Written by Jim Welsh
Macro Tides Monthly Report for May 2019
The Battle Between Populism and Maximizing Shareholder Value
The issues of CEO executive pay compared to the small increase in median income for workers in recent decades, corporate stock buybacks, and the broader issue of maximizing shareholder value will be discussed widely leading up to the November 2020 election. Some might be tempted to dismiss this debate since it is being led by Bernie Sanders and Elizabeth Warren. That would be a mistake.
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In the July 2017 Macro Tides I forecast that the rise in populism would take aim at the corporate goal of maximizing shareholder value:
“In coming years I expect a backlash against the focus within corporate America of maximizing shareholder value as populism within the U.S. grows and becomes a political force that leads to changes in corporate governess. I will be very surprised if the pendulum doesn’t begin to shift away from maximizing shareholder value toward better wages in the next five to ten years for one reason. The middle class needs a pay increase and the Federal government can’t afford another tax cut, but corporate America can allow profit margins to shrink modestly to pay higher wages.”
The issue of income inequality is real as is the huge disparity in wealth between the small number of those in the top 1% and the bottom 60% of Americans. This issue will resonate with many Americans since it will be easy to demonize the imbalances that have developed during the past 30+ years as the data confirms. A brief history of how changes in the goals of corporate boards led and contributed to these issues will provide a good backdrop.
Over the last 35 years maximizing shareholder value has been the dominant goal of executives of public companies and corporate director boards. The seed for this philosophy was planted in a New York Times Op-ed piece by Milton Friedman in 1971 making the case that corporate executives needed to have their incentives aligned with shareholders. According to Friedman, the best way to accomplish this was to primarily link executive’s compensation to the performance of the company’s stock. The secular bear market that lasted from 1966 to 1982 fomented shareholders’ frustration with poor stock returns and was a fertile environment for the seed Friedman planted to blossom. The Mission Statement of the Business Round Table in 1981 stated:
“Corporations have a responsibility, first of all, to make available to the public quality goods and services at fair prices, thereby earning a profit that attracts investment to continue and enhance the enterprise, provide jobs, and build the economy. The long term viability of the corporation depends upon its responsibility to the society of which it is a part. And the well being of society depends upon profitable and responsible business enterprises.”
In 1997 the mission statement of the Business Roundtable stated that the principle objective of a business enterprise “is to generate economic returns to its owners” and if “the CEO and the directors are not focused on shareholder value, it may be less likely the corporation will realize that value.”
The shift in emphasis from an enterprise to provide jobs that contribute to the well being of society in 1981 to a far narrower focus to generate economic returns to its owners in 1997 is clearly evident in how wages and profits as a percent of GDP has evolved since 1947. Corporate profits as a percent of GDP are near the highest level of the past 70 years, while worker compensation is near the lowest level since 1947.
(Chart compliments Doug Short, Advisor Perspectives)
At the end of 2018 Profit Margins as a percent of GDP slipped to 9.48% and Employee Compensation moved up to 43.0%.
The Korn Ferry Hay Group study of CEO compensation examined all forms of pay for CEOs at the 300 largest public companies with revenues of at least $9 billion in fiscal year 2016. Overall, CEO total direct compensation increased 4.2% to $12.5 million. However, median annual cash compensation for CEOs was flat at $3.5 million, including minimal base salary growth of 0.8% to $1.3 million and annual bonus payments remaining flat at $2.3 million. Stock awards were up 4.3% to $6.3 million and total longterm incentives grew 4.4% to a median value of $8.8 million.
The emphasis on performance awards as part of the long-term incentive mix increased to its highest level with performance awards accounting for 54.7%, followed by restricted stock at 22.7% and options at 22.6%. Base salary represented just 10.0% of total compensation while stock and stock option related income represented 50.3%
The Korn Ferry Hay Group study of CEO compensation was based on 2016 data and it is likely that Base salaries for the CEO’s of the 300 largest companies are up since 2016, and with the S&P 500 and NASDAQ Composite at new all time record highs, the stock and stock option portion of annual income is higher as well. For comparison I’m going to use the 2016 CEO data with current estimates of median income in the U.S. According to Sentier Research median household income in the U.S. dropped to $63,378 in February 2019. The ratio of CEO Base salary to median income is 19.7 to 1 while the ratio to Total compensation is an eye opening 196.7 to 1.
