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Weekly Commentary by Dr. Scott Brown

Income Inequality and Fed Policy
October 27 – October 31

“The extent of and continuing increase in inequality in the United States greatly concern me ... It is no secret that the past few decades of widening inequality can be summed up as significant income and wealth gains for those at the very top and stagnant living standards for the majority. I think it is appropriate to ask whether this trend is compatible with values rooted in our nation's history, among them the high value Americans have traditionally placed on equality of opportunity.”

– Janet Yellen, October 17

Income inequality has been an important topic this year, but it is one that is mired in politics. That means it is a potentially treacherous debate for the Federal Reserve chair to wade into. To be fair, Yellen said that the purpose of her recent talk on income inequality and opportunity was “not to provide answers to these contentious questions, but rather to provide a factual basis for further discussion.” She provided a mountain of evidence from the Fed’s triennial Survey of Consumer Finances, and then got out of the way, as appropriate.

However, what she didn’t say was even more important. Income inequality has begun to play a larger role in the economic outlook and will likely be increasingly incorporated (albeit indirectly) into the Fed policy outlook. Before she became Fed chair, Yellen was known to place considerable weight on the labor market. This emphasis has only increased since she took the helm. That does not mean that she is willing to sacrifice the Fed’s commitment to low inflation. It does mean that she will pay greater attention to the interactions between the job market and inflation in setting monetary policy.

While many short-term gauges of the job market (weekly jobless claims, the percentage pf people unemployed for a half a year or less) are trending at levels that one would normally associate with an economy that has fully hit its stride, other measures continue to suggest that an ample amount of slack remains. Views regarding how much slack are the key difference among policy monetary policy makers.

One of the key indicators of slack is the lack of real wage growth. Job growth is a key element of economic growth. However, average wages have struggled to keep pace with inflation, which means that most of the gains in consumer spending have come from added jobs rather than improvement in average wages (although wealth and borrowing have some impact on spending). The lackluster trend in average wages has also been a factor in income inequality. The share of national income going to profits is up; the share going toward labor compensation is down. Theoretically, this should take care of itself as the economy improves and the labor market tightens, but we may not see that happen for some time.

In its large scale model of the economy, the Federal Reserve sees inflation as a function of inflation expectations, the slack in the job market, and oil prices. Inflation expectations are a measure of inertia and market indicators suggest that they remain well-anchored. Oil is different from other commodities. Oil price increases show up quickly at the pump (declines show through more slowly). Goods have to be shipped. Offices have to be heated or cooled. However, the slack in the job market is seen as the more significant factor. The labor market is the widest channel for inflation pressure. As the job market tightens, wages should be bid up at a faster pace and firms ought to be able to pass some of that added cost along. However, the Fed’s economic model is only one factor in setting monetary policy. Officials will incorporate a lot more judgment.

The recent decline in oil and gasoline prices should factor into the Fed’s policy decisions, but it’s unclear how much and in what direction. Lower gasoline prices will add to consumer purchasing power, but it depends on the magnitude of the decline and how long prices stay low. There may be a small benefit to the consumer during the important holiday shopping season, but we’re likely to see a bigger impact in the early part of 2015 (provided gasoline prices continue to fall). Since consumer spending accounts for 70% of the economy, lower oil prices ought to help boost GDP growth in early 2015 and job growth should be higher than it would be otherwise. Hence, more labor market slack will be taken up.

On the other hand, lower oil and gasoline prices will put downward pressure on consumer price inflation, which has already been trending below the Fed’s comfort range. It is real (that is, inflation-adjusted) interest rates that matter. So, all else equal, lower inflation implies higher real interest rates. The lower inflation outlook should delay the timing of the Fed’s initial increase in short-term interest rates.

Yellen and other senior Fed officials have indicated that they are willing to tolerate some pickup in average wages. However, any meaningful increase in average wages is not expected until the labor market tightens a lot more. Clearly, there are many uncertainties ahead. Fed policy will depend on how the economic outlook evolves over the next several months.

After introducing the Fed’s data on income inequality, Chair Yellen was right to step away from the discussion. However, she did address something that just about everyone can agree with – that is, that all Americans should have the opportunity to succeed. One major concern is that the increased level of income inequality is contributing to a decrease in opportunity. Yellen cited support for early childhood education, access to higher education, and greater business formation as important “building blocks” for economic opportunity.

Risk and Uncertainty, Confidence and Fear
October 20 – October 24

In recent weeks, the financial markets appear to have been reacting less to weaker expectations of global growth and more to the increased downside risks – that is, to the fear that things could get a lot worse. The downside risks to Europe are considerable, but America is much less dependent on exports than most other countries and the prospects for moderately strong growth into 2015 remain promising.

