Inflation targeting

In recent years, central banks in several developed economies have adopted formal inflation targets. Proponents have claimed this would create greater transparency in the decision-making process and help central banks better communicate the reasons and rationales for any policy changes. The core reason behind this was that a low and stable inflation environment would anchor inflation expectations and also lead to greater macroeconomic stability.

Success for this type of monetary policy framework depends as much on selecting the appropriate basket as it does on the specific price target. US policymakers have selected the consumer price index (CPI) as the appropriate basket of items. At first glance, this traditional price index would seem to be the most appropriate measure of price change, since it captures the most dominant part of final demand.

However, the current structure of the CPI does not directly include the price of housing. Instead, the government statisticians create a proxy for house-price inflation based on trends in rents. This creates both a reality and a measurement problem because the rental market and the owner housing market are distinct markets.

Indeed, the current structure of the inflation-targeting framework sets a speed limit for a large chunk of the consumer basket—and no speed limit for housing. And policymakers only react to price changes in the housing market if the speed in housing prices creates a higher speed rate in the targeted basket of consumer items, or if house prices crash and burn and there is a potential spillover effect (negative) on the targeted basket.

Why this inflation-targeting framework is flawed

Housing, more than any other product or service in the economy, is highly influenced by the cost of borrowing, liquidity conditions and (at times) speculation. Directly and indirectly, all three of these conditions are influenced by the stance of monetary policy.

Also, the acquisition of housing involves the accumulation of debt. Consequently, by not formally monitoring prices and credit use, policymakers run the risk of creating macro imbalances in the economy that could become systemic.

 Economic performance during the inflation-targeting regime

In the US, an informal and formal inflation-targeting regime has been in place for more than two decades. The resulting macroeconomic record is poor—if not worse than before.

First, the 2000s decade had two economic recessions; its performance matched the uneven economic performances of the 1950s, 1970s and 1980s. Moreover, the 2007–2009 economic downturn was the longest in duration (18 months) and deepest in terms of depressed gross domestic product (GDP) output (–4%), lost jobs (8.5 million) and shrinking household wealth ($12.7 trillion) in the postwar period.

Second, the economy spent 26 months in recession during the 2000s—a period marked by low and stable inflation. The only other decade that recorded as many months in recession was the 1970s—a decade marked by high and accelerating inflation.

Why isn’t the trade-off between low and well-anchored inflation and economic performance any better than it was during high and rising inflation? Is the inflation-targeting regime flawed or have policymakers selected the wrong basket?

Proposed changes to the inflation-targeting framework

Olivier Blanchard, the chief economist for the International Monetary Fund, argues that inflation targeting has not worked because the specific inflation target has been set too low. He and other policymakers and academics continue to debate and question what the optimal inflation target is. Some of them suggest that inflation targets be set as a high as 4%.

While the setting of a price target is important, it’s not as important as the specification of the price measure, in our opinion. That’s because central banks can influence the cost of borrowing and aggregate liquidity conditions, but they cannot direct the liquidity flows. Only the private sector will push the flows in the directions that fit its needs.

Formal price targeting can only work well if policymakers focus on actual prices and include prices that are most sensitive to monetary policy changes. Any attempt to add more monetary stimulus to the system, with the simple goal of trying to achieve a narrow price target, is likely to result in even greater price imbalances and potentially more economic instability.

By Joseph G. Carson, US Economist and Director, Global Economic Research, AB

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The information contained herein reflects the views of AllianceBernstein L.P. or its affiliates and sources it believes are reliable as of the date of this publication. AllianceBernstein L.P. makes no representations or warranties concerning the accuracy of any data. There is no guarantee that any projection, forecast or opinion in this material will be realized. Past performance does not guarantee future results. The views expressed herein may change at any time after the date of this publication. This document is for informational purposes only and does not constitute investment advice. AllianceBernstein L.P. does not provide tax, legal or accounting advice. It does not take an investor’s personal investment objectives or financial situation into account; investors should discuss their individual circumstances with appropriate professionals before making any decisions. This information should not be construed as sales or marketing material or an offer or solicitation for the purchase or sale of any financial instrument, product or service sponsored by AllianceBernstein or its affiliates. Note to Australian and New Zealand Readers: This document has been issued by AllianceBernstein Australia Limited (ABN 53 095 022 718 and AFSL 230698). Information in this document is intended only for persons who qualify as “wholesale clients,” as defined in the Corporations Act 2001 (Cth of Australia) or the Financial Advisers Act 2008 (New Zealand), and should not be construed as advice.

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About the Liquidity Flows Indicator The Bureau of Economic Analysis (BEA) designed the liquidity flows indicator decades ago. The original series was based on the concept that changes in liquid balances lead to directional movements in nominal spending, with a lead time of six to nine months.

The original series consisted of the growth in broad money (adjusted for inflation), the growth in business and consumer credit, and the change in liquid assets.

Simply stated, the liquidity flows indicator captures all the ways spending might be financed: cash, credit or liquid assets. Financial markets have evolved since the series was initially constructed. As a result, some modifications were necessary. Over the lifespan of the series, one of the biggest developments was the birth of the mutual fund industry and the inclusion of dollar flows into bond and stock funds.

If the liquidity indicator had failed to capture these flows, it would have been missing a large and growing part of liquid balances, since mutual fund accounts are highly liquid assets and serve as very close substitutes for traditional bank accounts.

Working with statisticians at the BEA, we redesigned the series and revised the liquidity flows indicator, which has been one of our proprietary indicators for the past 25 years.

Recent Forecasting Record

To be fair, growth of the liquidity flows indicator has overstated real gross domestic product (GDP) growth for the past several years (Display 1).

Part of this overcalculation can be explained by the indicator’s direct link to trends in the private sector and lack of any link to the public sector; growth in credit and liquid balances captures the borrowing trends of nonfinancial corporate businesses and households and their liquid balances.

Over the past six years, average annual growth in the liquidity flows indicator was 3.3%, compared with 2.9% in private sector GDP. Overall real GDP growth of 2.1% came in well below trends in the private sector, because the public sector has contracted 1.3% per year since 2010.

