Inflation update

Today's October CPI report was unsurprising, showing inflation at the consumer level running at just over 2%. However, from a long-term perspective, inflation is averaging about 2.5% a year. That's not particularly troubling, until you realize that the Fed has been trying as hard as possible to push inflation higher.

The above chart plots the consumer price index on a semi-log scale. As the dotted line shows, the index has been rising at a 2.5% annualized rate over the past 10 years, with occasional periods of above- and below-trend growth. (A similar chart using the core CPI would show that inflation has averaged about 2.1%.) The Fed's inflation target is 1-2% growth in the core Personal Consumption Deflator, and that measure of inflation tends to run about 0.5 percentage points below the CPI. So what the Fed has accomplished in the past decade is to deliver inflation at the upper end of its target range.

There is absolutely no sign here of any deflation, and that is very significant given the prevailing belief at the Fed that weak economic growth poses a risk of deflation. We've had the weakest recovery ever in the past several years, with the economy slipping well below its potential and well below its long-term growth path. The chart below documents this:

In fact, this recovery has effectively shattered three long-cherished beliefs shared by many economists (though not by supply-siders): 1) that increased government spending can stimulate growth; 2) that accommodative monetary policy can stimulate growth, and 3) that weak and below-trend growth is deflationary.

Government is not as all-powerful as statists would have us believe. The Fed can't pull its monetary levels and fine tune growth, and Congress can't borrow and spend and expect that to create jobs. If there's any mystery here, it is that inflation has not proven to be much higher given the degree of monetary stimulus that has been applied already by the Fed. I've explained why that is the case here.

We haven't seen worrisome inflation yet, but that's not to say it won't happen going forward. There is a large degree of monetary uncertainty in the world, and that helps explain why gold is still trading in the stratosphere and the dollar is very close to its weakest level ever. Moreover, it's a testament to the inherent dynamism of the U.S. economy that it has managed to grow 2% a year for the past three years in spite of huge monetary uncertainty and in spite of the threat of a massive hike in future tax burdens (courtesy of four years of trillion-dollar deficits)

These musing beg the question: if fiscal stimulus doesn't work (and it most likely hurts rather than helps the economy), and if monetary stimulus doesn't work (since it only adds to the uncertainties), then why does Congress want to keep the pedal to the metal on fiscal policy, and why does the Fed want to add even more monetary stimulus? I'm reminded of the definition of insanity: doing the same thing over and over and expecting different results. Questions such as these are a big reason why economic growth remains lackluster.

A more enlightened fiscal policy would focus on reducing, rather than increasing government spending, and a more enlightened monetary policy would focus on reducing, rather than increasing monetary stimulus.

Until policymakers see the light, it's very slow and steady as she goes, with a chance of higher inflation on the horizon.

This is not necessarily bad for the stock market, however, since I continue to believe that both stocks and bonds are priced to the expectation that growth will be very weak or even negative in the years to come.

Retail sales update

After a surprisingly strong September report, October retail sales came in a bit below expectations (-0.3% vs. -0.2%) and September sales were revised down slightly. The net result is that sales are still in an uptrend, and consistent with an economy that continues to expand, albeit relatively slowly.

The top chart shows the level of nominal retail sales, which have risen at a 6.2% annualized pace since their March 2009 low. The bottom chart shows the inflation-adjusted level of sales, which have yet to break into new high territory.

Higher taxes on the rich would barely dent the deficit

On the eve of negotiations over the looming "fiscal cliff," here's a look at the current status of the federal budget and projected deficits, using the latest October figures released today.

Obama says it is critical that the rich pay higher taxes, and he has long argued that it was the Bush tax cuts which put us in this mess, since the rich aren't paying their "fair share." The Republicans say it is critical that we avoid raising tax rates on anyone, since higher tax rates would jeopardize the health of the economy. As the numbers show, higher tax rates on the rich would make only a small difference to the projected deficit, since the health of the economy and the level of federal spending are by far the major determinants of the deficit.

