Back to the Old Normal?

By Dennis Boone

After years of suggesting that  the economy had undergone a perilous and profound change—some called it the ‘new normal’— economists see a potential for better performance in 2015, fueled by a once-in-a-generation decline in oil prices.

At the dawn of a new year, “oil,” “output” and “optimism” have a lot more going for them than their alliterative possibilities: The six-month reversal in oil prices—plunging by more than half, from $115 to $47 per barrel of Brent North Sea crude between late June and mid-January—has economists almost uniformly projecting stronger economic growth for the U.S. this year.

What’s the significance of the current oil price floor? In inflation-adjusted terms, a barrel of oil today costs less than in 1974, the year following the first Arab oil embargo. And that means big things for U.S. economic prospects.

“Certain countries are getting hurt by the decline, obviously,” says Bill Greiner, chief economist for Mariner Wealth Advisors in Leawood. “But in general, for the rest of the world, the benefit of this is like a very, very large tax cut.”

Greiner is not alone. Among a sampling of economists from different sectors in the Kansas City region—working in financial services, academic settings and public policy venues—all cite the powerful and stimulating potential of oil prices that could go as low, some believe, as $40 a barrel. If theirs were a weather forecast, it would definitely be calling for sunnier skies.

But the economy is a complex weave of markets, transactions, policies, consumer behaviors and countless other variables. What about inflation? Interest rates? Employment levels, federal deficits or conditions in other nations?

When you try to unravel that tapestry and find its essential threads, oil is one that sticks out. Many of those other factors, though, seem to be aligning in ways that could make 2015 the best year for U.S. economic performance since before the onset of the 2007 recession, economists say.

“Interest rates are as low as they’re ever going to be in my lifetime,” said Michael Stellern, a professor of economics at Rockhurst University. “The federal deficit is now below $500 billion—it was $1.4 trillion just a couple of years ago—consumer confidence is up, and real disposable personal income was up almost 3 percent in the third quarter. So it just doesn’t get much more positive than what we’re seeing.”

Chris Butler, with the Butler Lanz & Wagler investment advisory firm in Overland Park, draws a distinction between current measurements and leading economic indicators—and it’s a distinction worth noting. Current indicators, he said, “are actually pretty good. Manufacturing, broadly defined, is driving the economic bus. Particularly, the shale oil and gas boom has really been a strength for this economy for the past five years.  We are experiencing a little deceleration in the fourth quarter, but nothing of any concern yet.” But he called the leading economic indicators “a bit more troubling. The growth rate in leading indicators corresponds with a low growth rate in the economy over the next year.”

Behind the Oil Boom
They seem almost quaint now, those fevered prophets of Peak Oil, the Web sites foretelling civilizational collapse and impending $200-a-barrel prices, and the tongue-lashings they delivered to those who said innovation within the industry would solve the riddle of high oil prices.

But innovation—in the form of hydraulic fracturing, horizontal drilling and advances in other oilfield production techniques—has stamped “Made in America” on the world’s current oversupply. Which raises a question: What happens to global oil prices when those same techniques are applied in nations that have endured declining oil output in recent years?

Six months isn’t much time to turn a boat as big as the U.S. economy, but momentum was clearly building even before oil prices reached their peak in June. Recent revisions in U.S. gross domestic product for the third quarter of 2014—to 5 percent, the best quarterly output in 11 years—are disputed by some economists nationwide as a statistical manipulation of the underlying economic realities. But that boost, following a 4.6 percent increase in the second quarter, will help offset the 2.1 percent first-quarter decline attributed to a horribly cold winter across much of the U.S., and should yield a solid final number for the year.

Driving those strong back-to-back quarters, economists say, is increased consumer spending, which historically has accounted for two-thirds of economic output in the U.S. And what’s fueling that?

“You’re spending $20 less a week on a tank of gas, so that’s $80 to $100 a month to spend going to restaurants, buying new clothes, saving for vacation,” said Stellern.

“And that higher level of spending begins now; consumers are not waiting for a tax return. Every time they go to the pump, they’re spending considerably less to fill up that tank, and that has a right-now effect, an immediate effect.”

That decline in oil prices won’t do much to help oil-driven Texas, North Dakota and Oklahoma, or industries such as oil-services firms, noted Ernie Goss, a Creighton University economist who extensively studies the region’s agricultural economy.  But for the rest of us, the news is good: “If oil prices remain around $50 per barrel for a period greater than six months,” Goss said, “U.S. GDP growth
will return to pre-recession levels.”

