Viewpoints

The US has experienced two asset bubbles in the last twenty years, and a third one, bigger than the prior two, has been underway for a few years. Yet, unlike the previous two, which were a function of investor optimism about new technologies and easy credit conditions and the belief that housing prices never fall, the current asset cycle is a function of monetary policy.

The Federal Reserve's influence in the financial markets has grown substantially since the Great Financial Crisis. The increased influence stems primarily from their new financial tool, quantitative easing (QE), or the purchases of debt securities. QE lowers interest rates (making the future value of equities relative to interest-bearing securities more attractive) and increases the demand for risky assets (mainly equities) by removing the supply of safer debt securities.

The Fed never fully reversed its first QE program before another adverse event (i.e., the pandemic) triggered a second and even more extensive program. At its peak in 2022, the Fed's holding of debt securities topped $8.5 trillion, up from $3.8 trillion before the pandemic, and currently stands at $7.2 trillion. This has had a ratchet effect, lifting asset values far above fundamental values, and the positive impact remains in play.

Determining when asset values are running counter to underlying fundamentals is difficult. Yet, one can get perspective by comparing current valuations to past periods.

Since QE's second program in 2020, the market valuation of tangible and equity assets relative to GDP has increased from 2.5 to 3.3 times. The latest reading is for Q3 2023. Given the surge in equity prices in the fourth quarter, the ratio of assets to GDP could come close to its record high of 3.6 at the end of 2021. By comparison, this ratio peaked at 2.9 during the housing bubble and 2.4 in the tech bubble.

The prior two asset bubbles were pricked or unwound by market forces. The tech bubble burst when hundreds of new start-ups ran through their capital and failed to become profitable. The housing bubble burst when people had to refinance at higher mortgage rates, and speculators could not unload the homes they bought.

Critics of QE have always focused on its impact on reported inflation. QE does cause inflation, but not the one that shows up in the CPI or PPI. It is asset inflation, pure and simple. So, the Fed should study the impact of QE on its financial stability mandate, not its inflation and employment mandates.

Yet, how does an asset bubble burst when a non-market buyer like the Federal Reserve drives it? The 500 basis point increase in official rates would have had a much more significant and sustained negative impact on equity and housing markets if QE did not exist on the scale it does.

Monetary policy can make things appear better or run longer. Still, even though there is no law of gravity in finance, recent history does show financial euphoria not grounded in solid economic fundamentals is not sustainable. The significant over-valuation of tangible and financial assets poses a substantial risk to the economy, and history says it's not if but when it will unwind.

Before he took over hosting The Tonight Show” in September 1962, Johnny Carson hosted an afternoon quiz television show called “Who Do You Trust” (originally titled “Do You Trust Your Wife”). I used to watch it when I came home from school before digging into my homework. Looking at the revisions to the monthly report of nonfarm payroll employment, the show’s title gained more relevance to me now. Billions of dollars, maybe trillions, of transactions in financial instruments take place in reaction to the first estimate of the change in nonfarm payrolls on the day each month that the Bureau of Labor Statistics (BLS) releases its report. That first estimate of the monthly change in nonfarm payrolls gets revised in each of the following two months. But those revisions, although sometimes mentioned by the mainstream financial media, tend to be put aside in the frenzy of trading that takes place in the nanosecond after the BLS releases its monthly report of the Employment Situation.

I decided to take a look at how much the monthly changes in total nonfarm payrolls get revised from their preliminary estimate to their “final” estimate two months later. (I put quotation marks around final because there are of course, subsequent benchmark revisions.) Plotted in Chart 1 are the BLS first estimates for monthly changes in total nonfarm payrolls (the red bars) and its third estimates (the blue bars). (Ignore the November and December 2023 data points inasmuch as the BLS has not yet reported its final estimates for the changes in nonfarm payrolls for these months.) Plotted in Chart 2 are the monthly differences in changes in total nonfarm payrolls between the third estimate by the BLS and its first estimate. Notice that in the 10 months ended October 2023, there is only one month, July 2023, in which the third estimate is greater than the first estimate. Plotted in Chart 3 are the 10-month cumulative totals in the monthly differences between the third estimates of the changes in total nonfarm payrolls and the first estimates. Attention should be focused on the last data point, October 2023, which reads minus 417 thousand. So, in the first 10 months of 2023, the cumulative total of monthly changes in nonfarm payrolls was 417 thousand less when the third estimate of the monthly change in nonfarm payrolls is compared with the first estimate. But these 417 thousand jobs that got revised away probably had no effect on the analyses of the state of the US labor market made by the talking heads on CNBC and Bloomberg when the November and December 2023 first estimates of changes in nonfarm payrolls were reported by the BLS.

