by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EST] Happy Fed Day!  The FOMC completes its first meeting of the year with a new slate of voters.

This shows the 2017 voters on the FOMC.  The red ‘X’ represents permanent voters.  The 2016 regional bank presidents who won’t vote this year are St. Louis FRB President Bullard, Kansas City FRB President George, Cleveland FRB President Mester and Boston FRB President Rosengren.  Bullard and Rosengren were very dovish, while George and Mester were hawkish.  This year’s average is about the same as last year as the dovish Chicago FRB President Evans and moderate Minneapolis FRB President Kashkari join two hawks, Philadelphia FRB President Harker and Dallas FRB President Kaplan.

As a reminder, the Mankiw rule would suggest the Fed needs to raise rates.  The Mankiw rule model attempts to determine the neutral rate for fed funds, which is a rate that is neither accommodative nor stimulative.  Mankiw’s model is a variation of the Taylor Rule.  The latter measures the neutral rate using core CPI and the difference between GDP and potential GDP, which is an estimate of slack in the economy.  Potential GDP cannot be directly observed, only estimated.  To overcome this problem, Mankiw used the unemployment rate as a proxy for economic slack.  We have created four versions of the rule, one that follows the original construction by using the unemployment rate as a measure of slack, a second that uses the employment/population ratio, a third using involuntary part-time workers as a percentage of the total labor force and a fourth using yearly wage growth for non-supervisory workers.

Using the unemployment rate, the neutral rate is now 3.79%.  Using the employment/population ratio, the neutral rate is 1.21%.  Using involuntary part-time employment, the neutral rate is 3.03%.  Using wage growth for non-supervisory workers, the neutral rate is 2.01%.  We know that the FOMC tends to support Phillips Curve models of the economy, which suggests there is a relationship between wage growth, inflation and unemployment.  What we don’t know is which of these four models holds the most sway.  However, we suspect the wage growth variation might be the most supported; if so, the Fed does need to start moving rates higher.

The implied LIBOR rate from the two-year deferred Eurodollar futures is projecting a 1.76% rate into the future.

The election of President Trump led the markets to reverse policy expectations and rapidly build in rate hikes.  For most of last year, this indicator was suggesting that slow economic growth and continued low inflation would lead the Fed to raise rates very slowly; in fact, last July, this indicator was signaling a fed funds of 60 bps two years from now.  The interest rate markets expect the new president to boost economic growth and inflation, leading the U.S. central bank to raise rates significantly compared to last summer.

Despite the Fed’s statutory independence, it is under the sway of political influence.  The administration, as we have recently noted, has been arguing that the dollar is too strong.  One of the key components of dollar strength is the divergence in monetary policy between the U.S. and the other major nations’ central banks.  If Trump can badger Yellen into not raising rates as rapidly or as far as the market expects, the dollar will likely weaken.  The risk is that financial markets will begin to build in inflation expectations, which will bring higher rates on long duration assets (which are more sensitive to inflation and less to monetary policy) and could lead to P/E contraction in equities.

What will Yellen do?  Will she cave into what we see as growing pressure on the Fed to be dovish?  Or will she press the Fed’s independence and move rates higher as the interest rate markets suggest she will?  Her history suggests she leans dovish; however, she has publically indicated she opposes fiscal expansion at this stage of the business cycle.  It is too early to tell, but one of the stories shaping up for 2017 may be Trump versus Yellen.  We might get our first clue today.  Although fed funds futures only expect about a 15% chance of a rate hike, we will be closely watching to see what the statement looks like because a hawkish tone could be an indicator that the FOMC is prepared to deal with opposition from the White House on monetary policy.  At present, fed funds futures are not expecting a hike this year until May; the odds for March are near 35%.  The Fed could tee up a hike for March with a hawkish statement.

