The Fed Audit

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

April 1, 2024

Several years ago some politicians started demanding that the Federal Reserve get audited. We think the idea has some merits but also some drawbacks, as well.

One problem with the Fed is that it doesn’t have a hard limit on its own spending. For example, let’s say the Fed wanted to hire a bunch of extra staff to write papers on climate change, income inequality, gun control, or other “political hot button” issues of the day that don’t really have a direct relationship with monetary policy or the Fed’s mission. Our understanding is that there’s nothing to stop the Fed from doing so, as long as it claims some relationship to monetary policy, no matter how tenuous.

And even if the appointed leaders at the Federal Reserve Board object, there are still twelve regional reserve banks around the country that could do so, and their leaders are not appointed by the president or confirmed by the Senate. In fact, the Chicago Federal Reserve Bank already has staff dedicated to researching topics that impact the “greater good” and “community development.”

Depending on the party in power, auditing the Fed could lead Congress to mandate more or less of these endeavors, and at the same time put more political pressure on the Fed to tilt monetary policy in a way that politicians see as favorable toward themselves, which would mean less Fed independence. History shows clearly that less central bank independence correlates closely with higher inflation and less currency stability.

What we would suggest is a law that limits the Fed to activities that directly, not indirectly, impact monetary policy. Those areas can be measured with an accounting audit by an outside firm, which the Fed already does. Last week the Fed released its audited financial statements for 2023 and they were…. interesting.

Most prominently, the Fed lost $114 billion last year. This is the first time the Fed has ever run an annual loss and the loss is a direct consequence of the Financial Panic of 2008 when the Fed started paying banks to hold reserves.

Prior to that change, the Fed did not pay banks to hold reserves, meanwhile earning interest on the securities in its portfolio (mostly Treasury bills). But after the change, when the Fed was holding rates close to zero, it still ran surpluses. When the Fed held rates low, it contributed an average of more than $75 billion annually to government revenue.

But holding rates too low creates distortions in financial markets and rates had to go higher. In order to “normalize” rates, the Fed now pays banks 5.4% on their excess reserves. The result is that the Fed paid private banks $281 billion in 2023.

But the Fed earns less than that on its bond portfolio. To repeat, it lost $114 billion in 2023 and has a total accumulated deficit of $133.3 billion since 2022. The Fed calls these accumulated losses a “deferred asset” because it expects to return to profitability in the future.

These kinds of losses should invite political oversight. Does the Fed just borrow more from the Treasury (the taxpayer) to meet payroll? If so, there is already a reason to doubt its independence from the political side of government. Rather than audit the Fed, which is already done, laws which require more transparency and a more focused mission, would be productive. The Fed has become too political. That should change.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

CPI Explained: Breaking Down the Basics

First Trust Three on Thursday

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

March 21, 2024

In this week’s edition of “Three on Thursday,” we take a deeper look at the Consumer Price Index (CPI). The CPI is a key measure of inflation, measuring the average change in price over time of a market basket of consumer goods and services. Its broadest and most widely used index, the Consumer Price Index for All Urban Consumers (CPI-U), represents over 90% of the U.S. urban population. The CPI-U reflects the cost of essential items such as food, apparel, housing, fuel, transportation, medical services, pharmaceuticals, and other products and services purchased for everyday living by nearly all urban residents, excluding those in rural areas, the military, and those in institutions, such as mental hospitals and prisons. Prices are collected monthly from 75 urban areas across the country from about 6,000 housing units and around 22,000 retail establishments. The CPI-U uses these prices, weighted by their importance in consumer spending, to calculate average price changes, which are then used to gauge inflation. To offer deeper insights, we’ve included three informative charts below.

The CPI-U consists of over 200 categories that are arranged into eight major groups, with weightings based on consumer spending patterns. The Bureau of Labor Statistics (BLS) calculates each category’s share of total expenditures by totaling the expenditures reported by households for each item and then determines the proportion of total expenditures that each item represents. In essence, items or categories where consumers spend a larger portion of their income will have higher weights in the CPI, indicating their greater importance in the overall index. The BLS now updates these weightings annually, using recent Consumer Expenditure Survey data to keep the CPI relevant and accurately reflect shifts in consumer spending on various goods and services. The largest group weighting by far in the CPI-U is housing which makes up 45% of the overall index weighting.

