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   Brian Wesbury
Chief Economist
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   Bob Stein
Deputy Chief Economist
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  Rate Hikes To Start in 2015
Posted Under: Government • Research Reports • Fed Reserve • Interest Rates

Unlike most meetings, today’s actions by the Federal Reserve were chock full of implications for the future course of monetary policy. At long last, the Fed finally removed the language in its statement that short-term interest rates will remain at essentially zero for a “considerable time” and replaced it with language that the Fed will be “patient” before starting to increase rates.

Several months ago, Fed Chair Janet Yellen let it slip that she thinks a “considerable time” means about six months. As a result, we are increasingly confident in our forecast that the first rate hike will come by June 2015, six months from now.

What’s striking about the rest of the Fed’s policy statement is how focused it is on the labor market, altering the wording of its statement as well as its economic projections slightly here and there to signal its own increased confidence in job creation and declining unemployment.

The obsession with the labor market helps explain why the Fed was willing to look past the recent oil-induced drop in overall inflation. Remember, the Fed doesn’t care as much about where inflation is today as where its own models are projecting inflation to go over the next few years. And while it expects inflation to remain low for the time being, it sees this as temporary and that one of the reasons inflation will rebound is improvement in the labor market. The Fed may be the most ardent advocate of the Keynesian Phillips Curve in the world.

When the Fed starts raising rates it is unlikely to raise rates at every meeting, as was done in the past two prolonged rate hike cycles under Alan Greenspan in the late 1990s and Ben Bernanke in the middle of the prior decade. Yellen cautioned against this view at the press conference following the meeting. In addition, the “dot matrix” showing where policymakers think interest rates will go over the next few years suggests the Fed will, for the first year of rate hikes, alternate between raising short-term rates at one meeting and then pausing at the next, making for one rate hike of 25 basis points per quarter through mid-2016.

The “median” dot may suggest a slightly faster pace of rate hikes, but we’re guessing that, as the leader of the Fed, Yellen will ultimately get her way and she is probably on the dovish side of the dot matrix. With the highest dot being the most hawkish, Yellen is probably around dot number 12, give or take, and that dot shows three rate hikes in 2015 and six in 2016.

Another issue is when the Fed’s balance sheet will go back to normal. We’re still forecasting that the Fed will keep reinvesting principal payments from its asset holdings to maintain the balance sheet at roughly $4.4 trillion through at least late 2015.

Notably, this last meeting for 2014 must have been a contentious one. Three members dissented. Once again, Minneapolis Fed president Narayana Kocherlakota disagreed from the dovish side, saying inflation was too low. The two other dissents were from hawks. Dallas President Richard Fisher thought rate hikes should come earlier and Philadelphia President Charles Plosser thought the statement was too focused on the timing of rate hikes rather than the economic conditions that would generate rate hikes. In addition, Plosser thought the statement was not optimistic enough.

The bottom line is that while the Fed is still behind the curve, it’s at least finally pointed in the right direction, and, barring some major shift in its outlook for the economy, the clock is ticking on rate hikes. Nominal GDP – real GDP growth plus inflation – is up 4.0% in the past year and up at a 3.9% annual rate in the past two years. A federal funds target rate of nearly zero is too low given this growth. It’s also too low given well-tailored policy tools like the Taylor Rule.

In the meantime, hyperinflation is not in the cards; the Fed will keep paying banks enough to keep the money multiplier depressed. But, given loose policy, we expect gradually faster growth in nominal GDP for the next couple of years. In turn, the bull market in equities will continue and the bond market is due for a fall.

