Fall 2023
The Beacon Outlook: United States
Welcome to The Beacon Outlook
This succinct, quarterly outlook delivers up-to-date analysis of leading indicators driving the national and state economies, including GDP growth, employment, housing and commercial real estate markets, taxable sales, international trade, and more.
HIGHLIGHTS
U.S. Economy Far From A Downturn
2023 data shows that the U.S. economy is actually stronger today than it was a year ago. GDP growth is solid, job growth continues, industrial production remains near record-high levels, profits and wages are rising, and U.S. debt markets are showing little sign of stress.
Still, There Are Headwinds
Despite current strength, Beacon Economics is less optimistic today than we were 12 months ago. The Fed’s excessive $5 trillion in quantitative easing and the 40% jump in the money supply that resulted, created massive government deficits and a large asset bubble. The U.S. economy has weathered rising interest rates over the last year largely because of these imbalances, but they also imply that inflationary pressures are not behind us and more
Limited Interest Rate Stresses
The sharp rise in the cost of capital is causing signs of stress, particularly in the real estate industry. But that stress has not spread to the debt markets as lending institutions continue to have record-low delinquencies.
KEY INDICATORS
U.S. GDP Growth Forecast
According to the Atlanta Fed, GDP growth in the third quarter of this year could come in between 5% and 6%.
Inflation Slowdown
The Personal Consumption Expenditures deflator has slowed from 7% to 3.3% in the last 12 months, and in the last 3 months prices have risen just 2%.
Soaring U.S. Deficit
The Federal deficit is currently $1.8 trillion, double what it was 6 years ago, and the largest deficit ever seen in a full employment economy. The issue? Spending is rising much faster than revenues.
U.S. FORECAST – OUTPUT
U.S. FORECAST – KEY INDICATORS
U.S. FORECAST – INFLATION
We Were Never In The Woods
“None of the post-war expansions died of old age. They were all murdered by the Fed.”
-Rudi Dornbusch, MIT Economist
It has been a little over a year since the forecast community began predicting that the U.S. economy would fall into a recession “within a year.” Of the 60 forecasters who contributed to the October 2022 Wall Street Journal Economic Forecasting Survey, almost one-third said there was a 75% or greater chance of a recession occurring by October 2023, while 4 out of 5 said there was a greater than even chance. A few even put the probability as high as 100%, a level of confidence that is, frankly, inappropriate in economic forecasting. Overall, the average probability in the Journal’s survey has been above 50% for a year now. [1] By the beginning of 2023, the media began to talk about this expectant downturn as if it was fait accompli—it wasn’t ‘if’ but ‘when’ and ‘how bad’.
Beacon Economics never bought into the recession hyperbole, and we never raised our probability above 20% in the Journal’s survey—one of only 2 contributing forecasts to be so optimistic over the past year. That optimism has been largely born out in the data; an even cursory glance at 2023 data shows that the U.S. economy is not only far from a downturn, it’s actually stronger today than it was a year ago. GDP growth over the last year has averaged 2.5% SAAR, buoyed by solid growth in consumer spending. The nation has seen continued job growth, industrial production remains near record-high levels, profits and wages are rising, and U.S. debt markets are showing little sign of stress. This strength is moving into the second half of the year. According to the GDPNow estimate from the Atlanta Fed, growth in the third quarter of this year could come in between 5% and 6%. [2]
Perhaps more telling, our best leading indicators suggest little change in the current trajectory. Manufacturing orders remain high even while inventories for key goods like autos remain low, housing permits and starts have stabilized at non-recession levels, and the job openings rate remains well above normal. Moreover, notwithstanding occasional news stories about rising credit card debt, overall household finances look great and net worth has recovered from last year’s decline. While overall household debt levels are growing slowly, debt burdens remain low and the consumer savings rate has actually started to rise despite a steady growth in spending. Amusingly, news headlines are now gushing about the economy’s “near miss” despite the reality that there was really very little to hit in the first place. We are out of the woods. We can comfortably forecast that the Wall Street Journal’s recession probability estimate will begin to fall over the next year.
This isn’t to say that the U.S. economy hasn’t faced headwinds. In the last two years, rates on the 1-year treasury, the 10-year treasury, and on a 30-year fixed rate mortgage have increased by 5, 3, and 4 percentage points, respectively, the largest increases since the late 1970’s. Albeit the jump back in the 70s went from high to very high, while the current jump in rates went from ultra-low to average – it isn’t the same kind of shock. Regardless, the sharp rise in the cost of capital is causing signs of stress, particularly in the real estate industry where transactions have sharply slowed and prices have been drifting down. But that stress has clearly not spread to the debt markets as lending institutions continue to have record-low delinquencies. This sector is also being partly supported by the health of the general economy, which means leasing activity has been solid outside of the commodity office space.