We are watching a couple of geopolitical items.  First, there has been a notable increase in fighting in eastern Ukraine.  We suspect that Putin is testing the West to see if it will react to further encroachment.  We don’t expect the Trump administration to push back against Russia; any resistance will need to come from Europe.  Although western European nations probably won’t do much, we do note that Poland has a mutual defense pact with Ukraine and if Poland were to send material support and then get attacked by Russia, it could trigger an Article 5 “collective defense” declaration.  Second, the Greek economic and financial crisis is brewing yet again.  Greece and its creditors are in negotiations over bailout support.  Athens has balked at creditor conditions for the next round of disbursements and the creditor nations, many facing elections this year, are loath to give into Greek demands for relief.  PM Tsipras is trying to hold onto a fractious coalition that only holds a five-seat majority.  If the government fails, it would mean another European election this year and add to political uncertainty in the EU.

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by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EST] There was a lot of political news overnight but it didn’t have much impact on financial markets.  However, this morning, Peter Navarro, the director of the newly formed National Trade Council, told the FT that Germany is using a “grossly undervalued” exchange rate to “exploit” the U.S. and its EU trading partners.  The EUR rose on the news, indicated by the red arrow on the chart below.

In terms of his analysis of the euro, we tend to agree with him.  Here is our parity model of the euro, using German and U.S. consumer inflation.

Purchasing power parity uses relative inflation to value exchange rates.  The theory is that in a freely floating environment, the exchange rate should move to equalize prices between nations.  So, if cars in Canada are cheaper than in the U.S., Americans would buy Canadian cars but the demand for Canadian dollars would rise as a result and the exchange rate would appreciate to eventually equalize the exchange rate-adjusted prices between the two countries.  Simply put, the lower price levels are in a nation, the stronger its exchange rate.  In reality, it’s only a guide to exchange rate valuation.  For example, not all goods in a consumer price index are tradeable, so relative inflation rates are not perfect proxies for exchange rate valuation.  Trade isn’t frictionless, so deviation in the price of goods can persist even if tradeable.  And, financial factors, such as interest rates, may overwhelm inflation.  However, at extremes, the measure has some value.

The model suggests the D-mark is trading almost two standard errors from the forecast, or around 18% undervalued relative to the dollar.  There have only been two other periods when the dollar has been this strong relative to the D-mark, in the mid-1980s and at the turn of the century.  Eventually, the exchange rate reversed.

Navarro’s claim that Germany manipulates its currency also has merit (although technically it’s Europe’s currency, in reality, Germany effectively controls it because of its economic dominance over the Eurozone).  Germany has traditionally suppressed consumption and boosted saving, macroeconomic policies designed to bring trade surpluses.  Until the introduction of the euro, Germany was typically prevented from expanding its trade surplus due to D-mark appreciation.  However, now that it uses the euro, its European trading partners can’t use depreciation to remain competitive.  Since the euro was introduced, Germany’s current account (trade surplus plus official and private remittances) has ballooned.

These charts show Germany’s current account (the vertical line shows the introduction of the euro) and the Eurozone and German trade accounts with the U.S.  Clearly, Germany and the Eurozone run persistent trade surpluses with the U.S. and the German current account has swelled since the introduction of the euro.[1]

Here are the complications in Navarro’s comments.  First, the Treasury has the mandate for currency policy.  If multiple voices start commenting on exchange rates, it will make it tricky to determine what the administration’s currency policy actually is.  Second, the U.S. runs trade deficits because this is how the system is designed.  As long as we are the reserve currency, other nations in the world have an incentive to adopt the same policies as Germany (and many do, including China, South Korea, Japan, etc.).  The U.S. does benefit from being the reserve currency; we receive goods from the world and give dollars back that are held as savings.  In fact, if these reserves are not immediately spent, those dollars are recycled back into the U.S. financial system in the form of investment, often in Treasuries.  This means that foreigners give us stuff and also help fund our deficit in return for dollars; The Economist describes this condition as writing checks that nobody cashes.  The downside?  If one competes in an industry facing import competition, there is a fair chance one will not be working at some point.  It’s hard to compete in a globalized world.