Butler expects prices to remain depressed through at least six months, but suggests pundits are overlooking the demand side of what’s happening with global oil markets. “For the most part, the financial and mainstream media have portrayed this to be a supply issue and it’s easy to see why,” Butler said. “But demand for oil has not remained constant. It’s been dropping for several years, and has been dropping even more lately as global economic growth has been slowing in places that usually contribute significantly to the global economy, like China, Japan and Europe.  This really needs to be framed as a demand story first.”

After all, he noted, supply could be reduced tomorrow by OPEC, given the proper incentives to do so. “But demand cannot just turn around on a dime,” Butler said.  

Robert Brazelton, a longtime economics professor at UMKC, called oil prices a double-edged sword. “Good for the East Coast perhaps, but not so much for the oil states if production and drilling is cut back.” Such a pullback, he said, “might cut employment in the oil states, and the oil states banks’ may be dangerously into oil loans at the higher price. If so, this is a financial danger to the area.”

That would influence the broader economy, Brazelton said, even though the worst would be felt in the Midwest where the production is. “This will be an offset to the effect of lower oil prices on consumption if such projected consumer demand from the lower oil price does indeed last,” he noted.

Risk Factors
The optimism may be shared, but it comes with a few caveats. The long-awaited risks of higher inflation and higher interest rates, for example, still lurk. Unemployment seems to be improving, but there are valid reasons not to gloat about a 5.8 percent jobless rate. In other words, we are not out of the woods just yet.

“I have three concerns, and No. 1 would be inflation,” said Stellern. “The Fed’s board of governors has pursued months—years—of Quantitative Easing, and there are record levels of M1 money out there.” The reason inflation hasn’t kicked in, he said, is that there hasn’t been enough spending from overly cautious consumers during the long stagnation. “But (Fed Chairman Janet) Yellen has said she wants inflation at 2 percent, and we’re almost a full percentage point below that now.”

Higher interest rates, said Goss, pose “the greatest risk to the U.S. economy for 2015. … If inflation should pick up significantly, which I do not expect it to, the Federal Reserve would have to raise rates at a pace that could push the nation back into slow- to no-growth territory.”

Greiner cited one other issue: “The second half of the year, we’re forecasting that capital spending growth rates are going to be shaved a lot,” he said. Which makes sense; fully 10 percent of the S&P 500’s capitalization comes from companies involved in the oil sector, he said, and those companies represent 30 percent of capital spend-ing in that group.

Their spending rates for the first half of the year, he said, “are baked in the cake. You can’t just flip a switch and stop pumping in the Eagle Ford. It takes a while to get all that cranked down.”

Nonetheless, Greiner said, second-half consumption growth should be up enough to add at least half a point to the 2015 GDP growth rate.

Perhaps the greatest risk being posed to a broader recovery is the economic distortion that comes from an environment of artificially low interest rates, Butler said. “As a result of our current monetary policy, firms are not as incented as they once were to grow their businesses,” he said. “They’ve discovered they can increase profit per share by simply buying back their own shares. In many
cases, these firms have taken advantage of low interest rates to issue bonds or take on other forms of debt to finance stock share buy-back programs.”

Artificially low rates, he said, affect the allocation of resources toward their most efficient uses and distort the economy’s productive structure.  “Five years into these distortions,” Butler said, “I’m concerned about the corrective process that usually follows.”

The Employment Riddle
On the jobs front, Goss is trying to see through the good news/bad news cloud inside his crystal ball. “The U.S. economy and the regional economy are adding jobs at a solid pace,” he said. “However, a high share of the additional jobs is in low-wage sectors and/or the jobs are part-time.” Result? Anemic wage growth that is only slightly outpacing the low rate of inflation.  

“Our monthly surveys of businesses in the mid-America region indicate that due to much weaker farm income, job growth for 2015 will be positive. but less than that for 2014,” he said, and a stronger U.S. dollar will continue to weigh on farm income and job growth for businesses with close ties to agriculture.

Complicating the task of federal policy-makers is the longstanding goal, only recently relaxed, of printing money with Quantitative Easing until the jobless rate fell to 6 percent. But that target may prove illusory, coming as it does amid an unprecedented drop in labor participation rates.

“I would like to see a lower target for unemployment than 6 percent,” said Brazelton, “and the lack of increased inflation so far is an argument in my favor.”