The stress from rising rates has not spilled into the construction industry either—at least not yet. Amazingly, total construction spending has been trending upwards, and in July 2023 hit a record-high $2 trillion (SAAR)—one-third higher than pre-pandemic, and 7% higher than July 2022. Part of this driver is new housing construction; housing starts have leveled out at 1.4 million amid falling inventories of new homes for sale. While it’s true that some markets may be getting oversaturated by new supply, this is the exception not the rule. The housing vacancy rate is still at record-low levels in the United States… hence, home prices are starting to rise again despite the hike in rates and already steep prices. Even with slowing population growth the nation is indeed very short on housing, testimony to changing lifestyles and rising incomes.
Perhaps more telling, our best leading indicators suggest little change in the current trajectory. Manufacturing orders remain high even while inventories for key goods like autos remain low, housing permits and starts have stabilized at non-recession levels, and the job openings rate remains well above normal. Moreover, notwithstanding occasional news stories about rising credit card debt, overall household finances look great and net worth has recovered from last year’s decline. While overall household debt levels are growing slowly, debt burdens remain low and the consumer savings rate has actually started to rise despite a steady growth in spending. Amusingly, news headlines are now gushing about the economy’s “near miss” despite the reality that there was really very little to hit in the first place. We are out of the woods. We can comfortably forecast that the Wall Street Journal’s recession probability estimate will begin to fall over the next year.
The best news of all has been slowing inflation. The Personal Consumption Expenditures (PCE) deflator has slowed from 7% to 3.3% (yoy) in the last 12 months, and in the last 3 months prices have risen at just a 2% annualized pace. [3] Some of this is due to slowing energy prices—the core rate hasn’t decelerated as much—hence Federal Reserve Chairman Jerome Powell’s ongoing hawkish tone regarding inflation. Regardless, it seems we may have managed the so-called ‘soft landing’—that magical combination of slowing inflation without rising unemployment. We’ve always felt this was a false choice, but either way, it should imply that the Fed can back off its anti-inflation effort and allow interest rates to drift back down.
Unfortunately, Beacon Economics is generally less optimistic today than we were 12 months ago, although we’re still far from calling for a near-term recession. The economy is in good shape, with plenty of momentum. Yet, the Fed’s choice to engage in a highly excessive $5 trillion in quantitative easing in 2020, and the 40% jump in the money supply that resulted, created a number of unsustainable imbalances in the economy—namely massive government deficits and a large asset bubble. The U.S. economy has weathered rising interest rates over the last year so well largely because of these imbalances, but they also imply that inflationary pressures are not fully behind us. And that implies more Fed tightening ahead. The bigger question, however, is how these imbalances will eventually work their way out of the system and what sort of headwinds they might create in the process.
In the short term, we are primarily worried about the Federal Reserve’s tightening activity (discussed at length in the next section). The key is that inflationary pressures remain. Tight labor markets, frothy asset markets, rising net worth, government deficit spending, and lots of free cash all imply that consumer demand will remain strong and prices will likely continue to rise at a faster pace than the Fed’s target of 2%. Consider the simple fact that households are sitting on $4 trillion in checkable deposits, 4 times the pre-pandemic level. That’s a lot of Taylor Swift tickets. All this implies that the Fed will continue its quixotic efforts to stem inflation, despite inflation being a non-problem that is fading on its own. The net result will be significantly higher longer term interest rates, along with a tightening of credit availability. The impact on asset markets and the Federal deficit could be profound depending on how far the Fed pushes it.
The Federal deficit is currently $1.8 trillion annually, double what it was 6 years ago, and the largest deficit ever seen in a full employment economy. This is on top of debt levels that have risen from $24 trillion to $32 trillion in 3 short years. The issue is spending, which has been rising much faster than revenues. This includes more spending on entitlements, defense, and new transfers to the states. Rising interest rates are adding to the problem, with interest payments increasing from less than $600 billion per year in 2019 to what will be over $1 trillion this year.
This unsustainable fiscal gap is being hidden behind loud but insincere fights over the debt ceiling, as neither party has a realistic plan to close the gap. How long can it go on? We’d rather not find out, but at some point Congress will need to face up to the problem. State and local governments are also seeing weaker revenue growth and will inevitably face declines in Federal subsidies. California, for example, will be confronting multiple years of budget deficits that will necessitate local belt tightening.
We are also worried about the ongoing and excessive exuberance of our asset markets. Asset prices rose dramatically in 2021 as excess household cash was pumped into the markets. The Fed’s $5 trillion in quantitative easing turned into $35 trillion in new household net worth. Asset prices have remained resilient in the face of rapid interest rate increases and, overall, are higher now than they were before the hikes began. While this may feel like good news, these wealth levels are not realistic when compared to the potential returns of the underlying assets—as a look at the recent numbers from the flow of funds suggests. Household net worth to GDP ratios (a rough estimate of a P/E ratio for the nation) are still far above normal. Consider what this means at a more disaggregated level. Current home prices don’t make sense relative to rising interest rates; affordability is at a record low. The P/E ratio for the stock market also makes no sense, with Shiller’s estimate currently running at 32. And cap rates on commercial properties remain remarkably low.