1986 and 1998 Offer Clues for 2016

The liquidity flows indicator is sensitive to changes in interest rates, lending The US economy has faced persistent fears of setbacks, but the recovery continues to move forward. Our proprietary liquidity indicator suggests that the economic cycle remains on solid ground and that GDP growth in 2016 will be faster than in 2015. conditions and the inflation rate. Over the past several months, the sharp outflow from equity mutual funds, which are included as liquid assets, has held back the growth rate of the overall indicator, but haven’t altered the underlying trend.

Sharp declines in energy prices that lead to a sizable drop in headline inflation have given a big lift to liquidity flow growth over time. Two periods—1986 and 1998— highlight this relationship. In those years, a 40% to 50% decline in energy prices triggered a 1- to 1.5%-percentage point drop in headline consumer price inflation, lifting real liquid balances. A similar phenomenon occurred in 2015; oil prices fell by close to 50% and headline inflation dropped 1.5 percentage points from 2014.

The link between stronger growth in liquidity flows and faster spending growth isn’t immediate. In fact, stronger flows suggested faster economic growth in 1986, but there was a noticeable drop in overall GDP growth of about threequarters of a percentage point. But the rebound in liquidity flows ultimately did translate into higher spending, with real GDP growth rebounding strongly in 1987. The playbook for 1998 was different: growth remained strong in that year and the following year.

If yesterday’s playbook is still accurate, real GDP growth should rebound by at least one percentage point in 2016, up from 2.4% growth in 2015.

By Joseph G. Carson, US Economist and Director, Global Economic Research, AB

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The information contained herein reflects the views of AllianceBernstein L.P. or its affiliates and sources it believes are reliable as of the date of this publication. AllianceBernstein L.P. makes no representations or warranties concerning the accuracy of any data. There is no guarantee that any projection, forecast or opinion in this material will be realized. Past performance does not guarantee future results. The views expressed herein may change at any time after the date of this publication. This document is for informational purposes only and does not constitute investment advice. AllianceBernstein L.P. does not provide tax, legal or accounting advice. It does not take an investor’s personal investment objectives or financial situation into account; investors should discuss their individual circumstances with appropriate professionals before making any decisions. This information should not be construed as sales or marketing material or an offer or solicitation for the purchase or sale of any financial instrument, product or service sponsored by AllianceBernstein or its affiliates. This document has been issued by AllianceBernstein Australia Limited (ABN 53 095 022 718 and AFSL 230698). Information in this document is intended only for persons who qualify as “wholesale clients,” as defined in the Corporations Act 2001 (Cth of Australia) or the Financial Advisers Act 2008 (New Zealand), and should not be construed as advice.

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The Economy in 2015

The economy slowed sharply in the fourth quarter, with real gross domestic product (GDP) growth rising at a mere 0.7% annualized rate. Once again, the strength of the economy’s performance was driven by household spending and investment. Real consumer spending on durable goods rose at a 4.3% annualized rate, while spending on housing climbed by an 8.3% annualized rate.

Despite these bright spots, the economy’s performance was negatively impacted by a series of items: Energy capital spending in structures declined by a 39% annualized rate; foreign trade subtracted 0.8 percentage from the quarter’s growth performance as real merchandise exports declined while real merchandise imports rose; companies scaled back on inventory investment, subtracting 0.5 percentage from the GDP growth rate; and unusually warm weather dramatically reduced household spending on utilities.

For 2015 overall, real GDP growth rose 2.4%, matching the growth rate of 2014. Depending on one’s perspective, the US economy was able to overcome the 50% collapse in energy capital spending (which subtracted 0.5% from the overall growth rate) and still post a modest advance in overall growth. Alternately, the fact that real GDP growth in 2015 only matched the pace of growth in 2014 suggests that the economy did not see any benefits from the sharp drop in energy prices.

History shows that the negative effects of sharp and large declines in energy prices are front-loaded, and that the positive benefits tend to surface 6–12 months after the initial drop in prices. The fact that energy prices have taken another nosedive in January indicates that there is still downside risk to energy capital spending in the first half of 2016. Also, the knock-on effect to equity prices has the potential to impact consumer spending—but so far there is little evidence of that in the sentiment reports and other hard data.

As we noted in our last commentary, incremental declines in energy capital spending and declines in equity markets (with negative wealth effects on consumer spending) raise the downside risks to our 2016 GDP growth estimate. Based on recent trends, we think it is prudent to lower this year’s growth rate to 2.7%— down from the initial estimate of 3.2%.

Fed policy

At the January 26–27 Federal Open Market Committee meeting, policymakers noted that the pace of growth had slowed in the fourth quarter, even though labor market gains stayed relatively strong. Yet the confusion caused by ongoing volatility in the energy markets and global financial markets left policymakers generally unsure about the growth and inflation outlooks.

As a result, they stated that they would be “closely monitoring global economic and financial developments and assessing their implications for the labor market and for the balance of risks to the outlook.” Clearly, policymakers are saying that it might take more time for them to gain clarity on the outlook—especially on the inflation front. Thus, delaying a rate hike until midyear is going to be the most likely result of their discussions. Consequently, we don’t expect the next official rate hike until the second quarter, probably June. And we are reducing our estimate of the number of rate hikes to three from four.

By Joseph G. Carson, US Economist and Director, Global Economic Research, AB

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The information contained herein reflects the views of AllianceBernstein L.P. or its affiliates and sources it believes are reliable as of the date of this publication. AllianceBernstein L.P. makes no representations or warranties concerning the accuracy of any data. There is no guarantee that any projection, forecast or opinion in this material will be realized. Past performance does not guarantee future results. The views expressed herein may change at any time after the date of this publication. This document is for informational purposes only and does not constitute investment advice. AllianceBernstein L.P. does not provide tax, legal or accounting advice. It does not take an investor’s personal investment objectives or financial situation into account; investors should discuss their individual circumstances with appropriate professionals before making any decisions. This information should not be construed as sales or marketing material or an offer or solicitation for the purchase or sale of any financial instrument, product or service sponsored by AllianceBernstein or its affiliates. This document has been issued by AllianceBernstein Australia Limited (ABN 53 095 022 718 and AFSL 230698). Information in this document is intended only for persons who qualify as “wholesale clients,” as defined in the Corporations Act 2001 (Cth of Australia) or the Financial Advisers Act 2008 (New Zealand), and should not be construed as advice.