Brian S. Wesbury, Chief Economist
Robert Stein, Dep. Chief Economist

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Posted on Wednesday, December 17, 2014 @ 4:25 PM • Post Link Share: 
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  The Consumer Price Index Declined 0.3% in November
Posted Under: CPI • Data Watch • Inflation

Implications: Due to plummeting oil prices, overall consumer prices declined in November at the fastest pace since the Panic back in late 2008. Despite the drop in prices, we still expect the Federal Reserve to remove the “considerable time” language in its statement this afternoon, which is a reference to how long they expect to keep short-term interest rates near zero. In the past, Fed Chief Janet Yellen has said short term movements in overall prices are sometimes little more than “noise,” and we anticipate the Fed will view today’s CPI report the same way. In turn, removing the language from the statement and replacing it with a word like “patient,” means the first rate hike should come in June 2015. Energy prices are the key reason for the “noise” we’ve seen lately in the CPI. They fell for a fifth straight month in November and are down at a 22.7% annual rate over the past three months. Gas is now below $3 per gallon in every one of the lower 48 states. One of the key reasons for the drop in energy prices is America’s booming energy production. (For more on oil, see our Monday Morning Outlook from two days ago.) As a result, consumer prices are up a modest 1.3% in the past year. Given the continued drop in oil prices in the first half of December, look for another tame reading on overall price gains in next month’s report. However, there are sectors where inflation is moving higher. Food and beverage prices are up at a 2.7% annual rate in the past six months and up 3.1% in the past year. So if you only use the supermarket to gauge inflation, we understand thinking the headline reports are too low and that “true” inflation is higher. In addition, housing costs are going up. Owners’ equivalent rent, which makes up about ¼ of the overall CPI, rose 0.2% in November, is up 2.7% in the past year, and will be a key source of any acceleration in inflation in the year ahead. In other words, there is no broad, tight-money-induced deflation out there, but increasing prices remain subdued - for now. One of the best pieces of news in today’s report was that “real” (inflation-adjusted) average hourly earnings rose 0.6% in November. These earnings are up 0.8% from a year ago and should continue to provide a boost to real consumer spending, which we now forecast should grow at a 3%+ annual rate in Q4, consistent with real GDP growth of around 2.5%.

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Posted on Wednesday, December 17, 2014 @ 10:10 AM • Post Link Share: 
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  Housing Starts Declined 1.6% in November
Posted Under: Data Watch • Home Starts • Housing

Implications: Another Plow Horse report on housing. Housing starts fell 1.6% in November but exceeded the 1 million pace for the third consecutive month, the first time since 2008. November’s drop of 1.6% for home building was all due to single-family units, which were down 5.4% in November. To smooth out the monthly volatility we look at the 12-month moving average for overall housing starts, which besides last month, is at the highest level since September 2008. The underlying trend remains upward and we expect that to continue. The total number of homes under construction, (started, but not yet finished) increased 1.2% in November and are up 18.3% versus a year ago. No wonder residential construction jobs are up 123,000 in the past year. Multi-family construction rose 6.7% in November and has taken the clear lead in the housing recovery. Single-family starts have been in a tight range for the past two years, while the trend in multi-family units has been up steeply. In the past year, 35% of all housing starts have been for multi-unit buildings, the most since the mid-1980s, when the last wave of Baby Boomers was leaving college. From a direct GDP perspective, the construction of multi-family homes adds less, per unit, to the economy than single-family homes. However, home building is still a positive for real GDP growth and we expect that trend to continue. Based on population growth and “scrappage,” housing starts will rise to about 1.5 million units per year over the next couple of years. In other housing news, yesterday, the NAHB index, which measures confidence among home builders, declined to 57 in December from 58 in November. Readings greater than 50 mean more respondents said conditions were good. Expect more Plow Horse-like gains in housing in the year ahead.

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Posted on Tuesday, December 16, 2014 @ 11:51 AM • Post Link Share: 
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  Oil Price: Looks Reasonable
Posted Under: Bullish • CPI • Gold • Monday Morning Outlook • Productivity
A former economic colleague, and mentor, used to say: “In the Bible, it says an ounce of gold will buy a fine suit of clothing.” We have read the Bible, and we haven’t found this, although there could be some high-powered math, using talents, cubits, frankincense and myrrh that make it true.