This first chart puts the federal budget in the proper long-term perspective, measuring spending and revenues as a percentage of GDP. Spending is still well above its post-War average (22.9% vs. 19.3%), whereas revenues are only slightly below their post-War average (15.9% vs. 17.3%). If you assume that post-War averages are the norm, then 72% of the current budget deficit of 7% of GDP is due to excess spending, and 28% is due to a revenue shortfall. It's important to note here that federal revenues exceeded their post-War average from 2005 to 2008 despite the Bush tax cuts. Those same tax rates are delivering disappointing tax revenues today because of a shortfall of jobs and the fact that our economy is about 10-12% below its potential output. It's the shrunken tax base, not lower tax rates, which is responsible for today's revenue shortfall. A healthier economy and faster jobs growth would do much more to close the deficit than any amount of higher tax rates on the rich.

The chart above plots the running 12-month total of nominal federal spending and revenues. Two rather surprising revelations are apparent. First,  after surging in 2008 and 2009, federal spending growth has slowed to a crawl, thanks mainly to Congressional gridlock and the unwinding of automatic stabilizers (e.g., fewer people collecting unemployment insurance). Second, revenues have surged by $446 billion since hitting a low in early 2010, without any increase in tax rates and despite a two-year payroll tax holiday, mainly because an expanding economy, rising corporate profits, and the addition of 5 million new jobs have expanded the tax base. Even if the economy were to continue growing at a measly 2% rate, there is every reason to think that revenues would continue to rise without the need for higher tax rates. Raising tax rates, however, might weaken the economy further, and that would make it much more difficult to generate higher tax revenues.

The chart above shows the impressive reduction in the federal deficit as a percent of GDP that has occurred over the past three years—from a high of 10.5% in late 2009 to the current 7%. If nothing changes and current trends were to continue (spending growth of 3% per year, revenue growth of 7% per year, and nominal GDP growth of 4% per year), the deficit would decline to approximately 6% of GDP by the end of next year, and return to its long-term historic average of 2% of GDP in seven years. Nobody's taxes need to be raised, and nobody's spending needs to be cut—the U.S. economy is already on a glide path to the restoration of fiscal sanity. Washington: are you listening?

But if anything is likely to change in a big way in coming years, it is increased entitlement spending, particularly under ObamaCare and Social Security. This is what should be getting the priority these days, not tax rates.

I happened on a Bloomberg News article this morning (which for some reason I am unable to find on the web) that reinforces my point that the shortfall in revenue today is not due to tax rates that are too low, but rather due to a weak economy:

... boosting taxes for the wealthiest 2 percent would bring in $58.1 billion in fiscal year 2013, according  to Bloomberg calculations based on data from the [left-leaning] Tax Policy Center. The CBO estimates the government's finances will show a shortfall of $1.04 trillion, assuming almost all the tax increases and automatic spending cuts that are slated to take effect next year are totally averted. 

"It's not very much, but it is a step in the right direction," Roberton Williams, a senior fellow at the nonpartisan Tax Policy Center in Washington, said in a telephone interview. "In order to close half the budget deficit by raising taxes on the rich, you would have to raise their tax rate up to about 90 percent. That's not going to happen."

According to some estimates I've seen, if Obama gets his request for higher income, dividend, capital gains and estate tax rates rise for those making more than $250K per year, that could raise up to $120 billion to federal revenues next year, assuming no adverse consequences for economic growth. That's not an assumption I'm comfortable making, but nevertheless the revenue gains that might result from boosting tax rates for the rich are still a relatively small fraction of the total projected deficit.

Greg Mankiw uses data from the Tax Policy Center to make the point that putting a cap on total deductions could raise significant revenue from the rich without increasing their marginal tax rates, and that is important since it avoids creating a disincentive to additional work and investment:

According to the Tax Policy Center, if we cap itemized deductions at $50,000 and keep tax rates as they are today, we would raise $749 billion in tax revenue over ten years. Moreover, according to the TPC's distribution table, 96.2 percent of the extra revenue would come from the top quintile, with 79.9 percent from the top one percent.