Housing, with a substantial 45% weighting, constitutes the largest share of the Consumer Price Index (CPI), with the Owner’s Equivalent Rent (OER) being its most significant component at a 26% overall weighting in the CPI. In essence, OER measures the change in the amount a homeowner would pay in rent or earn from renting his or her home in a competitive market. The investment portion that comes with purchasing a home is excluded in OER, so home prices are not factored into the estimate. This estimation is achieved through the CPI Housing Survey, which follows the rents of a large sample of renter-occupied housing units. Each month, one-sixth of a pricing area (called a panel) is measured, with all six panels priced twice a year. This methodology causes the CPI’s rent measures to lag behind market indices like Zillow and CoreLogic, particularly because the CPI captures rents for ongoing tenancies rather than just new listings, and only measures an area every six months. There is a very high correlation between home prices lagged 18 months and OER. If this relationship holds moving forward, the growth rate of OER should continue slow, putting downward pressure on the overall CPI.

Since November 2022, the Federal Reserve has honed its focus on a narrower inflation measure known as “supercore” inflation. Powell has highlighted its significance, stating that supercore inflation “may be the most important category for understanding the future evolution of core inflation.” Traditionally, core CPI excludes food and energy prices to provide a clearer view of inflation trends. The Fed’s approach to supercore inflation refines this perspective even further. Powell, along with other senior Fed officials, categorize core inflation into three segments: core goods, housing services, and core services minus housing. The latter category, often referred to as supercore, has garnered considerable attention. This focus stems from the Fed’s belief that service sector inflation, unlike goods prices, is predominantly influenced by labor costs—a factor the Fed can influence through interest rate adjustments. Raising interest rates typically cools economic activity, leading to slower hiring rates or even layoffs, thereby affecting inflation. In contrast, they believe goods prices are more susceptible to global dynamics like supply chain variations. Relative to the overall CPI, supercore has remained much more stubbornly elevated.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

Welcome to State-Run Capitalism

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

March 25, 2024

We’ve mentioned this before, but it bears repeating. It seems that investors pay as close attention to what the government is doing, as they do to actual business news. We don’t think investors are wrong to do this, but it’s only because government has become so big.

The US has moved from a simple Keynesian-type model to what we call “State-Run Capitalism.” When the economy turns soft, a typical “Keynesian” (demand-side) response would be to boost the budget deficit or print more money.

Now, the government is running permanent, and very large, deficits and using its budget to fund semiconductors, EVs, solar and wind energy generation, as well as redistributing more money to immigrants and students who are in debt. This all smells and looks like central planning…or State-Run Capitalism.

At the same time, because the Fed is now using an abundant reserve monetary policy, it has taken the financial system out of the process of determining short-term interest rates. Banks no longer need to trade excess reserves, so the federal funds rate has no real market. The Fed just makes that rate up.

So, here we sit in 2024, and a Wall Street Journal economics reporter, Greg Ip, just wrote a piece titled “The Economy is Great…”. We don’t think that’s really true, but real GDP did grow more than 3% last year and job growth has been robust.

A typical Keynesian response to this, the one most people were taught in economics class, would be for the government to run a surplus, or at least substantially shrink the deficit, and the Fed to be at least slightly worried about over-heating the economy.

Instead, Congress just pushed through a $1.2 trillion spending bill with a deficit that will approach $1.6 trillion, and the Fed announced that it was likely to cut rates three times in 2024.

What the heck? Why? Especially with inflation reports so far in 2024 coming in hot. The Cleveland Fed median price index is up 4.6% from 12 months ago, “supercore” CPI is up 4.3% over 12 months, and nearly 7% annualized over the past three months. With inflation this high, and the economy “great,” no traditional Keynesian would support these policies.

