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   Brian Wesbury
Chief Economist
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Deputy Chief Economist
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  Time for a Rate Hike
Posted Under: CPI • Employment • Government • Inflation • Markets • Monday Morning Outlook • Fed Reserve • Interest Rates • Bonds

According to the futures market, there is a 38% chance the Federal Reserve raises rates when it meets in mid-March.  If the Fed were to stand by what it has said the past several years, the odds should be much higher.  But the market is used to the Fed finding reasons to put off justified rate hikes.

The Fed has consistently said it wants to see the inflation measure for Personal Consumption Expenditures (also called the PCE deflator) at 2%. We won't get an official PCE number for January until the middle of next week, but based on January's 0.6% increase in the consumer price index (CPI), it looks like the PCE index will be up 0.4% in January and 1.9% compared to a year ago.  And if that's not close enough, all we need in February is a mere 0.1% monthly increase and the PCE will be over the 2% mark.

Meanwhile, the jobless rate is already 4.8%, exactly the level the consensus at the Fed thinks is the long-run average when the economy is neither "too hot" nor "too cold."

And yet the Fed's short-term interest rate target remains in a range between 0.5% and 0.75%.  That's simply too low.  Under normal conditions the Fed's target for short-term rates should be a little lower than the trend growth in nominal GDP – real GDP plus inflation.  But in the past year nominal GDP is up 3.5% and it's up at a 3.2% annual rate in the past two years.

A gap that large between the trend growth in nominal GDP and short-term rates means there is excess liquidity in the financial system and monetary policy is too loose.  No wonder inflation has been heading up and the jobless rate continues to trend down.

Moreover, the yield curve remains unusually steep, with about 180 basis points separating the yield on the 10-year Treasury Note from the Fed's short-term interest rate target, versus an average of 106 basis points since the mid-1950s.  The bond market has been holding the 10-year to 30-year spread tight, because it believes long-run inflation will be contained, but clearly the market is pricing in higher short-term interest rates.

The signposts for higher inflation are already in place.  In January, the M2 measure of money, which includes currency, checking deposits, savings deposits, small CDs, and retail money funds was up 6.7% from a year ago.  By contrast, it was up only 6.2% in the year ending in January 2016 and 6.0% in the year ending in 2015.  Wage growth has accelerated as well, with average hourly earnings up at a 2.5% annual rate in the past two years, the fastest since the recession ended. 
One argument for waiting past March is that the Fed needs a chance to see what kinds of budget proposals – taxes and spending – are likely later this year.  But we highly doubt anything President Trump and Congress come up with will be viewed by the Fed as "contractionary."  Instead, they're going to push proposals the Fed views through its Keynesian lenses as "stimulative." 

So why wait?  Raising rates in March doesn't pre-commit the Fed to raise rates more than three times this year.  If circumstances change, there's plenty of time for the Fed to change its mind and skip a rate hike in June, or September, or December.  
In addition, raising rates sooner rather than later, gets the Fed closer to dealing with the elephant in the room - its balance sheet.  Quantitative Easing has pushed assets on the Fed's books to more than $4.4 trillion, with over $350 billion in repos and nearly $2 trillion in excess reserves. 

So far, sluggish monetary velocity, including tight regulation of the banking system, has kept a relatively tight lid on the inflationary impact of those reserves.  But, now that the animal spirits are stirring and less burdensome financial regulations are on the way, those reserves pose an increasing inflationary risk.

Fed Chief Yellen's recent congressional testimony left the door open for a rate hike in March.  The economy and markets are ready for the Fed to cross the threshold.                    

Brian S. Wesbury - Chief Economist
Robert Stein, CFA – Deputy Chief Economist

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Posted on Tuesday, February 21, 2017 @ 10:25 AM • Post Link Share: 
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  M2 and C&I Loan Growth
Posted Under: Government • Fed Reserve


Source: St. Louis Federal Reserve FRED Database

Posted on Tuesday, February 21, 2017 @ 7:53 AM • Post Link Share: 
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  Housing Starts Declined 2.6% in January
Posted Under: Home Sales • Home Starts • Housing