Students of forecasting learn that there are two parts to any projection. There’s the point estimate, the expected value at a certain point in the future, and there’s the uncertainty around that point forecast. In economics, that forecast uncertainty is often embarrassingly high and usually isn’t symmetric (meaning that downside risks could be a lot different than upside risks). That doesn’t mean that forecasting the economy is a useless effort. It’s just that one should take such forecasts with a grain of salt. It’s far more important to develop a consistent story and look for ways that the story could go wrong.

Similarly, investors typically face a given set of expectations, while the risks surrounding those expectations can be quite substantial and may increase or decrease over time. Recently, the IMF lowered its outlook for global growth in 2014 and 2015. That should have surprised no one. What has been troublesome for the financial markets is that the downside risks to that outlook have increased. Europe has faced important challenges over the last few years, but the current phase, as it battles the threat of deflation, is expected to be more difficult. Inflation is low in the euro area and the European Central Bank’s policy rates are near zero (and in the case of the rate on the deposit facility, a bit negative). The ECB has to do more, and that means quantitative easing. However, there may be legal challenges.

Europe has been an on-again off-again concern for U.S. investors in recent years, mostly reflecting concerns about the survivability of the monetary union. Those fears were put to bed when ECB President Mario Draghi promised to do “whatever it takes.” Yet, austerity efforts in Europe have been self-defeating and growth has slowed. While the U.S. economy still has a long way to go, we have remained firmly on the recovery track, with few signs of the types of excesses that would lead to an economic downturn. After a while, U.S. market participants have repeatedly put aside their worries about Europe. This recent focus on Europe may not be much different. Worries about Europe could lead U.S. firms to pull back on hiring and capital expenditure plans. However, foreign trade is much less important to the U.S. than it is to other advanced economies. Trouble in the rest of the world may have a significant impact on some U.S. firms, but it’s not expected to have a large effect on the domestic economy as a whole.

One side effect of a soft global economy is a strong U.S. dollar and downward pressure on commodity prices. That should be helpful for consumers. Along the usual seasonal pattern, retail gasoline prices can be expected to fall about 12% from May to December. This year, they’ve fallen about 13% so far, with further declines expected in the weeks ahead. That’s somewhat supportive for the consumer spending outlook, but not enough to boost sales activity sharply for the holiday shopping season. The impact of lower gasoline prices depends on the magnitude of the decline and how long prices remain low.

As Fed Governor Stanley Fischer recently noted, monetary policy, while focused on the outlook for the job market and inflation, must consider what’s happening in the rest of the world and take into account the feedback from abroad in reaction to any policy changes. The downward pressure on inflation is likely to contribute to a delay in the Fed’s initial increase in short-term interest rates. Indeed, most private-sector economists are likely to push out their forecasts of the timing of the first rate hike. Some are suggesting that the Fed may even want to delay the end of QE3 or introduce QE4. That is unlikely. Remember, QE3 was meant to impart positive momentum in the economy, especially in the job market (mission accomplished). Officials believe that asset purchases are less effective over time and potentially more risky. So QE4 isn’t going to happen unless the economy takes a serious turn for the worse, and there’s not much chance of that.

The exaggerated fears of Ebola are a good example of the difficulties in defining downside risks. Your chances of contracting the Ebola virus are extremely low. You are much more likely to die of the flu than Ebola (and, as an aside, you can reduce that risk by getting a flu shot). Yet, Ebola fears played a role in last week’s market volatility. One recent survey showed that 25% of Americans are worried about catching Ebola. If 10% of those people decide not to travel, then you’re talking about a 2.5% reduction in air travel (that’s assuming that the 25% are a representative sample of potential travelers, which is a leap). Granted, this is a crude (and almost certainly wrong) estimate of the impact, but it gives you an idea of how a panic can begin to affect the economy. Most likely, the cable news stations will eventually find something else to worry about.

Friday’s rebound in the stock market was encouraging, but we may still see an elevated level of market volatility in near term. This week’s economic calendar is not going to have much of an impact on the overall picture, but the following two weeks will be a lot more eventful, as we get some indication as to where the U.S. economy is heading in the near term. Mostly, the outlook will remain moderately positive, especially in comparison to the rest of the world. Investor confidence should improve.

Global Worries (And Some Benefits)
October 13 – October 17

In the latest update of its World Economic Outlook, the IMF revised lower its expectations of global growth in 2014 and 2015. None of that should have surprised anyone. At this point, the IMF expects that European GDP will be relatively weak in 2014 (+0.8% 4Q14/4Q13) and should improve in 2015 (+1.6% 4Q15/4Q14). However, risks are weighted predominately to the downside. Weaker European growth and a stronger dollar will have a significant impact on many U.S. firms, but may have some benefits for the economy as a whole.