(Data compliments of Sentier Research, Chart above compliments Doug Short, Advisor Perspectives)
The red line shows that Median Income has increased from $40,597 in January 2000 to $63,378 in February 2019. On the surface the increase of 56.1% looks impressive. After adjusting for inflation based on the Consumer Price Index, the increase in real wages is a meager 3.1% since 2000. ($61,471 to $63,378) The weak growth in real wages is the real reason why the majority of Americans don’t feel they are getting ahead and after reviewing the data it’s easy to see why they feel that way.
The Economic Policy Institute is a non-profit progressive leaning American think tank based in Washington, D.C. that carries out economic research and analyzes the economic impact of policies and proposals. Based on their data the ratio of CEO compensation to the average worker is 276 to 1. EPI’s ratio is higher than my estimate of 196.7 to 1, since EPI’s estimate of the typical worker’s income is quite a bit less than Sentier Research’s estimate of median income. Despite the difference the message is the same and clear. CEO compensation has accelerated since the early 1980’s and exploded since the mid 1990’s. It is interesting that in the 1960’s the CEO ratio was about 20 to 1 which is about where the ratio is now based on CEO base pay.
It is fairly argued that this ratio does not include the significant income transfers that the government provides through Social Security, Medicare, Medicaid, and a host of other programs that supplement many Americans income. Even when adjusted for income transfers the gap between those in the top 10% and the bottom 50% and 90% is enormous. As you can see the gap began to really widen in the early 1980’s and has persisted ever since.
So what changed in the early 1980’s that may have contributed to growing income inequality?
Prior to 1982 share buybacks were virtually non-existent in the U. S. due to regulations aimed at limiting the potential for share price manipulation. The Securities and Exchange Commission (SEC) reconsidered its position in 1982, and established a safe harbor for companies wishing to distribute cash to investors via share buybacks. An August 2018 analysis by MSCI of 610 companies within the MSCI US Index for the 15 year period ending December 2016 produced some interesting numbers.
Over this 15-year period, the 610 MSCI USA constituents paid over $3.86 trillion in cash dividends, and repurchased just under $5.19 trillion of their own shares. Excluding financial companies, which report total assets differently, the combined total payout was equal to 48.6% of total 2016 constituent assets, or $3.2 trillion in dividends, and $4.4 trillion in buybacks.
After the SEC changed the buyback rule in 1982 the frequency and amount of share buybacks began to rise almost immediately, eventually exceeding dividends as the primary means of distributing corporate profits to investors. At the 610 MSCI USA Index constituents MSCI studied, total buybacks have exceeded total dividend payments every year since 1997.
The increase in buybacks since 1997 for the 610 companies analyzed coincided with a pronounced drop in expenditures on CAPEX from 8% of Total Assets in 1997 to 4% in 2016 and a decline from 3.8% on Research and Development in 1997 to 2.1% in 2016. On the surface it appears that companies have become more focused on the short term benefit of buying back stock at the expense of the long term benefits derived from investing in R&D and CAPEX.
MSCI concluded some of the decline in CAPEX and R&D was due to the shift away from manufacturing and for a greater portion of growth coming from acquisitions, rather than internal investments. While those factors may account for some of the decline in CAPEX and R&D spending, the shift toward maximizing shareholder value has played a role. According to the 2017 CEO and Executive Compensation Practices published by the Conference Board, stock awards represented 47.4% of compensation for the CEO’s of companies in the S&P 500 in 2017. Base salary has fallen from 14.22% in 2010 to 11.3% in 2017. The result of the Conference Board’s review of executive compensation in 2017 is aligned with the Korn Ferry Hay Group study of CEO compensation for 2016. Data for 2018 is not yet available.
