The economy is moderating... so says the Fed. If you are an avid reader of this site, you'll know that I'm fairly entrenched in the Keynesian style of economics. I believe that there actually is a starting point of all economic activity: The consumer. From there, the government may get involved in the economy and help the economy along (supply side economics).
However, this style of economics is able to send a nudge to a dry economy, but is not the predominant economy that we have. So, is the economy slowing? To answer that question, you need to look at the factors that affect the economy: Consumption. And where do Americans get the money to consume: Paychecks.
Tracking these two indicators is how I track how the economy is moving along. Here is the latest chart on both compared looking at the y/y change with both indicators:
Okay... What are you looking at? The red line is real average hourly earnings. This represents about 65% of the employed here in the U.S. The reading, from the Bureau of of Labor Statistics, excludes management and farmers from this release and tracks salaries and hourly wages. Why is this a good indicator to track? Because if you don't have a paycheck, you can't consume. This figure is also seasonly adjusted.
The blue line represents personal consumption, seasonally adjusted as well. This is the disposable income that was used by consumers. Take paychecks, then subtract taxes, savings and transfer payments, and the remaining is what was spent. That is consumption.
The correlation of the two of these is very strong. After all, if incomes go up, then consumption follows. That's what Ken & Barbie do. They spend. When incomes increase (or decrease) consumption goes up. Likewise, decreases do the same with incomes and consumption. However, there is a large gap right in the middle of the chart in the 1980's where there was an significant increase in consumption but incomes were as flat as a board... and kind of trickled lower. How is that? Enter two tax cuts by President Ronald Reagan. Incomes didn't move much higher but consumption did because Americans had more available to spend. And that's what they do best. Spend.
Now that I've mentioned tax cuts... some of you may have already questioned the 2001 tax cuts to see if there was any affect on consumption? Sure enough, the tax cuts of 2001 did have an ever so moderate affect on an increase in consumption during a period where there was a significant decline in incomes. Whereas Reagan's tax cuts had a significant affect on the economy, Bush's did not. That pretty much shows the effectiveness of the current administration, regardless of how many times they get up on stage trying to convince us that their tax cuts worked.
There is another large divergence between incomes and consumption right after the Bush tax cuts. If I were to super-impose mortgage refinancing over top of the very end of this chart, you would see a large increase in the REFI rate during this time. Incomes were declining, and instead of cutting back on consumption, Americans merely refinanced their homes and spent the "earnings" keeping the economy propped up.
Now that historic econ 101 lesson is done... where are we headed now?
Take a close look at this chart... at the very end of the chart. We have a significant divergence between incomes and consumption. The rate of growth in incomes is increasing. But, consumption is falling. The most likely scenario going forward is that consumption will begin to head higher. However, there are some economic factors that might need to be considered before this is conclusive. The first question is: Why is the divergence so dramatic? Perhaps it has something to to do with the price of energy. As gasoline consumption increases due to higher prices, it's logical to conclude that there is a decline in other areas. However, incomes are increasing, which would lead most to believe that consumption will catch up. However, unit labor costs are increasing. If the Federal Reserve, who have highlighted this concern, were to start to target this factor as being inflationary, then it is possible that the Fed will raise rates and push income growth back down. That would have a like affect on consumption.
Personally, I am leaning towards an economy that is moderating in income increase while there is a simultaneous increase in consumption. This will take several months of data to pan out. Keep in mind, the Fed is forward looking and is likely to see their own economic scenario continue on until the Spring of 2007. That may be about the timeframe that it takes until we see these two charts start to move in chorus with each other.
For now, the economy appears to be slowing.... But it also is potentially on the verge of taking off again very soon.