Tips From Donna (December 2016 Wesban Monthly)
by Donna Gordon on February 15th, 2017

​Job Growth: Strong Enough for a Rate Hike, Weak Enough to Frighten

World markets generally didn't do very much this week after strong volatility in previous weeks because of the U.S. presidential election. However, almost all equity markets were down for the week as the excitement of potential Trump tax cuts and stimulus was tempered by economic data, especially a jobs report that was less than expected.
Auto sales were no gem, either, with increased incentives, fleet sales, and extra selling days unable to drive year-over-year growth any higher than 3.6%. Adjusting for the added selling days, sales were down 4.7% from a year ago.
Revised third-quarter GDP growth data (from 2.9% to 3.2%) was good news and bad news. The good news is the total GDP growth wasn't as bleak as we believed just a few weeks ago. Consumption was revised sharply upward, but a lot of business spending categories now look a little worse. The bad news is that growth will be more difficult to achieve in the fourth quarter. This is especially true since the consumption and employment data reported this week started the quarter off on a bad note. Employment data looked OK month to month, but was substantially below year-ago levels, which won't be great news for holiday sales.
Worries about stimulus, tax cuts, and a highly likely interest-rate increase by the Federal Reserve in December kept bond markets on their heels, especially at the beginning of the week (before some softer economic data rolled in on Thursday and Friday). The U.S. 10-year Treasury bond yield was almost unchanged for the week at roughly 2.4%, well off the 1.6% low of the year and much higher than the measly 0.25% rate increase the Fed is expected to make in two weeks. A lot of other bond markets, particularly municipals, fared a lot worse than the 10-year Treasury. Markets are now way out in front of the Fed, potentially blunting the impact of the actual rate increases, when and if they are announced. Obviously, markets believe the Fed's hand will be forced harder and faster than expected in 2017.
Commodities were the star of the week, gaining 3.4% in aggregate, driven by higher oil prices. Those in turn were driven by much higher oil prices that resulted from an oil producers' meeting that promised some substantial production cuts. While this may indeed help oil prices set a firmer floor, I still believe that with U.S. shale producers being the new swing producers, the days of setting oil prices between just a few countries in a smoke-filled room are behind us. Also, I don't think markets have figured out that demand is also an issue, with increased conservation measures really taking hold.
The revisions to GDP, consumption, and especially consumer incomes were large and comprehensive. They substantially changed the trajectory of economic growth that had begun to look very dismal. Unfortunately, there wasn't even time to heave a sigh of relief as the data for the rest of the week seemed to indicate that the bad prospects had merely been pushed out to a later date and not eliminated. Potentially compounding the weakness is the fact that sharply higher mortgage rates could stifle growth in the housing market. Higher rates in general will not be helpful for those businesses and individuals wishing to borrow more. We fear that the pain of higher rates and potential trade issues will begin to bite before any of the tax cuts or stimulus measures are even voted on.
Employment Growth Fails to Accelerate Much
Friday's employment report was a mixed bag. Total job growth of 178,000 was better than last month's total and in line with the average for the past 12 months. Other job-related reports this week (Challenger Gray lay-offs and ADP) had raised everyone's hopes for much better numbers. We certainly raised our expectations in this week's preview video, but cautioned that everyone's expectations were driven by high hopes for seasonal retail sales help, which failed to materialize.
Still, the number doesn't look horrible relative to recent months.
​However, comparing this November to last November, things didn't look so great for private-sector employment. Last November, job growth was almost a 100,000 higher than this year, comparing the left most and right most bars of the graph above.
Historically, November has been one of the strongest months of the year for job growth.
​In that context, the 156,000 private-sector jobs created last month (government kicked in another 22,000) seem like a cause for worry and not for cheering.
Year-Over-Year Averaged Data Continues to Slump
We always prefer looking at the jobs data on a percentage basis, year over year and averaged. That eliminates a lot of the fluky month-to-month data that is so hard to rationalize.
Private-sector growth continues to drop, as shown by the blue line in the graph below. That rate has fallen from a high of 2.5% to 1.8%, a nontrivial drop. Still, we wouldn't panic, because strong 2015 results were partly due to an easy comp: winter 2014 was cold and stormy compared to a mild and tame 2015 winter.
​Components of Total Wage Growth Continue to Shift
Normally, much slower job growth would be a reason for panic. However, hourly wage rates are just as critical, if not more, to total wage growth as the level of employment. The graph below shows that wage growth and employment growth have just about reversed places, cushioning the blow.
​However, lower hours growth (actually a decline now) has moved total wage growth down a smidge. Perhaps the truncated scale makes it look like more than a smidge, but in the scheme of things this isn't much of a change, especially given the weather-related booms and busts.
​Nominal Wage Growth Acceptable, but Inflation-Adjusted Data, Not So Much
We characterize the overall, nominal total wage shrinkage as a smidge, but inflation-adjusted data shows a dramatic drop, which won't be good news for the all-important consumption sector that makes up 70% of GDP.
​Adjusted for much higher inflation today than a year ago, growth in total wages paid has been cut nearly in half from almost 5% to 2.5%.
Consumption and Wages Generally Track Each Other Closely
Most of the time, wage growth is very close to consumption. They move in tandem without one consistently leading the other. With wage growth now at about 2.5%, there is a very real possibility that consumption will fall from its current 2.7%.
​Like employment growth, consumption rates have slowed, as reinforced by this week's consumption report. While the consumption moderation is not as severe as the wage data, it is still well below peak level.
Still, there have been huge shifts in some of the underlying categories. Much cheaper grocery prices have driven up grocery store sales dramatically and put a real damper on restaurant sales, as shown below.
​Healthcare Growth Diminishing 
As a lot of healthcare insurance programs have been fully implemented, expenditure growth has slowed dramatically in the second-largest consumption category behind only housing.