With so much of executive compensation coming from stock awards, the conflict of interest between executive compensation and stock buybacks is the elephant in the room. Over time stock prices rise as corporations use cash flow and borrowed money to buy back their stock, which increases the value of executive’s stock options.
Milton Friedman believed that corporate executives needed to have their incentives aligned with shareholders and the best way to accomplish this was to primarily link executive’s compensation to the performance of the company’s stock. Friedman would be pleased to see what has occurred since he wrote his article in 1971, but executives may have been overpayed between 2006 and 2016. Analysis by the investment research firm MSCI published in October 2017, found that 61% of the 423 companies it studied in the ten years ending in 2016 had 10-year shareholder returns that were “out of whack” with the pay CEOs took home over the same period:
“These findings suggest that the 40-year-old approach of using equity compensation to align the interests of CEOs with shareholders may be broken.”
A number of Democratic candidates running for president have targeted stock buybacks with proposals to regulate them. In an early February Op-Ed in the New York Times Senator Bernie Sanders (D-Vt.) and Senate Minority Leader Chuck Schumer (D-NY.) said they plan to propose legislation that would bar companies from buying back their own stock unless they do other things first, such as paying their workers at least $15 an hour, provide seven days of paid sick leave, and offer decent pensions and more reliable health benefits.
Sen. Tammy Baldwin (D-Wis.) has introduced legislation that would repeal the Securities and Exchange Commission rule allowing stock buybacks by ending corporations’ ability to repurchase stocks in the open market:
“The surge in corporate buybacks is driving wealth inequality and wage stagnation in our country by hurting long-term economic growth and shared prosperity for workers. We need to rewrite the rules of our economy so it works better for workers and not just those at the top. This legislation makes it clear that empowering the voices of our workers and investing in our workforce is more important than using tax breaks and corporate profits to reward shareholders with more stock buybacks.”
Baldwin’s bill is co-sponsored by Senators Elizabeth Warren (D-Mass.) and Brian Schatz (D-Hawaii) and would require one-third of a public company’s board to be chosen by its workers. It comes as no surprise that a number of prominent unions support efforts to curb stock buybacks including the AFL-CIO and the Communications Workers of America.
In aggregate the $806 billion in buybacks by S&P 500 companies in 2018 and $223 billion in the fourth quarter is an easy target for politicians to stir negative sentiment and anti-corporate attitudes. However, a large portion of the buybacks in 2018 were concentrated among a small number of companies and those companies spent far more on Research and Development than the average U.S. firm. Apple bought $74.2 billion of its stock in 2018 while the top 10 firms accounted for $177 billion of the $271 billion increase in 2018 or 66%. Those 10 companies spent 13% of sales on Research and Development compared to 9% for companies in the S&P 500.
This highlights an important point. A large portion of stock buybacks are being done by companies that are growing the fastest and investing more to keep growing. These companies are rewarding investors in the short term but also for the long term based on their heavy Research and Development spending.
However there are older companies in sectors that are not growing quickly like IBM that continues to buy back stock even as its sales revenue continues to fall. It’s certainly possible that smart R&D spending by IBM in past decade could have resulted in more sales and better stock performance.
Politicians love one-size-fits-all solutions since they usually lend themselves to an oversimplified solution to a complex problem. This is why so many political solutions result in negative unintended consequences that undermines the good the legislation was intended to accomplish.
There are two problems with the amount of compensation executives receive and how they are paid. The amount of compensation has clearly created a problem of income inequality that has become a divisive issue for our society. The average executive in large companies is making 197 times the median income of all workers. I’m sure most executives feel they are indispensible to the survival of their companies, but no one is worth 197 times the average worker.
The second problem is that so much of executive compensation (more than 50% in 2016) is based on stock and stock option related income. I’m willing to assume that the majority of executives do their best to make the optimal strategic decisions for the long term benefit of their companies, but the conflict of interest from stock incentive plans is always lurking.