Nonetheless, the point stands – over long periods of time, relative value remains somewhat constant. Gold is trading at $1,210/oz. today and that’s about the cost of a fine suit. There are suits that cost more, and less, but, well, you get the point.

The reason we bring this up, is that the same “relative price relationship” should hold true for other commodities over time. The gold-oil ratio (using West Texas Intermediate crude prices) has averaged 15.8 over the past 30 years – meaning one ounce of gold would buy 15.8 barrels of oil.

In 2005, the ratio reached a low of 6.7; in 1986, it hit a high of 30.1. From 1990-1999 oil prices averaged $19.70/bbl and gold prices averaged $351/oz – a ratio of 17.8. Today, oil is $57/bbl and gold is $1,210/oz., meaning an ounce of gold will buy 21.2 barrels of oil.

In other words, relative to history, either oil is cheap or gold is expensive. Looking at other commodity price relationships, like silver, shows the same thing. One interesting fact is that in the past 30 years, the CPI is up 126%, while oil is up 116%, showing that, right now, with oil prices down almost $50 from their recent peak, oil has risen about the same as a broad basket of consumer goods.

This doesn’t mean that oil prices can’t fall further. After all, markets do what markets do. What it does mean is that the recent collapse in oil prices is not a sign of broad deflation. It is result of a shift in the “oil supply curve” to the right, due to new technologies in energy – horizontal drilling and hydraulic fracturing. Remember, the supply curve slopes upward from the lower left to the upper right. When a new technology increases supply at any price, like the invention of the tractor did with crops, the entire supply curve shifts. When this happens, output rises and prices fall, unless there is a shift in demand.

These days, two things are happening to keep a lid on demand. First, developing economies, like China and Russia are experiencing slower growth. Second, new technologies – like LED lighting, more efficient computer chips and less waste in office buildings, homes and manufacturing – are reducing energy consumption. For example, an iPad uses $1.36 of electricity every year, while a desktop computer uses $30 of electricity per year.

So, a right-ward shift in the supply curve is occurring at the same time demand is falling short of what was previously expected. In other words, the decline in oil prices is due to macro-economic forces, and those forces are mostly good, not bad. As a result, the drop in oil prices is a good sign, not one that indicates economic problems. The drop in stock prices last week, if it was based on the idea that falling oil prices are a negative thing, is temporary.

More importantly, most relative price indicators suggest the oil price decline has gone too far. Using the current price of gold, a barrel of oil is fairly valued near $77. Alternatively, comparing oil to multiple different prices, including a fine suit of clothing, oil is fairly valued somewhere between $55 and $70/bbl.

Bottom line: stocks and oil have fallen too much. Stocks should rebound soon and, barring a collapse in gold, we look for stability and then rising prices for oil in the years ahead.

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Posted on Monday, December 15, 2014 @ 12:26 PM • Post Link Share: 
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  Industrial Production Rose 1.3% in November
Posted Under: Data Watch • Industrial Production - Cap Utilization

Implications: Looks like the Plow Horse is carrying some Christmas gifts! After last week’s report that retail sales were strong, today we got news that industrial production skyrocketed up 1.3% in November, the largest monthly gain since 2010. Auto production and utilities led the way, both up 5.1%. These are two of the most volatile parts of the report. The third is mining, which was down 0.1% (due to a 0.5% drop in oil and gas well drilling). But even stripping out these three volatile sectors and only looking at manufacturing outside of autos, production was up a very robust 0.9% in November and is up 4.6% versus a year ago. In the past 16 months, this key measure has only declined once, and that was last January during the worst of an unusually brutal winter. We expect continued growth in the industrial sector in the year ahead. The housing recovery has further to go and both businesses and consumers are in a financial position to ramp up investment and the consumption of big-ticket items, like appliances. No wonder the production of consumer goods, led by cars, electronics, and energy boomed 2.5% in November, the largest gain since August 1998. As a result of the increases in production, capacity utilization hit 80.1% in November, the highest so far in the recovery and higher than the average of 78.9% in the past twenty years. Further gains in production in the year ahead will push capacity use higher, which means companies will have an increasing incentive to build out plants and equipment. In other news this morning, the Empire State index, a measure of manufacturing sentiment in New York, declined to -3.6 in December versus 10.2 in November. We’re guessing this is a lagged effect of the deep snowfall in some parts of upstate New York and is an outlier relative to the other generally robust manufacturing data. Expect the report to show a solid rebound next month.