That 6 percent figure, Greiner said, is probably not a valid target. The reason has to do with something called NAIRU (the Non-Accelerating Inflation Rate of Unemployment). “Most pointy-headed economists say NAIRU is between 4.5-5 percent; I think it’s closer to 5.5, up to 6 percent,” Greiner said. “The old standards of this rate/that rate being the rate we ought to use to measure whether things are going like they’re expected, that’s not a valid number. The true number of unemployed is probably a lot higher.”

In fact, Goss said, the labor force participation rate sits at its lowest level since 1978. Worse yet, he said, “the individuals who have left the work force will find it increasingly difficult to re-enter the job market, even when the economy has fully rebounded. Their skills are depreciating, making re-entry to the work force more problematic.”

Even though the official rate is below 6 percent, Stellern said, “there is a significant percentage of people who are underemployed; they have a job, but are not doing what they could be—the accounting major selling hamburgers at McDonald’s.”

Even Yellen has questioned whether that seismic shift in the labor participation rate represents a structural change in the economy, he said. “So is it really structural change, or when the economy is improving, will Baby Boomers who stopped looking for work jump back in and increase the participation rate to back where it was?”

Some analysts, noted Butler, have claimed that the stubborn refusal of the employment-to-population ratio to budge was the result of an aging work force with more retirements. “At first blush, that makes sense,” he said, “but the facts don’t bear that out. Since the end of the last recession, it’s actually the more aged who have gotten the lion’s share of the jobs.”

One consequence of more older Baby Boomers remaining in the work force, he said, “means the anemic employment-to-population ratio shows that there are more able-bodied people not working, for whatever reason, than should be the case for a recovery.”

Winners & Losers
So who’s poised to win this year—and who’s at risk?

“For the first time since the recession began in 2007, the retail sector is poised to take advantage of relatively low oil and fuel prices,” said Goss. “Furthermore, wage growth for 2015 will be well above that for 2014 for workers who are skilled and/or well educated.”
Stellern said interest rates could determine some winners. “I would think the housing industry, because rates are so low,” he said. “And I would guess the retail industry, because of the extra money consumers are getting from the decrease in gas prices.” His list of losers includes energy-sector companies. “They’re laying people off now,” he said.

Other losers, he said, would be in the renewable energy fields. “This is going to jeopardize the solar and wind industries, all of these renewable energy sources that don’t pollute like oil and gas do. They’re all going to be threatened.”

Personal consumption, Greiner said, “is going to show a nice pop on the upside—in the 3 percent range, roughly speaking. And that’s a real number, after inflation. In recent years, it’s been muted, and consumer sentiment was very poor with the high unemployment levels. Over the last 12 months, the sentiment has improved, and with gas prices down, it’s improving more rapidly. The stage is set for continued improvement.”

Conditions Abroad
Face it: Even in the middle of America, our fortunes are not truly our own. Global events will intervene. The only question is, how—and how significantly?

“Europe can’t seem to figure out a way to grow without falling on their faces,” Greiner said. “They risk falling into their third recession in six years, and the risk is very real.

I don’t expect it to, but it will be touch-and-go in Europe for economic growth the next 12 months or so.”

Much of the issue there, he said, is the lack of capital investment. Because of its huge tax increases, he said, “France, for example, has been eating its seed corn for four years with a capital base in an economy that’s shrinking.” Japan, too, “is swimming against a real strong tide as far as growth.” And if you throw in Russia for good measure, segments of South America like Brazil and the basket case known as Venezuela, “upwards of 40 percent of the world’s economic environment, 35 to 40 percent, is at zero growth,” he said. “Major segments of the world’s economy are really struggling, and we don’t see an end to that in 2015.”

After inflation, Goss said, “the second-greatest risk is the collapse of global growth, especially Asian and Chinese growth.”

China is of particular concern, economists here and nationally say. Even though its GDP growth, as officially stated, is an enviable 7.3 percent, there are reasons to suspect the Communist leadership is fudging the numbers. For one, figures from nations exporting to China are far less than what China reports as imports.

Moreover, if the Chinese economy were roaring along at that rate, let alone the double-digit rates seen for most of the past generation, oil prices wouldn’t be where they are. Neither would the prices of base metals—aluminum, copper, lead, nickel and zinc—all of which are on a downward price trend in recent months.

The reality, as Greiner said, is that “what happens to Japan and China matters to our economy.”