Implications:  Higher auto production, a weather-related boost from utilities, and continued gains in mining pushed industrial production higher in March, following February's strong gains.  More importantly, industrial production has increased 4.4% in the past year, the largest 12-month increase since 2011.  Motor vehicle production helped manufacturing eke out a 0.1% increase in March on the back of February's upwardly revised 1.5% gain, the largest monthly increase going all the way back to 2009.  However, non-auto manufacturing fell 0.2% in March, which might worry some analysts. But because this drop follows a very large 1.3% jump in February, and was due to weakness in food, plastics, and textiles, we don't think it suggests any fundamental weakness in the industrial sector.  Meanwhile, after a relatively warm February, utility output surged in March as temperatures around the country returned closer to normal.  Given the late arrival of Spring across much of the U.S. in April, utilities look likely to provide a boost to production in next month's report as well.  The other reason for growth in production in March was mining, which rose 1.0% in March on the back of healthy gains in oil and gas extraction.  In the past year, mining production is up 10.8%.  Drilling slowed in the second half of 2017, most likely associated with hurricanes Harvey and Irma, but remains up 17% from a year ago.  In addition, the rig count has continued to rise in recent weeks, suggesting gains in mining production will continue in the months ahead.  Taken as a whole, the tailwinds from tax cuts and deregulation continue to boost business investment and a general pickup in economic activity.

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Implications:  Housing starts rose much more than expected in March to eke out a gain after falling in February.  Starts rose 1.9% in March to a 1.319 million annual rate, and are now up 10.9% from a year ago.  However, today's positive number came exclusively from the very volatile multi-unit sector, which can't be relied on for consistent growth.  In fact, all the growth in housing starts in Q1 came from multi-unit starts, which are up 18.4% versus the Q4 2017 average while single family starts are down 0.5% over that period.  That said, single family starts are still up 5.2% versus a year ago, and continue to be the main driver of trend growth, as the chart above shows. Look for single-family starts to bounce back in the months ahead.  A transition to more growth in single-family construction than multi-family will be good news for the overall economy.  On average, each single-family home contributes to GDP about twice the amount of a multi-family unit.  Even though permits for new single-family construction fell 5.5% in March, the horizon continues to look bright for future activity.  Single-family permits are still up 1.7% from a year ago, while the number of single-family units currently under construction are at the highest pace since the last recession. As these projects are completed it will free up developers to start new ones which will show up in the headline numbers.  Notably, the gain in the past twelve months has happened despite a significant uptick in mortgage rates, which some analysts claimed would derail the housing recovery.  Based on population growth and "scrappage," housing starts should eventually rise to about 1.5 million units per year.  And the longer this process takes, the more room the housing market will have to eventually overshoot the 1.5 million mark.  Although tax reform trimmed the principal limit against which borrowers can take a mortgage interest deduction to $750,000 versus the prior amount of $1 million, the law only affects new mortgages.  Large reductions to marginal tax rates in the early 1980s, which reduced the value of the mortgage interest deduction, coincided with a rebound in housing.  In other words, we don't expect the changes in the deduction to cause problems for the housing industry at the national level, although we do expect some shift in building toward regions with lower taxes and land prices.

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Implications: Retail sales rebounded in March, rising for the first time in  four months and beating consensus expectations.  Retail sales rose 0.6% in March driven by gains in autos and internet & mail-order sales. It looks like the lull after the post-hurricane spending spree, which pulled sales forward into last Fall, is now over.  It was a solid report all around as eight of 13 major categories showed gains.  Retail sales are up a healthy 4.5% from a year ago, both overall and excluding auto sales.  That being said, plugging today's report into our GDP models suggests real consumer spending will be up at a roughly 1.2% annual rate in Q1, the slowest pace for any quarter in almost five years.  As a result, it now looks like real GDP only grew at about a 2.0% annual rate in Q1.  However, this has more to do with the timing of economic growth than the trend.  We remain very optimistic about an acceleration of growth in 2018 and still expect growth of 3.0%+ for the year, which would be the best since 2005.  As we get back to normal, expect overall retail sales to continue the trend higher in the months to come.  Why are we optimistic about retail sales growth in the months ahead?  Jobs and wages are moving up, tax cuts are taking effect, consumers' financial obligations are less than average relative to incomes, and serious (90+ day) debt delinquencies are down substantially from post-recession highs.  In other news this morning, the Empire State index, a measure of manufacturing sentiment in New York, declined to a still very healthy 15.8 in April from 22.5 in March.  Also today, the NAHB index, which measures homebuilder sentiment, fell slightly to 69 in April from 70 in March, remaining at a historically elevated level signaling optimism among builders.