We don’t blame investors for reading the tea leaves and realizing that all this stimulus is probably good for the markets in the short run. Lower rates mean more growth and higher price earnings ratios. The market seemingly (and perhaps correctly) has decided that the Fed, and the Federal Government, can manage the economy to keep stocks up.

But all of this will come with a price. No centrally managed economy has been permanently made to go only one way. It can look good for a time, but eventually the sheer size of the government and the mishandling of monetary policy catches up. On a smaller scale, the US tried this in the 1970s, and the result was stagflation. Russia, Venezuela, and a host of other countries have all failed.

But it doesn’t happen overnight. More importantly, because the Fed has separated the growth of the money supply and the level of interest rates, rate cuts may not mean what many people think they do. Yes, rates may come down this year, but the money supply has contracted in the past year. A contraction in the money supply is never a good sign.

We still expect a recession this year. The US will have an irresponsible deficit, but it will be slightly less irresponsible than it was last year. Add in a decline of M2, and the morphine pumped into the system over the past few years has worn off.

If the Fed is cutting rates because it is an election year, and if the government is spending money in an effort to entice some voters to see it as personally beneficial to vote for big government, it’s a recipe for lousy economic outcomes.

When the government pushes money in directions that are politically beneficial, they are often not efficient in a true economic sense. This means less growth and more inflation. We are very worried about stagflation in the years ahead.

Between now, and whenever that is, the market may completely ignore it. And, investors will think the government has found a recipe for permanent prosperity. But after thousands of years of trying, and never making it happen, we bet against even this new version of State-Run Capitalism.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

Rate Expectations

First Trust Economic Research Report

Robert Stein, CFA - Dep. Chief Economist

Brian S. Wesbury - Chief Economist

March 20, 2024

There was zero chance the Fed was going to cut rates today; instead it was all about what today’s meeting, the dot plot, and the press conference meant for the timing and pace of rate cuts in the months ahead.

Starting with today's statement, there was only one change from January, and it was a minor one. While prior language stated that job gains “have moderated since early last year but remain strong” today’s statement removed language concerning moderation and simply stated that “job gains have remained strong.” That – along with a slight adjustment lower to the unemployment rate forecast for 2024 –suggest that a stronger than anticipated job market has weakened Fed confidence that inflation will trend sustainably towards 2.0%.

The survey of economic projections provided more clarity. Forecasts for real (inflation-adjusted) GDP growth in 2024 rose to 2.1% from 1.4% in December. And with that outlook for stronger growth, their unemployment rate expectation shifted down to 4.0% from 4.1% while core inflation expectations rose to 2.6% from 2.4%. It's worth noting that with unemployment at 3.9% and core inflation at 2.8%, this suggests the FOMC members see very little movement in either category over the remaining nine months of the year.

While the combination of faster growth, higher inflation, and a stronger job market didn’t shift the Fed’s expectation for the equivalent of three 25 basis point cuts between now and year end, the distribution of forecasts shows that only one FOMC participant now expects more than three rate cuts will be appropriate this year, down from five members at the December meeting. And rate cut expectations for 2025 shifted to three cuts from four.

Beyond rate cuts, markets have been wondering when the Fed will start to taper back the pace of quantitative tightening (QT). During today’s press conference, Powell wouldn’t confirm or deny that the process could begin as soon as the next Fed statement on May 1st, but he did say that it would be appropriate to start “fairly soon” with plans to gradually cut the pace of roll-offs. In other words, May looks to be on the table.

We expect the Fed will start cutting rates in June. That said, the Fed should take a cautious approach once the process begins, with a primary focus on not cutting rates too aggressively or prematurely, which could re-ignite the inflation problem like the Fed did on multiple occasions under Chairman Arthur Burns in the 1970s. The economy is still growing, but we think it falls into recession before the year is out and that real GDP growth significantly lags the predictions of the FOMC members. This, in turn, heightens the risk that the Fed takes a more aggressive path on rate cuts in response to economic weakness, bringing the threat of reaccelerating inflation to the forefront in the years ahead.

