Retail Spending Clobbers Expectations — The Capital Note


People walk through the Westfield Stratford City shopping centre in London, England, December 5, 2020.
(Henry Nicholls/Reuters)

Welcome to the Capital Note, a newsletter about business, finance, and economics. On the menu today: Retail spending surges, Texas freeze worsens chip shortage, Citigroup loses debt dispute, and the two sides of the output-gap debate. To sign up for the Capital Note, follow this link.

The Reflation
Retail spending grew 5.3 percent in January, beating expectations of a 1 percent increase and marking the first month of spending growth since early fall. The bump in spending follows the distribution of $600 checks included in Congress’s second coronavirus-spending package and indicates that first-quarter GDP could surpass consensus estimates of 3–4 percent.

The impact on markets is somewhat paradoxical. Though increased consumer spending would typically be an indicator of inflation, long-term U.S. government bonds sold off on the expectation that the Federal Reserve would tighten monetary policy sooner than previously expected. And the bump in consumption also decreases the probability of Congress passing Biden’s $1.9 trillion spending proposal.

Meanwhile, the producer price index (PPI) — which measures the change in prices for production inputs — rose by 1.3 percent, its biggest jump since 2009. In tandem with consumer-spending data, the January PPI suggests that price growth is broad-based rather than concentrated in certain pockets of the economy.

As states begin to roll back pandemic restrictions in the next few months, spending growth will likely persist as pent-up demand is unleashed. That’s good news for GDP, but it will also put the Fed’s new “average inflation targeting” regime to the test. The central bank has committed to holding down rates until at least 2023, even if inflation runs above its 2 percent target, but bond prices suggest skepticism on the part of investors. While the average-inflation target means the Fed can live with price growth, markets worry that a serious overshoot will lead to increased rates.

In a speech this morning, Boston Fed president Eric Rosengren said he does not believe that inflation will hit the Fed’s 2 percent target in the foreseeable future. While he continues to see low inflation as a bigger risk than excessive inflation, Rosengren said that “the Fed will take care of it” if prices go too high.

However the Fed chooses to respond to increased consumption, recent data paint an unequivocally optimistic portrait of the U.S. economy. Corporate earnings in the fourth quarter of 2020 came in higher than the same period in 2019, clobbering expectations of a double-digit decline.

As Bloomberg’s Joe Weisenthal pointed out in his newsletter this morning:

Not only is the overall state of the economy and the outlook far better than feared, the present situation is better. There were widespread assumptions of a substantial winter slump due to the current wave of the virus, and yet the economy is still growing throughout this. Just yesterday for example, Jed Kolko of the job site Indeed pointed out that job postings in the U.S. are currently growing at a pace similar to last summer’s sharp rebound. Also yesterday we got the latest Empire Fed Manufacturing Report, which came in way better than expected at 12.1 versus 6.0 survey estimates.

If a surge in economic activity poses a problem for central bankers, it’s a good problem to have.

Around the Web
Texas winter storm blackouts hit chip production

While chip manufacturing in the US is at a far smaller scale than the largest plants in Taiwan and South Korea, the timing of this week’s shutdowns could not be worse for the industry, which has already been struggling to increase supply to meet resurgent demand. The chip shortage has slowed automotive production around the world and threatens to delay other forms of electronics, including smartphones.

In the midst of a major cost-cutting campaign, Wells Fargo is spending billions on risk management to meet regulatory requirements

Wells Fargo is simultaneously shelling out money to remake the vast risk-and-control systems that regulators have said were inadequate to catch the fake-account scandal that got it in hot water more than four years ago. Wells is still subject to 10 regulatory penalties known as consent orders. The harshest, from the Federal Reserve, has capped the bank’s growth for three years.

During a high-stakes dispute over the collateral value of loans made to Revlon, a Citigroup banker accidentally wired $500 million to the cosmetics maker’s creditors. A judge ruled this week the lenders can keep the money.

“The resulting payments equaled — to the penny — the amounts of principal and interest that Revlon owed on the loan to its lenders,” Furman noted in his ruling, adding that Citi had made “one of the biggest blunders in banking history.”

After Citi made those accidental payments to the lenders, many held onto the money, first thinking it was an early repayment before Citi alerted them to the mistake. When those lenders continued to hold onto that money, Citi ended up filing lawsuits against each of them.

Random Walk
Goldman Sachs economist Jan Hatzius put out a report yesterday arguing that the output gap is larger than conventionally assumed:

We argue that standard output gap models currently understate slack because they suffer from severe end-point bias, a spurious tendency to find that the latest actual GDP level is closer to potential GDP than it really is. Striking examples of weakness in model-implied potential GDP following weakness in actual GDP include the successive CBO downward revisions to US potential GDP following the 2008 crisis, and to pre-pandemic non-US potential GDP by the OECD and the European Commission over the past year. It is hard to square these revisions with the consistent inflation shortfalls since 2008.

How much more spare capacity might be available? To get a rough sense, we start by estimating the pre-pandemic output gap based on the employment/population ratio for men aged 25-54 in late 2019/early 2020 relative to its level in 2005-2007 (when we assume economies were at full employment). We then extrapolate to the current output gap by using actual real GDP growth over the past year relative to its pre-pandemic potential growth rate.

Our illustrative output gaps are 3-4pp larger than the average official estimates in the US and the UK, and as much as 5-6pp larger in France, Italy, and Spain. These simple estimates support our view that inflation risk remains limited in the US and largely absent in Europe, despite our above-consensus GDP growth forecasts.

Contrast that with a recent Tyler Cowen blog post:

I’ve never accepted the standard story about “being at full employment” vs. “having unemployed resources” around, though often I write in that framework for reasons of intelligibility…

If you are at what others call “full employment,” you can indeed do better, or at least try to do better.  Start 300 companies that aim to be the next Stripe, Facebook, SpaceX — whatever.  In the short run, you will create jobs, people at jobs will work harder, and so on.  Employment, output, and also tax revenue will rise.  You can pat yourself on the back and say you were not at full employment.

The thing is, you have accepted a higher level of risk.  Many of those companies are likely to fail.  And since they were started by humans consuming a broadly common set of cultural and media inputs, those risks will to some extent be correlated as well.  Of course it might pay off big time as well.

You can always move “beyond full employment” by accepting more risk.  Alternatively, you could deploy some common sense and suggest that no single point on the risk-return frontier corresponds to “full employment.”

And should you be happy about moving beyond full employment?  Was the ex ante level of risk too low, too high, or just right?  Depends!  Even if you think ordinary Americans are too complacent, it does not follow the same is true for the marginal entrepreneurs.

In this setting, failure does not have to mean the gambles were bad ex ante, nor does success validate the initial fervor, as maybe everyone just got lucky.

— D.T.

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