Implications:  Housing starts took a breather in January, slipping 2.6%, after a surge in December.  However, we think the general upward trend is still intact.  Multi-family starts, which are very volatile from month to month, dropped 10.2% in January and accounted for all decline.  Meanwhile, single-family starts rose 1.9% in January and are now up 6.2% from a year ago.  Permits to build single-family homes, declined 2.7% in January but are up 11.1% from a year ago, supporting the case for a continued increase in the pace of home building.  Based on population growth and "scrappage," housing starts should eventually rise to about 1.5 million units per year, so much of the recovery in home building is still ahead of us.  In addition, the "mix" of construction has been generally shifting toward single-family building.  When the housing recovery started, multi-family construction led the way.  But the share of all housing starts that are multi-family appears to have peaked in 2015, when 35.7% of all starts were multi-family, the largest since the mid-1980s, when the last wave of Baby Boomers was growing up and moving to cities.  In 2016, the multi-family share of starts fell to 33.3%.  The shift in the mix of homes toward single-family is a positive sign because, on average, each single-family home contributes to GDP about twice the amount of a multi-family unit.  In other recent housing news, the NAHB index, which measures sentiment among home builders, dropped slightly to a still-high 65 in February.  More jobs, faster wage growth, and, for at least the time being, optimism about more market-friendly policies from a Trump Administration, are encouraging both prospective home buyers and builders.  More broadly, new claims for jobless benefits rose 5,000 last week to 239,000.  Continuing claims slipped 3,000 to 2.08 million.  It's still early, but it looks like nonfarm payrolls will be up close to 200,000 in February.  On the manufacturing front, the Philadelphia Fed index, which measures factory sentiment in that region, soared to 43.3 in February from 23.6 in January.  The reading for February was the highest since the early 1980s and signals optimism about a major positive shift in economic policies.

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Posted on Thursday, February 16, 2017 @ 10:24 AM • Post Link Share: 
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  Industrial Production Declined 0.3% in January
Posted Under: Data Watch • Industrial Production - Cap Utilization


Implications:  Industrial production took a breather in January after surging in December.  However, the key to understanding this month's report is in the details, which were much stronger than the headline decline of 0.3%.  Utilities and auto production, which are very volatile from month to month, were large drags on production.  January was unusually warm in the lower-48 states, resulting in lower demand for heat and causing the largest monthly drop in utility output since 2006.  Meanwhile manufacturing, which excludes mining and utilities, rose 0.3% in January despite a 2.9% drop in auto production.  We like to follow "core" industrial production, which is manufacturing excluding autos, and this measure increased 0.5% in January and has been accelerating lately.  Even though this measure is only up a tepid 0.3% in the past year, it's up at a 3.2% annual rate during the past three months.  We think the acceleration in core production is, in part, a lagged effect of the rebound in oil prices, which adds to the production of machinery used in the energy sector.  The rebound in energy prices is also having a direct effect on mining, which jumped 2.8% in January and posted its first positive year-over-year reading since April 2015.  Further, oil and gas-well drilling posted its eighth consecutive gain in January, jumping 8.5%, and is now up at a massive 144% annual rate in the past three months.  Based on other commodity prices, we think oil prices are in the "fair value" range, which should keep mining in recovery after the problems of the past two years.  Although weak overseas economies will continue to be a headwind for production, we expect solid growth in the year ahead.  In other news this morning, the Empire State index, a measure of manufacturing sentiment in New York, surged to +18.7 in February from +6.5 in January, signaling continued improvement in the factory sector.

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Posted on Wednesday, February 15, 2017 @ 11:07 AM • Post Link Share: 
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  Retail Sales Rose 0.4% in January
Posted Under: Data Watch • Retail Sales


Implications:  Could the Plow Horse economy be starting to trot?  Retail sales started off 2017 at a healthy pace, and we hope the Federal Reserve is paying attention.  Sales rose 0.4% on the back of an upwardly revised 1.0% gain in December, coming in much higher than the consensus expected.  Overall retail sales are now up 5.6% in the past year, the best reading since March 2012, and we expect that trend to stick.  Sales are up at a 6.3% annual rate in the past six months and a 6.0% rate in the past three months.  What was most impressive is the gain in January came even though auto sales declined 1.4%.  Excluding autos, retail sales rose 0.8% and are up 5.3% in the past year, also the best year-to-year reading since March 2012.  The gain in sales in January was broad-based with nine of thirteen major categories showing growth.  Although gas station sales rose the most due to higher fuel prices, "core" sales, which exclude autos, building materials, and gas, rose 0.6% in January, the sixth consecutive monthly gain and the 11th gain in the past 12 months.  Core sales are now up 4.3% from a year ago and we expect that trend to accelerate in the year ahead.  Job growth continues, nominal wages gains are accelerating, and consumer debt service obligations are very low by historical standards. 