Asset prices have shown an amazing unwillingness to fall in the face of rising interest rates as economic theory suggests they should… but fall they must. If the declines occur explosively, it could cause a recession. On the other hand, if they do manage to stay elevated, then we will likely start to see dangerous trends in terms of over consumption by consumers and rising debt levels. So, pick your poison, falling asset values now or dangerous economic trends later.
Add it up and we see few risks of a slowdown in the short term. But our hot economy is being propelled by a dangerous web of deficit driven government stimulus, frothy asset prices, and piles of new cash generated by the Fed’s excessive stimulative efforts during the pandemic. Moreover, the Fed, despite being the original creator of this web, is now trying to snip the strands holding it all together in a bid to cool inflation. If they snip enough, our current prosperity could rapidly start to look very different.
[1] A review of nearly two decades of results from the WSJ’s Economic Forecasting Survey shows that there were only two other times when this average probability rose above 40%, in January 2008 and March 2020. Notably, these were the months after the starts of the Great Recession and Pandemic Recession, respectively. In other words, the forecast community tends to predict recessions after they have already begun, although to be fair, these official start dates are determined retroactively by the National Bureau of Economic Research. One could say that forecasters have been good at ‘current casting’. Perhaps this, along with a general preference for bad news, is why many in the media began to treat a coming recession as fait accompli at the start of 2023.
[2] https://www.atlantafed.org/cqer/research/gdpnow
[3] These numbers come from the correct, albeit less dramatic, PCE deflator. The Consumer Price Index, on the other hand, is a poor measure, and the Fed doesn’t look at it.
Indiana Powell and the Inflation Crusade
While inflation has clearly slowed, much of the deceleration is due to temporary factors such as the decline in energy costs—costs that are again starting to climb. While we doubt inflation will drop below the Fed’s target level, we also don’t expect it to rise above the 4% mark, perhaps sitting in the mid 3’s, simply because prices are close to where they need to be given the Fed generated surge in the money supply. Nevertheless, the fact that the rate of inflation is greater than 2% suggests that the Fed will likely continue to tighten. Consider recent quotes from Chairman Powell: “[a]lthough inflation has moved down from its peak … it remains too high,” he stated at Jackson Hole, assuring the audience that the Fed would raise rates again to achieve its target rate.[4] He also noted that the Fed has no intention of increasing its target rate.
This may just be tough talk to try and spook the current frothy rally in the financial markets. But whether or not the Fed follows through on the increase in the funds rate, they are still continuing their quantitative tightening efforts. The Fed’s balance sheet is falling by $100 billion per month and their assets have fallen almost a full $1 trillion to date. As we have noted in past outlooks, this decline is having an immediate impact on bank deposits; the overall deposit base in the United States has fallen by $1 trillion. This is creating a whole new credit crisis, despite still record-low delinquencies in outstanding bank loans.
One impact of credit tightening is the increase in long run interest rates; both the 10-year treasury and mortgage rates recently hit a two-decade high. Banks are also increasing their standards, according to data from the Senior Loan Officer Survey, even as growth in outstanding bank loans has largely ground to a halt. At the current pace, we foresee mortgage rates getting into the 8% to 9% range by the end of the year. The slowdown in lending will cause another, likely worse, swoon in the otherwise stabilizing real estate space. Meanwhile, the same pressures that sunk two San Francisco Bay Area banks earlier this year are starting to build. We are liable to see more bank failures in the months ahead. If the Fed pushes it far enough, they may well prove the pessimists right in terms of their recession prediction, even if they were early on the call.
The real mystery is why? Why would the Fed force their anti-inflation crusade to the point of potentially murdering this adolescent expansion? The narrative being plugged by Chairman Powell is that he must put out the inflation fire before it gets out of control… and this is surely worth the cost of higher rates and the probability of causing a mild recession right now. The cure may be painful, Powell is saying, but trust us, it is worth it.
Yet, as with so many of the narratives about the current bout of inflation, Beacon Economics finds little evidence to support this conclusion. The question we should be asking is what, exactly, is this Fed policy curing? By all the measures we’ve seen and shown here, inflation has done little harm to the U.S. economy over the past few years. In fact, inflation has seemingly created a strong enough surge in economic activity that the economy has managed to overcome the Fed’s best efforts to ruin the fun by raising rates so dramatically. This shouldn’t suggest that some individuals and families are not being stung by rising rates but bear in mind that the U.S. poverty rate was 11.5% in 2022, according to the U.S. Census. The only time the official rate was lower was in 2019 and 2000. For every family falling behind there is more than one other getting ahead.
