What gold, commodities and the dollar tell us about monetary policy

This chart illustrates the strong tendency of Federal Reserve monetary policy to follow the ups and downs in the economy. Capacity Utilization (blue line) is a proxy for the strength of the economy, and the real Fed funds rate (red line) is a good measure of how tight or loose monetary policy is. The stronger the economy, the more the Fed is prone to tighten monetary policy by increasing the real Fed funds rate, and the weaker the economy, the lower the real funds rate.

Capacity utilization has literally soared in the current recovery, as the manufacturing sector has enjoyed a V-shaped recovery with no end yet in sight, but the Fed continues to keep monetary policy very accommodative. Ordinarily this would be highly disturbing, since it would point to accelerating inflation pressures. But this time around things are very different, given the troubles in Europe which have greatly increased the world's demand for dollar liquidity. The Fed understandably wants to be sure there is no shortage of safe-haven dollars in the banking system to satisfy the world's apparently insatiable demand for them. If the Fed were only concerned about the US economy, they would not be keeping interest rates so low for so long, because the great majority of economic indicators—industrial production and residential construction numbers released today being the two most recent examples—point to continued US economic growth.

The behavior of gold, commodities and the dollar in the past year or so also supports the Fed's decision to keep policy very accommodative. The CRB Spot Commodity index is off 17% from last year's high, and gold has dropped 19% from last September's high, and the dollar is up some 13% from last year's low against other major currencies. All three of these key indicators of monetary conditions are consistent with strong demand for dollar liquidity—and some would even say these moves are symptomatic of a relative shortage of dollars. I'm not prepared to accept that dollars are in short supply, however, since these same charts show that gold and commodity prices are still very high from an historical perspective, and the dollar is still very weak. Instead, I would argue that on the margin there has been an increase in dollar demand relative to supply, but that dollars are still relatively abundant from a broader perspective.

In other words, I don't see any emerging deflationary pressures resulting from the recent weakness in gold and commodities and the strength of the dollar, but rather an easing of inflationary pressures. That is confirmed by the relatively tame readings we saw in yesterday's CPI release, as illustrated in the above chart. So far, so good.

The big thing to watch for is an easing of the tensions in Europe, since this has the potential to dramatically change the world's demand for dollars, and that in turn could result in monetary policy becoming once again inflationary—unless the Fed takes decisive steps to mop up any excess dollar liquidity by either draining reserves or increasing the interest rate it pays on reserves.

UPDATE: I should add the obvious, which is that the first chart suggests that the real Fed funds rate should be approximately 2% by now, if everything else were normal. To get there, given that the core PCE deflator is currently 2% and assuming that the Eurozone situation were to normalize by the end of this year, the Fed would need to raise the funds rate to somewhere in the neighborhood of 4%, and that could be done over the course of a year or two. That would undoubtedly be tough on the T-note and T-bond markets, but not insurmountable, particularly since the steepness of the yield curve implies that some degree of tightening is quite likely. The pain of raising rates is probably exaggerated: For one, a healthier Europe would almost surely be a boost to the US economy, and a stronger economy would boost tax revenues. If spending growth can be held in check, a stronger economy would all by itself bring the deficit down to manageable levels (3-4% of GDP) within a few years. In fact, we're already halfway there: the deficit as a % of GDP is down from a high of 10.4% to the current 7.4%. In other words, as the market loses its desire for Treasuries, the government's need to sell Treasuries would be declining at the same time. The solution to all this is not impossible by any means.

Residential construction is definitely improving

For several months we've seen emerging evidence of the long-awaited upturn in residential construction, and now with today's April figures and upward revisions to prior months, it looks pretty official: the housing market has bottomed and is now posting impressive gains—up 30% in the past year, and up 50% from the 2009 low—that should be the norm for the next several years. If a recovery in the residential construction market was the one key piece missing from the US recovery, it is now in place. I find it hard to believe that today's troubles in tiny Greece are going to derail the giant US economy.

Industrial production remains healthy

April U.S. industrial production was stronger than expected, rising 5.2% above year-ago levels. We haven't seen year over year growth this fast since March of last year. As a follow-on to my post yesterday covering Eurozone industrial production, this chart compares U.S. with German industrial production. The pickup in U.S. output is welcome indeed, but it pales in comparison to the strength of German production over the past seven years. Germany has stalled for most of the past year, of course, but March gains were strong, resulting in a 12.6% annualized gain in the first quarter—thus raising hopes that Germany at least has broken free of the stagnation afflicting much of the rest of the Eurozone.

Abstracting from utility output, US manufacturing production continues to improve, having risen at a 6.9% annualized rate over the past six months.

Year over year gains in these charts are hardly what one might term "very strong," but they are healthy gains, and, perhaps more importantly, they do not show any sign of the US economic slump/double-dip recession or Eurozone contagion that has been widely expected and feared over the past 6-8 months.