The argument that investors benefit from stock buybacks doesn’t hold much water. According to Gallup, just over half of Americans own stocks at all. The richest 10% of Americans own 84% of all stock shares, while the bottom 80% of earners own just 6.7%, according to Edward N. Wolff, an economist at New York University based on data at the end of 2016. And that includes everyone’s stakes in pension plans, 401(k)’s and individual retirement accounts, as well as trust funds, mutual funds and college savings programs like 529 plans. In other words, rich people benefit a lot more from stock buybacks than your average worker with a 401(k) or individual investors who own mutual funds in an IRA.
A simple way to reduce income inequality is to lower the multiple from 197 to 1 that CEOs receive of median income. Better yet would be to apply the multiple to the average earnings of the production / non-executive pay of the workers in the companies they manage. Congress, in its infinite wisdom, can decide whether 50 or 100 is the appropriate multiple ceiling. For instance, if the average production / non- executive employee earned $40,000 a year, the CEO would be paid a maximum of 50 to 100 times that amount. That would limit the CEO to somewhere between $2 million to $4 million in total annual compensation.
In 2016 the average CEO stock and stock option related income represented 50.3% of their total compensation. I would cut that in half to 25% to reduce the conflict of interest between using corporate buy backs to boost the value of stock options held by the CEO and other executives. A limit of 25% is still meaningful enough to support Milton Friedman’s concept of aligning executive’s compensation to the performance of the company’s stock. If the average production / non- executive employee earned $40,000 a year, the CEO would earn a maximum of $4 million (multiple of 100) with a maximum of $1 million coming from stock incentives. Congress could mandate that this information be made public.
If workers were paid more they would in the aggregate have less debt, more savings, and the capacity to spend more. The economy would grow faster, saving would be higher, and fewer working Americans would be living paycheck to paycheck. Corporate America would benefit from an increase in GDP growth over time and would thus recapture some of the higher wages paid to their employees.
Reaching this outcome via a government mandated increase in wages would help some workers but likely result in some negative unintended consequences. In states and cities whose cost of living is well below New York, California, and the majority of large cities, a government mandated increase in the minimum wage to $15.00 an hour would lead some companies to close locations that became unprofitable.
An analysis by the Congressional Budget Office in 2014 estimated that an increase in the national minimum wage to $10.10 an hour in 2016 would lift the income of many low wage earners above the poverty level, but also result in the loss of 500,000 jobs. An increase to $15.00 an hour would result in more job losses.
As noted, politicians love one-size-fits-all solutions since they usually lend themselves to slogans and an oversimplified solution to a complex problem. Congress could ask companies to adopt and honor the 1981 Business Roundtable Mission Statement:
“Corporations have a responsibility, first of all, to make available to the public quality goods and services at fair prices, thereby earning a profit that attracts investment to continue and enhance the enterprise, provide jobs, and build the economy. The long term viability of the corporation depends upon its responsibility to the society of which it is a part.”
Reminding corporations of this repsponsibility doesn’t have the same political buzz as burning overpaid executives in effigy and proposing solutions that may cause as much harm as good, but resonate with an uninformed electorate.
Demographic changes will be the driving force behind changing the corporate boardroom obsession with maximizing shareholder value. Members of the Millennial and Gen Z generations believe the government should do more to solve problems. According to a recent survey by the Pew Research Center, 64% of Millennials support more government intervention to solve societal problems, while Baby Boomers are split. Those born after 1996 are part of the Gen Z generation and are even more supportive of the government doing more (70%) compared to their Gen X parents (53%). As the children of Baby Boomers, Millennials are 15% more in favor of the government taking a bigger role, while Gen Z’s are 17% more supportive of a larger role for government than their Gen X parents.
A University of Chicago’s GenForward Survey of Americans age 18 to 34 conducted in 2017 found that 62% think “we need a strong government to handle today’s complex economic problems,” with just 35% saying “the free market can handle these problems without government being involved.”
