quantify how living standards (as measured by 2023 per capita GDP) affect progress on environmental issues (as measured by the 2024 EPI). From these data, we can verify that per capita GDP is strongly correlated with EPI scores. Like the Yale study, we noticed that the gains from higher per capita GDP diminish as nations become wealthier. We were able to model this by taking logs of per capita income. As the chart shows, an increase in per capita GDP from 4 to 5 ($10,000 to $100,000) is associated with an increase of 15 points in the overall EPI score. The goodness of fit (adjusted R2) for this regression is 60.4 percent.

The ratio of the home price to median household income has nearly doubled since 2000. It's counterfactual to think that would have occurred if the BLS (Bureau of Labor Statistics) had not changed in 1999 its survey of owner-occupied housing to measure implicit owner-rents. Unbeknownst to many, the change has led to a significant undercount of housing and overall CPI inflation for decades.

In 1999, BLS made a significant change by 'simplifying the housing survey' to measure owners-rents in the CPI. It no longer tracked two types of housing units, owners and renters, with different characteristics and, in many cases, various locations. BLS argued that this change was necessary because it could no longer find an adequate sample of owner-occupied units for rent. BLS stated that the change was made to ensure the accuracy of the data, but the actual outcome was an understatement of housing inflation and overall inflation.

During the housing boom of the early 2000s, a crucial period that underscored the importance of accurate inflation data, I debated with BLS at an annual economic conference in 2004. Our research found that the rental survey underestimated actual or experienced inflation by several hundred basis points each year in the owner-occupied housing market. My main point was that the owner and rental markets were two distinct housing markets with different vacancy rates, and the latter was a primary determinant of rent changes.

BLS countered, stating, "There is no clear theoretical relationship between the homeowner vacancy rate and owners' equivalent rent." I emphasized that the practical relationship states otherwise. When housing prices are rising rapidly, and there is a short supply of housing units, why would owner-rents track the rental market and not the owner-housing market? Different markets yield different inflation.

This practical relationship, often overlooked, is crucial to understanding the actual inflation rates in the owner housing market. During the housing boom of the early 2000s, owners' rents increased between 2% and 3% per year, as they were linked statistically to rents of primary residences, while house prices rose at double-digit rates. Even today, owners' rents are not tracking house price inflation.

Many factors are behind house price inflation. Yet, if consumer price inflation tracked actual house price inflation versus a "hypothetical measure," it is hard to argue against the view the fact that overall inflation would not be higher, as official and market interest rates would be as well, resulting in a median house price much below current levels.

The change in the housing rent survey is a much more significant BLS blunder than the recent controversy over the overstatement of payroll job growth, as it affects reported inflation, inflation adjustments to entitlement programs, and, in some cases, workers' wages and official and market interest rates.