Never underestimate the ability of politicians to mess up a good thing. They're certainly trying in Washington, D.C.

Unfortunately, many people are concerned about the wrong thing.  Nice even numbers fascinate people, and through the first eleven months of this fiscal year (October 2018 through August 2019), the U.S. budget deficit was over $1 trillion ($1.067 trillion to be exact), up 19% versus the same eleven months the year before.  The government usually runs a surplus in September, so the budget deficit for full Fiscal Year 2019 should come in at roughly $950 billion – that's close enough to $1 trillion for government work.

Meanwhile, the public debt is at a record high $22.5 trillion, and the Congressional Budget Office projects roughly $1 trillion annual deficits as far as the eye can see.  So, it's easy to understand why so many are concerned.  Some even think the US is headed for bankruptcy.  And, unlike with Greece, there's no one big enough to bail-out the US.       

Here's what they're missing: in spite of record debt, the net interest on the debt should finish the year at 1.8% of GDP.  For perspective, that's lower than it ever was from 1980 through 2001, during which it averaged 2.7% of GDP – and some of those years saw budget surpluses.

Moreover, net interest relative to GDP is unlikely to rise dramatically anytime soon.  Imagine we wake up tomorrow morning and Treasury yields are miraculously at 4.0% across the entire yield curve, from short-term securities to long.  That would be well above the 2.5% average interest rate taxpayers already pay on all marketable Treasury debt outstanding, including the securities issued many years ago. 

Moving from 2.5% to 4.0% is a 60% increase in interest costs, which also means that, once we roll-over enough debt, the interest burden relative to GDP would rise by 60%, as well.  But a 60% increase from 1.8% of GDP, would put us at 2.9%, very close to the long-term average in the 1980s and 1990s.  And, interest rates aren't going to 4% in the real world anytime soon, plus it takes time for the debt to rollover.

The Treasury Department could use the current era of low long-term interest rates to lengthen the maturity of the debt.  The best idea we've seen is for the Treasury to issue perpetual inflation-indexed debt and then step aside and let the private sector slice and dice these instruments into bespoke securities. The market could create everything from plain vanilla 10-year Treasury notes, to 50-year zero-coupon debt, to debt instruments that don't pay interest for the first twelve and a half years and then pay every six months after that.

But here's another reason not to fear the current debt of $22.5 trillion: the assets of all US households combined are $129.7 trillion.  Yes, they have debts worth $16.2 trillion, but that still leaves a net worth of $113.5 trillion.

Now let's imagine households paid off not only their own debts but the federal government's, as well.  That would have left them with $91.4 trillion in mid-2019.  That's about 4.3 times GDP.  From the early 1950s through the mid-1990s, this ratio – the net worth households would have after paying off their debt and the national debt – hovered between 2.8 and 3.3 times GDP.  Now it's near a record high. 

None of this means US fiscal policy is in a good place; it's just that the debt is manageable, we're not going bankrupt.  The real fiscal problem is the level of spending and the need to fix entitlements: Social Security, Medicare, Medicaid, and "Obamacare."  If we don't fix these programs, then in the next few decades the federal government will be spending relative to GDP in a normal year as much as it was spending at the peak of the crisis after the last recession.  And when all we hear about is the deficit, it takes away the focus on spending and lets politicians sell the idea that it's all excessively low taxes that cause it, even though tax collections are at an all-time high.

The problem is that out of control spending gradually erodes the character of the American people. It pushes citizens toward dependence on government checks for their income, rather than their own efforts.  In a democracy, we want our fellow citizens to know the value of hard work, shrewd investment, and entrepreneurship.  Having too many people living off taxpayers is no way to conserve those traits.  