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Posted on Wednesday, February 15, 2017 @ 10:39 AM • Post Link Share: 
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  The Consumer Price Index Increased 0.6% in January
Posted Under: CPI • Data Watch • Inflation


Implications:  Today's inflation report was a clear sign the Federal Reserve needs to move away from the loose stance of monetary policy or risk falling behind the curve.  Consumer prices jumped 0.6% in January, the largest single-month increase since 2013.  The leap in prices was led by the volatile energy sector, which rose 4% in January and is up 10.8% in the past twelve months.  However, "core" prices, which exclude both food and energy rose 0.3% in January, the largest gain for any month in more than a decade.  Overall, consumer prices are up 2.5% in the past year while core prices are up 2.3%.  Moreover, both the overall CPI and the core CPI have been rising faster in the past six months than in the past twelve months, and even faster in the past three months.  The Fed's favorite measure of inflation is the PCE index.  We have a model that uses the CPI to forecast the PCE and that suggests the PCE index was up 0.4% in January.  If so, it would also be up 1.9% from a year ago, just a hair below the Fed's 2% target and likely to move to that target or above by March.  The worst news in today's report was a 0.5% decline in real average hourly earnings.  Real hourly earnings rose a modest 0.8% in 2016, a slower pace than the 1.8% gain in 2015, but given continued employment gains and a tightening labor market, this should rebound soon.  With inflation heading to the Fed's 2% target and continued strength in the job market, we expect the Fed to raise rates at least three times in 2017, with four hikes a distinct possibility as well.  Fed Chair Janet Yellen told the Senate Banking Committee yesterday that every meeting is "live," and investors should believe her.  The odds of a rate hike in March have risen from a long-shot to over 40% and the data show action is warranted.

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Posted on Wednesday, February 15, 2017 @ 10:18 AM • Post Link Share: 
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  The Producer Price Index Rose 0.6% in January
Posted Under: Data Watch • Inflation • PPI


Implications:  Producer prices rose at the fastest monthly pace in more than four years to start 2017.  And this comes after healthy increases in November and December as well.  Some will point out that energy prices, which rose 4.7% in January and are up 14.0% in the past year, have been a key contributor to the rise in consumer prices in recent months. But even stripping out the volatile food and energy components shows "core" prices accelerating from a 1.2% increase in the past year to a 3.7% annual rate in the past three months.   Goods prices once again led the index higher in January, rising 1.0% on the back of energy prices.  Meanwhile, service prices have shown consistent, if moderate, inflation, rising 0.3% in January.  We expect this trend to continue in the coming months, which will push overall inflation toward, and eventually above, the Fed's 2% inflation target.  The Fed, to no surprise, held off on action at their meeting earlier this month. However, if data continue on the track of today's inflation reading and the consensus-beating January jobs report, the Fed could be pushed to move before the market projected June meeting.  Expect three, if not four, rate hikes in 2017.  In other recent inflation news, import prices rose 0.4% in January and are up 3.7% from a year ago.  Petroleum import prices jumped 5.2% in January following December's 6.8% rise.  While the long decline in energy prices that began in mid-2014 appears to be over, don't be surprised if we see fits and starts on the road higher.  Export prices also rose in January, up 0.1%, and have increased 2.3% in the past year.  The Fed has plenty to watch before they meet again in March, and all eyes will be on the wording of that statement to see if the Fed will risk falling behind the curve.  

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Posted on Tuesday, February 14, 2017 @ 9:36 AM • Post Link Share: 
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  Brian Wesbury Discusses How NAFTA has affected Canada-U.S. trade on Fox Business
Posted Under: Trade • Video • TV • Fox Business
Posted on Monday, February 13, 2017 @ 3:36 PM • Post Link Share: 
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  Keep It Simple, Stupid (KISS)
Posted Under: Government • Monday Morning Outlook • Taxes

The biggest tax debate in Washington right now is not between Republicans and Democrats, but between Republicans and Republicans.  Both sides of the debate seem to understand that the US tax code, particularly the fact that the US has the highest corporate tax rate of any industrialized country, is harming the competitiveness of US companies.