Pent-up demand and record monetary and fiscal stimulus drove' inflation's first act. Inflation's second act will revolve around higher house prices, partly driven by record financial wealth and higher wages. Inflation's second act may not run as hot as the first, but it will only be broken with a monetary response.

Statistically, reported inflation has been decelerating, but actual inflation, especially core inflation, has risen again. House price inflation, which is not part of the official price index, has rebounded over the past five months and stands nearly 5% higher than year-ago levels, according to the Cass-Shiller home price index.

The government measure of consumer prices does not include house prices but instead uses an imputed rent measure as a substitute or proxy. But that is not a measure of inflation. For one, it's not an actual price; secondly, no homeowners have ever experienced or paid that inflation. To be accurate and timely, inflation measurement must use transactional prices that people confront in the marketplace. One of the reasons the spike in core inflation in recent years was not as disorderly as previous periods of similar inflation was because two-thirds of households, or homeowners, never felt or experienced it.

House price inflation could run hot for many months. Household's direct holdings of equities relative to real estate stand at close to their highest level recorded during the tech boom. Back then, there was massive portfolio reshuffling away from equities and toward tangible assets, and it should happen again, especially given the sharp drop in borrowing costs in recent months.

The second act of the inflation cycle will also include significant wage increases. In Q4, UPS workers won the most lucrative wage and benefits package in history, lifting wages immediately by roughly 10%. UAW won an 11% wage increase in year one and additional gains over the contract's life. That triggered a flurry of wage increases at non-union companies; for example, Volkswagen raised pay by 11% at its Tennessee plant, Nissan increased wages by 10%, Honda an 11% increase, Toyota by 9%, Tesla hiked wages by 9% at its battery plant, and Hyundai said it would lift wages by 25% over a series of years. Also, Congress recently approved a 5.2% pay increase for federal workers, the most significant annual increase in forty years.

The large and broad wage increases indicate at least a 5% increase in the employment cost index (ECI) in 2024. Since the ECI series started in 1983, there have been only three years in which the annual increase topped 5%, the last being 1990. 2024 should be the fourth; at some point during the year, the Fed will realize a 5% increase in employee costs is inconsistent with a 2% inflation target.

Inflation's second act may not run as hot as the first, but it will be hard to break without a monetary policy response.

The Federal Reserve Bank of Philadelphia’s state coincident indexes in November were comparable to the October showing, tending toward the weak side. 30 states show declines from October, with Montana down 1 percent and West Virginia off nearly .9 percent. Of the 20 states with increases, Minnesota led with a .5 percent rise. Over the 3 months ending in November, 22 states had declines, with West Virginia off by 2.5 percent, and Montana and Michigan down by more than 1 ½ percent. Nevada rose 1.1 percent and Texas was up 1.0 percent—fairly soft performances for states at the top. Over the last 12 months Maryland again led, with a 6.6 percent increase, and Vermont’s index rose 6.1 percent. The measures for Arkansas and New Jersey fell over the last year.

The independently estimated national figures of growth over the last 3 months (.7 percent) and 12 months (3.0 percent) both look to be roughly in line with what the state figures suggest.

State real GDP growth rates in 2023:3 ranged from Kansas’s 9.7% to Arkansas’s 0.7% (the latter in Q3 being Wasn’t rather than Ar Kansas). As Kansas would suggest, states with relatively high concentrations in agriculture tended to rank high, but there was also strong growth in the Rocky Mountains as well as Florida.

The distribution of personal income growth was comparable to real GDP; Arkansas was also at the bottom, while Kansas was 3rd (Texas was number 1, which is something often heard there for many other things). As is often the case, aggregate personal income growth can be heavily affected by seemingly random movements in transfer payments. In general, transfer payments fell in Q3. In New York, though, an anomalous 4.4% rate of growth in transfers pushed the state’s aggregate income growth about the national pace, despite a rather soft gain in net earnings.

After considerable delay, reflecting the compilation of new benchmark output by industry data, BEA has issued state GDP numbers for 2023:Q2. Wyoming’s 8.7 percent was the fastest in the nation, while Vermont’s -1.9 percent was the lowest. Growth was generally highest in the Southwest and Rocky Mountain regions; the Southeast wand Great Lakes were weakest. Aside from Vermont, Mississippi, Delaware, Arkansas, Missouri, and Wisconsin saw declines in real output. In general, highly variable contributions from agriculture explain much of the variation between high and low-growth states (agriculture contributed 2.2 percentage points to Wyoming’s growth rate, but subtracted .75 points from Vermont).

California, Texas, New York, and Florida are the states with annual rates of nominal GDP higher than $1 trillion. California’s is higher than $3 trillion, and in Q2 Texas surpassed $2 trillion.