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

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Source: St. Louis Federal Reserve FRED Database

Implications:  Existing home sales rose for the second month in a row in August, continuing the upward trend that began in January.  Moreover, the recent recovery in sales has now pushed growth positive on a year-over-year basis for two consecutive months following seventeen months of declines.  That said, one piece of worrying news in today's report was that inventories have now fallen year-over-year (the best measure for inventories given the seasonality of the data) since June, following ten straight months of gains.  This is concerning because a reversal in the steady increase in listings we've seen recently could be a headwind for future sales.  Keep in mind, the primary culprit behind the weak existing home market in 2018 was lack of supply.  The good news is that yesterday's report on housing starts showed new home construction hit a post-recession high, so builders are beginning to respond. As these properties are finished, and people trade up or down to a new home, more inventory of existing homes will become available.  However, it's important to note that the inventory shortage is doubly important for properties worth $250k or less, where sales remain down from a year ago and continue to show the most weakness.  What this means is that the "mix" of homes sold is more and more tilted towards the higher end. When you add in mortgage rates that have fallen roughly 100 basis points since their peak in November 2018, it's no surprise that the year-over-year growth in median prices has begun to reaccelerate.  This measure had been slowing consistently since early 2017 but is now up 4.7% in the past year versus its low of just 3.3% in December.  It's also important to note that the months' supply of existing homes – how long it would take to sell the current inventory at the most recent sales pace – was only 4.1 months in August and has now stood below 5.0 (the level the National Association of Realtors considers tight) since late 2015.  With demand so strong that 49% of homes sold in August were on the market for less than a month, continued gains in inventories will remain crucial to sales activity going forward.    It won't be a straight line higher for sales in 2019 but fears the housing recovery have ended are overblown.  In employment news this morning, initial jobless claims rose 2,000 last week to 208,000, and continuing claims declined 13,000 to 1.661 million. Plugging this data into our models suggests nonfarm payrolls will continue to grow at a healthy pace in September.  Finally, on the manufacturing front, the Philly Fed Index, a measure of East Coast factory sentiment, dropped to still strong +12.0 in September from +16.8 in August.

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As expected, the Fed cut short-term interest rates by 25 basis points today, moving the range for the federal funds rate down to 1.75 - 2.00%.  At the same time, it lowered the interest rate on excess reserves (IOER) to 1.8% and the re-purchase (repo) rate to 1.7%, five basis points below the bottom of the Fed Funds range. In his press conference, Chair Powell confirmed these were "technical changes" in reaction to repo rate pressures earlier this week.  We published a piece earlier today with our thoughts in the repo market jitters, but suffice it to say we see the issues coming from poor regulatory policy, not a lack of money in the system.
 
Oddly, while cutting rates, the Fed made only minor changes to it's economic outlook, doubling-down on the move away from data dependence.  Perhaps that's why there are now more quarrels within the Fed itself, with three voting members dissenting. Kansas City Fed President Esther George and Boston Fed President Eric Rosengren voted today to keep rates unchanged, while St. Louis Fed President James Bullard voted to cut rates by 50 basis points. 

Chair Powell highlighted two reasons for moving rates. First, business "uncertainty" and slower global growth - which seem to have passed employment and inflation as areas of focus for the Fed, despite admission by the Fed that it doesn't have the tools to impact the trade dispute - have the Fed concerned about future growth. And second, Powell stated that the Fed's view on the appropriate level of rates to sustain growth have "changed significantly" towards a lower path.  If the data doesn't support your actions, move the goal post.  It's the policy justification equivalent of saying "It's not you, it's me."
 
All that said, the dot plot suggests no more rate cuts in 2019. But take that with a grain of salt.  While no further rate cuts are needed in our view (on a nominal basis the U.S. economy has grown at a 5% annualized rate over the past eight quarters), and we don't think either of this year's rate cuts were justified.  In Fed forecasts as recently as June, the median dot in the dot plot showed no rate cuts this year. Since then the Fed has cut rates twice.  Our best guess is that the Fed will probably – not definitely, but probably – cut rates one more time in 2019, and, if so, more likely reduce rates in December than October.
  
Brian S. Wesbury, Chief Economist
Robert Stein, Dep. Chief Economist

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In the past few days, stresses in the financial system have shown up. These stresses have pushed the federal funds rate above the Federal Reserve's desired target range of between 2.00% and 2.25% (as of Tuesday), and some reports have funds trading as high as 9%.

The Fed has responded by using repos - re-purchase agreements - to put cash into the system and bring down short term interest rates.  The question is, does this signal a systemic problem in the banking system.  Our answer: an emphatic NO.

We believe the stresses are caused by overzealous banking regulation put into place after the crisis of 2008. The most likely culprit being LCR, or the liquidity coverage ratio.