Both sides want to cut this tax rate and both sides want to allow for full and immediate expensing of business investment in plant and equipment.  Both sides also propose to end the deduction for the interest companies pay on their (new) debts.

What they're fighting about is making the US corporate tax system "border adjustable."  Some want to exempt from taxation any income generated by exports, and at the same time, no longer allow US companies to deduct the cost of imports from revenue.  Like a Value-Added Tax (VAT) used in many other countries, the idea would be to promote exports.  Meanwhile, it would create a level playing field between foreign and US companies trying to sell to US consumers. 

Let's say the new tax rate is 20%.  A Napa Valley vineyard could produce a $100 wine and pay $20 in taxes.  Then, after a retailer sells that bottle for $150, the retailer pays a $10 tax on their $50 profit.  Total, the IRS gets $30.  If the retailer buys the $100 bottle from a French vineyard and sells it for the same $150, the retailer now pays the 20% tax rate on the full $150, and so sends the IRS the total tax of $30. 

The retailer's revenues don't change, but its tax payments to the IRS soar while its after-tax profits plummet.  In effect, a border adjustable tax forces US retailers to attempt to extract tax payments from foreign producers or US consumers.  This is why retailers in the US are fighting so hard against it. 

Some say retailers shouldn't care because the value of the dollar will soar as well, reducing the cost of imports.  But, if this is really true, why haven't all the other countries with border adjustments in their VATs been able to take down the dollar?  The theory might work on an academic chalkboard, but the value of the dollar depends on many factors. Betting on a stronger dollar to fix border adjustable tax rate problems is a HUGE gamble.

Don't get us wrong, the US should have lower tax rates.  But why not just do it within the corporate tax system we already have instead of a system that's never been tried before?  Trillions of dollars of decisions have been made based on the tax system we have in place today.    Having the government suddenly change the "rules of the game" will create massive windfall winners and losers that may completely offset any potential positives from a change in the tax code.           

Meanwhile, what if the forecast of a stronger dollar really happens?  Many emerging-market companies borrow in dollars and might find it hard to repay their debts at the same time they find it tougher exporting to the US.  Would the US find itself on the hook for foreign bailouts?  And what about US exporters?  Wouldn't a stronger dollar make it harder for Boeing to sell abroad and compete against Airbus?  Would Boeing then lobby the government for looser monetary policy and a weaker dollar?      

Instead, we need to keep tax reform simple.  Policymakers should focus on cutting tax rates and excessive regulation (to make the US more competitive) and not get distracted by policy changes that will create big (and often arbitrary) windfall winners and losers.

Brian S. Wesbury - Chief Economist
Robert Stein, CFA – Deputy Chief Economist

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Posted on Monday, February 13, 2017 @ 1:19 PM • Post Link Share: 
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  Executive Order and Presidential Memoranda Watch 2/9
Posted Under: Government
Providing an Order of Succession Within the Department of Justice (2/9/17) – Outlines the order of succession for performing the duties of the Attorney General in the event that the Attorney General becomes unable to perform the functions and duties of the office.

Presidential Executive Order on Enforcing Federal Law with Respect to Transnational Criminal Organizations and Preventing International Trafficking (2/9/17) – Prioritizes federal law enforcement focus on international criminal organizations, including cooperation across Federal agencies and with foreign counterparts.

Presidential Executive Order on Preventing Violence Against Federal, State, Tribal, and Local Law Enforcement Officers (2/9/17) – The executive branch will develop strategies to further the protection and safety of law enforcement offices, and the Attorney General is tasked with developing strategies to improve prosecution of crimes related to violence against officers.

Presidential Executive Order on a Task Force on Crime Reduction and Public Safety (2/9/17) – The Attorney General will establish a task force to develop strategies for crime reduction in the U.S., including evaluation of current shortfalls in existing laws and the quality and availability of existing crime related data that can provide information regarding crime trends. The task force will submit a report to the president within one year outlining findings and making recommendations for policies to reduce crime.
Posted on Monday, February 13, 2017 @ 9:05 AM • Post Link Share: 
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These posts were prepared by First Trust Advisors L. P., and reflect the current opinion of the authors. They are based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.
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