The South by Southwest Conference & Festival is a 9 day music and media festival that was held this year in early March. The Conference has become more political in recent years. Attendees, who paid between $1,325 and $1,650 for their “primary access to ALL events” passes, got to listen to Democratic presidential candidates Sens. Elizabeth Warren, Amy Klobuchar, Julifln Castro, Robert Francis O’Rourke, and Alexandria Ocasio-Cortez, who filled 3,200 seats in the Convention Center on March 9.
During Alexandria Ocasio-Cortez hour long interview with Briahna Gray of the Intercept, a left-wing news site, AOC as she is known to her supporters and fans provided some valuable insights into her views of capitalism:
“The most important thing is the concentration of capital, and it means that we prioritize profit and the accumulation of money above all else, and we seek it at any human and environmental cost:
“Capitalism is an ideology of capital – the most important thing is the concentration of capital and to seek and maximize profit. So to me capitalism is irredeemable. We are driven to work 80 hours a week when we are being the most productive at any point in American history.” [If the profits weren’t] “skimmed off and given to a billionaire,” [we would] “be working the least amount we’ve ever worked.”
This view of billionaires was expressed succinctly by one of AOC’s top aides who recently tweeted:
“Every billionaire is a policy mistake.”
I wonder how AOC would characterize Bill Gates, Steve Jobs, and Jeff Bezos. Bill Gates created the operating system which made personal computers possible and affordable for the masses. Steve Jobs created personal computers, iPod, iPad, and the iPhone, which I’m sure AOC and her staff use constantly since she is a huge social media user. Jeff Bezos made it easier for people anywhere to buy and receive products usually for less cost, which is why Amazon is so popular with AOC’s Millennial generation.
The vast majority of the wealth accumulated by Gates, Jobs, and Bezos came from the appreciation in their company’s stock and not from income. The rise in their stock’s value helped pension funds improve their investment results and made millionaires out of many of the early employees in their companies. These three companies have created a lot of good paying jobs – Microsoft employs 131, 000 workers, Apple 132,000, and Amazon 566,000. The American form of capitalism has always been a work in progress and is still far from perfect. But to say it is irredeemable suggests that Alexandria Ocasio-Cortez has passed judgment and wants to replace it with her brand of socialism with like-minded associates calling the shots.
The point is that Millennials and Gen Z’s are more receptive to this messaging and will become the largest number of voters in the next 10 years. They will hold more elected positions in federal, state, and local governments than Baby Boomers, and therefore be in position to set policy and the direction of this country. Some of the receptivity to the messaging of Bernie Sanders, Elizabeth Warren, Alexandria Ocasio-Cortez, and other candidates is based on ignorance.
The average person believes that for every $1.00 of sales the average company makes $0.36, according to a survey by the American Enterprise Institute. In January 2018 and based on the N.Y.U Stern database for more than 7,000 companies in the U.S., the average profit margin is 7.9% and 6.9% for the 6,000 non financial companies. The median profit margin was 6.0% with 72% of the 100 industries analyzed having singledigit profit margins. According to Commerce Department’s National Income data, from 1947 through the end of Q3 2018, average profit as a percent of GDP was 6.90%.
Just as the issue of income inequality is real, the huge disparity in wealth between the small number of those in the top 0.1% and the bottom 90% of Americans is real and indefensible. The top 0.1% now owns 22% of total household wealth compared to 24% owned by the bottom 90% of households. In the late 1920’s, the top 0.1% owned more than the bottom 90% but the current level is extreme according to any reasonable metric.