Given today's political realities, the best outcome of the "fiscal cliff" negotiations, from my perspective, would be an agreement to meaningfully reduce future spending on entitlements, extend the current tax structure for at least another year or two, and put a cap on total deductions. This would reinforce the fiscal sanity glide path (i.e., slow growth in spending coupled with continued expansion of the tax base), and give politicians and markets plenty of time to notice that the U.S. federal budget outlook is not nearly as bad as most seem to believe.

If the "fiscal cliff" negotiations end up being driven by political considerations rather than economic realities, higher tax rates on the rich would only increase the odds that the economy is likely to continue growing at a sub-par pace (i.e., growth that is insufficient to return the economy to its full potential) for the foreseeable future. That would be a very unfortunate conclusion to such an important policy debate.

Craven spin on Prop. 30

Here's how the WSJ reported the passage of California's Proposition 30:

In approving a ballot measure sought by Gov. Jerry Brown to raise taxes for several years, Californians took a step toward improving the state's fiscal situation and avoiding education cuts.

The approval is a significant victory for Mr. Brown, a Democrat, who has staked his governorship on a campaign to raise taxes to ease the effects of the state's budget crunch.

"Last night, Californians made the courageous decision to protect our schools and colleges and strengthen the California dream," Mr. Brown said in prepared remarks. "The people of California have put their trust in a bold path forward and I intend to do everything in my power to honor that trust."

Here's the real, unvarnished truth:

In approving a ballot measure sought by Gov. Jerry Brown to raise taxes for several years, Californians relieved their governor of the need to impose much-needed fiscal discipline. 

Californians made the "courageous" decision to seize yet more money from upper-income earners, who already shoulder most of the burden of taxes, and give it to the educational system, which consumes unprecedented quantities of money yet delivers miserable results.

Yes, as Milton Friedman once said:

There’s been one underlying basic fallacy in this whole set of social security and welfare measures, and that is the fallacy - this is at the bottom of it – the fallacy that it is feasible and possible to do good with other people’s money. That view has two flaws. If I want to do good with other people’s money, I first have to take it away from them. That means that the welfare state philosophy of doing good with other people’s money, at it’s very bottom, is a philosophy of violence and coercion. It’s against freedom, because I have to use force to get the money. In the second place, very few people spend other people’s money as carefully as they spend their own.

It's hardly courageous for the majority of voters to decide to take money from a minority and spend it on another minority. Instead of patting ourselves on the back, we should be ashamed of our cravenness.  Will no one stand up to the teachers' union?

In any event, it should come as no surprise to supply-siders if, in fact, the money that Prop. 30 promises to raise fails to materialize. Prop. 30 is likely to encourage even more of the "rich" and small business owners to join the ongoing exodus from California to states with lower tax burdens and a more friendly business climate.

Australia is expensive, and the U.S. is cheap

For those considering an escape to a less-unfriendly business climate such as Australia's, an important caveat: the Australian dollar is very expensive and the U.S. dollar is very cheap. Selling here to move there is therefore an extremely expensive proposition.

The above chart compares the Aussie dollar exchange rate to my calculation of its Purchasing Power Parity with the US dollar. (PPP is the exchange rate that would cause US visitors to Australia, and Aussie visitors to the US, to conclude that most prices in the two countries were roughly the same.) I estimate that the PPP exchange rate today is about 0.66 dollars per Aussie dollar. But since the current exchange rate is 1.04, that implies that, from the point of view of a U.S. expat or a U.S. tourist, the average price level in Australia is more than 50% higher than in the U.S. Ouch. Moreover, the Aussie dollar has almost never been so strong. Lots of things are going to have to continue to go right for the Aussie dollar to remain at these lofty levels.

This next chart of spot commodity prices suggests that a big reason the Aussie dollar is so strong is that commodity prices—commodities are Australia's major export—are very strong. There is a very strong tendency for the Aussie/US exchange rate to track changes in commodity prices. Rising commodity prices bring a flood of new money into the Australian economy, and that tends to bid up the value of the Aussie dollar.