Below is a quote from Jamie Dimon, CEO of JP Morgan, during a panel discussion at a Barclays financial services conference on September 10th, 2019.

"And I just want to mention. One way to look at the LCR thing and this, I'm talking about monetary transmission policy, you see recently China changed the reserve requirement. And when they do that, it frees up $100 billion of lending. You can't do that here because of LCR.  Because – it's got nothing to do with monetary policies, it's a conflicting regulatory policy.  And LCR also means that I can't finance a corporate bond and include it in liquidity anywhere. So when you all – if you all are selling corporate bonds one day, and you want JPMorgan to take on – finance $1 billion, I can't, because it'll just immediately affect these ratios. So we've taken liquidity out of certain products. And it won't hurt you very much in good times. Watch out when times get bad and people are getting stressed a little bit."

The LCR is calculated by bank regulators, and determines the amount of cash a bank would need in the event of a severe financial crisis. In other words, banks are forced to hold enough liquid assets to meet cash flow needs under a made-up stress test. These regulator-created stress tests are extraordinary, as are their estimates of potential losses.

So, how does this fit into today's financial market conditions and the management of monetary policy?

With the advent of quantitative easing, the Federal Reserve has put a massive amount of excess reserves in the banking system. However, the Fed has also limited banks' ability to use those reserves through regulation, by putting rules, like LCR, in place. 

Stories about what is going on with the repo market are filled with suggestions that the banking system does not have enough reserves. With $1.4 trillion of excess reserves in the US banking system, that's simply not true.

Because of those excess reserves, trading in the federal funds market has become very thin.  Back in the 1990s, daily trading in federal funds was on the order of $150 to $250 billion per day and it climbed much higher in the 2000s.  On Monday, total trading in reserves was just $46 billion, and in the past year trading in federal funds run near a 40-year low.

Why?  Because banks are forced to hold more reserves than they actually need.  QE flooded the system.  A spike in the federal funds rate might have signaled a systemic (system wide) problem pre-2008, but not anymore.

So, what has happened this week?   While the Fed isn't talking, this is our belief.

1)  Fed rate cuts and low long-term rates increased the demand for mortgages, which reduced cash in banks.
2)  Many companies also took advantage of lower rates and issued corporate debt, which some banks likely bought.
3)  Oil prices spiked after the drone attack in Saudi Arabia and may have squeezed financial entities who had written contracts protecting their oil clients from changes in oil prices.
4)  Third quarter corporate tax payments reduced deposits at US banks.

With such a small amount of federal funds trading, its highly likely that one or two (at most a small handful) US banks got caught offsides.  We believe this is a short-term problem, not a long-term one.

One way to deal with this temporary issue is to change the overly strict rules on LCR and avoid limiting liquidity.  That's our preference.  It could also just let the market run and teach a small group of banks a lesson.  Using repos or adding more QE is micro-managing the situation, it's not in the long-term best interest of the economy.  Excess liquidity and rewarding bad management creates problems down the road.

But most important, these problems signal that the new path of monetary policy the Fed started in 2008 has grave issues. The Fed should not be as active in managing the economy as it has become.

In the end we think the market, and market pundits, have over-reacted.  There are no true liquidity issues in the US, other than those caused by misguided regulation.     