It appears the administration is figuring out that its goals of reducing the trade deficit and boosting jobs in the U.S. could be thwarted by a strong dollar.  In fact, the controversial border adjustment in the GOP House corporate tax reform bill won’t be inflationary if only the dollar appreciates.  So, the administration is finding itself at cross-purposes.  On the one hand, it wants to create more jobs in the U.S. and is targeting import reduction as a policy to achieve that goal.  However, as long as the dollar is the primary reserve currency, other nations will take steps (e.g., currency depreciation) to maintain import flows into the U.S.  In fact, the more barriers we erect, the more aggressive foreign nations will become because the dollar is still the best currency to use for global trade.

Perhaps the most important person in this whole debate is Chair Yellen.  If the Fed turns more hawkish on fears of inflation and fiscal expansion, the dollar will tend to appreciate.  As we continue to say, we will be watching very closely to see how the president reacts to Fed tightening.  If the Fed faces a strongly negative reaction from the administration, the dollar may not rally much from here.  Of course, the lack of monetary tightening, a weaker dollar and trade impediments are a recipe for inflation and higher interest rates, especially on long-duration assets.

So, the FOMC meets tomorrow.  Current expectations for a rate hike are only at 13%; in fact, they don’t exceed 50% until June (all based on fed funds futures).  This suggests the markets are not expecting an overly hawkish statement.  Stay tuned…

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[1] For a deeper look at this issue, see this week’s WGR.

by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EST] One of the key themes we have been monitoring since Trump’s election has been the uneasy alliance between the populists and the GOP establishment.  We personalized this interaction as Speaker Ryan versus Chief Strategist Bannon.  The policies that would be supported from the Ryan camp are primarily personal and corporate tax reform, which would mostly be in the form of lower marginal rates.  This group would also want to maintain globalization (including open immigration) and deregulation, with a focus on relaxing financial regulations and environmental rules.  This group is cool to the call for infrastructure spending.  The Ryan group is where the fiscal budget hawks reside.  The latter group, represented by Bannon, are economic nationalists who want to curtail globalization by restricting immigration and reducing the trade deficit through trade barriers, if necessary.  This group wants to see fiscal expansion via defense and infrastructure spending.  They are less concerned about tax cuts but are also less worried about deficits.

Although equity markets retreated in the early hours after the election, that pullback was short-lived.  After a surprisingly conciliatory acceptance speech, equities turned and have been rallying ever since.  It appears to us that this rally is predicated on the idea that the Ryan cohort will generally prevail, meaning we would mostly see an establishment GOP program of tax cuts and deregulation.

The key unknown is which group will eventually prevail.  It would make sense for Trump to swing between these two groups; in fact, if he completely favors one over the other, it may either lead to him being a one-term president or undermine his ability to work with Congress.  In reality, we expect him to give “bones” to each side over the next four years.  However, we do have to say that Bannon has won the last few days.  The executive order to ban Muslim immigrants, refugees and, for a time, U.S. green card holders from a handful of Islamic nations comes purely out of the Bannon agenda.  Although reports are somewhat conflicting, it does appear that this policy change caught much of the government by surprise.  According to reports, Bannon and his inner circle were behind the executive order.

The other important decision was to appoint Bannon as a permanent member of the National Security Council while indicating that the director of National Intelligence and the chair of the Joint Chiefs of Staff will no longer be permanent members of the council.  For background, this council was created by President Truman to offer the president advice and assistance with national security and foreign policy issues.  The statutory attendees are the president, vice president, secretary of state, secretary of defense and secretary of energy.  These members are required, by statute, to attend.  Before President Trump’s recent decision, the chair of the Joint Chiefs of Staff and the director of National Intelligence were also required by statute to attend; that is no longer the case.  The director of National Drug Control Policy is also a statutory member.  All other members, now including the chair of the Joint Chiefs of Staff and the director of National Intelligence, are invited to meetings that pertain to their responsibilities.