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When the report on international trade came out earlier this month, protectionists were up in arms.  Through February, the US' merchandise (goods only, not services) trade deficit with the rest of the world was the largest for any two-month period on record.  "Economic nationalists" from both sides of the political aisle, think this situation is unsustainable. 

Meanwhile, some investors ran for the hills when President Trump started announcing tariffs on steel, aluminum, and other goods, thinking this was the reincarnation of the Smoot-Hawley tariffs that were a key ingredient of the Great Depression.      

We think the hyperventilating on both sides needs to stop.

In general, nothing is wrong with running a trade deficit.  Many states run large and persistent trade imbalances with other states and, rightly, no one cares.  We, the authors, run persistent trade deficits with Chipotle and Chick-fil-A, and we're confident these deficits are never going away.

Running a trade deficit means the US gets to buy more than it produces.  In turn, we have this ability because investors from around the world think the US is a good place to put their savings, leading to a net capital inflow that offsets our trade deficit.  Notably, foreign investors are willing to invest here even when the assets they buy generate a low rate of return.  As a result, this process can continue indefinitely.  

It's important to recognize that free trade enhances our standard of living even if other countries don't practice free trade.  Let's say China invents a cure for cancer and America invents a cure for Alzheimer's.  If China refuses to give their people access to our cure, are we better off letting our people die of cancer?  Of course not!

Imposing or raising tariffs broadly would not help the US economy.  Nor would imposing tariffs on specific goods, like steel or aluminum.  Giving some industries special favors will only create demand for more special favors from others.  It'll grow the swamp, not drain it.   

All that said, we understand the frustration policymakers have with China, in particular, which has been levering access to its huge market to essentially steal foreign companies' trade secrets and intellectual property.  It has a long-term track record of not respecting patents or trademarks.

In theory, letting China into the World Trade Organization was supposed to stop this behavior.  But no company wants to bring a WTO case against China when it thinks China would respond by ending its access to their markets and letting in competitors who are more willing to be exploited.         

In addition – and this is very important – China is unlike any of our other trading partners in that it is a potential major military rival in the future.  There is a national security case to be made - even if one takes a libertarian position on free trade in general - that the US could accept a slightly lower standard of living by limiting trade with China, if the result is a lower standard of living for China as well.          

And China doesn't have much room to fire back at recent US proposals (none of the tariffs targeted specifically at China have been implemented, by the way).  Last year, China exported $506 billion in goods to the US, while we only sent them $130 billion. 

That gives our policymakers room to raise tariffs on China much more than they can raise them on us.  If so, China would generate fewer earnings to turn into purchases of US Treasury debt.  Yet another reason for fear among bond investors.  However, don't expect China to outright dump Treasury securities in any large amount.  They own our debt because it helps them back up their currency, not as a favor to the US.            

We're certainly not advocating a trade war.  But an approach that focuses narrowly on China's abusive behavior could pay dividends if it moves the world toward freer trade.