Just as tension builds up along a fault line prior to an earthquake, tension will continue to build on the issues of wealth and income inequality since they are the fault lines of our time. The changes required to address both issues will not come easily and are more likely to be forced upon the top 10% of wage earners and the wealthy through higher taxes on earnings and assets. Elizabeth Warren’s proposal to require the top 75,000 households to pay an annual tax of 2% on each dollar of their net worth above $50 million and 3% on every dollar above $1 billion may be the first attempt to levy a tax on assets, but it won’t be the last. As Warren noted in an email to her supporters:
“The top 0.1% of American families – the richest 1 in 1,000 – now have nearly the same amount of wealth as the bottom 90% of American families combined. Meanwhile, for everyone else, opportunity is slipping away. We need structural change to fix it.”
The point of this discussion is not to pass judgment on whether the coming changes are good or bad. It is hoped that by anticipating the changes they won’t be a surprise and ideally will provide insight into how and when they will affect the financial markets as they surely will. Most earthquakes cause some damage and when the fault lines under income and wealth inequality give way, I can’t imagine there won’t be some economic disruption that has the potential to increase volatility in the financial markets significantly. My guess is that it may be several years before these issues are confronted with legislative remedies but the 2020 election will be illuminating and provide a guide as to the timing.
Trade Negotiations At Critical Phase
The expectation has been that monetary and fiscal stimulus in China would lead the way for a recovery in China, subsequent improvement in Europe, and the global economy in the second half of 2019. That expectation is based on a positive trade outcome with China and the EU with no additional tariffs being enacted. Should negotiations collapse with either China or the EU the outlook for the second half of 2019 would be negatively altered. The month of May could prove pivotal in resolving the trade negotiations with China and the European Union.
On April 30 White House Chief of Staff Mick Mulvaney was asked if Secretary Steven Mnuchin’s suggestion that the White House could announce an agreement with Beijing in the next two weeks. Mulvaney responded:
“I think you’ll know one way or the other in the next couple weeks.”
On February 17 the Commerce Department gave its recommendations to President Trump on whether he should apply tariffs on imports of auto parts and autos from the European Union. President Trump has 90 days to make his decision which targets May 17 as T-Day. The U.S. has long wanted the E.U. to open up its agricultural markets to U.S. farmers. Negotiations made no progress during the Obama administration and the E.U. has continued to reject opening its agriculture markets to U.S. farmers despite President Trump’s threat of tariffs. The question is whether President Trump will choose to use a threatened 25% tariff on E.U. vehicle imports to pressure the E.U. into negotiating changes to its agricultural trade policy. I doubt that strategy would succeed and the EU has emphatically said it would impose retaliatory tariffs on the US.
Global Economy
Changes in central bank monetary policy precede changes in credit, which lead changes in economic growth by 6 to 12 months. The most recent example is China which began to ease monetary policy progressively in the second half of 2018, which suggested economic data would begin to improve before mid year. This expectation has been realized as recent data from China indicate that its economy has begun to stabilize and register better growth.
The Citigroup Economic Data Change Index for China illustrates the progressive weakening in growth through 2017 and 2018 and the significant positive turn up in data in the last two months. Although the Data Change Index is still negative, the improvement helped first quarter GDP to come in better than the forecast of 6.3%.
The ongoing improvement in China is expected to continue in coming months and begin to lift the EU. In the primary 19 countries within the European Union, exports represented 47.4% of GDP in 2018 up from 45.7% in 2016. The largest customer for E.U. goods and services is China, which is why any improvement in China’s economy will provide a lift to the E.U. and especially Germany. A review of the PMI indices for manufacturing and services in Germany show that the weakness in the German economy has been concentrated in manufacturing mirroring the decline in China throughout 2018.
The PMI for services has remained remarkably stable despite the softening in exports to China. This suggests that as China strengthens its demand for imports from Germany should improve and lead to an improvement in the overall German economy. Germany represents 30% of EU GDP so as Germany goes so does the EU.
Worldwide credit growth has picked up after being negative in the second half of 2018 and in early 2019. The improvement in credit growth bodes well for global growth in the second half of 2019.
