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Come fly with me

| September 7, 2018

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

Recent production delays at Boeing illustrate the bottlenecks that are spreading, especially in the manufacturing sector, as the economy grows at a well-above-trend pace while the unemployment rate slides further below estimates of the natural rate. Economists and policymakers continue to debate the proper stance of monetary policy when wage and price inflation fail to accelerate decisively, despite the fact that the economy is operating well beyond potential. The economy is so hot that it has arguably moved into territory not seen for decades, which could challenge the current confidence of many that inflation will never move much above the Fed’s 2% target.

Bottlenecks in the economy

The economy is currently running quite high.  The first area to show serious supply constraints was the labor market.  Complaints by firms about the inability to find qualified workers have been plentiful for several years and continue to spread.  This year, both the number of initial unemployment claims and the headline unemployment rate have dropped to their lowest levels since 1969.

More recently, the signs of constraints in product markets have begun to pile up.  The supplier deliveries index in the monthly ISM manufacturing survey has run far above the break-even mark of 50 for almost two years straight, signaling that vendors are taking longer to deliver supplies to factories.  In fact, the June and August readings were the two highest since 2004 and, aside from a handful of readings in 2004, the strongest in 30 years (see Exhibit 1).

Exhibit 1: ISM Manufacturing Survey Supplier Devices Index

Source: ISM

The interpretation of a high reading for this measure varies widely depending on the stage of the business cycle.  As Exhibit 1 shows, the index tends to spike early in recoveries, as supplier deliveries lengthen back to normal after shrinking dramatically during recessions.  Brief surges in supplier deliveries occurred in 1983-84, 1994-95, 2003-04, and 2010, as supply chains and order books normalized after recessions.

Nine years into an expansion, a surge in supplier deliveries means something quite different.  A late-cycle deterioration in vendor performance suggests that supply chains are under stress and that bottlenecks may be developing.  The last time that the ISM manufacturing survey’s supplier deliveries index exceeded 60 late in a business cycle was the 1987-88 period.  At that time, like today, the unemployment rate was also running below estimates of the natural rate.

As the economy strained to meet torrid demand, core inflation accelerated significantly.  After declining through much of the 1980s, the year-over-year advance in the core PCE deflator rose from around 3% in early 1987 to a peak of 4.7% in February 1989.  In response, the Fed hiked rates by over 300 bp in a year, reaching a cycle peak of 9.875% in February 1989.

This is not to suggest that core inflation is about to accelerate by 200 bp in a year or that the Fed will need to raise rates by 300 bp in 2019.  The world is very different today than it was in the 1980s.  Most importantly, inflation expectations are well-anchored, which should help to prevent such a dramatic inflation outbreak.  Though it would be overly complacent to trust that inflation cannot accelerate simply because it has been well-behaved over the last 20 years.

Boeing as an example of bottlenecks

The recent travails at Boeing offer a concrete example of the sort of strains that are becoming more common in the economy and especially in the manufacturing sector.  A September 3rd article in the Wall Street Journal details the difficulties at the airplane maker.  Assemblies are being delayed by two key suppliers: an engine maker and a fuselage manufacturer.  The engine maker has had trouble smoothing the production process on a new engine, suffering from parts shortages from its own suppliers; the fuselage firm had trouble adding enough workers to keep up with the step-up in the pace of assemblies at Boeing.

Boeing’s deliveries suffered in July, sinking to 29 for the month, down from a norm of over 50.  This was a large enough problem that it affected several key macroeconomic indicators for the month, contributing to a drop in durable goods shipments and merchandise exports.  Meanwhile, Boeing is running out of room to park the mostly-finished planes that are waiting for engines.  It has contracted with the local small airport near its factory to park planes on idle runways, between buildings, and wherever else the airport can make space.  The flipside of the drop in shipments and exports in July was a massive rise in inventories of “work in process” aircraft.  These swings in the data are likely to be largely offsetting in terms of GDP – lower business investment in aircraft and exports offset by a rise in inventories – but it is rare to see one company’s problems rise to the level of creating distortions in the broad economic data.

Boeing’s order book is so large that a new order placed today will not be filled for years.  In an effort to chop through some of the backlog, the firm is trying to ramp up production over the next few years.  The difficulties seen in recent months show what happens when labor and product markets get so hot that it becomes tough to grow one’s business.

There is very little in the experience of the last 25 years that can tell us how the economy will respond to these difficulties.  Inflation may remain anchored at or near 2%, in which case, firms will probably throw up their hands and stop trying to add workers and expand production in an environment where it is impossible to do so while maintaining an appropriate cost structure.  Alternatively, firms are likely to at least try to test the waters to recover some of the cost increases they are experiencing.  We will see whether businesses and consumers will accept the grasp at pricing power or not.

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