My primary purpose in writing about the economy has historically to explain in reasonably K.I.S.S. terms the nowcast and the forecast for average American workers and consumers. While I get deep down into the weeds daily, post a nerdy forecast and nowcast weekly, and several times a year update my long-term and short-term forecast models, I haven’t written a 30,000-foot view of the economy for quite a while, and have been meaning to do so. So here goes, with (relatively speaking!) a minimum of charts and graphs, just - hopefully - a pithy explanation.
1. You can hide a multitude of economic sins with low gas prices
When it comes to prices and inflation, the last 20 years have been all about the price of gas. Gas prices hit their lowest point in 40 years at the end of February 1999, at $0.91/gallon. Here’s what they look like in the 20 years since then:
They rose almost relentlessly for the next 8+ years until they hit their peak of $4.23/gallon in July 2008, playing an important role in exacerbating the Great Recession. For a while after the bottom, the “Oil choke collar” was in play, until the big declines of 2014-15. As of last week, gas prices were $2.69/gallon.
Why has the economy been all about gas prices? Because when you take them out of the equation, here’s what inflation looks like for the past 20 years:
It has been remarkably stable, running between 1.5% and 2.5% except in the immediate run-up to the two recessions, and for 3 months in 2011.
And here’s what the price of gas looks like when we divide it by average hourly wages for non-supervisory workers of the past 20 years:
This gives us the amount of time that the average worker has to work in order to buy a gallon of gas. With the exception of a few months at the depths of the Great Recession, and a few months in early 2016, gas has not cost significantly less than it does now at any point in the last 15 years. And needless to say, wage gains of 2.5% to 3.5% YoY look a lot better in comparison with 1.5% to 2.5% inflation.
2. Low inflation caused by low gas prices has given the Fed a lot of room
Ever since 1960, the reason that the Fed has raised interest rates was to combat inflation. Since inflation only came down with weak economic growth - or outright contraction - typically Fed rate-hiking cycles have ended with recessions.
But this time actually *has* been different. The Fed has raised rates gradually over the past 3 years not to combat inflation, but to “normalize” rates so that they can be lowered substantially whenever the next recession does hit. Setting aside whether or not that has been wise, the fact remains that with quiescent inflation between 1.5% and 2.5%, the Fed is under no pressure to “have to” raise rates. If the Fed chose to cut rates by 0.5% at its next meeting, there is little danger that suddenly inflation would be let loose.
3. The Fed’s gradual rate hikes also work in its favor
Unlike during most of the last 60 years, when the Fed hiked in 0.50% increments, usually at a rate of 2% or more a year, this time the Fed has only hiked in 0.25% increments, at no more than a pace of 1% YoY:
Rate rises of 2% or more a year have a bigger and more intense impact on the economy than rises of 1% or less a year. Any resulting weakness is likely to be less intense, and so easier to reverse, without having caused a recession in the interim.
4. But the effects of the Fed’s rate hikes in the past several years are being felt
Long-term interest rates hit their low just after the 2016 Brexit vote. For example, mortgage rates, which bottomed at 3.4% in July 2016, rose as high as just below 5% in November of 2018:
With rising interest rates and rising home prices, the housing market was hit, peaking between late 2017 and early 2018 depending on which measure you use. The least volatile measure, single-family building permits, made a new low last month:
Other long leading indicators, like money supply and corporate profits, also rolled over last year. Below I am showing the YoY% change in those two, plus corporate interest rates and housing permits:
Late 2018 marked the first time all 4 were either negative YoY, or in the case of corporate profits, q/q. Even before we get to the yield curve which everybody has been obsessing over, this is a warning signal for the economy, especially as we get later into this year.
5. Some of this longer leading weakness has fed through into shorter range indicators
Many of the shorter leading indicators are still doing well: both the stock market and initial jobless claims have completely bounced back from recent weakness. And vehicle sales continue to do well, with some monthly variation.
But other shorter leading indicators, like commodity prices and the strength of the US$, suggest economic weakness ahead. Manufacturing indicators, which last year were red hot, are still positive, but only tepidly so. And the leading components of the jobs report - factory hours, and temporary, construction, and manufacturing jobs - in the past three months have all shown weakness.
Because weakness in the long-term forecast should feed through into the shorter-term forecast, I am looking for more weakness in the months ahead.
6. But the nowcast looks decent
I think that the government shutdown caused a brief stall, or even a mini-recession in December and January. There is some evidence that data is beginning to bounce back. Certainly, the total March jobs gain of 196,000 was good and gains of 3.4% YoY in non-supervisory wages are also good (relative to the past 10 years). We’ll have to wait a few weeks to see if production and spending also bounce back, but I suspect they will.
That being said, once again I expect weakness to show up in these measures later on this year, as the weakness caused by higher interest rates last year feeds through the economy.
7. Which returns us to the Fed and gas prices
As I said a few months ago when I went on “Recession Watch” for later this year, one of the important reasons my default scenario was slowdown rather than recession was that the Fed sees this data too, and it can act on it in a way that makes a difference - just as in “A Christmas Carol,” Scrooge can act on what he has been shown by the Ghost of Christmas Future and change his fate.
Since I am not a mind-reader, I can’t know what the Fed’s future course will be. The bond market, in the form of Fed Funds futures, thinks it likely it will lower rates by 0.25% in the next 12 months. I don’t know if that would be enough.
But the point is, the economy’s future over the next 12 months is not set in stone and depends in part on the human decisions made by the Fed.
In that regard, it will have a much freer hand if gas prices remain low, and thereby inflation remains low as well. That optimistic scenario took a ding in March as gas prices, which rose about 9% during the month contributed to a +0.4% rise in consumer prices, which caused the YoY inflation rate to rise to 1.9%:
One final point: the collective bond market’s view of the Fed’s credibility matters as well. if the Senate approves Trump’s picks of Moore and Cain, and the bond market collectively decides that they are complete buffoons, the market is likely to start charging a premium in the form of higher long-term rates as insurance, to the extent that it believes Fed decisions become politicized and/or imbecilic. And as we saw in 2018, the economy does not like higher long-term rates.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.