We suspect that the chair of the Joint Chiefs of Staff and the director of National Intelligence will end up attending most meetings.  Thus, the downgrade of their positions may be more form over substance.  However, appointing Bannon as a permanent member elevates someone whose position has traditionally been more of a political advisor rather than security advisor.  It’s a bit like putting Karl Rove on the council.  It is a clear indication of Bannon’s influence on the administration.

We are watching the impact on financial markets.  If Bannon’s influence grows, we would expect Trump’s policies to lean more toward the populists and less toward the establishment.  That would be bearish for long duration debt and likely also bearish for equities as we would look for multiples contraction over time.  Simply put, populist policies are inflationary and negative for financial markets.  The major “known/unknown” is how the FOMC will react.  Central bank independence is granted by the political system and thus can be taken away by that same system.  A Bannon-influenced Fed will have more in common with the Burns/Miller era than the Volcker/Greenspan era.

At the same time, it is important to remember that President Trump needs Congress to get major things accomplished.  Thus, some sort of accommodation to the GOP establishment is probably necessary.  We are closely watching the U.S. political situation as well.  Trump may very well represent a major rejiggering of party affiliation.  It seems hard to imagine that labor may find its home in the GOP while the Democrats become the party of business, but such shifts have occurred before.  The Democratic Party was the party of Jim Crow before the 1964 Civil Rights Act and the GOP was the party of trade protection before WWII.  Thus, we are paying close attention to party affiliation changes.

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by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EST] It was a quiet night overall; the big news is Q4 GDP, which we will cover below.  Here are a few items we are watching:

The Italian Constitutional Court finally clarified the 2015 election reform law, known as the “Italicum.”  It ruled against a runoff system (similar to France’s) but did retain the proposal to offer “bonus seats” to parties winning over 40% of the vote.  The goal is to eliminate the influence of smaller parties and make Italian governments less fragile.[1]  This change probably won’t lead to that outcome as it is highly unlikely that any single party will gather 40% of the vote.  Thus, coalition governments will remain the norm.  Italy isn’t scheduled to hold elections until early next year but now that this Italicum has been clarified, the odds will increase that the current government may be dissolved early and we could see another major European election this year.

PM May is meeting with President Trump today.  There are reports that the president may offer May a bilateral free trade deal as a “reward” for Brexit.  Making such an offer, especially with TTIP virtually dead, may encourage other nations that are considering leaving the Eurozone (Italy, France) to look to bilateral deals with the U.S.  European unity is coming under strain and how this meeting goes today may lead to even more concerns in the EU.

Greece refused to extradite Turkish military officers who participated in last July’s coup.  Eight officers fled Turkey as the coup failed, seeking refuge in Greece.  Greek courts ruled that the alleged coup conspirators may face overly harsh punishment if they are returned and thus did not allow the government to extradite the soldiers.  Needless to say, this decision will infuriate Turkey and worsen already poisoned relations between the countries.  The legal decision is being hailed as a victory for “European values,” which will undermine EU relations with Turkey as well.  Will this prompt Turkey to open its borders and allow refugees to return to Europe in retaliation?  This is an issue we will be monitoring.

In our travels to the coasts we have noted a common comment that foreign money is boosting real estate values in local markets (not an issue here in St. Louis, BTW).  Similar reports are often heard from cosmopolitan cities such as London, Sydney and Melbourne.  Bloomberg is reporting that real estate agents in many cities are saying that there has been a sudden drop in interest, and transactions are not being consummated due to China’s tightening of capital controls.  One of the rules the Chinese State Administration of Foreign Exchange (SAFE) enacted late last year was a clause that forced anyone who was using their legal quota of moving $50k offshore to promise not to use the funds for offshore property investments.  Violating the promise would lead to a three-year ban on foreign currency and a money laundering investigation.  This change has apparently cooled the ardor for shifting assets out of the country.  As a general rule, regulation can’t completely halt capital flight but it can raise the cost of moving money out of the country.  Recent regulations appear to have succeeded for now, although we would expect new tactics to emerge over time which will allow Chinese citizens to invest overseas.