Text of the Federal Reserve's Statement:

Recent indicators suggest that economic activity has been expanding at a solid pace. Job gains have remained strong, and the unemployment rate has remained low. Inflation has eased over the past year but remains elevated.

The Committee seeks to achieve maximum employment and inflation at the rate of 2 percent over the longer run. The Committee judges that the risks to achieving its employment and inflation goals are moving into better balance. The economic outlook is uncertain, and the Committee remains highly attentive to inflation risks.

In support of its goals, the Committee decided to maintain the target range for the federal funds rate at 5-1/4 to 5-1/2 percent. In considering any adjustments to the target range for the federal funds rate, the Committee will carefully assess incoming data, the evolving outlook, and the balance of risks. The Committee does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2 percent. In addition, the Committee will continue reducing its holdings of Treasury securities and agency debt and agency mortgage-backed securities, as described in its previously announced plans. The Committee is strongly committed to returning inflation to its 2 percent objective.

In assessing the appropriate stance of monetary policy, the Committee will continue to monitor the implications of incoming information for the economic outlook. The Committee would be prepared to adjust the stance of monetary policy as appropriate if risks emerge that could impede the attainment of the Committee's goals. The Committee's assessments will take into account a wide range of information, including readings on labor market conditions, inflation pressures and inflation expectations, and financial and international developments.

Voting for the monetary policy action were Jerome H. Powell, Chair; John C. Williams, Vice Chair; Thomas I. Barkin; Michael S. Barr; Raphael W. Bostic; Michelle W. Bowman; Lisa D. Cook; Mary C. Daly; Philip N. Jefferson; Adriana D. Kugler; Loretta J. Mester; and Christopher J. Waller.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

Focused on the Fed

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

March 18, 2024

The Fed meets this week, which means investors and analysts will be sifting through Wednesday’s FOMC statement, updated economic projections, the “dot plots,” and Powell’s press conference searching for any signal – real or imagined – about what our central bank will do next. In particular, the market is on tenterhooks about when rate cuts will start, how fast those rate cuts will come, or if the Fed will simply hit the “pause” button on the prospect of rate cuts until deep into 2024.

We think this obsession with the Federal Reserve is unhealthy. Instead of an obsession with slight policy shifts out of Washington, DC, we think investors need to be focused on more important matters, like the process of innovation, entrepreneurial risk-taking, and corporate profits. In the end, it’s these factors that will drive stock market valuations the most, not the vagaries of the short-term interest rate target by the mandarins of money.

Things have changed a great deal since the last Fed meeting on January 31. Back then, the futures market expected about six rate cuts of 25 basis points each this year, with the first cut coming in March. As of Friday’s close, the market was expecting only three rate cuts this year, with the first one coming in either June or July.

No wonder the shift in rate expectations given recent reports on inflation. The two CPI reports since then show consumer prices up at a 4.6% annual rate in the first two months this year. And no, this was not food and energy; “core” prices, which exclude those two volatile categories were also up at a 4.6% annual rate so far this year.

Even worse for the Fed is that the newly made-up slice of the CPI that the Fed and others call the “Super Core” measure of inflation, which includes services only (no goods) but also excludes food, energy, and housing rents, rose 0.8% in January and 0.5% in February. That’s a growth rate of 8.2% annualized so far this year. Notice how you used to hear a lot about this measure a year or so ago when it was indicating lower inflation and now few dare speak its name when it shows inflation re-accelerating! Meanwhile, overall producer prices are up 5.4% so far this year and “core” producer prices are up at a 4.5% annual rate.

None of these figures are remotely close to the 2.0% inflation goal the Fed claims it’s still targeting.

The problem for the Fed is that there are signs that the economy may be slowing. Although retail sales rose 0.6% in February, after factoring in downward revisions to prior months, retail sales rose a tepid 0.1%. “Core” sales, which exclude volatile categories such as autos, building materials, and gas stations — and is a crucial measure for estimating GDP — increased by 0.1% in February, but was revised significantly lower for previous months, down 0.5%. If unchanged in March these sales will be down at a 0.7% annual rate in Q1 versus Q4, which would be the first quarterly decline since the COVID lockdowns.