As this chart of the real, trade-weighted value of the dollar shows, the US dollar has almost never been so weak. It's not hard to understand why: monetary policy is extremely accommodative, the U.S. economy has never experienced a weaker, more disappointing recovery, federal deficits are extraordinarily large, entitlement programs are long overdue for reform, and regulatory burdens are very high and rising (e.g., ObamaCare). In contrast to conditions in Australia, lots of things need to continue to go wrong in the U.S. economy for the dollar to remain this weak.

For the time being, leaving the US for greener pastures overseas is in general a very expensive proposition.

Green shoots are still to be found

Fortunately, in contrast to my supply-side-induced gloom and doom this week, the evidence continues to support the view that the housing market is recovering. As this chart shows, the stocks of major home builders have more than doubled since September 2011.

This may be the most miserable recovery in modern times, but it nevertheless remains a recovery, and that is very important. The U.S. economy doesn't need the ministrations of policy to recovery; it's fully capable of recovering by itself. In fact, if policy were less blatantly stimulative, we would probably have a much healthier economy today.

Still no sign of labor market deterioration

As disappointed as I am with the reelection of Obama, I don't think the economy is likely to underperform the market's dismal expectations. Misguided monetary and fiscal policy have been behind the economy's sluggish growth, and I don't see that getting worse. Some argue that very slow growth such as we've had increases the risk of a recession, using the analogy of an airplane that approaches "stall speed" being at risk of falling out of the sky, but I don't believe that analogy works for an economy. Recessions happen when unexpected and unpleasant things happen; they don't happen just because growth is disappointingly slow. Besides, the U.S. economy has an inherent dynamism which you underestimate at your peril. Most people want to advance by working harder, smarter, and by taking on extra risk. Americans by nature are problem solvers, and love to overcome obstacles and undertake challenges. And boy do we live in challenging times: successful entrepreneurs and businesses today are more likely to be demonized than appreciated, while some who fail to succeed are bailed out. That's not fair, in my view, but it hasn't stopped people from working harder.

I've argued for years that even though the recovery would be sub-par, the economy was likely to outperform the market's expectations, and for the most part that has been exactly what has happened. Although it is hard for me to be optimistic about another four years of Obama, I still think the economy can generate enough growth (even if it's only 2% per year) to beat the expectations that drive people to buy 10-yr Treasuries with a measly 1.7% yield, and to eschew equities with an earnings yield of 7% in favor of cash yielding zero.

For those who hold cash to be rewarded, the economy has to deteriorate significantly. However, so far there is no sign of any deterioration. Sandy may have caused claims to be a bit lower than expected, but even if they were higher the story would still be the same: seasonally adjusted claims have been flat for almost the entire year.

The above chart takes the numbers from the first chart and compares them to the size of the workforce. What this tells us is that in the past 60 years there have been only about 10 years in which a smaller percent of those working were at risk of losing their job. The economy isn't adding a whole of jobs, but neither is it firing very many. The problem is not layoffs, it's the lack of new jobs.

As this next two charts show, the one thing that has been very different about the last recession and the current recovery is the unprecedented number of people who have received unemployment insurance, thanks to Congress' decision in mid-2008 to create an "Emergency Claims" benefit. That is now winding down, with the result that there are 20% fewer people today receiving unemployment insurance than there were a year ago. This is one of the biggest changes on the margin in today's economy, and it doesn't get the attention it deserves. It's a perfect example of how the influence of government in the labor market is declining to a meaningful degree. Whenever government intervenes in a market, it almost always creates unintended consequences: disincentives to work, corruption, crony capitalism, and bureaucratic waste. As government pulls back, market forces come more into play and things improve. More people now have a greater incentive to find and accept jobs, even though they don't pay as much as they would have liked to get. This isn't fun, but that is the best way for excess labor to be reabsorbed. This is a good indicator that jobs are likely to continue to grow, if only because government is no longer making it easy for people to stay home.