Finally, we note that Amazon (AMZN, $839.15) has been granted a patent for a robot that would pack shipping boxes, something that is currently being done by humans.  It’s not that humans are inefficient; CNN[2] reports that Amazon warehouse workers spend only about a minute fulfilling each order, which includes 15 seconds packing the box with bubble wrap and tape.  Automating the process suggests that the company simply wants to reduce the amount of labor involved.  It is fairly clear that the current administration wants to boost jobs in the U.S., especially the routine jobs that have traditionally been held by the middle class.  Trump and his government appear convinced that foreign trade is the primary reason these jobs have disappeared.  However, economists mostly believe that automation has probably played a larger role and so, if the goal is to increase routine jobs with good pay, regulations against automation may eventually be required.[3]

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[1] Not the word from the movie A Christmas Story which is usually associated with an Italian word describing a leg lamp.

[2] http://money.cnn.com/2016/10/06/technology/amazon-warehouse-robots/

[3] https://www.nytimes.com/2017/01/25/business/dealbook/how-efficiency-is-wiping-out-the-middle-class.html

by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EST] Global equities are holding this week’s gains on renewed optimism that tax changes and infrastructure spending will lift the economy and earnings.  We note that the GOP House leadership is pressing the idea that tax changes should be mostly revenue-neutral and there is a renewed push for border adjustments in the Ryan bill.  As a reminder, the border adjustment would tax imports but not exports.  There is also some marketing going on, with proponents suggesting the border tax is a “fee” to avoid the stigma of a tax.  According to some sources, Trump is uncomfortable with the border adjustment; he is said to believe it’s too complicated and it limits his freedom to unilaterally support friends and harm enemies.  However, these sources also claim that advisor Steve Bannon likes the border adjustment idea.  It appears to us that without the border adjustment, corporate tax cuts will reduce revenue to the Treasury significantly and will lead to a higher marginal rate.  It should also be noted that Congressional Republicans are not strongly behind infrastructure spending but the president is pressing the case for public investment.  It remains to be seen how Trump will handle this if Congressional Republicans refuse to yield.  Will the president team up with Democrats and threaten GOP unity to get infrastructure spending?  We will be watching but we do expect that some infrastructure spending will be forthcoming; the right-wing populists are counting on it.  That infrastructure spending will likely include the border wall that the president is proposing.

In Europe, we are monitoring a couple of political developments.  First, the Social Democratic Party of Germany (SPD) has a new leader, Martin Schulz, and he is apparently looking to run against Chancellor Merkel.  The CSU/CDU conservative parties, led by Merkel, are currently governing with the SPD.  It doesn’t appear to us that one could create a government by excluding either the mainstream conservatives or socialists, but the composition of power could change.  In other words, if the SPD does well in the November polling, the CSU/CDU/SPD coalition could remain but the SPD might win more positions of influence in the government.  Currently, Schulz’s popularity rivals Merkel’s.  If the SPD gains more power, it may be more willing to expand fiscally and reduce pressure on the southern tier nations by boosting imports.