This isn’t too surprising. After all, a bout of inflation is not always bad—as we learned from John Maynard Keynes a long time ago in his espousal of the use of monetary policy to stimulate a moribund economy. Eventually the value of this boost fades away, leading to Milton Friedman’s worries about the long run impact of inflation on investment and inequality. But this is not a concern today due to the slowdown in price growth and given that money supply is back in line with the size of the economy. The Fed may have inadvertently done a great thing with their short burst of M2 growth. Unfortunately, their policy now is to blow that legacy up by trying to cure a problem that doesn’t exist.
All of this stems from the oddest narrative—the confusion shown by Fed leadership as to why we have experienced inflation over the last few years. Consider this quote from Chairman Powell from 2022: “If the public expects that inflation will remain low and stable over time, then, absent major shocks, it likely will… unfortunately, the same is true of expectations of high and volatile inflation.”[5] In other words, Powell appears to think that inflation is really just a function of inflation expectations. Putting aside the emptiness of such a theory (where do we start?), it also fails miserably in the data. Inflation expectations are a horrible leading indicator of inflation. In fact, the data suggests the opposite, that expectations are driven by inflation.
We might knock Chairman Powell for this odd theory, but to be fair, plenty of other economists have even sillier ideas. Esteemed macroeconomist and Treasury Secretary Janet Yellen was initially telling us that inflation was due to supply chain disruptions—but she can’t explain why clearing the supply issues hasn’t brought prices back down. Lawrence Summers, the famous Harvard economist and regular on the DC policy circuit, has blamed inflation on President Biden’s budget deficit, despite former President Trump’s deficits having little impact on price growth prior to the pandemic. In a recent op-ed in the Washington Post he discusses at length the factors that worry him about inflation—without ever once mentioning money supply.[6] Mohamed El-Erian, the famed Pimco economist, blames the Fed for keeping rates too low too long, despite a near decade of record-low rates pre-pandemic without inflation showing up. The New York Times columnist and Nobel prize winning economist Paul Krugman has been open about his having predicted no inflation at all.
All these theories from leading economists and policymakers beg one key question—what about the 50% expansion in M2 caused by the Fed’s massive quantitative easing effort? The theories seem to ignore that $5 trillion elephant in the room. Why? Friedman famously quipped, “inflation is always and everywhere a monetary phenomenon,” meaning that everything else amounts to second order effects. Friedman’s data and theory-driven wisdom on prices and price levels have seemingly been forgotten, or at least ignored, in today’s conversation. One issue is that money supply and inflation are difficult to fully correlate in our models on price levels, but this was predicted by Friedman when he said that monetary shocks ripple through prices with “long and variable” lags. In short, this is an empirical problem driven by our poor measures of prices and money, combined with the fact that the relationship between price and money is situation dependent. But we know this is how it works in the long run, ergo, we cannot just throw out the model. This is the tragedy of modern econometrics.
What does this mean for Beacon Economics’ inflation outlook? A glance at the unit money supply is a good indicator of where inflation is heading. This metric—M2 divided by nominal GDP—is an accurate measure of how much excess cash there is in the economy. Too much cash means a relatively high unit money supply, and hence inflationary pressures.[7] The power of this metric can be seen in the 1970s when rapid increases in money supply meant rapid increases in nominal GDP—this was price inflation, not real growth. The unit money supply metric also drifts over time for unclear reasons. After remaining steady up until the early 1990s, the non-inflationary ratio of M2 to nominal GDP has been increasing. But if we are to take this current trend as an estimate of the stable relationship between money and prices, then the pre-pandemic era can be thought of as one that was short on money. Fed policy was excessively tight, and that may well explain the slow growth during those years. The pandemic stimulus went too far with the fix, hence the burst of inflation and surge in economic activity. Today, prices and money seem to be back on trend, suggesting the inflation problem is solved.
In other words, there shouldn’t be any confusion about why we have inflation. Nor should there be much worry about the path inflation will now take given that the money supply seems back in line with the size of the nominal economy. Why isn’t this obvious answer the centerpiece of our money supply policy? That is a whole separate lecture involving political science and the tragedy of academic economics. In the meantime, we can expect Fed policy to continue to pursue the wrong goals and create more economic turbulence than it will solve.
[4] https://www.cnbc.com/2023/08/25/fed-chair-powell-calls-inflation-too-high-and-warns-that-we-are-prepared-to-raise-rates-further.html
[5] https://www.thestreet.com/personal-finance/jerome-powell-quotes
[6] https://www.washingtonpost.com/opinions/2023/08/24/federal-reserve-jerome-powell-inflation/
[7] It also happens to the 1 / velocity, but this is misleading, since money markets don’t necessarily clear immediately. The estimate of velocity is different from the theoretical idea of it.
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