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Oil-price plunge: A historical perspective

In the summer of 2014, domestic spot oil prices hit a peak of $108 a barrel. They’ve been on a steady but irregular decline ever since. Currently, the spot oil price for West Texas Intermediate oil is roughly $30 a barrel. That’s the lowest price since 2003, and it represents a decline of nearly 75% from its summer 2014 peak.

To understand potential repercussions, we compared the current oil-price plunge to that of the 1986 drop (Display 1), because both price declines were driven primarily by an additional (unexpected or unappreciated) increase in available supply.

In September 1985, OPEC increased its oil production and lowered its price. At year-end 1985, OPEC members shifted from a policy of targeting prices to one of focusing on market share. In part, that policy change occurred because OPEC was worried about the increased oil supply coming from the North Sea. So, to thwart competition and keep its market share, OPEC lowered its price.

The additional supply catalyst in 2014 stemmed from an increase in US oil production—a direct by-product of shale technology. In fact, US oil production in 2014 had increased by 4 million barrels per day from 2010, thereby boosting domestic production to its highest level since the 1970s. As global prices fell, OPEC again sought to preserve market share and responded by maintaining current production. This surprised non-OPEC oil producers and investors, resulting in a plunge in oil prices that even the most pessimistic forecasts of 2014 did not anticipate from the outset.

Economic adjustments

Sharp and large downward changes in oil prices produce a string of economic adjustments, both negative and positive.

The most obvious negative adjustment is in the capital spending of energy companies. The sharp curtailment in oil-rig construction has resulted in a 50% reduction in nonresidential structures in investment in the mining and energy segment—a decline that’s roughly comparable to the peak-to-trough decline in 1986. However, the oil-price decline of 2014–2016 is larger than that of 1986, and there is no clear indication of when prices will bottom, let alone rise again. Consequently, we expect further declines in this investment segment.

On the flip side, the manufacturing-sector investment in new structures increased roughly 50% over the course of 2015, and now stands slightly above that of investment in energy-related structures (Display 2, next page). The last time investment in manufacturing structures exceeded energy-related investments was in the early 1970s.

Shifting consumer preferences

Disruptive changes have also occurred in consumer preferences. For example, in 2015, new vehicle purchases totaled 17.33 million. Albeit, that sales total fell just short of the record 17.35 million set in 2000. But purchases of trucks (light and heavy) did set a record. According to Ward’s Automotive, 10.3 million trucks were purchased last year, exceeding the prior sales total by 1 million and representing the highest tally ever (Display 3). Lower gasoline prices were a clear factor in the strong sales performance.

The shift in buying patterns toward lightduty trucks has pushed motor vehicle manufacturers to alter and rush their investment plans. Domestic firms as well as foreign transplants are adding billions of dollars to their investment plans in the US. The goal is to increase domestic production capacity for trucks, based on what they see as a permanent shift in buyer preference. This clearly reflects the view that oil prices will be low for a long period. And that influx of investment dollars will add to the strong uptrend already apparent in new structure investment by manufacturers.

Shifts in US consumer behavior are also evident in driving patterns. Total miles driven in 2015 reached a record level, and the increase in miles driven represents the largest annual gain since 1992. A more mobile consumer results in other spending-pattern shifts. For example, the greater use of a vehicle results in more wear and tear, which increases spending on maintenance and shortens the life of the vehicle. Also, spending on services such as eating and drinking away from home and domestic travel increased as well.

The sharp drop in oil prices plays a large part in overall pricing patterns and other disruptive economic changes, too. Businesses, with the greatest benefit flowing to transportation companies, consume as much energy/oil as consumers, so a sharp and permanent drop in fuel costs can motivate firms to upgrade their fleets, as well as pass along the windfall to shareholders, workers or customers. It’s hard to say at this juncture with any certainty how energy-consuming firms will spend the windfall, but it is an accumulating benefit and hugely positive to the broad economy.

How low? How long?

How deep oil prices plunge and how long they remain low have important implications for monetary policy. Policymakers have been arguing that the oil-price decline is a temporary phenomenon: as prices flatten or stabilize, headline inflation will start to move up, more accurately reflecting current trends in core prices, which increased 2.1% in 2015 (according to the Consumer Price Index).

Yet the sharp oil-price plunge in just the first few weeks of 2016 further delays any rebound in headline inflation. And since several policymakers raised concern over the inflation outlook at the December Federal Open Market Committee meeting, it’s quite possible that policymakers could signal a delay in the rate normalization policy at next week’s meeting.

All in all, we tend to view an energy-price decline as a net positive for the economy over a 12- to 18-month period. Yet the initial negative impacts tend to outweigh the positive—so growth and inflation could be about 0.5 percentage point below our forecasts for 2016 if oil prices remain at current levels through the end of the first quarter.

By Joseph G. Carson, US Economist and Director, Global Economic Research, AB

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The information contained herein reflects the views of AllianceBernstein L.P. or its affiliates and sources it believes are reliable as of the date of this publication. AllianceBernstein L.P. makes no representations or warranties concerning the accuracy of any data. There is no guarantee that any projection, forecast or opinion in this material will be realized. Past performance does not guarantee future results. The views expressed herein may change at any time after the date of this publication. This document is for informational purposes only and does not constitute investment advice. AllianceBernstein L.P. does not provide tax, legal or accounting advice. It does not take an investor’s personal investment objectives or financial situation into account; investors should discuss their individual circumstances with appropriate professionals before making any decisions. This information should not be construed as sales or marketing material or an offer or solicitation for the purchase or sale of any financial instrument, product or service sponsored by AllianceBernstein or its affiliates. This document has been issued by AllianceBernstein Australia Limited (ABN 53 095 022 718 and AFSL 230698). Information in this document is intended only for persons who qualify as “wholesale clients,” as defined in the Corporations Act 2001 (Cth of Australia) or the Financial Advisers Act 2008 (New Zealand), and should not be construed as advice.

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Manufacturing vs. Nonmanufacturing

Sectors Each month, the Institute for Supply Management (ISM) surveys purchasing agents and supply managers in the manufacturing sector and the nonmanufacturing sector. These survey results offer early and real-time insight into the underlying trends in business activity, order commitments (domestic and foreign), employment trends and pricing power for 18 manufacturing and 18 nonmanufacturing industries.