Some additional perspective on Europe

These charts provide some interesting perspective on the Eurozone economies. The top chart compares industrial production in the U.S. to industrial production in the Eurozone economies in aggregate. Note how there has been a significant gap that has opened up since last August, and note also how closely production in the two major economic areas had tracked up until that time. But as the second chart makes clear, the sluggish performance of Eurozone industrial production since August is mainly driven by the same countries that are facing rising default risk. Germany is doing quite well, and its industrial production recovery has been stronger than that of the U.S.

The second chart breaks out the behavior of industrial production across six major economies within the Eurozone. It seems the Eurozone is split these days between those who produce and those who don't. German industrial production has been the mainstay of Eurozone growth, since German production levels today are only 2.8% below their pre-recession peak. Not surprisingly, Greece is bringing up the rear, with industrial production having collapsed by almost one third since its pre-recession high. France, UK, Italy, and Spain have all experienced almost no recovery in industrial production for the past three years.

The charts also suggest that the problems that have led to the Eurozone's sovereign debt crisis go way beyond Greek contagion, and their roots in fact go back many years. In short, Germany has been doing something right that most of the others have not. For one, Germany made significant cuts in corporate tax rates in 2001 and then again in 2007. Just as importantly, Germany instituted labor market reforms in the mid-2000s that reduced wage costs to levels that were once again competitive. The laggards have allowed their public sectors to bloat and their costs to rise, and have made no attempt to cut tax and regulatory burdens.

As further evidence for the power of tax cuts, I note that Ireland's industrial production is only down 7% over the past four years, after rising by an astounding 300% from the early 1990s, thanks to the country's decision to slash corporate tax rates and keep them low in spite of continual protests from other Eurozone countries who pronounced them to be "unfair" competition.

Germany's fiscal policy has been much more growth-favorable than the policies of the countries that now struggle with default risk. This is a very important point, since it strongly suggests that the austerity measures being proposed in the countries that are still struggling—which consist mostly of attempts to increase taxes—are the problem, not the cure for what ails these countries. Sooner or later the laggards are going to figure this out: the right kind of austerity consists of public sector spending cuts that are accompanied by lower tax and regulatory burdens.

There's a lesson for California here as well. Imagine that the government of California is like the management of a business that is losing customers and money—after all, taxpayers and companies of all stripes are fleeing the state because of its heavy tax and regulatory burdens. California is like a company whose products have become too expensive to remain competitive, but instead of cutting its costs and becoming more competive (e.g., by lowering taxes and reducing regulatory burdens), California's management is trying to increase its prices (i.e., increase tax rates) to stay afloat. It's simply not going to work.

Retail sales continue to be strong

For the third time in the past two years, the world is obsessed with the idea that a breakup of the Euro is going to bring down the global economy. The chart above uses the ratio of the Vix index (which rises as fear increases) to the 10-yr Treasury yield (which falls as the world despairs over the prospects of economic growth) to gauge the amount of destruction that the market is worried about. It was worse in the prior two episodes, but it's pretty bad right now, as market chatter essentially assumes the imminent exit of Greece from the Eurozone, followed by a significant devaluation of the Greek currency, and the subsequent impoverishment of all Greek citizens. 

But to judge from this chart of U.S. retail sales, the revolving Eurozone crises have had no discernible impact on the U.S. economy. By just about any measure (ex-autos, ex-building materials, and/or ex-gas stations) U.S. retail sales are rising at a healthy 6% annual pace, with no signs of any slowdown. Moreover, sales have significantly exceeded their pre-recession highs, even though there are 5 million fewer people working today than at the end of 2007. Indeed, the Eurozone crisis probably has helped boost the U.S. economy, since capital has fled Europe for the relative safety of the U.S. banking system. Things could be a lot better here, but they are improving, albeit slowly.

In other news today, the May home builders' market index rose to a new post-recession high, providing yet more evidence that we have seen the bottom in the housing market. Furthermore, as Mark Perry notes, "there are now at least 25 metro markets that have reported double-digit gains in either the number of homes sold, or median home prices, or in some cases, both."

So what's not to like? Well, of course there are still many problems lurking in the wings, and the list is long, beginning with the "fiscal cliff" of sharply higher tax rates that is approaching come January 1st, followed by the risk that a re-elected Obama might be able to boost tax rates even more, and the possibility that Europe might return to the financial dark ages as governments refuse to tighten their belts and the Eurozone banking system implodes. But meanwhile, life goes on for the vast majority of the globe's population, markets are slowly but surely enforcing some badly-needed discipline on politicians of every stripe, and the internet—via outlets such as this blog—is providing more information and perspective on what's going on than has ever been available before.

Markets work best when they have plenty of information; big problems happen only when something unexpected comes out of the blue. We've known about the Eurozone debt and banking problem for over two years, and we've known about the U.S. fiscal problem for over three years. The U.S. housing market has been under tremendous pressure for over 5 years; there can't be a single sentient, potential homebuyer in the U.S. that isn't aware of the problem of an overhang of foreclosed properties. It's my belief that most or all of the problems have been priced in by now: 10-yr Treasury yields are as low as they've ever been, reflecting a market that holds little or no hope for the future; despite record-setting corporate profits, the PE ratio of the S&P 500 is only marginally higher today than it was at the end of 2008, when the global financial system threatened to collapse; and although swap spreads are off their highs, they are still quite elevated in Europe.

