What Correlation? The prior Commentary’s graph of real (inflation-adjusted) M3 versus payrolls is used again, because it is currently the most important near-term signal on the economy, and I want to make sure that it is understood. One reader questioned why the graph was published, where the full correlation between the two series is not consistent over time. The graph is intended to help establish only the relationship between year-to-year contractions in M3 and year-to-year contractions in the broad economy, as represented here by payrolls.

There are times when the economy has fallen into recession without money supply contracting first. Rising year-to-year growth in M3 not always is followed by increasing economic activity (the proverbial Fed pushing on a string), and a growth in the economy not always is preceded by growth in real M3.

Whenever real M3 has contracted on a year-to-year basis, however, the economy always has followed, either falling into recession, or if already in recession, intensifying. Such makes sense. If liquidity is strangled enough, the broad economy will suffer, every time. The present contraction in broad liquidity is the deepest of the post-World War II era. The lead time between the liquidity signal and economic activity is roughly six-to-nine months (the plot of M3 in the graph is shifted six months ahead on the time scale versus the payrolls).  

The lead-time appears to be shorter in an existing recession, and evidence of an intensifying downturn should be imminent. This morning’s (May 14th) reporting of April retail sales and industrial production, however, had no downside surprises, showing somewhat stronger-than-consensus results (although the retail sales gain was statistically indistinguishable from a contraction).

Nonetheless, near-term economic activity will turn down, with major negative implications for the federal budget deficit, U.S. Treasury fundings, systemic solvency and the U.S. dollar. Such developments should place significant upside pressure on domestic inflation. U.S. difficulties eventually should dwarf the European sovereign solvency concerns currently helping to roil the markets. Accordingly, the long-term outlook for the U.S. dollar and U.S. equity and credit markets remains bleak, while the long-term outlook for gold and silver remains extremely strong.

The inflation outlook and the financial markets will be reviewed in greater depth with next week’s Commentary following the CPI release.   

Retail Sales Revisions Could Impact First-Quarter GDP Revision Negatively. Despite the stronger near-term retail sales reporting, benchmark revisions recast the relative strength of first-quarter 2010 reporting versus fourth-quarter 2009. Net of inflation, the annualized growth rate for first-quarter retail sales slowed in revision to 5.7% from 6.3%. That, in turn, should be reflected in somewhat slower than previously estimated first-quarter GDP growth. That GDP revision, however, may not surface until the annual GDP revisions due in July.     

Reported Nominal Retail Sales. Today’s (May 14th) retail sales report for April 2010 — issued by the Census Bureau — indicated a statistically-insignificant, seasonally-adjusted monthly gain of 0.42% (up 0.88% net of revisions) +/- 0.6% (95% confidence interval). Such followed a revised 2.12% (previously 1.60%) monthly gain in March. On a year-to-year basis, April 2010 retail sales were reported up by 8.82% from April 2009, versus an upwardly revised 8.52% (was 7.62%) annual gain in March, with the April and March annual changes exacerbated by the severe trough seen a year ago and downside benchmark revisions to same.

Benchmark Revision. An annual benchmark revision, published on April 30th, revamped seasonal factors and encompassed detail from the 2008 economic census. The revisions were more significant in shifting monthly patterns than they were in altering annual levels. The contraction in annual 2009 retail sales deepened from 6.2% to 6.5%, with particular downside revisions to sales reported for February through May of 2009. April 2009 revised downward by 0.45%. Such had the effect of boosting April 2010 on a relative year-to-year basis and possibly may have shifted the seasonal factor distortions arising from the unusual length and depth of the current downturn.

For all of 2009, the level of annual sales was revised lower by 0.2%. The level of inventories also was revised lower, by 0.9% for the year. Lower sales and inventory would suggest lower levels of production than previously reported, or revisions to trade activity.

Real Retail Sales.  Estimates of real (inflation-adjusted) retail sales will be published on Wednesday, May 19th, in the Commentary following the release of the April CPI data. Month-to-month real growth in retail sales for April likely was minimal, with annual growth somewhat over 6%.