The information is timely, as it is released in the first week of the month and covers trends in the prior month. The indexes also have a very good forecasting record, accurately capturing the broad cyclical growth trends in the economy. The one shortcoming from the surveys is that the composite indexes are diffusion indexes, which means they capture the “breadth” of change (or how many industries are seeing growth or declines in specific areas of their business) as opposed to the “magnitude” of change. Nonetheless, intelligence on the number of industries growing and declining at the same time still offers valuable information about the underlying trends in the economy.

Starkly Different December Results

In December, the manufacturing survey composite index stood at 48.2—the weakest reading in six years. In contrast, the non-manufacturing index stood at 55.3, which is just a tad lower than the readings of the past year (Display 1). The difference is even more striking in some of the underlying components.

For example, the index of business activity (or sales/production) in the nonmanufacturing sector stood at 58.7 in December, compared to a 49.8 reading in the manufacturing sector (Display 2, next page). Meanwhile, the new orders index of 58.2 in nonmanufacturing was 9 percentage points over the manufacturing reading of 49.2 (Display 3, next page). Large and positive gaps for the nonmanufacturing sector were also reported for the backlog of orders and for employment.

The absolute and relative strength in the nonmanufacturing sector is also evident in news on the manufacturing, or goods, sector. One systemic reason for this is that the manufacturing/goods sector dominates the economic reports of the government. Every month, the government reports on retail sales (consumer demand for goods), wholesale sales (business demand for products), manufacturing production, and new orders for durable and nondurable goods. It also reports monthly on business inventories for the retail, wholesale and manufacturing sectors, as well as merchandise trade, which captures goods exported and imported.

In contrast, there’s not one single monthly government report on demand or sales trends in the private service sector. The only monthly source is the ISM surveys. Plainly, the lack of timely and credible information on the service sector makes it very difficult for growth in the service sector to be accurately captured in the initial gross domestic product (GDP) reports.

There is the relatively new quarterly report on revenues from the US Census Bureau that covers a broad list of service industries. It does provide some data, but it’s released three months after a quarter is over—and after two GDP estimates have been released. Moreover, the newness and volatility in the data force government statisticians to use four-quarter rolling averages for many of the service sectors.

To get around the shortfall in the data, we have relied on soft data (business surveys) and hard data (employment and tax receipts) to help gauge underlying trends in the economy. The payroll employment data confirm that a solid growth trend is still under way, but it is difficult to identify sources or sectors that are experiencing the growth in demand since there are no hard sales data from the service sector. Yet the fact that a broad array of service sectors (which account, overall, for 60% of GDP) are hiring indicates that they need additional labor to meet ongoing increases in demand. There’s no quibbling that a faster overall growth rate in 2016 requires a recovery in the manufacturing sector. But for now, the growth in the nonmanufacturing sectors (which include construction) is sufficient to keep the economy on an even keel.

By Joseph G. Carson, US Economist and Director, Global Economic Research, AB

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The information contained herein reflects the views of AllianceBernstein L.P. or its affiliates and sources it believes are reliable as of the date of this publication. AllianceBernstein L.P. makes no representations or warranties concerning the accuracy of any data. There is no guarantee that any projection, forecast or opinion in this material will be realized. Past performance does not guarantee future results. The views expressed herein may change at any time after the date of this publication. This document is for informational purposes only and does not constitute investment advice. AllianceBernstein L.P. does not provide tax, legal or accounting advice. It does not take an investor’s personal investment objectives or financial situation into account; investors should discuss their individual circumstances with appropriate professionals before making any decisions. This information should not be construed as sales or marketing material or an offer or solicitation for the purchase or sale of any financial instrument, product or service sponsored by AllianceBernstein or its affiliates.T his document has been issued by AllianceBernstein Australia Limited (ABN 53 095 022 718 and AFSL 230698). Information in this document is intended only for persons who qualify as “wholesale clients,” as defined in the Corporations Act 2001 (Cth of Australia) or the Financial Advisers Act 2008 (New Zealand), and should not be construed as advice.

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Economy Impacted by “New Normal” and Abnormal Factors

Proponents of the “new normal” for economic growth point to several factors that argue for a sustained period of subpar growth—at about 2% or so. These include slower productivity (lack of innovation and little new investment), slower labor force growth (decline in participation rate), tighter lending standards and higher capital requirements for banks, and relatively high debt levels for the private and public sectors.

Certainly, these economic and financial headwinds have been powerful and persistent over the past five years, and the new normal crowd has accurately captured their impact. But there are also two unprecedented—or abnormal—factors that have played an equal role in suppressing gross domestic product (GDP) growth.

Once in a Generation or Even Longer

First, there was an outright contraction in household borrowing in two of the past five years (Display 1). This is unprecedented on its own, let alone during the start of a recovery. The only other years that household borrowing declined were 2008 and 2009—during the most severe market-induced credit crunch since the Great Depression. To be fair, the new normal crowd was correct in arguing that the household sector would delever and that would restrain spending and GDP growth. But the household sector’s classic deleveraging path consists of slower growth in borrowing relative to growth in income. Never before did household deleveraging include an outright contraction in borrowing. Moreover, the 1.0% cumulative change in household borrowing from 2010 to 2014 is the smallest gain in any economic recovery in the postwar era.

Second, nominal government spending in the GDP accounts declined in three of the past five years, also another first (Display 2). Here, too, the cumulative growth for the five-year period (2.0%) is the smallest gain of any recovery during the postwar era. Taken separately, each of these occurrences is a once-in-a-generation event, or even longer. The odds of both happening concurrently are something for others to figure out.

Gauging the Effect of the Abnormal Pullbacks

In order to illustrate the impact on the economy from each of these abnormal events, we estimated the elasticity of government spending to GDP, and of household borrowing to consumer spending—and the latter’s consequent impact on nominal GDP. (Note that these statistical results of estimating the impact of the growth in government spending and household borrowing on nominal GDP are not additive.)

Based on our research covering the last 60 years, the historical elasticity of government spending to nominal GDP is 1.07. That means a 1% growth in government spending would increase the growth in nominal GDP by a similar (just slightly higher) amount. And, if there had been no fiscal drag over the past five years, nominal GDP would have increased 1.4% faster each year. Thus, instead of an average annual growth rate of 3.8%, nominal GDP growth would have been 5.2%.

