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Weekly Commentary by Dr. Scott Brown

The road back, and ahead
January 26 – January 30

The U.S. economy data are likely to be mixed in the near term, but there is little doubt that we are gathering steam. The plunge in gasoline prices is an enormous tailwind. However, this isn’t just an energy story. The fundamentals are getting better.

This wasn’t your father’s recession we went through in 2008-2009. It was your grandfather’s depression. Policymakers made all the wrong choices in the Great Depression, but this time they got it mostly right. That doesn’t mean that everything turned out okay. Rather, policy efforts minimized the downside. The recovery process was bound to take a long time. That is what happens following a major financial crisis.

The Chicago Fed’s National Activity Index is a composite of 85 economic indicators, which can be divided into four broad categories. One of these categories, personal consumption and housing, has lagged in the recovery process. That reflects the aftermath of the housing bubble collapse. Importantly, housing has become much less of a drag on the overall economy.

The recession can also be characterized as a deleveraging of the financial system. Outside of the financial sector, levels of business debt, often a magnifying factor in economic downturns, were relatively mild. Cash flows were strong ahead of the recession and debt burdens were easily manageable. Most of the leverage was in the financial sector. As the financial crisis expanded, financial deleveraging fed through adversely to the real economy. Note that financial sector deleveraging was largely offset by an increase in government borrowing. As the federal budget deficit rose to 10% of GDP, national borrowing actually declined a bit. The Fed’s Flow of Funds data now suggests that credit conditions have improved – and with moderate loan growth, you get moderate economic growth.

One of the most disturbing developments in the fall of 2008 was banks cutting lines of credit to small businesses – not just reducing credit lines, cutting them completely! During the financial crisis, large firms were soon able to borrow from the big banks or raise money in the bond market. Not so for smaller firms. Bank credit to consumers and small businesses is still relatively tight, but it is gradually getting easier. That’s important, as small and medium-size firms account for much of the job growth in an economic expansion.

Yet, small firms with good credit have been reluctant to expand in recent years. These firms are unlikely to hire more workers or add to capital until they see evidence of a sustained increase in the demand for the goods and services they produce. We may have now reached that phase. In 2014, nonfarm payrolls posted the largest gain in this century. Hiring at smaller firms appears to have been a big part of that.

The drop in gasoline prices is expected to provide important support for consumers and small businesses in 2015. It’s estimated that the typical household will save an average of about $750 this year on gasoline expenditures. For the middle class, this extra cash is very likely to be spent, and that spending is someone else’s income (in other words, there will be a significant multiplier effect). Businesses will save on lower transportation costs and lower commodity prices.

So how long can a strengthening U.S. economy go on? Measuring the precise amount of slack is difficult. However, despite the strong job growth in 2014, many labor market measures suggest that there is still a large amount remaining. That means that the economy can grow above trend (which may be seen as somewhere between 2.0 to 2.5%, reflecting about 1% labor growth plus 1.0% to 1.5% productivity growth). We could easily grow at 3% per year for two or three years without generating much upward pressure on wages and prices. The Fed can still be expected to begin raising rates later this year, but only to begin a long, gradual trudge toward normal, not to take away the punchbowl as the party gets going.

Deflation, low inflation, and monetary policy
January 19 – January 23

Central bank policymakers fear deflation more than anything. However, there is good deflation and there is bad deflation. Yet, even low inflation can create problems for an economy. Low inflation is expected to be a key factor in the ECB’s decision to embark on quantitative easing and ought to have some influence on the timing of the Fed’s initial rate hike.

Deflation, a negative inflation rate or a general decline in the overall price level, is a scary prospect for monetary policymakers. Consumers will have little incentive to spend, as prices will be expected to fall the next month. Business will have little incentive to make capital expenditures, since they are less likely to realize a return on that investment. Debt becomes much more burdensome, as borrowers end up paying off the debt with dollars that are worth more. Yet, Japan’s experience with deflation is that it need not be the death spiral that theory would suggest. During Ben Bernanke’s tenure, first as Fed governor, then as chairman, the Fed went from “making sure it doesn’t happen here” to being relatively complacent.

There are different types of deflation. Lower prices that are due to rapid productivity growth or falling commodity prices are nothing to fear (for example, falling gasoline prices make it easier to service debt). Deflation caused by weak demand is what we fear. It is due to slack in the economy and represents an underutilization of resources.