Industrial production rose a tepid 0.1% in February but that follows declines of 0.3% and 0.5% in December and January, respectively. We like to follow manufacturing output excluding the auto sector (which is volatile) and that is down 0.9% from a year ago. Not a good sign.

As always, we will be watching the press conference following Wednesday’s meeting for any mention of the Fed looking more closely at the money supply, but we won’t get our hopes up. The M2 measure of money is down 2.0% in the past year, which would not be good for the economy if these figures are accurate and if they continue.

Another key issue is whether the Fed will publicly abandon it’s 2.0% target to make it easier on themselves to achieve their goal. We think that will happen eventually, but that’s several years from now, not soon. The Fed likely thinks it would lose credibility if it announced a higher target for inflation, and could send long-term interest rates spiraling upward; that’s not a risk the Fed would take, particularly in an election year.

Our advice to investors: listen to and watch the Fed but don’t obsess about it. The changes in monetary policy from meeting to meeting don’t matter nearly as much as the productive capacity of the American people.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

Is the Job Market Really That Strong?

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

March 11, 2024

If you only look at the headlines about the monthly payroll report, the job market has looked surprisingly strong in recent months. Nonfarm payrolls rose 275,000 in February, beating the consensus expected 200,000 as well as the average of 229,000 per month in the past year.

But a deeper look at the data makes it look about as fishy as week-old sushi. Now, we’re not alleging some sort of “Deep State” conspiracy, we’ll leave that to others. But reviewing the report in its entirety show the job market is not nearly as strong as the top line payroll readings suggest.

For example, look at the revisions. Payrolls in December and January were revised down by a total of 167,000 (the largest monthly downgrade for any non-shutdown months since late 2008), meaning February was just 108,000 above the original January level. And it was even worse in the private sector, where payroll gains were a paltry 19,000 for the month after netting out revisions for prior months.

What’s odd about these downward revisions is that they seem to happen pretty darn often of late. In 2023, for example, the regular two-month revision process reduced the initial monthly report by 30,000, on average. That ain’t chump change. In the past few decades, negative revisions like this have normally been associated with recessions or the immediate aftermath of recessions.

It's also important to follow civilian employment, an alternative measure of jobs that includes small-business start-ups. On a monthly basis, these figures are volatile, and are affected by estimates of the size of the total population, so take them with a grain of salt. But the trend is important and isn’t anywhere as strong as payrolls. While payrolls are up 2.7 million in the past year, civilian employment is up 0.7 million and the unemployment rate has risen to 3.9%. Moreover, the gain in civilian employment in the past year has all come in part-time work, with a slight loss for full-time jobs.

There may be solid technical reasons for this large gap. The figures are generated by two different surveys (one for employers, the other for households), and maybe the massive influx in immigrants, even if largely illegal, is finding its way into payroll expansion (perhaps with illegal hiring or false documents) in a way not being picked up by the civilian survey. We’re guessing many recent immigrants are not eager to answer surveys sent by the Labor Department.

Notably, among those who do answer the survey, civilian employment among the native-born population is down around 900,000 from a year ago – the first drop since the onset of COVID – versus an increase of about 1.5 million among the foreign-born.

Only time will tell the true underlying health of the labor market. There is no clear signal we’re in a recession, but the patient isn’t looking well. What is clear, is that economic risks abound, and a soft landing is far from guaranteed.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

Is a Debt Spiral Already Here?

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

March 4, 2024

Washington DC continues to spend much more than it gets in revenue. In the Calendar Year of 2023, the federal government spent $6.3 trillion, but only collected $4.5 trillion in taxes. This $1.8 trillion gap drove the national debt to $34 trillion in December 2023. And it is only going higher.

One problem with these budget numbers is that government accountants, rightly or wrongly, lowered spending in 2023 by about $300 billion after the Supreme Court struck down a large part of President Biden’s proposal to forgive student loans. That legal decision didn’t change the government’s cash flow last year in any significant way, but it did let the Department of Education “write up” the value of its loan portfolio by about $300 billion. This, they counted as “negative spending,” which then reduced the official budget deficit. So, while the reported deficit in 2023 was $1.8 trillion, the Treasury needed to borrow more than $2 trillion to make ends meet.