In terms of household borrowing and consumer spending, we estimate the historical average elasticity of borrowing to spending at 0.84. Thus, if household borrowing had merely matched the growth in disposable income since 2010, nominal personal spending would have increased 2.7% faster each year—and nominal GDP would have increased 1.9% faster, all else being equal.

Each of these abnormal factors directly exerted a powerful and persistent retarding influence on nominal GDP growth. And the deliberate maintenance of zero interest rates, along with the implementation of quantitative easing, by the Federal Reserve over the past several years was intended to offset these (and other) headwinds.

Resetting the New Normal Parameters

As the economy enters 2016, these abnormal factors are in the process of reversing their course. We expect that to be reflected in a faster pace of nominal GDP growth before very long.

On the government side of the equation, we can confidently conclude that the fiscal drag is over. State and local budgets are much improved, and nominal spending has been rising for two consecutive years. Additionally, federal government spending is poised to rise in 2016, given the recent congressional agreements on spending levels for defense and nondefense. It also appears that next week Congress will pass a five-year, $305 billion bill to fund highways and mass transit projects. This is the first multiyear highway bill in more than two decades, and most of the spending increase will show up in state and local government accounts, since the monies are disbursed to each state. Taking these developments together, we estimate that the growth in nominal government spending could increase 200 basis points in 2016—the largest acceleration since 1999.

Household borrowing has also started to increase at a faster rate. Indeed, according to the Federal Reserve Bank of New York, third-quarter US household borrowing increased $212 billion—the largest quarterly gain since 2007. And with lending standards becoming more relaxed and household balance sheets in much better shape, we will expect continued growth in household borrowing in 2016. Albeit, we don’t expect the household sector to relever (i.e., raise the growth in borrowing above that of income). But if households resume borrowing proportionately to underlying income growth, that will result in a 200-basis-point increase in the growth in borrowing, which will give a powerful lift to spending and GDP growth.

Next year should prove an interesting test of which factors—the new normal or abnormal ones—had the greatest impact in producing the economy’s subpar growth trends over the past five years. Certainly, both sets of factors were operative. But the abnormal factors appear to be reversing direction, moving from retarding to promoting growth.

Interestingly, that change isn’t currently reflected in the market or the Fed’s nominal growth and interest rate expectations. But that directional shift may be large enough to disrupt the new normal narrative before long. n

By Joseph G. Carson, US Economist and Director, Global Economic Research, AB

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The information contained herein reflects the views of AllianceBernstein L.P. or its affiliates and sources it believes are reliable as of the date of this publication. AllianceBernstein L.P. makes no representations or warranties concerning the accuracy of any data. There is no guarantee that any projection, forecast or opinion in this material will be realized. Past performance does not guarantee future results. The views expressed herein may change at any time after the date of this publication. This document is for informational purposes only and does not constitute investment advice. AllianceBernstein L.P. does not provide tax, legal or accounting advice. It does not take an investor’s personal investment objectives or financial situation into account; investors should discuss their individual circumstances with appropriate professionals before making any decisions. This information should not be construed as sales or marketing material or an offer or solicitation for the purchase or sale of any financial instrument, product or service sponsored by AllianceBernstein or its affiliates. This document has been issued by AllianceBernstein Australia Limited (ABN 53 095 022 718 and AFSL 230698). Information in this document is intended only for persons who qualify as “wholesale clients,” as defined in the Corporations Act 2001 (Cth of Australia) or the Financial Advisers Act 2008 (New Zealand), and should not be construed as advice.

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The changing script

At the September 16–17 Federal Open Market Committee (FOMC) meeting, policymakers voted 10 to 1 to leave official rates unchanged. They acknowledged that the domestic economy was growing at or above their expected pace and that labor-market improvement had exceeded their expectations. Yet policymakers were concerned that “recent global economic and financial developments may restrain domestic growth and put further downward pressure on inflation.”

While policymakers had included language concerning international developments earlier this year, this was the first meeting that it appears to have overshadowed the domestic economy. In fact, Fed Chair Janet Yellen conceded during Thursday’s press conference that “the recovery from the Great Recession has advanced sufficiently far and domestic spending appears sufficiently robust that an argument can be made for a rise in interest rates at this time.”

A Widening gap among policymakers?

The one dissent came from Federal Reserve Bank of Richmond President Jeffrey Lacker, who wanted to raise the target on the federal funds rate by 25 basis points. Mr. Lacker’s dissent was not a surprise as he has argued that the Fed’s labor market mandate has been achieved and a zero rate policy is no longer required.

At this time, most policymakers still expect to raise official rates before year-end. In fact, six of the 17 FOMC participants are currently calling for two rate hikes before year-end.

However, four participants are now calling for no rate hike until 2016—up from two members at the last meeting. With only two meetings remaining on the calendar before year-end, there seems to be a widening split on the committee. Still, on balance, the majority of policymakers expect one 25-basis-point hike before year-end. In the press conference Q&A, Yellen indicated that the upcoming October 27–28 FOMC meeting should still be considered a “live” meeting, even though it won’t be followed by a press conference. She noted that policymakers could have sufficient information at that time to decide to raise official rates. And, the committee could quickly schedule a press conference to discuss the decision.

We think the odds of that occurring are extremely low. Such a quick U-turn in the policy decision would certainly hurt the credibility of policymakers. But more important, a near-term rate hike would definitely be a surprise to the financial markets and trigger increased volatility— something that influenced the Fed’s decision to delay any rate move this month.

Are decisions truly data dependent?

Up to now, policymakers, especially Yellen, have argued that their decisions are data dependent. But the economic data has been generally strong recently, including numerous positive revisions—particularly for labor-market data and consumer spending. It seems to us that a data-dependent policy is only credible if you follow it, instead of making detours when the tough decisions are at hand.

We think policymakers are making a mistake similar to their decision not to taper their bond purchasing program in September 2013. That decision had been preceded by policymakers telegraphing a move to start slowing their asset purchase program, but they then surprised markets by delaying the tapering for another three months—owing to some soggy economic data and tightening financial conditions. In hindsight, that decision proved to be wrong, as the economic data was revised up and the economy soundly advanced 3.5% over the second half of 2013.