Another encouraging sign comes from the Regional Economic Surprise Indexes outside the US. In the April Macro Tides I discussed why the Economic Surprise Indexes were ready to improve:
“Arbor Data Science combines all 35 of Citigroup’s Economic Surprise Indexes and calculates what percent of the 35 countries are positive or negative. The stunning aspect of Arbor’s analysis is that the percent has fallen to just 6%, which means only 2 of the 35 Economic Surprise Indexes are above 0%. The last two times the percent has been below 10% was in 2008-2009 during the financial crisis, when global GDP contracted by -1.7%, and in 2003. The International Monetary Fund (IMF) estimates global GDP will slow to 3.5% in 2019 down from 3.7% in 2018. This suggests that negativity about the global economy has become excessive relative to economic reality. The potential for positive surprises in coming months is good and will come as a surprise since expectations are so low.”
The Economic Surprise Indexes for every region has turned higher except for the U.S. While this may cause concern, and reinforce the expectation that the Federal Reserve’s next move will be to lower the federal funds rate, there may be an obvious explanation. The tail is wagging the dog in the sense that the U.S. is finally experiencing the effects of the global slowdown that progressed throughout the second half of 2018 and into 2019. If the global economy improves as expected, the U.S. will be the beneficiary of a tailwind, rather than the headwind the slowing in global growth represented. In coming months the Citigroup Economic Surprise Index based on Hard Data in the U.S. is expected to show improvement.
Federal Reserve
The Federal Reserve’s preferred inflation metric, the Core Personal Consumption Expenditures (CPE) Index, fell to 1.6% from March 2018, which is comfortably below the Fed’s 2.0% inflation target. The decline has been particularly sharp in the last 3 months.
This has led to speculation that the Fed will lower the federal funds rate before the end of 2019. This speculation has been spurred in part by Tweets by President Trump prompting the Fed to lower the fed funds rate by 0.5% a few weeks ago to suggesting the Fed cut by 1.0% after GDP grew by 3.2% in the first quarter. Let’s be clear, no one on the FOMC is swayed by any Tweet from the President or anyone else.
Chair Powell through some cold water on the low inflation motive to lower rates at his post FOMC meeting press conference. Powell explained that the central bank sees the weakness in the Core PCE as the result of “transitory” factors, such as lower portfolio management service fees, lower apparel prices, and airfares. During his press conference Powell used the word transitory or some version of it a total of 9 times, just in case market participants didn’t get the message after the first 5 times. After Powell’s comment the probability of the Fed cutting rates before the end of 2019 dropped from 68% to 55%.
With so many still expecting a cut, it would be a rude surprise if the economy strengthened in the second half of 2019 and inflation began to grind higher. The prospect that the FOMC may have to consider a rate increase before the end of 2019 would shake things up.
Although the Core Personal Consumption Expenditures Index has been the Fed’s favorite measure of inflation, there are indications that the FOMC has been reviewing other inflation indexes. In recent interviews FOMC members James Bullard and Robert Kaplan have mentioned their preference for the Dallas Fed’s Trimmed Mean Inflation Rate (TMIR). This is how the Dallas Fed defines it:
“Calculating the trimmed mean PCE inflation rate for a given month involves looking at the price changes for each of the individual components of personal consumption expenditures. The individual price changes are sorted in ascending order, and a certain fraction of the most extreme observations in both tails of the distribution are thrown out, or “trimmed”. The trimmed mean inflation rate is then calculated as a weighted average of the remaining components.”
By trimming the most volatile components within the Consumer Price Index, (when the monthly figure is outside its longer term moving average), the TMIR is less volatile and the Dallas Fed researchers found that it was more accurate over time. While the PCE ex Food and Energy fell from 2.0% in December to 1.6% in March, the TMIR was flat at 2.0%. This likely influenced Powell and other FOMC members that the decline in the PCE was due to the transitory factors Powell described.
Economic data are not either too weak or too strong to require any response from the FOMC. Although inflation is closer to its target of 2.0% according to the TMIR, there are no indications that inflation is headed higher in the near term. This allows the FOMC to remain patient until the outcomes of the trade negotiations with China and the EU are known.
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