There’s nothing magical about 0% inflation. Extended periods of low inflation can also cause problems. In the first half of 2014, The Federal Open Market Committee noted in its policy statements that “the Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, and it is monitoring inflation developments carefully for evidence that inflation will move back toward its objective over the medium term.”

The Fed’s concern about low inflation seemed to disappear in the second half of 2014, as this phrase did not show up in the policy statement. That partly reflects confidence that economic slack is being taken up and the belief that inflation will eventually move toward the Fed’s 2% goal. That outlook is largely based on the trajectory of the job market. On balance, the labor market data indicate improved momentum. In 2014, private-sector payrolls posted their largest gain since 1997, supported by hiring by small and medium-sized firms. Bank credit for these firms is still relatively tight, but has been gradually getting easier and optimism is on the rise. However, many labor market indicators, including lackluster growth in average hourly earnings, suggest that there is still ample slack.

The U.S. picture is a contrast to that of the euro area, which appears to face a more immediate threat of deflation, but as previously noted, even low inflation can create problems. With short-term interest rates at zero, quantitative easing is the only game in town for the ECB. This isn’t an easy decision. Some members of the Governing Council will be strongly opposed. However, the risks of not doing QE are greater. QE should put more downward pressure on the euro, which will help exporters, but it should also boost inflation somewhat.

For the Federal Reserve, lower oil prices are a blessing. It’s not the type of deflation that officials should worry about. It ought to support economic growth, which will eventually lead to a tightening up of resources. It gets back to the same old questions. How much slack is there in the labor market? How rapidly is that slack likely to be taken up in the months ahead? And will firms be able to pass higher labor costs along (in the form of higher prices)? None of this is currently clear, but the Fed has time to be patient and watch things develop. Officials have noted that they are watching financial market conditions. Unsettled conditions could keep the Fed on hold for a lot longer, but we ought to see market volatility begin to settle down.

The Job Market and the Fed
January 12 – January 16

The December Employment Report presented a mixed job market picture. The establishment survey data reflected strong job growth, but with a lackluster trend in average hourly earnings. The household survey showed a larger-than-expected drop in the unemployment rate, but that was due to a decline in labor force participation. What should Fed policymakers make of this report? Patience, grasshopper, patience ...

Next month, the Bureau of Labor Statistics will release annual benchmark revisions to the payroll survey data. That’s unlikely to alter the recent picture. In September, the BLS indicated that it expects that (based on payroll tax receipts) the March 2014 estimate of payrolls will be lifted by a mere 7,000 (or less than 0.05%). The BLS will also add two lines to the payroll table, the three-month average monthly gains for total and private-sector payrolls. This isn’t a hard calculation. Rather, the BLS will be emphasizing the trend in payroll growth over the monthly change. That’s a good thing. Investors pay way too much attention to the monthly figure, which is noisy and subject to revision. Payrolls averaged a 246,000 monthly gain in 4Q14. The average for private-sector payrolls was +238.000. This is over twice the rate of growth of the working-age population.

Nonfarm payrolls rose by 2.952 million in 2014, the strongest year since 1999. Private-sector payrolls rose by 2.861 million, the best since 1997. The ADP payroll estimate suggests that job gains are being led by small firms, with good strength in medium-size hiring as well. This is what one should naturally expect to see as the economy gathers steam.

The household survey data painted a somewhat different picture. The unemployment rate fell to 5.6% (a level which was once considered to reflect “full employment”). However, the decline was due to a drop in labor force participation. The employment/population ratio, the preferred measure of labor utilization, held steady – up just 0.4 percentage point from a year ago. That suggests that while labor market slack is being taken up, the improvement is very gradual. Progress is more apparent for the key age cohort (those aged 25 to 54), but the ratio remains well below the pre-recession level (which was well short of the peak in the late 1990s).

A month ago, average hourly earnings were reported to have risen 0.4% in November, which led some to declare that more rapid wage growth had finally arrived. Whoops. Average hourly earnings fell 0.2% in December, while the November figure was revised down to +0.2%. Luckily, a drop in the Consumer Price Index will boost real earnings for December. However, the lackluster growth in hourly earnings is one more sign of slack.

Minutes of the December 16-17 Fed policy meeting noted that officials could begin raising short-term interest rates even if inflation remains low (as long as it’s expected to move to the Fed’s 2% goal) and policy will remain very accommodative for a long time after the initial rate hike. At some point, the Fed will simply have to take its foot of the gas. Nevertheless, the risks surrounding the timing of tightening aren’t symmetric.

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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