A similar scenario is likely to unfold again this time, especially if our above-consensus growth forecast is close to the mark. Yet this time, the jobless rate would probably be at or below 5%. And starting from a position of a near-zero federal funds rate, policymakers will need to play catch-up—something Yellen said she was trying to avoid.

By Joseph G. Carson, US Economist and Director, Global Economic Research, AB

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The information contained herein reflects the views of AllianceBernstein L.P. or its affiliates and sources it believes are reliable as of the date of this publication. AllianceBernstein L.P. makes no representations or warranties concerning the accuracy of any data. There is no guarantee that any projection, forecast or opinion in this material will be realized. Past performance does not guarantee future results. The views expressed herein may change at any time after the date of this publication. This document is for informational purposes only and does not constitute investment advice. AllianceBernstein L.P. does not provide tax, legal or accounting advice. It does not take an investor’s personal investment objectives or financial situation into account; investors should discuss their individual circumstances with appropriate professionals before making any decisions. This information should not be construed as sales or marketing material or an offer or solicitation for the purchase or sale of any financial instrument, product or service sponsored by AllianceBernstein or its affiliates. This document has been issued by AllianceBernstein Australia Limited (ABN 53 095 022 718 and AFSL 230698). Information in this document is only intended for persons that qualify as “wholesale clients,” as defined in the Corporations Act 2001 (Cth of Australia), and should not be construed as advice.

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Services Sector: Broad Underperformance in Growth Rates

Almost all services sectors—both public and private—have recorded slower nominal spending growth over the past four years relative to trends that were in place prior to the financial crisis period (2007–2010). We can readily point to government budget pressures at the federal, state and local levels over the past several years for the depressed showing by the government services part of the equation. But a similarly obvious cause isn’t apparent for the sluggish growth among private services sectors.

Display 1 provides a detailed picture of the nominal spending trends of the major private services sectors and compares the current cycle growth rate with that of the 1996–2006 period—in other words, the nominal trends that were in place prior to the recession.

Rents Up, Home Purchases Down

The residential rental (apartment) market is the only private services sector that has seen a faster spending trend in the current cycle. That makes sense because of the structural shift in the housing market. For example, home ownership rates have declined five percentage points—from 68.4% in 2007 to 63.4% in mid-2015, the lowest rate in nearly 50 years. And that, in turn, has reduced the growth in the owneroccupied housing stock (which shows up as slower growth for imputed rents for owner-occupied housing), while at the same time accelerating growth in rents (because of a sharp decline in rental vacancies and a concomitant rise in rental occupancies).

The slower pace of nominal growth in healthcare (off 190 basis points) reflects three factors: slower employment gains (at least in the early part of the current cycle), the cost-shifting burden from businesses to workers for healthcare expenses and slower healthcare inflation.

But the underperformance in education, finance, communication, transportation and recreation (which includes live sports events and motion pictures) is somewhat baffling. The sluggish nominal growth rates in these areas beg the question of whether a fundamental structural shift is occurring in many of these sectors or if there will be a revision at some point.

Accurate Accounting for Tech Advances?

In one of our recent commentaries (“The US Growth Paradox—The Curious Lag in The scale of the slowdown in the nominal growth rate for the service sector is as baffling as it is surprising. It raises the prospect of either a major mismeasurement or a fundamental shift in the workings of the services industries. Services”, August 7, 2015), we raised the idea that the advancement in technology— particularly gadgets with a broad range of functions and applications—has enabled the average consumer to do more things for themselves, such as increase their productivity. And, in the process, this result may have caused a significant bypass of the traditional pay-as-you-go business services model to consumers.

While it’s hard to quantify this possible shift, here are a few things to keep in mind. First, the household sector has seen rapid capital accumulation of technology products. Indeed, household spending on technology equipment has doubled since 2008 and is up tenfold since 2001. In the business world, capital deepening—broadly defined as arming labor with more capital to perform their functions—is highly correlated with improved labor productivity. Could there be a similar outcome in the household sector? In other words, are households armed with new gadgets and functions now doing significantly more tasks for themselves?

Second, new technologies typically require the acquisition of new knowledge. Sometimes, there are long lag times between the initial purchase of the + Joseph G. Carson, US Economist and Director—Global Economic Research, joe.carson@abglobal.com 2 technology and the reaping of the actual benefits. In the business world, using the existing capital stock more efficiently is called multifactor productivity. Is it possible that the introduction of the smartphone is now starting to significantly improve household productivity? After all, these devices combine the function of a traditional cell phone with an operating system of a computer, and they allow consumers to do a number of functions, such as bank, shop, book travel, watch movies, read books and newspapers, listen to music, and communicate to others domestically and globally… and often for free.

Household Production Isn’t Part of GDP

Following our initial commentary last month, we received some insights concerning gross domestic product (GDP) calculations from Robert Parker, former chief statistician and associate director of the Bureau of Economic Analysis. He pointed out that as households do more things for themselves, “household production increases, which isn’t in GDP, and that reduces business output and GDP.”

Parker also noted that “for-free innovation products’ GDP is understated.” And it’s understated because we don’t know how to price (or quality adjust) smartphones. This issue is something we’ve raised in past commentaries (see “The Productivity Paradox: Is Innovation Mispriced?” March 20, 2015, and “The Productivity Paradox Part 2: Is Innovation Mispriced (and Missing),” April 2, 2015).

Operating Margins Offer a Clue So where do we stand?

We agree with Parker that innovation is either miscalculated or not fully captured in the GDP statistics. The best evidence to support that claim is that real operating margins for nonfinancial companies have now remained above 14% for four consecutive years, a trend that was last duplicated in the early 1960s. Clearly, companies have gained economic efficiency in recent years, and the improved efficiency has been apparent whether payroll job growth has been weak or strong.

One example of innovations that are not yet part of GDP has to do with computer storage device manufacturing and the US Federal Reserve Board’s new output figures. By using quarterly data from IDC on revenue and factory shipments for more than 700 models from 2002–2014, the Fed’s research staff found that the quality adjustment for these new devices was substantially understated. Annualized output growth now runs close to 30% per year—a substantial revision from its previous estimate of 5%. To be fair, computer storage device manufacturing is a relatively small component of total manufacturing production, as it accounts for less than 1%. Nevertheless, it still illustrates the estimation problems associated with new devices and gadgets. Another example involves prices and quality adjustments for cell/smartphones. Price measurements for cell phones track the service contract and not the quality and improved functionality of cell/smartphones. As a result, this understates the added value of these gadgets.