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

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Implications:  Following three months of declines, housing starts surged in August, beating even the most optimistic forecast by any economics group.  The construction of new homes now sits at a 1.364 million annual rate, a new post-recession high, and activity is up a healthy 6.6% in the past year.    Most of the gain in August was due to the more volatile multi-family sector where starts jumped 32.8%, the biggest monthly gain since 2016.  However, single-family starts also rose 4.4% in August, posting the third consecutive monthly gain. It's important to note that single-family starts have been on a general upward trend since bottoming in February and are in spitting distance of new highs.  Meanwhile, multi-family starts have been range bound since 2015 when the upward trend broke down.  On average, each single-family home contributes to GDP about twice the amount of a multi-family unit, so a continued shift back towards single-family construction will be a boon for economic growth.  Building permits were another source of strength in August, rising 7.7% following a similarly strong 6.9% gain in July. Those back to back increases managed to push permits to a 1.419 million annual rate, also a post-recession high. It looks like developers are becoming more optimistic about their prospects following an all-around tepid year for housing in 2018. This higher sentiment also showed up in yesterday's release of the NAHB index which hit an eleven-month high in September.  Part of this may be that housing completions have moved higher over the past couple months, which means labor is being freed up to start new projects in the months ahead.  Further, unfilled jobs in the construction sector have fallen recently from the all-time highs.  Remember, when the National Association of Home Builders released their survey of top challenges for builders in 2019 at the beginning of the year, concerns related to the cost and availability of labor were the most prevalent, with 82% of developers surveyed citing them as their biggest challenge in the year ahead.  In other words, labor has been a primary headwind for starts, and that looks like it is starting to ease.  On the demand side, fundamentals for potential buyers have improved markedly over the past several months.  Mortgage rates have dropped more than 100 basis points since the peak late last year, and wages are now growing near the fastest pace in a decade, boosting affordability.  Our outlook on housing hasn't changed: we anticipate a rising trend in home building in the next few years.  Based on fundamentals – population growth and scrappage – the US needs about 1.5 million new housing units per year but hasn't built at that pace since 2006. 

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Implications:  Industrial production surged in August, easily beating consensus expectations to post its largest monthly increase in a year.  And the details of the report were as good as the headline, with nearly every major category showing growth.  The one exception came from auto manufacturing, which fell 1.0% in August.  However, that comes on the heels of three consecutive months of strong gains, and auto production is still up 0.5% from a year ago.  Meanwhile, the best news came from manufacturing outside the auto sector (which represents the majority of manufacturing activity) where production rose 0.6%, its largest monthly gain in over a year.  Putting the two series together shows overall manufacturing increased 0.5% in August but is still down 0.5% from a year ago.  This represents a considerable slowdown in the twelve-month growth rate since the end of 2018, and the same pattern can be seen in overall industrial production as the chart above shows.  However, the slowdown has begun to taper off, and there is evidence that manufacturing activity may be turning a corner. Over the past four months, manufacturing has risen at a 2.6% annualized rate, a stark reversal from an annualized decline of 5.8% during the first four months of 2019.  Despite all the recent doomsday predictions related to the US-China trade dispute, it's important to remember that we also saw a similar slowdown in 2015-16 during the oil price crash, and no recession materialized.  Keep in mind that manufacturing is only responsible for about 11% of GDP, and is much more sensitive to global demand than other sectors of the economy.  Finally, mining activity rebounded 1.4% in August following a sharp temporary decline in July due to hurricane Barry.  In the past year, mining is still up 5.1%, showing the fastest year-over-year growth of any major category.  Expect a further acceleration in the coming months as US shale drillers ramp up activity to fill the gap in production caused by the recent attacks on Saudi Arabia's oil infrastructure.  In other news this morning, the Empire State Index, which measures factory sentiment in the New York region, fell to +2.0 in September from +4.8 in July.  On the housing front, the NAHB index, which measures homebuilder sentiment, rose to 68 in September from 67 in July, an eleven-month high. This represents a significant and consistent rebound in optimism following the collapse in the index at the end of 2018.
 

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"We are all Keynesians now," is a phrase that caught on in the late 1960s and early 1970s, variously attributed to Milton Friedman and President Richard Nixon.  Uncle Milty was commenting on the general political/economic environment, not saying he was a Keynesian.  Richard Nixon, on the other hand, actually said "I am now a Keynesian."

We bring this up because it's happening again.  While we won't explain the entire theory of economics proposed by John Maynard Keynes, it was a "demand-side" belief system.  A key tenet was using government spending, budget deficits, and loose money to let bureaucrats exert control over the economy.

After its failure in the 1970s, Ronald Reagan and Margaret Thatcher changed the world by moving it back toward a supply-side, small government mentality.  The U.S. and U.K. moved from high inflation, high unemployment, and slow growth, to low inflation, low unemployment, and strong growth.

But, since the crisis of 2008, the commanding heights of economic control have once again shifted toward big government.  Quantitative easing, zero percent interest rate policy (ZIRP), negative interest rate policy (NIRP), TARP, infrastructure spending, minimum wages, and new ideas for wealth taxes, free healthcare,...etc., have all been either proposed or tried.