We are also watching reports that French authorities have opened an investigation of embezzlement against François Fillon, the current leading presidential candidate representing the establishment-right in France.  According to reports, authorities are investigating whether Fillon’s spouse was paid €500k of public money for a “no-show” job over an eight-year period.  There were two jobs, one as Fillon’s parliamentary assistant and one as assistant to Marc Jouland, who took Fillon’s seat when he became a government minister in 2002.  It should be noted that hiring family members is not illegal in France (about 10-15% of members of Parliament practice nepotism), but it would be against the law if Penelope hadn’t actually done anything.  Fillon has been running as a right-wing candidate in the Reagan/Thatcher mode, which is unusual for France.  He is calling for sharp cuts in government spending and a reduction in government jobs; he has also been supportive of ending Russian sanctions.  French presidential elections can go two rounds if no candidate wins a majority.  In the second round, only the top two candidates participate.  There are currently three candidates, Fillon, Marine Le Pen of the National Front and Emmanuel Macron, running as an independent (although a Socialist, he is offering free market positions, almost a center-right platform).  The Socialists are still deciding on a candidate.  There has been some speculation that if the current polls are accurate and there is a runoff between Fillon and Le Pen, leftist voters may lean toward the National Front which could bring a populist who wants to leave the Eurozone.  If the charges against Fillon stick, it might reduce Le Pen’s chances, although we tend to think it will simply upend the election and make it harder to predict.  Anything that boosts Le Pen will likely be taken as bearish for the EUR.

We monitor a number of issues in our analysis, in part, to turn “black swans” (issues that are completely unexpected, called “unknown/unknowns”) into “grey swans” (“known/unknowns”).  Infectious disease is one of those factors.  The NYT is reporting that the WHO is monitoring a bird influenza circulating in China that seems to have a rather high mortality rate.  The strain, called H7N9, has been present every winter in China since 2013; more than 1,000 cases have been reported over the past four years with a 39% mortality rate.  So far this year, 225 cases have been confirmed and China is about to embark on the New Year’s migration, where millions of Chinese migrate home for the weeklong holiday.  Vacation travel can increase the likelihood of transmission as travelers mix in close quarters.  This strain has mostly affected those directly involved in poultry farming and processing (it is a bird-flu), but there are two suspected cases of human-to-human transmission; if the virus can be directly transmitted, it could indicate it has mutated into a more dangerous influenza.  Influenza pandemics have the potential to slow global growth as illness and precautions against contracting the disease affect spending and travel.  At this point, this strain remains contained but it does bear monitoring.

U.S. crude oil inventories rose 2.8 mb compared to market expectations of a 2.5 mb build.

This chart shows current crude oil inventories, both over the long term and the last decade.  We have added the estimated level of lease stocks to maintain the consistency of the data.  As the chart below shows, inventories remain elevated.

Comparing the seasonal pattern to the current inventory accumulation is supportive.  Although it is early, oil inventories are rising slower than average.  To justify current prices, inventories will need to decline this year.  As the chart shows, that process should begin in earnest in Q2.

 

Based on inventories alone, oil prices are overvalued with the fair value price of $39.96.  Meanwhile, the EUR/WTI model generates a fair value of $37.71.  Together (which is a more sound methodology), fair value is $36.63, meaning that current prices are well above fair value.[1]  OPEC has managed to lift prices but maintaining these levels will be a challenge given the dollar’s strength and the continued elevated levels of inventories.

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[1] The forecast that uses both independent variables is lower than the two separate models because the €/$ exchange rate and oil inventories are highly inversely correlated at -89%.  In theory, it appears that some investors may be using oil inventories as a way to protect against dollar weakness.

by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EST] After a sluggish start to the year, equity markets have resumed their northward march.  There isn’t a whole lot of news to trigger this rise, although the reversal of the Obama policy on pipelines may have lifted hopes that deregulation is really on the agenda.  Another factor that might be behind the lift is hopes for infrastructure spending.  The Democrats in Congress have suggested a $1.0 trillion spending package; their program has no path for funding.  However, we sense that this president isn’t overly concerned about the size of the deficit.  We suspect that the Democrats are doing this, in part, as a political ploy, thinking they might break the “Ryan/Trump coalition.”  However, it isn’t clear to us that such a coalition really exists.  Trump may be sui generis and could be more than open to supporting a massive infrastructure build over the objections of his own party (and strong objections from his appointee for OMB).  The KC Star and the McClatchy Washington Bureau[1] report that the president’s team has compiled a list of 50 infrastructure projects costing around $137.5 bn.  The fact that his administration is lining up projects surely suggests that he is amenable to infrastructure spending.  Would President Trump team up with Democrats over the objections of Congressional Republicans to approve infrastructure spending?  We believe this is a distinct possibility.