Core Retail Sales.  The "core retail sales" methodology was revamped recently, where the net relative monthly increases and/or decreases in gasoline station and grocery store sales were subtracted from the full monthly retail sales number, instead of the total of gasoline station and grocery store revenues each month. Assuming that the bulk of non-seasonal variability in food and gasoline sales is in pricing, instead of demand, the revamped reported "core" change more closely reflects the actual retail sales experience. In April a reported month-to-month decline in grocery store sales slightly more than offset a gain in sales at gasoline stations. 

This approach remains a work in progress and eventually will be used in the development of additional SGS alternative economic measures. The "core" retail sales is reported in two versions, where Version I uses the original methodology, and Version II version appears to provide a more balanced picture of the impact food and energy inflation in the standard retail sales reporting.

Consistent with the Federal Reserve’s predilection for ignoring food and energy prices when "core" inflation is lower than full inflation, "core" retail sales:

Version I — April retail sales net of total grocery store and gasoline station revenues — rose by 0.6% versus the official aggregate gain of 0.4%.

Version II — April retail sales net of the monthly change in revenues for grocery stores and gasoline stations — rose by 0.4% versus the official aggregate gain of 0.4%. 

April Industrial Production Received Relative Boost from Revisions. The Federal Reserve Board reported today (May 14th) that seasonally-adjusted April 2010 industrial production rose by 0.80% (0.65% net of revisions) for the month, versus a revised 0.21% (previously 0.09%) monthly gain reported for March. Helping the relative reported monthly gains in April and March (revised), the level of industrial production in March was revised lower by 0.15%, with February revised lower by an even greater 0.26%.   

The year-to-year change in April rose to 5.18% from a revised March annual gain of 3.80% (was 3.95%). The spike in annual growth was due largely to the pattern of collapsing activity a year ago, which bottomed out in June 2009. 

The cycle-low reading in June 2009 of 95.75 reflected a 13.3% year-to-year contraction, the steepest annual decline in production growth since the shutdown of war-time production following World War II. For the last 16 months, the production index has averaged 99.07, around which the series has been fluctuating, with April’s six-month moving average reading at 101.01 versus 102.27 for the single month.

 

The "recovery" in production is shown in the above graph, where month-to-month volatility is smoothed using a six-month moving average. Production activity had leveled off at a low-level plateau of activity that effectively wiped out the last eight years of growth in industrial production. Despite the near-term upside bump generated by short-lived stimulus and seasonal distortions, the series generally still appears to be bottom-bouncing and should begin to soften anew, significantly, in the next several months.

March Trade Deficit Deterioration Should Have Minimal Impact on GDP Revision. For March 2010, the Bureau of Economic Analysis (BEA) and the Census Bureau reported the nominal (not-adjusted-for-inflation) seasonally-adjusted monthly trade deficit at $40.4 billion, up from a revised $39.4 (previously $39.7) billion deficit in February, and up sharply from the $28.8 billion monthly deficit in March 2009. 

Against February 2010, the March trade balance — as with February against January — reflected both higher imports and exports, with a sharper increase in imports. Higher March oil imports reflected both higher physical volume and oil prices.  Specifically, for the month of March 2010, the not-seasonally-adjusted average price of imported oil was $74.32 per barrel, versus $72.92 in February 2010 and $41.36 in March 2009. In terms of not-seasonally-adjusted physical oil imports, March 2010 volume averaged 9.660 million barrels per day, versus 8.689 million in February 2010 and 9.345 million in March 2009.

Adjusted for seasonal factors and inflation (2005 chain-weighted dollars as used in reporting real GDP), the January, February and March 2010 respective merchandise trade deficits were $40.9, $42.3 (previously $42.5) and $43.8 billion (new), or an annualized quarterly rate in first-quarter 2010 of $508.3 billion, worse than the annualized fourth-quarter shortfall of $492.5 billion (previously $492.2). The GDP includes trade in services in addition to merchandise, and the first-quarter’s "advance" estimate of 3.2% annualized real GDP growth was a guesstimate, including deteriorating net exports based on two of three months of trade deficit. With the March deficit near consensus estimates, the net effect of the hard number on the May 27th first-quarter GDP revision should be neutral to slightly negative.