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Posted on Monday, December 15, 2014 @ 11:23 AM • Post Link Share: 
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  M2 and C&I Loan Growth
Posted Under: Government • Fed Reserve

Posted on Monday, December 15, 2014 @ 9:32 AM • Post Link Share: 
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  The Producer Price Index (PPI) declined 0.2% in November
Posted Under: Data Watch • PPI

Implications:  Still no sign of inflation in producer prices. After a surprise to the upside in October, producer prices declined 0.2% in November coming in slightly lower than the consensus expected. The decline in overall producer prices was all due to the goods sector, where prices fell 0.7%, primarily due to energy. Energy prices fell 3.1% in November and are down 6.7% in the past three months (-24% at an annual rate), a testament to fracking and horizontal drilling. Although energy prices have dropped further in December and may decline into early 2015, that trend won’t last forever. As a result, our forecast is that the US suffers neither hyperinflation nor deflation for the next few years. Instead, it’s going to be a slow slog upward for inflation. Prices further back in the production pipeline (intermediate demand) show that it will take a while for inflation to move up. Prices for intermediate processed goods are down 0.3% in the past year while prices for unprocessed goods are down 1.7%. Regardless, with the labor market improving rapidly now that extended unemployment benefits are done, the Fed is still on track to start raising rates around the middle of next year. These rate hikes will not hurt the economy; monetary policy will still be loose and will likely remain that way for the first couple of years of higher short-term rates. Counterintuitively, higher short term rates may boost lending as potential borrowers hurry up their plans to avoid even higher interest rates further down the road. In other words, the Plow Horse economy won’t stop when the Fed shifts gears.

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Posted on Friday, December 12, 2014 @ 10:27 AM • Post Link Share: 
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  Retail Sales Increased 0.7% in November
Posted Under: Data Watch • Retail Sales

Implications: This year, Santa is delivering early! The consumer is alive, well, and kicking. Retail sales rose 0.7% in November and 1.1% including upward revisions for September and October. The gain in November beat consensus expectations and was the best since March. Plugging recent reports into our models suggests real GDP will be revised up to a 4.6% annual growth rate in Q3 versus the 3.9% rate reported two weeks ago. What makes the recent gains in retail sales so impressive is that gas prices are down significantly. This has pulled spending on gasoline down by 20% in the past two months. But any drag from gas prices has been offset by what appear extremely nimble shoppers who have not only shifted their purchases faster than usual, but utilized rising incomes as well. For example, sales at electronics/appliances stores, helped by the iphone 6, are up $458 million in the past three months, offsetting, all by itself, one-third of the reduction in gas station sales. The strongest gain in November, by far, was for autos. But consumers also increased purchases of building materials (maybe shovels in Buffalo), at non-store retailers (internet and mail-order, before Cyber Monday), and at restaurants & bars. “Core” sales, which exclude autos, building materials and gas, increased 0.6% in November and 0.8% including upward revisions to September and October. These sales, which are a key input into GDP calculations, are up 10 months in a row and, if unchanged in December, will up at a 5.9% annual rate in Q4 versus Q3. We expect consumer spending to accelerate in the year ahead, as payrolls rise by about 3 million and wage gains accelerate at the same time consumer debt service burdens hover near multiple-decade lows. In other news this morning, new claims for jobless benefits declined 3,000 last week to 294,000; continuing claims increased 142,000 to 2.51 million. Look for more job gains in December, but not as fast as in November. On the inflation front, still no sign of a problem in the trade sector, especially given the strength in the US dollar. Import prices fell 1.5% in November, although they declined only 0.3% excluding petroleum. Export prices fell 1% in November, -1.2% ex-agriculture. In the past year, import prices are down 2.3% while export prices are down 1.9%. This environment of expanding consumption, low inflation and new innovation is still a great one for equities. Don't let the bearish forecasters scare you.