The high levels of borrowing are causing some investors to fear some sort of imminent and unprecedented snowballing of federal debt. Continual borrowing will lead to skyrocketing interest rates (and higher interest payments), which will lead to severe problems in the financial system.

In particular, they note that since June 2023, when the debt ceiling was suspended, total Treasury debt outstanding has gone up by nearly $3 trillion. That includes a total of $874 billion in the second quarter of 2023, $835 billion in the third quarter, and $834 billion in the fourth quarter. Other than 2020-21, during COVID lockdowns, the debt has never gone up this rapidly, not even in 2008-2009.

But it’s important to remember that the debt does not go up at a steady rate during the course of the year. In 2023, during March and April, the federal government received a surge in tax receipts, which temporarily reduced the amount of debt outstanding. We think this will happen again this year, particularly because the S&P 500 went up 24% last year and the federal government is therefore likely to reap lots of non-withheld revenue.

As a result, the Congressional Budget Office estimates that individual income tax payments will be up 13.4% this year and the budget deficit will come in at roughly $1.5 trillion versus $1.7 trillion in Fiscal Year 2023. On that score, we are not as optimistic. Even as we write this, Congress is debating foreign aid measures that, whether you like the underlying policy or not, will, by themselves, boost the deficit.

And while the cost of servicing the debt is going up, the interest measure that matters is the net interest on the debt relative to GDP. In other words, what matters is how much of our national income is needed to service the debt. That measure, while climbing and a problem, is still below the average of roughly 3% of GDP it was back in the 1980s-90s.

However, because we think interest rates will remain higher than government accountants think, the carrying cost of our debt will move higher.

The bottom line is that federal government spending is way too high and most politicians do not seem to care. There are those who look at these numbers and assume some kind of imminent crisis, when what we see is a slow, but unavoidable decay in our underlying potential to grow. New technologies are raising productivity, but a huge government acts like a ball and chain on those benefits.

For now, the markets are ignoring this, and assume a soft landing with lower interest rates. But the more economic growth is undermined, the less likely this outcome.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

Watching the Fed

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

February 26, 2024

Every day this week, investors will get data on the economy. New home sales today, then capital investment, GDP, consumer incomes and spending, manufacturing, and auto sales are on the list. All of this will feed into the outlook for what the Federal Reserve might do with interest rates this year.

Pretty much everyone expects the Fed to cut rates this year, but expectations have changed. A month ago, the futures market was pricing in five or six twenty-five basis point (bps) rate cuts in 2024 (125 - 150 bps in total); now the market is pricing in three or four (75 - 100 bps total). Two relatively strong employment reports and an upside surprise with Q4 GDP data caused some rethinking, but this could be reversed just as easily.

While all these data points matter, we will be watching another release very closely, as well, one that few investors pay attention to and the Fed itself either doesn’t care about or is doing a great job pretending it doesn’t care about: tomorrow afternoon’s report on the growth of the money supply, or lack thereof, the M2 measure of money, in particular.

That measure of money, in spite of QE, did not soar during the Great Recession and Financial Crisis of 2008-09, and therefore did not cause inflation. The main reason is that though the Fed did trillions in QE, through heavy-handed regulation, banks were forced to boost reserves.

But 2020-21 was different. Banks were paid to push the money into the economy (remember PPP loans?) and M2 skyrocketed 40.7%. This led to the surge in inflation that followed in 2021-22. Since then, M2 has actually declined 3.2% in 2022-23, taking the steam out of inflation, but so far hasn’t affected economic growth.

But in the last two months of 2023, M2 started growing at a moderate pace again, up at a 4.1% annualized rate. If the Fed keeps it up, not just for one month but as a trend, that would be good news and might even reduce the risk of a recession later this year.

While we watch M2, others have been eyeing the relationship between long and short interest rates. In October 2022, the 3-month Treasury yield rose above the 10-year yield, and has stayed there. This is called an “inverted yield curve” and historically signals that the Fed is tight and a recession is often on the way.