​Inflation Accelerates, but It Isn’t the 1970s Again

Equity markets generally continued to rally this week, especially the Russell 2000, which made a new all-time high. However, emerging markets continued to worry about what a Trump victory means and had another rough week. Bonds also continued to express their concern about Trump, with some rates, but not all, moving higher this week.  
Economic news this week was generally positive, especially on a month-to-month basis. Retail sales, industrial production, and housing starts all showed nice progress, lifting the cloud of impending doom that was hanging over many economic statistics. We do caution that most of these metrics made little improvement on a year-over-year basis, but they did not get any worse. Inflation did heat up, causing some concern, with the October data showing a 0.4% increase. (Most of today's piece focuses on why higher inflation worries us.) Clearly, U.S. Federal Reserve Board Chair Janet Yellen is also concerned, hinting that rates would move higher soon. The market seemed untroubled about the Fed this week, for a very refreshing change of pace.

This week's release of October price data showed acceleration across both year-over- year and month-to-month data. The month-to-month data looked particularly ominous, increasing 0.4%, which approximates a 4.8% annual rate. Year-over-year inflation was also at the highest rate of the year, 1.6%, slowly and methodically approaching the core inflation rate of 2.1% (excluding food and energy items), which has changed little over the past 12 months. Together, this seems like a reason for at least some worry, and suggests that the Fed may need to take action sooner than later. 


However, We're Not Going Back to the 1970s
As much as we would like to say 'we told you so' in terms of higher inflation, the October report was not as dire as some of the headlines suggested. Gasoline, which was up a stunning 7% on seasonal factors and pipeline issues, and shelter prices that were up 0.4%, drove over half of the huge month-to-month inflation increase. Remember, a large part of the shelter number is owner-equivalent rents, which don't represent 'cash' outlays. I am sure the Fed has done the same analysis, probably looking at core inflation rates, which still haven't changed much.
 
​Though, no one really wants to see core rates move higher than the 2.2% rate, which the is current year-over-year three-month averaged rate. That suggests that some action was warranted as long as a year ago, but things have necessarily worsened a lot lately. As we have said again and again, headline inflation is the number-one indicator of recessions, not some hypothetically constructed 'core rate.'


The graph below shows that inflation does help predict how well the economy will do. The relationship between total CPI and consumption is quite tight. In fact, inflation generally leads consumption. Higher prices lead to lower consumption by several months. Periods of inflation should line up with periods of high consumption. That's why the red line, representing prices, forms peaks and troughs before the orange consumption line. To make the relationship clearer, we reversed the scale for inflation so that lower inflation rates are at the top and higher rates at the bottom. Consumption data is shown the conventional way with highest values on the top, using the right hand scale.

 
​To follow up with a real-world example, in 2008, inflation reached its peak in August 2008, the lowest red point on the line, or 5.4%. Consumption reached its nadir in May 2009, the very lowest point on the graph at negative 2.9% year-over-year change in consumption. Likewise, inflation (really deflation) was at its lowest in August 2009 and consumption peaked in January 2011. The headline CPI data correctly predicted the 2016 slowdown in consumption. So far, consumption has slipped from 3.5% to 2.6% as headline inflation has moved from 0.1% to 1.6%. That suggested that consumption growth has more room to fall, especially because it will be all but impossible for the CPI data to move up given now-increasing energy prices.