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Posted on Thursday, December 11, 2014 @ 11:16 AM • Post Link Share: 
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  The Myth of QE: Why Rates Are Headed Higher
Posted Under: Government • Monday Morning Outlook • Fed Reserve • Interest Rates
It’s a myth; an abused narrative. Those who disagree are called economic heretics. What are we talking about? The idea that Quantitative Easing (QE) drives interest rates down. This myth has a fervent following even though virtually no evidence supports it.

Yes, the Federal Reserve has done a massive amount of QE. And, yes, interest rates have been low. But, correlation does not equal causation. Just look at Europe, where the European Central Bank (ECB) has allowed its balance sheet to contract in recent years – Quantitative Tightening. Yet, interest rates are even lower than they are in the U.S. Not just German and French 10-year bond yields, but Italian and Spanish as well.

Federal Reserve Chair Janet Yellen understood this back in December 2008, when she said, “As Japan found during its quantitative easing program, increasing the size of the monetary base above levels needed to provide ample liquidity to the banking system had no discernible economic effects aside from those associated with communicating the Bank of Japan’s commitment to the zero interest rate policy.”

In other words, by ending QE, the Fed is implicitly ending its commitment to low rates. As a result, the 2-year Treasury yield has jumped from 0.31% in mid-October to 0.64%. Not because of tapering, but because rate hikes are now expected.

There is no mystery here. QE signals a low interest rate policy. In Europe, the ECB keeps threatening to start QE again, which is the same thing as saying don’t expect rate hikes.

It’s the promise to hold interest rates low that matters, not the actual bond buying. When the Fed (or any central bank) indicates it will hold overnight rates at zero for one year, then 1-year yields will be close to zero. The same holds true if the promise is for two years.

In other words, QE is just another version of “forward guidance.” As that guidance shifts, interest rates will rise. That’s happening in the U.S. right now.

Since mid-October, the Fed has increased its holdings of bonds with 1 to 5-year maturities by $58 billion. At the same time is has decreased its holdings of Treasury bonds with maturities five years and longer by $52 billion.

Nonetheless, the 2-year Treasury bond yield is soaring, while the 10-year Treasury bond yield has remained stubbornly stable. The yield curve is flattening – exactly the opposite result that supporters of QE have claimed would happen.

It’s a magic elixir. In Europe, by not doing enough QE, the ECB is supposedly causing deflation, which, in turn, holds bond yields down. In the U.S., QE itself was supposedly holding interest rates down. In Japan, interest rates were already low, and QE was supposed to boost growth, but instead a renewed recession is underway. It’s the Wizard of Oz. Please don’t look behind the curtain.

What does all this mean? Well, first it means QE isn’t magical. We do not believe QE boosted economic activity or equity values in the US, nor did it keep interest rates down. All it did was boost bank holdings of excess reserves.

This is why tapering has not hurt the U.S. economy or equities. Job growth has accelerated, GDP, too, and the stock market has reached record highs.

What’s missing from just about every conversation about central banks is their inability to offset the damage done by excessive taxes, government spending, or regulation. Europe and Japan will continue to underperform the U.S. as long as their governments spend more as a share of GDP.

The bottom line: The U.S. has turned the corner. Government policy is headed in a better direction, growth is picking up and interest rates are now headed higher, probably for quite some time. But, it’s not because QE is over, it’s because the Fed can no longer justify a zero percent overnight interest rate. “Forward guidance” is kaput. That means higher interest rates are on their way.

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Posted on Monday, December 08, 2014 @ 11:09 AM • Post Link Share: 
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  M2 and C&I Loan Growth
Posted Under: Government • Fed Reserve

Posted on Monday, December 08, 2014 @ 7:52 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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