But in an “abundant reserve” monetary policy, higher short-term interest rates no longer signal “tight” reserves. In fact, with reserves so abundant, the Federal Funds Rate is no longer determined in a market, but is actually set at the whim of the Fed. Technically, this is price fixing.

So, the yield curve doesn’t mean what it once did. Longer-term bond yields now are hugely affected by what investors think the Fed might do with rates, rather than how those rates reflect underlying economic trends. The Fed has convinced itself and the markets, that it can move rates up and down with the economic data perfectly, but this is hubris. The Fed has held interest rates below inflation roughly 80% of the time since 2009, leading to distortions in markets and the banking system.

Having said that, with short-term rates no longer excessively low, and the money supply down in the past 18 months, we believe the economy is starting to falter.

Retail sales have declined in three of the past four months. Manufacturing production, excluding the auto sector has declined four months in a row. Meanwhile, home building got hammered, with both housing starts (-14.8%) and completions (-8.1%) dropping sharply while new home sales are down 5.3% in the past four months.

We advise watching the path of M2 to tell how much additional faltering it will do in the year ahead.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

January Stagflation

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

February 20, 2024

A key economic mistake people make is thinking growth leads inflation. One reason they do that is because inflation is a monetary phenomenon. When money is too easy, first growth rises, and then inflation rises with a longer lag due to excess dollars in the system. This process reverses when money is tight, first growth slows, then with a longer lag inflation does too.

That makes 2023 an anomaly. The economy has remained resilient, but year-over-year consumer price inflation has moderated from a peak of 9.1% in mid-2022 to 3.4% in December 2023.

One theory is that the high inflation was all due to economic bottlenecks and supply constraints during COVID, so the end of lockdowns and the process of getting back to normal has expanded supply, leading to both faster growth and lower inflation. There’s no doubt that the imposition of lockdowns and then the re-opening from those lockdowns had “supply-side” effects – first negative, then positive – and are consistent with this explanation.

But it’s a flawed explanation. If supply constraints and their loosening were the key drivers of inflation, we would expect pandemic driven inflation to be followed by outright deflation as the economy reopened and returned to normal. That clearly hasn’t happened, and inflation remains stubbornly high.

Instead, we believe monetary policy played the key role. The M2 measure of the money supply soared 41% in 2020-21, the fastest since World War II. This measure of the money supply then declined 3.2% in 2022-23, the largest two-year drop since the Great Depression. These swings in M2, the relative sizes of the swings (larger up than down), and the long lags between shifts in M2 and inflation do a much better job explaining the inflation pattern of the past few years.

The problem with this theory of “monetary dominance” is that classical liberals like Milton Friedman and the Austrians would expect economic growth to take a hit before inflation were brought back down to normal. And yet Real GDP grew 3.1% in 2023, which is above the 2.0% long-term trend.

So what gives? Our belief is that the US injected so much money, so rapidly, that the economy couldn’t absorb it instantaneously. So, now, what we have seen is that even though M2 has declined, we still haven’t absorbed all the money that was added. Some call it excess savings, we call it excess M2.

But the US has finally absorbed the excess money, and fiscal stimulus is waning as well. And guess what? Recent reports for January show an economy that may be weakening faster than most investors realize. Retail sales fell 0.8% for the month and have declined in three of the past four months. Manufacturing production fell 0.5% in January and manufacturing excluding the auto sector (the auto sector is volatile) has declined four months in a row.

Meanwhile, home building got hammered in January, with both housing starts (-14.8%) and completions (-8.1%) dropping sharply. It’s possible that colder than normal January temperatures were a factor, as well as unusually high precipitation, but the drop in starts was in every major region of the country, the drop in completions happened in most regions (except for the West), and while weather was bad, quantitative measures of national heating requirements were not unusually high in January.

We’ve had bad weather before – and apocalyptic weather reports are clearly clickbait for some in the news media – but housing starts in January were the second lowest for any month since mid-2020, during the onset of COVID when lockdowns still prevailed in much of the country. In other words, we see these data potentially signaling broader economic weakness, consistent with the drop in retail sales and decline in manufacturing production in January.

