Macroeconomic Background Remains Good -- And A Critique of the Critics

The macroeconomic background remains positive for stocks and neutral to negative for Treasuries.  Real GDP Growth should speed up in Q218 -- and US economic data over the next two weeks should support this expectation.   While Payrolls still risk printing sub-200k in May, they are climbing above trend -- as seen in the decline in the Unemployment Rate to 3.9% in April.  Meanwhile, underlying inflation is subdued.

This background has puzzled a number of prominent economists, including Larry Summers, Paul Krugman and Alan Blinder.   They recognize that conventional models do not predict this scenario of above-trend growth, low unemployment and stable inflation.  In my view, these models don't adequately capture, if at all, the impact of the globalization of output and labor markets.  In addition, the models don't capture the effects of regulatory clampdown on bank lending after the 2008 financial crisis.  These considerations support a gradual tightening approach by the Fed and possibly a lower end point than Fed officials project.

Secular Stagnation
Summers defends his secular stagnation thesis, arguing the above-trend growth resulted from temporarily stimulative fiscal policy.  He also argues the stimulative monetary policy of the past several years, with its negative real interest rates, is unsustainable in the long run, as it likely leads to rising "financial risk, unsound lending and asset bubbles with potentially serious implications for medium-term stability."

I would argue the need for policy-induced excessive spending by the federal or private sector is required to maintain GDP in the face of China and other countries keeping their currencies low for the purpose of grabbing market share in the US.   So, what seems to be temporary may have to be a permanent fixture of the US economy -- unless Trump is successful in getting China to change its ways.

The stimulative fiscal and monetary policies offset the drag from higher imports on US GDP Growth.  In other words, some sector of the US economy -- public or private -- needs to spend more than normally to make up for the output lost to China.  And, in a growing economy, with an ever-increasing drain of spending abroad, this "deficit" spending (in dollar terms) has to increase over time.  The secular stagnation observed by Summers is likely in part a result of the excessive spending not being enough to fully offset the drag from the Chinese grab.

The other likely cause of the sub-par growth in the past few years was an overly aggressive clamping down of bank lending practices (as well as other regulations with anti-growth implications).  Tighter bank lending standards worked against low interest rates in their attempts to spur economic growth.  It is probably an important reason why the "neutral" funds rate is below levels seen prior to the Great Recession, as Fed officials keep mentioning. 

Phillips Curve Doesn't Work
Krugman and Blinder point out that the failure of wage inflation to rise significantly when the Unemployment Rate fell sharply to low levels runs counter to the Phillips Curve.  (The Phillips Curve relates wage inflation to labor market conditions and inflation expectations.)  Estimated models of the Phillips Curve do not contain a variable representing competition from low-paid workers in other countries.  And, my guess is that this competition or the fear of it has kept wage inflation at bay.   So, while some pickup in wage inflation is likely, given the tightening US labor market, the pickup will probably be  more muted than standard models predict.

Recent and Upcoming Inflation Data
The April Core PPI and Core CPI were noteworthy since their low 0.1% m/m prints reflected widespread softness.   In particular, the decline in Household Appliances in the Core PPI supported the idea that the impact of tariffs (remember the tariff on washing machines in January) would be temporary --  a relative price change rather than a pickup in underlying inflation.   While airfares dropped 2.7% m/m in the April CPI, they subtracted a tiny 0.02% pt from the Core CPI.  So, even if they rebound in May -- which is likely given the jump in oil prices and the increase in airfares seen in the PPI over the past few months -- they may not give a noticeable lift to the Core CPI.

Looking ahead, May Average Hourly Earnings risk printing a low 0.1% m/m -- as they did in April, based on calendar considerations as well as the fundamental factors mentioned above.  The y/y would edge down to 2.5% from 2.6%.