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

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Source: St. Louis Federal Reserve FRED Database

Implications:  Falling gasoline prices pushed the consumer price index lower in March, masking a gain in most other categories.  Gas prices fell 4.9% for the month, pushing energy prices down 2.8%.  Meanwhile food prices rose a modest 0.1% in March.  Stripping out these two typically volatile components shows "core" prices increased 0.2% in March.   Core prices are now up 2.1% in the past year and accelerating, up at a 2.6% annual rate in the past six months and a 2.9% annual rate in the past three months.  To put that into perspective, the 2.6% annual rate over the past six months is tied for the fastest pace going back to 2008.  Paired together, the persistent and consistent rise in prices and the acceleration in recent months has the Fed at risk of falling behind the curve if they hesitate in raising rates four times in 2018.  A closer look at "core" prices shows housing and medical costs led the increase in March, rising 0.3% and 0.4%, respectively.  Both remain key components pushing core prices higher and should maintain that role in the year ahead.  Among the best news in today's report was a 0.4% increase in real average hourly earnings in March.  These inflation-adjusted hourly earnings have shown little movement over recent months, however this earnings data does not include irregular bonuses – like the ones paid by companies after the tax cut.  In addition, earnings are still up a modest 0.4% in the past year, while job growth is accelerating.  We expect a visible pickup in wage pressures in the months ahead.  In sum, the headline news from today's report is the continued acceleration in core inflation, which increases pressure on the data-dependent Fed to lift interest rates.

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Implications:  Rising costs for health care, machinery, and vegetables pushed producer prices higher by 0.3% in March.  And producer prices are now up 3.0% in the past year, matching the fastest twelve-month pace going back to 2012.  Breaking down today's report show food prices rose 2.2% in March, led by a 31.5% surge in the cost of vegetables.  Meanwhile, energy prices fell 2.1% as fuel prices declined, but remain up 8.5% in the past year.  Strip out the typically volatile food and energy groupings, and "core" producer prices rose 0.3% in March and are up 2.7% in the past year (the largest twelve-month increase going back to 2011).  For comparison, "core" prices rose 1.5% in the twelve months ending March 2017, and 1.1% in the twelve months ending March 2016.  A look further down the pipeline shows the trend higher is likely to continue in the coming months.  Intermediate processed goods declined 0.3% in March, but are up 4.6% from a year ago, while unprocessed goods fell 4.8% in March but are up 4.2% in the past year.  And stripping out the food and energy components in intermediate goods shows a faster pace of inflation in the pipeline.  In short, producer prices are rising at a healthy pace, and the data gives the Fed a green light to raise rates three more times in 2018, so four rate hikes this year in total.  The pouting pundits of pessimism may cry fears of rising rates slowing economic activity, but the Federal Reserve is still running a loose monetary policy.  This is especially true now that anti-bank attitudes and regulation are being reversed, which reduces the headwinds to monetary growth.  Given the pickup in inflation, and with employment growth remaining strong, the greater risk now is that the Fed falls behind the curve.   

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An entire generation of investors has been misled about interest rates: where they come from, what they mean, how they're determined. 

Lots of this confusion has to do with the role of central banks.  Many think central banks, like the Fed, control all interest rates.  This isn't true.  They can only control short-term rates.  It's true these can have an impact on other rates, but it doesn't mean they control the entire yield curve.

Ultimately, an interest rate is simply the cost of transferring consumption over time.  If someone wants to save (spend less than they earn today) in order to consume more in the future, they must find someone else who wants to spend more today than they earn, and then repay in the future. 

Savers (lenders) want to be compensated by maintaining - or improving - their future purchasing power, which means they need payment for three things: inflation, credit risk, and taxes.

Lenders deserve compensation for inflation.  Credit risk – the chance a loan will not be repaid – is also part of any interest rate.  And, of course, those who earn interest owe taxes on that income.  After taxes, investors deserve a positive return.  In other words, interest rates that naturally occur in a competitive marketplace should include these three factors.

So, why haven't they?  In July 2012, the 10-year Treasury yield averaged just 1.53%.  But since then, the consumer price index alone is up 1.5% per year.  An investor who paid a tax rate of 25% would owe roughly 0.375% of the 1.53% yield in taxes.  In other words, after inflation and taxes (and without even thinking about credit risk, which on a Treasury is essentially nil), someone who bought a 10-year bond in July 2012 has lost 0.35% of purchasing power each year, in addition to capital losses as bond prices have declined.

Something is off.  The bond market has not been compensating investors for saving, it has been punishing them.