The sum of the fears that still plague the market can also be found in the intense demand for safe-haven liquidity. Fortunately, both the Fed and the ECB have taken extraordinary measures to accommodate this demand for liquidity by expanding their balance sheets to a truly unprecedented degree. I'm not saying that the fears are overblown. I'm simply pointing out that markets have had plenty of time and help in evaluating and accommodating these fears, and that therefore the consequences are not likely to be as bad as the market seems to be expecting.

This has been my thesis ever since the end of 2008, and it continues to be: markets are priced to horrible expectations, but the reality is likely to be less awful than expected.

Federal budget outlook continues to improve

Thanks to April's stronger-than-expected gains in federal tax revenues and weaker-than-expected growth in federal spending, the 12-month federal deficit has shrunk to $1.15 trillion, down significantly from its high of $1.48 trillion in early 2010. By my estimates, the federal budget deficit now has dropped from a high of 10.4% of GDP to 7.4%. This is very good news that I imagine most people are completely unaware of, and it's come about in the best possible way: government is slowly shrinking relative to the economy, and this is allowing the private sector to grow, with the result that tax revenues are rising even though tax rates are not. If these trends were to continue, our spending and deficit problem would fix itself without the need for any political haggling or agonizing.

Here's the big picture. Note that spending has been almost flat since the end of the recession, while revenues have increased by $350 billion. Congressional deadlock can be a wonderful thing: by not increasing spending in recent years, Congress has managed to get federal spending as a % of GDP down from a high of 25.3% to 22.7%.

How many people realize that the federal budget deficit as a % of GDP has declined by almost 30% in the past few years? It's now comfortably below the 9% of GDP level that studies suggest is the tipping point beyond which an economy begins to destabilize.

This chart highlights the progress that has been made in federal revenues. Tax receipts have been much stronger this year, thanks to more people working, rising incomes, rising corporate profits, and increased capital gains realizations. Looked at another way, since government is consuming a smaller portion of the economic pie, the private sector has been able to put those resources to more efficient use, and as a result the pie is growing.

As I've long argued, and as Robert Barro points out in his op-ed in today's WSJ, declining budget deficits are not "austerity," and in fact can be stimulative. Keynesian "stimulus" spending just doesn't work—trimming the size of government and allowing the private sector to expand is a far better way of encouraging economic growth. Here's a key excerpt:

Despite the lack of evidence, it is remarkable how much allegiance the Keynesian approach receives from policy makers and economists. I think it's because the Keynesian model addresses important macroeconomic policy issues and is pedagogically beautiful, no doubt reflecting the genius of Keynes. The basic model—government steps in to spend when others won't—can be presented readily to one's mother, who is then likely to buy the conclusions.

Keynes worshipers' faith in this model has actually been strengthened by the Great Recession and the associated financial crisis. Yet the empirical support for all this is astonishingly thin. The Keynesian model asks one to turn economic common sense on its head in many ways. For instance, more saving is bad because of the resultant drop in consumer demand, and higher productivity is bad because the increased supply of goods tends to lower the price level, thereby raising the real value of debt. Meanwhile, transfer payments that subsidize unemployment are supposed to lower unemployment, and more government spending is good even if it goes to wasteful projects.

Looking forward, there is a lot to say on economic grounds for strengthening fiscal austerity in OECD countries.

We can only hope that more and more policymakers and politicians around the world begin to understand the fallacy of traditional "stimulus" policies. What most countries need these days is less public sector spending, not more, and lower and flatter tax rates. Government needs to get out of the way and let the private sector work its growth magic.

Trade update: continued growth a positive

Imports rose more than exports in March, causing the trade deficit to increase, but that is not necessarily a sign of weakness. The more important thing is that both imports and exports continue to increase at a healthy rate, since that means the U.S. economy is growing and dynamic, and the rest of the world is also growing and dynamic.

This chart focuses on goods exports over a shorter time frame, and here we see how export growth has picked up in recent months after a period of sluggish growth in the latter half of last year. This is especially encouraging, since it suggests that the weakness in the Eurozone has not had a significant impact on demand for U.S. exports. The export sector of the U.S. economy is doing quite well (goods exports are up 57% in the past three years!), in part because of the weak dollar, but also because the rest of the world is growing and consuming more.

This chart illustrates just how much the U.S. trade gap has narrowed over the past decade, thanks mainly to strong export growth. Note also the huge impact that increased international trade has had on the U.S. economy in recent decades. Since 1980, when we imported and exported about 5% of our GDP, trade has roughly tripled in importance: in the first quarter of this year, exports were equal to 13.5% of GDP, while imports were 16.5%. Today, the U.S. economy is far more integrated with the rest of the world than ever before, and there is every reason to think that this trend will continue.