The result? Ever since government assumed the high ground, global growth has slowed.  Especially when compared to what it was in the 1980s and 1990s when government was reducing its role in the economy.

Does the consistent failure to create growth matter to those who are proposing bigger government?  Absolutely not.  They ignore it and call for even more government intervention. 

Just this past week, Mario Draghi, in his last action as head of the European Central Bank, cut the interest rate it pays on excess reserves to -0.5% from -0.4%.  But negative interest rates have been little short of a disaster.  European and Japanese banks are suffering.  Their loans and economic activity haven't budged.  There is zero evidence that negative interest rates help economic activity, but plenty of evidence they hurt.

Draghi, himself, called for "fiscal" policy help for the economy, but he wasn't suggesting tax cuts and regulatory relief, he meant more government spending – a purely Keynesian prescription.

Here's the problem.  Demand-side, Keynesian policies don't work.  Growth comes from the supply-side – from inventions, innovation, and entrepreneurship.  In fact, between 2009 and 2016, without the tremendous tailwinds from the likes of fracking, smartphones, apps, and 3-D printing, it is easy to believe that two major tax hikes, increases in regulation and spending, and massive fines on financial institutions would have pushed real GDP growth negative.

Government is bigger and tax rates and regulation more burdensome in Europe.  That's why it's lagged U.S. growth for decades.  What the world learned in the 1980s was quickly forgotten by Europe, and now it's being forgotten by thought leaders in the U.S.

These old ideas have also transfixed investors, who cannot think about the economy without coming at it from a government policy point of view.  How much new QE will the ECB propose?  And what about President Trump's tweet that the U.S. should have negative interest rates?

This is all dangerous for long-term economic growth in both the U.S. and abroad.  People will suffer to the extent these policies are followed.  The good news is that, in the near-term, corporate tax cuts in the U.S. and a continued reduction in regulation are positives for the supply-side, more than offsetting the cost of trying to bring China in-line with global norms.  Thanks to these supply-side policies, the U.S. does not face a recession.  New technology is continuing to lower costs, increase profit margins, and boost earnings. 

None of this positive news is from government spending.  In fact, government spending only crowds out the private sector and reduces investment and opportunity.  If the U.S. does not change course, and follows Europe through the Keynesian looking-glass, it will eventually pay a price.  A damaging price.  But for now, it's just words and fear.  And profits and growth beat out words and fear every day.  

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

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Source: St. Louis Federal Reserve FRED Database

Implications:  Add today's retail sales report to the litany of other positive news coming out on the US economy over the past few months.  A truly "data dependent" Fed should not have cut rates in late July and would not be heading for another rate cut next week, like it has signaled and as the financial markets fully anticipate.  Today's retail sales report shows the consumer is doing very well.  Sales increased 0.4% in August, rising for the sixth consecutive month.  The details of the report were a little more mixed than the overall headline would suggest as sales rose in only six of thirteen major categories, but there is no doubt the consumer is doing well.  Autos and non-store retailers (think internet & mail order), led the way rising 1.8% and 1.6% in August respectively. Non-store sales are up 16.0% from a year ago, sit at record highs, and now make up 12.8% of overall retail sales, also a record.  The largest decline in sales in August was for restaurants & bars, which had a 1.2% decline, the largest drop since September of last year.  This drop may have been due to the approach of Hurricane Dorian late in the month, in which case they should rebound in the months ahead.  "Core" sales, which exclude autos, building materials, and gas stations (the most volatile sectors) were unchanged in August, but are up 4.5% from a year ago.  And even with the flat reading in August, "core" sales are up 9.4% at an annualized rate since the start of 2019, the fastest eight-month pace of growth we have seen since record keeping began in 1992!   Jobs and wages are moving up, companies and consumers continue to benefit from tax cuts, consumer balance sheets look healthy, and serious (90+ day) debt delinquencies are down substantially from post-recession highs.  For these reasons, expect continued solid gains in retail sales in the year ahead.  In other news today, on the inflation front, import prices fell 0.5%, while export prices declined 0.6% in August.  In the past year, import prices are down 2.0%, while export prices are down 1.4%.  We expect these inflation figures to move higher in the coming months.   

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