Some blame Quantitative Easing.  The theory is that when the Fed buys bonds, yields fall. It's simply supply and demand.  But this is a mistake.  Bonds aren't like commodities, where if someone buys up all the steel, the price will move higher.  A bond is a bond, no matter how many exist.  Just because Apple has more bonds outstanding than a small cap company doesn't mean Apple pays a higher interest rate.

If the Fed bought every 10-year Treasury in existence except for a single $10,000 Note, why would its yield be less than the current yield on the 10-year note (putting aside artificial government rules that goad banks into buying Treasury securities)?  It's the same issuer, same inflation rate, same tax rate, same credit risk, and the same maturity and coupon.  It should have the same yield.  It didn't become a collector's item; it still faces competition from a wide array of other investments.  It's still the same bond.

The real reason interest rates have remained so low is because many think the Fed will keep holding short-term rates down below fundamental levels well into the future.  If the Fed promises to hold the overnight rate at zero for 2-years then the 2-year Treasury will also be close to zero.  And since the 10-year note is made up of five continuous 2-year notes, then Fed policy can influence (but not control) longer-term yields as well.  The Fed's zero percent interest rate policy artificially held down longer-term Treasury yields, not Quantitative Easing.  That's why longer-term yields have risen as the Fed has hiked rates.

And they will continue to rise.  Why?  Because the Fed has held short-term rates too low for too long.  Interest rates are below inflation and well below nominal GDP growth.  The Fed has gotten away with this for quite some time because they over-regulated banks, making it hard to lend and grow.  Those days are ending and low rates now are becoming dangerous.

With inflation and growth rising, and regulation on the decline, interest rates must go higher.  It's true the Fed is unwinding QE, but that's not why rates are going up.  They're going up because the economy is telling savers that they should demand higher rates.

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

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Source: St. Louis Federal Reserve FRED Database

Implications:  Don't get bent out of shape about the soft jobs number this morning; it's not a sign of a weak economy.  Nonfarm payrolls rose 103,000 in March, below consensus expectations and the smallest increase in six months.  Meanwhile, civilian employment, an alternative measure of jobs that is volatile from month to month but includes small-business start-ups, declined 37,000.  However, earlier this week, we gave three reasons to expect a soft number: payback for unusually strong job growth in February, a winter storm that hit the Northeast during the survey week, and the tendency in recent years for March payrolls to come in below consensus expectations.  We expect a rebound in job growth in April and think a robust trend is still intact.  Payrolls are up 188,000 per month in the past year, almost exactly the same as the 190,000 per month in the year ending in March 2017.  Given tax cuts and deregulation, we expect similar gains in the year ahead, despite a dwindling pool of available workers.  We also expect the unemployment rate, which has been stable at 4.1% for the past six months, to start declining again soon.  As always, we like to track what the jobs report means for consumers' purchasing power, and that part of the report was strong.  Average hourly earnings rose 0.3% in March and are up 2.7% in the past year.  Meanwhile, total hours worked rose 0.1% in March and are up 2.3% from a year ago.  As a result, total earnings, which combine the total number of hours worked and average hourly earnings, are up 5.1% from a year ago.  Moreover, this gain doesn't include extra earnings from irregular bonuses and commissions, like those paid out after the tax cut was passed.  Some analysts will dwell on the 158,000 drop in the labor force in March, despite the labor force growing 1.2 million in the past year.  Others will focus on the increase in part-time jobs in March, while full-time jobs declined.  But these figures are very volatile from month-to-month, and the past year has seen a 1.9 million gain in full-time jobs while part-time jobs are up just 285,000.  One interesting fact flying under the radar is that the share of the unemployed that's made up of people who quit their previous jobs hit 13.1% in March, the highest since 2001.  This shows growing confidence among workers that they can find a better job.  In turn, we expect the Federal Reserve to stay on a path of lifting rates three more times this year (so, four times in total).  Complacent investors who think today's report is a reason to shift toward "safer" Treasuries and away from equities are missing the forest for the trees.     

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