Global investors have worried a lot about Europe in the last few years. However, the key fear, that we’d see a breakup of the monetary union, was largely put aside when ECB President Mario Draghi promised to “do whatever it takes.” Issues present at the creation of the monetary union had finally come to a point where they had to be addressed. Critics cautioned early on that Europe needed a banking union and a fiscal union to make the monetary union work. European authorities have made progress in recent years, but still have a long way to go.

While Europe’s crisis of the last few years has been called a “sovereign debt crisis,” government debt was not the catalyst for weakness. It’s been a crisis of capital flows. With lower borrowing costs, money poured into the peripheral countries when the euro was introduced (contributing to housing bubbles in Ireland and Spain), then capital started to flow out during the global financial crisis. Many had expected Europe’s difficulties to lead to a flight-to-safety in the U.S. dollar. However, the safety flow went largely to Germany, leaving little impact on the exchange rate. More troublesome, the misdiagnosis of the cause of the crisis led to the bad prescription: austerity.

Government budget deficits and debt levels are important long-term issues. There are well-known concerns about using fiscal stimulus (lower taxes, increased government spending) to boost growth (how big, how to unwind), but what’s clear is that fiscal tightening (higher taxes, reduced government spending) in an economic recovery is a bad idea. It contracts the economy. Growth will be slower than would have occurred otherwise. Moreover, slower economic growth means a slower recovery in tax revenues, and less budget improvement than was anticipated. It’s a self-defeating policy.

Europe is now in a much more precarious phase. Inflation is trending very low. Economists note that it’s real (that is, inflation-adjusted) interest rates that matter. For any given level of interest rates, lower inflation implies a higher real rate of interest – and slower economic growth than you’d see otherwise. The European Central Bank has lowered benchmark interest rates to near zero (and in case of the interest rate on the deposit facility, negative). It can’t go lower.

Saddled with the zero lower bound on interest rates textbook economics (granted, graduate-level textbooks) suggest that the central bank can expand its balance sheet to support economic growth. The ECB is embarking on an asset purchase program, but this is more akin to the Fed’s TALF, the Term Asset-Backed Securities Loan Facility (from March 2009 to June 2010). The central bank receives asset-backed securities and gives the banks cash, which they will use to make more loans (or at least, that’s the theory). This is different from outright quantitative easing, but has similar economic effects in the short-run. The ECB is widely expected to undertake real quantitative easing (the outright purchases of sovereign debt) in the months ahead (at the clear objections of the Germans).

Whether the ECB’s efforts to spur growth will work soon enough is an open question. The key point for financial market participants is not that Europe’s economy will necessarily fall apart, but that the downside risks are considerable. Weak European growth will have a negative impact on countries like China, which remain dependent on exports (China may also have to contend with the collapse of a housing bubble).

European weakness will have a significant impact on many U.S. firms, which are expected to see weaker earnings growth from Europe and a loss in the currency translation (due to the stronger dollar). However, while we should see a decline (or at least softer growth) in exports to Europe, that weakness is unlikely to drag the broader economy down.

There may be some parallels with the Asian financial crisis of 2007 (of course, there are many more differences than similarities to the current situation in Europe – just hear me out). In the Asian financial crisis, the hit to U.S. exports subtracted a full percentage point from GDP growth. However, the crisis put downward pressure on inflation and boosted capital inflows, which was far more significant. Similarly, we are now seeing a stronger dollar put downward pressure on commodity prices. Increased capital inflows should help keep long-term interest rates relatively low and the stronger dollar will likely delay the Fed’s first increase in short-term rates.

Gasoline prices have drifted lower in recent months, but not enough for a sharp boost in consumer spending (note that gasoline prices normally fall about 12% from May to December, and have fallen about 10% so far this year). However, gasoline prices are likely to fall faster in the near term and a further decline (to below $3 per gallon) would add more significantly to consumer purchasing power into early 2015.

The Asian financial crisis had a negative impact on the U.S. stock market, but that turned out to be a great buying opportunity. We may see some imbalances develop (a wider trade deficit), but the U.S. may benefit from Europe’s weakness.

The opinions offered by Dr. Brown should be considered a part of your overall decision-making process. For more information about this report – to discuss how this outlook may affect your personal situation and/or to learn how this insight may be incorporated into your investment strategy – please contact your financial advisor or use the convenient Office Locator to find our office(s) nearest you today.

All expressions of opinion reflect the judgment of the Research Department of Raymond James & Associates (RJA) at this date and are subject to change. Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete. Other departments of RJA may have information which is not available to the Research Department about companies mentioned in this report. RJA or its affiliates may execute transactions in the securities mentioned in this report which may not be consistent with the report's conclusions. RJA may perform investment banking or other services for, or solicit investment banking business from, any company mentioned in this report. For institutional clients of the European Economic Area (EEA): This document (and any attachments or exhibits hereto) is intended only for EEA Institutional Clients or others to whom it may lawfully be submitted. There is no assurance that any of the trends mentioned will continue in the future. Past performance is not indicative of future results.

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