And yet inflation was also a problem in January, with both consumer and producer prices rising 0.3%, faster than the consensus expected and inconsistent with the Federal Reserve’s 2.0% target inflation.

A weakening US economy with inflation remaining (temporarily) stubbornly high would be consistent with the monetary dominance story of inflation’s rise and fall and would also be a problem for the stock market. Using our Capitalized Profits Model, with a 10-year Treasury yield at about 4.25%, economy-wide corporate profits would need to rise 30%+ to justify an S&P 500 at 5,000. But there’s no way profits (ex-Fed), which are already high relative to GDP would surge that much higher in a soft economy. The current consensus puts profit growth at roughly 10% this year.

Time will tell if the weakness in January becomes more widespread. On the surface, the job market still looks fine, with payrolls up more than 300,000 in both December and January. But the labor market can be a lagging indicator.

Unprecedented policies during COVID have created noise in the data. But underneath it all, we still believe Milton Friedman had it right. A decline in money will lead to recession, and then a decline in inflation.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

CBO’s Rosy Scenario

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

February 12, 2024

Last week the Congressional Budget Office set out new projections for budget deficits and debt in the decade ahead, and they weren’t quite as bad as they looked last year. The CBO now projects a deficit of 6.4% of GDP in 2033 versus a prior forecast of 7.3%. Total accumulated debt by 2033 is now forecasted to be 114% of GDP versus 119%. None of this is “good” news – deficits and debt would still be too high – but it is “less bad.”

The problem is that the CBO’s assumptions are way too rosy. In particular, it assumes the end of many of the tax cuts enacted in 2017 without any negative effects on the economy. Fat chance! More likely, growth would slow and revenue would come in low, meaning bigger budget deficits.

But it will also be tough to hit the CBO’s revenue projections if we keep the 2017 tax cuts fully in place. The CBO is forecasting “real” (inflation-adjusted) economic growth of about 2.0% per year, on average for the decade ahead, the same growth we’ve experienced since the end of 2000 (before the 2001 recession) and since the end of 2019 (the business cycle peak prior to COVID). If we tax that economy at lower rates than CBO projects it’ll yield less revenue than CBO projects, as well.

The bottom line is that no matter what candidates say this year on the campaign trails in their races for the White House, Senate, and House, both parties are going to have to find ways to limit deficits in the years ahead. If we get a GOP sweep – which we believe would result in a continuation of the 2017 tax cuts (and on which we put 35% odds, up from 30% last November) – we expect measures to fight the deficit to include curbs on “green energy” subsidies, more tariffs, and Medicaid reform.

If the Democrats sweep (20% odds) then we think a wide range of tax hikes will be on the table, including raising the top income tax rate (now 37%) back to 39.6%, raising the top longterm capital gains and dividends tax rates (now 20%) to at least 24%, reducing estate tax exemptions, raising the standard corporate tax rate (now 21%) to 35%, and possibly introducing a carbon tax, which the Clinton Administration very briefly considered in 1993. Back then, both Senators from Nebraska were Democrats, which helped keep President Clinton away from a carbon tax; now the Democrats get very little support from energy-intensive states.

But in a world where the current House majority is razor thin and some election maps are still being redrawn, it shouldn’t shock anyone if we end up with “mixed government” in 2025- 26, with the GOP holding at least one of the White House, Senate, and House, and the Democrats holding at least one, as well. We’d put the odds on that at about 40-45%, at present.

With mixed government, expect some brutal political fights. Does anyone think a Speaker Hakeem Jeffries would simply rollover for a Republican president and accept a full extension of the 2017 tax cuts, or anything close? Why wouldn’t a Republican president test the Supreme Court by “impounding” (refusing to spend) money appropriated by Congress, which hasn’t happened since the early 1970s? The bottom line is that for all the fighting, mixed government scenarios would likely generate no entitlement reforms and little deficit reduction, leaving plenty of time for the bond vigilantes to sharpen their knives.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.