Core inflation, excluding food and energy prices, can provide some of those same clues as headline inflation. There's a number of theoretical and observational reasons to favor using the headline number, at least for economic forecasting.
​As seen in this graph, most of the time total CPI provides more lead time than core. Note the red line usually, but not always, moves ahead of the blue line. Additionally, the fact that total CPI moves over a broader range of values means that it can be easier to spot trends. That is why we had to use two different scales to make the data line up.


On a theoretical level, food and energy represent more than 20% of consumer spending, so tossing them out of the calculation is eliminating some of the real pain that consumers are feeling. It might make a little sense to toss out food and energy if a very short-term price spike will quickly reverse itself. However, using our year-over-year averaging methodology accomplishes much the same thing.


Slow-Moving Wages and Fast-Moving Inflation Are Often Key Causes of Recession
The reason inflation is so devastating is that higher prices, especially food and energy, must be paid for almost immediately. However, wage increases come but once a year. The same is true of Social Security recipients, an increasingly larger part of the consumption base. The pressure might not be so bad if consumers could switch to purchasing other goods instead of the more expensive items, but that is particularly difficult in the case of food and energy.


And it gets worse. Wage increases generally move in line with core inflation and not total inflation.
​Workers Paid on Core Inflation, not Headline Inflation
In the short run, workers get raises that have some relation to core inflation. Again, there are practical and theoretical reasons for this. On a theoretical level, over the long run core and total inflation are about the same. Although food and energy prices are exceptionally volatile, over the long term, inflation rates in the key categories are relatively similar. Given this pattern, paying on core rates of inflation could make some sense. Otherwise, wages would need to go both up and down, which is something that both workers and businesses find distasteful. However, this does set up the economy for recessions as consumption slows as wages decline in real terms.
​To close this thought, inflation is a key cause of recessions, no matter how it is measured. Currently, inflation is getting worse and explains the lower consumption rates we have seen in 2015 and 2016. If wage growth accelerates to cover higher inflation, the economy will do fine. With labor markets now exceptionally tight as baby boomers retire, for the first time in decades that is least a possibility. Also, the stronger dollar could keep goods inflation lower than we expected and falling food prices have been a surprisingly potent force in both helping consumers and keeping headline inflation manageable. While any gap between inflation and wages is not a good thing, the gap would need be a lot wider than we are seeing at the moment to trigger a recession. Generally, headline inflation needs to be close to 4% to trigger a recession. While we see a clear path in relatively short order, to 2.5%-3.0% inflation, a move to 4% doesn’t seem like the most likely case over the next year.


Inflation Experiences a Changing of the Guard
We used the table above to show that inflation rates by broad category tend to converge over time, as shown by the averages at the bottom of that table. Also interesting is that there has been a large shift in category data over the past year. Energy price changes that had been dropping at a rate of 17% a year ago are now falling at only 4% in the most recent year-over-year averaged data (on a single-month to single-month basis energy gained 0.9%, the first increase since 2014, all but assuring energy inflation in the months ahead). Food, on the other hand, continues to fall. While not as volatile as energy, food inflation has fallen from 1.6% a year ago to deflation of 0.2%. The food category carries a weight 3 times higher than energy, and hits a wider swath of consumers.


Goods Deflation Continues
Goods deflation, generally one of the lower inflationary categories because of the impact of imports, also remains below long-term averages at 0.6% deflation year over year. A strong dollar and an aging population that consumes fewer goods (and consumes more healthcare) are likely keep the pressure on the nonenergy goods category.
​Services Got a Little Worse Month to Month, but Stabilized Year Over Year
Services make up about 60% of the CPI and have been running hot for some time. They have moved up modestly from 2.7% to 3.1% over the past year, but are off their peak of 3.2%. This category is driven largely by owner-equivalent rent, real rents, and healthcare. We had hoped that the completion of many new apartment complexes would have helped put a lid on rents, but rents are still up 3.5%. Higher home price inflation, which likely helps determine owner-equivalent rents, isn't helping, either. At least healthcare took a bit of a breather, registering two months in a row of zero declines. Still, year-over-year medical services are up 4.1%. Though it goes in the goods bucket, drug price growth slowed for at least one month, but the year-over-year data is still at a whopping 5%.




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