Who wins?  All firms involved in construction and equipment and probably those long the dollar.  The losers?  Treasury bond investors.  A widening deficit and fiscal stimulus in an economy that is arguably near full employment could boost inflation and prompt the Fed to raise rates.  Of course, this assumes the FOMC will continue to follow the policy pattern that has been in place since Paul Volcker, which is to quell inflation by raising rates.  However, we would not be shocked to see this president try to strong-arm monetary policymakers to keep policy accommodative, similar to the Burns/Miller era of the 1970s.  If we get the latter, the dollar weakens, commodity prices rise and long-term interest rates rise as well.  This situation is one of the most significant “known/unknowns” that we are watching.

We do note that this topic of slack in the economy isn’t necessarily settled.  Yes, the unemployment rate would clearly suggest that the economy has little unused labor resources available.  However, the data is not completely clear on this issue.

This is one of our favorite charts to measure the problem of determining slack.  The blue line shows the U-3 unemployment rate, while the red line shows the employment/population ratio.  The two series were highly correlated (+84%) from 1980 until the end of the last business cycle, at which point it has become evident that the relationship between the two series has broken down.  This difference is significant; had the relationship remained the same, the economy would have added 8.3 mm more jobs.  Why has this divergence occurred?  Some of it is due to an increase in retirements.  The term “population” is defined by the BLS as the civilian non-institutional population over the age of 16.  Thus, those in the military and in prison are not counted.  However, as retirements rise, the number willing to work in the population group does fall.  Still, we have serious doubts that this alone accounts for eight million jobs.  Thus, there may be more slack available than the unemployment rate itself would suggest.

In addition, the level of involuntary part-time employment remains elevated.

This chart shows the level of involuntary part-time employment as a percentage of the labor force.  Although the number has been falling recently, it remains well above the troughs seen in the last two business cycles, which may suggest that firms could tap the part-time market for additional workers.

Finally, wages are remarkably low given the current unemployment rate.

This chart looks at the unemployment rate relative to wage growth for non-supervisory workers.  Note that on the graph, the scale for the unemployment rate is inverted and advanced nine months.  In the past, when the unemployment rate has been this low, wage growth has been running a bit higher than 3.75% per year.  It is currently around 2.5%.  The lack of wage growth could suggest that there is enough “hidden unemployment” to keep wages suppressed.

Finally, capacity utilization is consistent with available resources.  Utilization in manufacturing is less than 75%.  We do note the relationship between capacity utilization and inflation isn’t all that clear.  One reason is that the economy is constantly competing with overseas capacity, which may be cheaper to utilize.  This is where the president’s trade policy may have an impact, leading to both higher utilization here and rising price levels.  Still, at present, it appears that the economy could absorb the strain from fiscal spending on infrastructure.

Of course, the other issue is the return on infrastructure investment.  Any investment, either public or private, is measured on its return.  Unfortunately, by its very nature, public investment doesn’t have a clear return otherwise the private sector would willingly provide it.  In theory, roads could be completely privately funded and paid for by user fees.  In a world of electronic tolling, one could even engage in congestion pricing and offer “sales” during slack road use periods.  But some public investment simply can’t be priced; defense is a classic example as are some elements of public transportation.  The issue of wise public investment is complicated.  Many projects turn out to be less of a boost to the economy than planned.  Still, the argument that the economy doesn’t need public infrastructure spending now because it isn’t needed is not necessarily true, as we outlined above.

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[1] http://www.mcclatchydc.com/news/politics-government/white-house/article128492164.html