The Fed’s research staff estimates that the prices (which are not adjusted to capture quality improvements, as Parker noted) are falling at a rate of 15% to 20% per year because of the rapid advance in new applications (in other words, the added value of smart phones is understated in GDP).

But even if government statisticians eventually succeed in identifying and quantifying the new innovations, those statistical recalibrations won’t have any impact on a company’s operating results since they will already have been documented and reported to investors.

The argument for mismeasurement also seems plausible, but virtually impossible to gauge. Indeed, federal tax receipts offer some of the hardest data, as they are free of manipulation and seasonal adjustment. Moreover, individual and corporate tax receipts are inextricably linked to the vagaries of the business cycle. Collectively, receipts from these two sources grow faster than nominal GDP during recoveries and slow down (or actually contract) during recessions.

Tax Receipts Far Outpace GDP

Growth Over the past five years, the growth in federal individual and corporate tax receipts has increased three times the rate of nominal GDP growth. That’s unusually fast and twice the ratio of the relative growth rates of the 1990s (Display 2). Even if we exclude the surge in revenue in 2011, which represented a strong rebound from the depressed revenue levels tied to the recession, the pace of recent revenue growth still stands at 2.7 times.

To be fair, over the past several years there have been a series of federal tax law changes (tax base broadening and top marginal rate changes) that have been aimed at raising tax revenue. And some of the tax changes are tied to investment income and not regular income, so the relationship between tax receipts and nominal GDP may have changed somewhat. Yet the 1990s also had a number of tax law changes, and the hike in the top marginal rate from 28.0% in 1990 to 39.6% in 1993 was far greater than what occurred in the current cycle.

Although the strength in federal tax receipts raises questions about the accuracy of the GDP figures, we still have no hard evidence that there are measurement issues in GDP. It might just be that today’s economic structure is changing faster than we can measure it. The data in use today rely on the 2007 economic census information, and the results from the economic census of 2012 are being incorporated on a rolling basis over the next few years. Also, new gadgets, services or industries that are not currently part of GDP may be included in the future.

In the final analysis, the US economy is clearly undergoing some substantive changes, and some of the changes may be so transformative that it’s nearly impossible to capture them accurately and timely. That’s why aggregate business reports (earnings and margins) and tax data may be offering better information on the economy’s performance long before it’s captured in GDP.

By Joseph G. Carson, US Economist and Director, Global Economic Research, AB

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Modest Rebound in 2Q

GDP In the second quarter, real gross domestic product (GDP) growth rose an estimated 2.3% annualized, following an upwardly revised gain of 0.6% in the first quarter (Display 1), according to the Bureau of Economic Analysis (BEA). Previously, first-quarter GDP was reportedly down 0.2%. But even though that contraction in the early part of 2015 was revised away, the economy’s performance in the first half of the year is still subpar.

One key reason for the first half’s lackluster growth is the sharp and sudden collapse of capital spending in the energy sector. According to the BEA, investments in oil and gas exploration and mining collapsed at an annualized rate of 45% in 1Q and 68% in 2Q (Display 2, next page). This two-quarter decline mirrors the sharp plunge in energy capital spending in 1986—another period in which domestic oil prices collapsed.

The sharp drop in energy capital spending shaved 0.5% off the first quarter’s real GDP growth rate and 0.7% off the second quarter’s growth. At the same time, it masked a very powerful capital spending trend in manufacturing structures— primarily tied to the chemical industry building new smelters in the southwest (Display 3). Indeed, the twoquarter annualized growth rate of 79% in manufacturing structures was the second highest two-quarter gain in the past 50 years.

Growth should pick up during the second half of 2015. The drag from the collapse in energy capital will fade, given that the oil rig count has stabilized. The powerful upturn in manufacturing-structures investment will become more dominant in the aggregate capital spending numbers. Also, we expect continued gains in real consumer spending—close to the 2Q performance of 2.9% annualized growth. Along with that, we see further gains in housing investment, linked to the strong rebound in building permits. Thus, the US economy should be able to produce 2H real GDP growth in the 3.0%–3.5% range.

US Growth Potential? Apparently, Not What It Used to Be From a historical perspective, the US economy growing at a 3% annualized pace is not that unusual, nor should it trigger any concern over domestic price pressures. But revised long-term GDP data suggest that the US growth potential is a lot lower than it used to be. The US economy grew only 2.1% over the past five years instead of the previously reported 2.25%, and growth in the private sector was downwardly revised to 3.0% from 3.2%.

Thus, if the US economy’s long-term potential growth rate is 2% or less, a growth rate of 3% for the second half of this year would place further downward pressure on domestic resources (labor) and upward pressure on domestic prices (inflation).

At this time, the upward pressure on prices seems to be modest, but occurring nonetheless. For example, employer costs for labor seem to be moving up–although the weaker-than-expected 0.2% gain in the employment cost index (ECI) for 2Q does raise questions over tightness in the labor market and breadth of wage increases. The weakness in the 2Q ECI was centered in sales and incentive-type compensation jobs. Yet the data doesn’t square with business surveys and tax data. Upcoming reports on jobs and wages will offer more intelligence on labor-market tightness.

Upward price pressure is also showing in consumer prices for domestic services (such as medical care, education, transportation, rents, etc.). These were running at 2.5% in the past year, while the rate of increase in the first half of 2015 ran at 3.0% annualized—the fastest gain since 2008. To be fair, prices for consumer goods (motor vehicles, apparel, medical products and furniture) are still contracting at a rate of about 0.5% per year, due to international competition and a strong dollar. Yet prices for consumer goods account for only 10% of the overall consumer price index, so the upturn trend in domestic services will ultimately dictate the trend in overall inflation.