BEA announced that the Q3 estimates will be released on December 22, bringing them more in line with national GDP figures.

At the outset of 2023, most forecasters, even some policymakers, thought a mild recession was in store for the economy. Yet, the economy expanded at an annualized rate of 3% during the first three quarters and looks to grow somewhat slower in the fourth quarter. What happened? Here are five reasons why the economy beat the odds and did not fall into a recession in 2023.

First, the inverted Treasury yield curve was "artificial." The inversion of the yield curve in the fourth quarter of 2022 was one of the most cited reasons for the recession occurring in 2023, especially with the Fed telegraphing more official rate hikes. But yield curve inversion was a direct result of another Fed policy tool.

Before the Federal Reserve started raising official rates in March 2022, it embarked on the most extensive quantitative easing (QE) program in history, purchasing approximately $4.5 trillion of debt securities in 24 months. The primary purpose of QE is to keep long-term interest rates (one side of the yield curve measure) lower than otherwise would be the case. Some analysts estimated QE was the equivalent of 150 to 250 basis points of Fed easing. Even today, the Fed's balance sheet is approximately $3.5 trillion above when they started QE in March 2020.

Second, monetary policy was not restrictive. Monetary policy influences the growth of nominal spending. At the end of Q3 2023, nominal GDP growth of 6.3% of the past year was still 100 basis points over the fed funds rate level. There has never been a recession in the past 50 years in which the level of federal funds did not equal or exceed the growth in nominal GDP.

Third, interest-sensitive sectors grew in 2023. The goods and structures sectors expanded each quarter in 2023, hitting a new record high in Q3, with an annualized growth rate of 6.9% and 3% in the past twelve months. If the economy were to enter or be in a recession, it would be most visible in these two sectors as they have consistently contracted during recession periods.

Fourth, labor demand outpaced labor supply. In 2023, the labor market was unbalanced, with the number of job openings exceeding the number of unemployed workers. At the end of Q3 2023, there were 9.5 million job openings or 1.5 jobs for every unemployed person.

Fifth, household liquidity grew in 2023. Based on the current level of equity prices and the rally in bond yields, household direct holdings of equities, debt securities, and deposits are estimated to increase between $10 and $15 trillion in 2023. Fed tightening cycles are supposed to drain liquidity, but that did not happen in 2023.

Many of these factors are still operative for 2024. The most significant positive factors for 2024 are the need for labor and the growth in household liquidity, as both would support continued growth in consumer spending.

The wild card is what happens to official and market interest rates in 2024. If the Fed raises official rates again, market rates could quickly reverse the recent decline in yields. That would have a huge and abrupt negative impact on equity prices and household liquidity; people's equity holdings account for 55% of total liquid assets directly held.

Many factors could trigger a bad outcome in 2024. But those factors need to drain liquidity and trigger contraction in interest-sensitive sectors based on the history of recessions.

The second guesstimate by the Bureau of Economic Analysis (BEA) of Q3:2023 real Gross National PRODUCT’s annualized growth came in at 5.2%, up from the first guesstimate of 4.9%. Along with these data, the BEA reported its first guesstimate of annualized growth in real Gross Domestic INCOME (GDI) , 1.5%. In theory, both GDP and GDI should be the same. Both represent the value of goods and services produced in the economy. GDP calculates this value by adding up the value of expenditures in the economy – personal consumption, business expenditures, including the change in inventories, government expenditures and the change in net exports. Income is earned by some entities for the production of goods and services. So, GDI is the sum of wages, profits, interest income, rental income and taxes minus production/import subsidies.

As I mentioned above, in theory, real GDP and real GDI should be the same. But, in practice, they are not. Plotted in Chart 1 are the quarterly observations of the year-over-year percent changes in real GDI (blue line) and real GDP (red line) from 2010 through Q3:2023. Also plotted in Chart 1 are the quarterly observations of the percentage point differences between the year-over-year percent changes in real GDI and real GDP (the green bars). Notice that in the three quarters ended Q3:2023, these differences have widened out considerably, widened out to the negative side. The median difference from Q1:2010 through Q4:2022 has been 0.09 percentage points. That’s close enough for government work for saying real GDI and real GDP, as separately calculated, are the same. But in the four quarters ended Q3:2023, the median difference has been negative 1.97 percentage points. In Q3:2023 by itself, the difference between the year-over-year percent change in real GDI and real GDP was minus 3.16 percentage points, the widest absolute difference between changes in real GDI and real GDP in the period staring in Q1:2010 through Q3:2023. Granted, the real GDI data point for Q3:2023 is the BEA’s first guestimate of it.