Rate Lift-Off in September? At the July 29 Federal Open Market Committee (FOMC) meeting, policymakers upgraded their current assessment of economic growth. They noted better trends in consumer spending and housing, but acknowledged weaknesses in investment and net exports. Also, policymakers said that the labor markets have shown “solid gains,” and that it would only take “some” further improvement in labor markets for the Fed to be in a position to lift the target on the official rate.

We think policymakers purposely changed the language with respect to labor markets because of growing signs of wage pressures and favorable trends in leading indicators of employment—such as jobless claims, job openings and business surveys indicating labor shortages.

Although the FOMC’s wording change doesn’t guarantee an official rate hike in September, the path to the initial rate hike seems largely dependent on labor market gains and labor costs. And on that front we expect continued gains in the months ahead.

By Joseph G. Carson, US Economist and Director, Global Economic Research, AB

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The information contained herein reflects the views of AllianceBernstein L.P. or its affiliates and sources it believes are reliable as of the date of this publication. AllianceBernstein L.P. makes no representations or warranties concerning the accuracy of any data. There is no guarantee that any projection, forecast or opinion in this material will be realized. Past performance does not guarantee future results. The views expressed herein may change at any time after the date of this publication. This document is for informational purposes only and does not constitute investment advice. AllianceBernstein L.P. does not provide tax, legal or accounting advice. It does not take an investor’s personal investment objectives or financial situation into account; investors should discuss their individual circumstances with appropriate professionals before making any decisions. This information should not be construed as sales or marketing material or an offer or solicitation for the purchase or sale of any financial instrument, product or service sponsored by AllianceBernstein or its affiliates. This document has been issued by AllianceBernstein Australia Limited (ABN 53 095 022 718 and AFSL 230698). Information in this document is only intended for persons that qualify as “wholesale clients,” as defined in the Corporations Act 2001 (Cth of Australia), and should not be construed as advice.

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US Budget Position: Good in the Near Term…

For fiscal year 2015, the Congressional Budget Office (CBO) estimates that the US budget deficit will be $468 billion, down $25 billion from the 2014 deficit. This modest improvement is primarily driven by continued relatively strong gains in revenues (+5.9%) and somewhat slower growth in outlays (+4.9%).

This marks the sixth consecutive year in which the deficit has declined relative to gross domestic product (GDP). And at 2.6% of GDP, the scale of the current deficit is back to levels last seen in 2005, and it stands very close to the 50-year average of 2.7%.

…but Longer-Term Picture Is Bleak

But the long-term budget projections from the CBO aren’t as rosy. In June, it updated its 10-year budget baseline projections. They show the US budget deficit remaining at current levels over the next few fiscal years, but then show them starting a steady climb—hitting 3% near the start of the next decade and 4% in 2025 (Display 1).

To be fair, the longer-run budget projections, which are prepared by the CBO on an annual basis, are not done for the sole purpose of predicting actual budget outcomes. Actually, their main purpose is to provide a perspective on the future trends of revenues and outlays (and resulting deficits), as it frames the current set of tax and spending laws against a backdrop of consensus economic growth and interest-rate projections.

Continued Growth Does Not Generate Budget Balance

Understandably, the economic and interest-rate projections are critical to any long-run budget projection. Yet as a rule, the CBO employs conservative assumptions in framing the outlook. In fact, the current 10-year budget projections are based on a continued economic growth of 2.2% per year, a consumer price inflation of 2%, and a normalization of near- and longer-term interest rates to 3.5% and 4.5%, respectively, starting in 2018.

One of the key takeaways from the CBO’s 10-year budget projections is that a prolonged economic growth cycle is not likely to generate a sufficient enough increase in revenue to cover the rise in outlays associated with an aging population, increased federal health costs and rising interest payments on the outstanding federal debt. Ordinarily, budget deficits are highly cyclical in that they rise during recessions and narrow during economic growth cycles. But CBO estimates show that even if the economy continues to expand at its potential pace of 2.2%, the budget deficit will start to widen within five years from today and then steadily increase into the next decade.

The spending side of the budget is mainly responsible for the rising tide of higher deficits. Indeed, by 2025 the CBO estimates that federal spending will equal 22.2% of GDP, which is more than 200 basis points above the 50-year average. And all of the higher spending is concentrated on mandatory programs (entitlements and healthcare) and interest payments.

Time for a Long-Term Reality Check

In Washington right now, there’s almost no attention being placed on the US budget outlook beyond the next year or two. After all, projections over the next few years paint a picture of budget tranquility, with deficits that are broadly in line with historical averages.

But the US faces a rising tide of unaffordable outlays that will ultimately force us to take on a mountain of additional debt in order to pay for all of the promises that have been made in the past. The country would be well served if our leaders started crafting a list of options to deal with the prospect of rising deficits. By postponing necessary changes in spending and tax law, the scale of the required fiscal actions will become progressively larger. Indeed, CBO budget projections beyond the next decade are even more ominous (Display 2).

The current environment is ripe with examples of countries, states and municipalities that have postponed making hard fiscal decisions. In the end, the scale of the adjustment had to be much larger than what would have otherwise occurred if the decision makers started sooner. Currently, the US still has a window of opportunity to phase in incremental changes that would likely be less disruptive and less costly over the long term. The question remains whether the US will harness the political will to make effective changes in time.

By Joseph G. Carson, US Economist and Director, Global Economic Research, AB

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The information contained herein reflects the views of AllianceBernstein L.P. or its affiliates and sources it believes are reliable as of the date of this publication. AllianceBernstein L.P. makes no representations or warranties concerning the accuracy of any data. There is no guarantee that any projection, forecast or opinion in this material will be realized. Past performance does not guarantee future results. The views expressed herein may change at any time after the date of this publication. This document is for informational purposes only and does not constitute investment advice. AllianceBernstein L.P. does not provide tax, legal or accounting advice. It does not take an investor’s personal investment objectives or financial situation into account; investors should discuss their individual circumstances with appropriate professionals before making any decisions. This information should not be construed as sales or marketing material or an offer or solicitation for the purchase or sale of any financial instrument, product or service sponsored by AllianceBernstein or its affiliates. Note to Australian Readers: This document has been issued by AllianceBernstein Australia Limited (ABN 53 095 022 718 and AFSL 230698). Information in this document is only intended for persons that qualify as “wholesale clients,” as defined in the Corporations Act 2001 (Cth of Australia), and should not be construed as advice.

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