tis the season -- or this year, not -- but keep it out of our data

As yet more snow falls, we're reminded ... that it's the start of spring? While this year is colder than any I remember, though not so bad in terms of total snow, it does raise the question of how to interpret economic data. Of course housing starts are down, but they're always down this time of year. Some prices are up and others down, again as in the past. Since it was the most recently updated series -- the new data were released at 8:30 am this morning -- I use the Consumer Price Index as an example.

The graph on the left is of the raw CPI "headline" series, unadjusted for seasonality. As you can see there are regular spikes, up and down, in the data. If you look at the unadjusted series, you'll find that there is a downward spike every November, and an upward spike that includes March. (Click to open it in the FRED database, if you hover your cursor over the graph you'll see the date and value for each point.) If we're the Federal Reserve, trying to gauge what is happening to inflation, we thus know the March number will give a number that is too high, the November one too low. Now we can look at changes from the year before, but that is less than perfect because random factors -- unseasonal weather, Easter falling in March rather than April -- might make price changes in one month higher or lower than normal. We could do a regression to get a monthly adjustment factor, but that implicitly assumes a constant pattern across a span of a dozen or more years.

Work by economists in statistical agencies around the world points to using deviations from a rolling average as superior to a regression. (In fact the methodology was initially implemented in Canada, not in the US.) Formally this is an ARIMA correction [AutoRegressive Integrated Moving Average], which in the software iteration currently used across the government allows correcting for anticipated idiosyncratic factors such as alternate dates for major holidays, e.g., a New Years that falls in the middle of a week or an Easter that falls in April and so shifts the timing of the Spring Break found in many school schedules.

The result is a seasonally adjusted series; I have that for the CPI just below the unadjusted one. It's not a totally smooth series, because the underlying data aren't smooth, but the upward spike in March is muted or absent, and the downward November spike vanishes. The real test comes from looking backward: the consensus of the users of the data is that the correction is pretty good, and that large deviations are generally a function of one-time events that all know will affect the data, but for which there's no historical precedent to make a correction. (An example is the impact of this winter's series of blizzards in the Northeast or the Federal shutdown of a few years ago on employment data – we know there will be one, but it's hard to know the magnitude.)

Now seasonal corrections are not for everyone. If you're trying to do a short-term budget, you want to know the actual price change this year, not whether it is higher or lower than in recent months or relative to a "normal" year. For most purposes, however, we do want seasonal corrections.

For more detail see the relevant BLS page.

Promises versus Deliverables: Jeb Bush and 4% Growth

Jeb Bush has set the presidential race pace with a promise of 4% growth. Other contenders, Democratic and Republic, will make similar promises, or perhaps already have – I've not looked. My intent here is to examine the issue, not the man.

In the medium and long run growth rates are about the supply side. Now in the short run demand factors matter, and since we're still in recovery from our Great Recession, we can hopefully have a few years of above-normal growth. My own estimation, taking into account the retirement of the baby boomers, is that we're about 7 million jobs short of where we need to be. Of course the next Administration won't take office until early 2017, and realistically their policies won't kick in until 2018. We're adding jobs at a 2 million per year pace. So if we keep that up, by then we'll be pretty close to normal. Looking at the supply side is thus sensible.

4.0% growth isn't going to happen

So what are long-term growth prospects? Basic (macro)economics is that over the long haul growth is a weighted average the growth of inputs – here I look at capital and labor – and total factor productivity, the growth of the economy over and above that due to more inputs. Work in this tradition goes back to a 1957 paper by the Nobel laureate Robert Solow; we thus have nearly 60 years of work, and a sense that the approach is pretty robust way to organize our thinking. So what we need to do is gauge the range of these three factors.

Let me begin with labor force growth. My own estimate, based on Census projections of the population by age and the propensity of people of different ages to work, is that by 2018 the underlying trend will be on the order of 0.4%. Now the baby boomers are working longer than their predecessors, so this may prove a tad low, but it is the right order of magnitude. For example, if we look at past employment growth, we see that it has gradually fallen over the past 75 years, averaging over each decade. While the rate as of January 2015 was 2.0%, that reflects the recovery from the deep trough of 2009 and is not sustainable. In fact, the (geometric) average of employment growth since 2000 is 0.5%. So I'll use that as my base case.

Next is the growth of productive resources, factories and housing and cars and shopping malls. At present investment is far below normal, particularly for structures and residential, and for investment by the government (down in all subcategories, from roads to office equipment). So we could see an uptick. Looking at the pre-Great Recession average, we might see 2.2% growth in business and residential investment, and 2.5% if we add in consumer durables such as automobiles. On the other hand, with population growth down and the average age rising, we may well see all forms of construction remain at lower levels. I'll use the higher numbers here.

Finally, there's productivity. The trend over the past roughly 30 years is 1.1% growth (or more precisely 1983-2011), with a lot of volatility. Will it come in higher? I see no reason to think that will happen. Yes, we are seeing lots of innovation. No, it is not boosting growth. Biotechnology has been advancing for 10,000 years, since the early domestication of wheat, sheep and cattle. To pick one modern crop, selective breeding at the International Rice Research Institute in Los Baños, Philippines led to high-yielding varieties in the 1960s. Modern genetic engineering is a continuation of this trend, and the productivity gains from the standpoint of the overall economy of future innovation will be modest. Likewise adding to longevity will do little in the short run to boost output, as reversing the trend toward retirement will require decades. IT is leading to an array of gadgets, but "robots" have been central to our factories for the past 2 decades, and while my first computer could not always keep up with my typing speed, in my own work I've seen diminished returns to improvements in hardware, software and improved data resources. As emphasized by Robert Gordon, there are many reasons to think that productivity gains will not pick up. Even if they do, that's also a long-run process, as workplaces gradually reorganize to incorporate new tools. In sum, we won't see a surge during 2018-2021; a 1.0% rate is all we'll get.

...and there's not much a future president can do about it

Let's put it together: 1.0% productivity, 0.5% employment growth, 2.5% capital growth. Discount the latter (as per economic theory) for diminishing returns (which matches their share in output) by (respectively) 0.6 and 0.4. That gives us 1.0 + 0.3 + 1.0 or 2.3% growth.

Guess what? Growth of 2.3% happens to be what we've averaged since the 2009 trough of our Great Recession. It's also consistent with interest rates, as the gap in yields between 3- and 5-year bonds implies 1-year interest rates of 2.2% in 2019 and 2.6% in 2021. (Look for a pending post.)

So 4.0% growth isn't going to happen, and there's not much a future president can do about it.

Let me put in a plug for my home institution, Washington and Lee University. For over a century our students have held a Mock Convention to nominate the presidential candidate of the party out of power. In due course, as the primaries unfold, I will urge our economics majors to analyze the economic proposals of the candidates. I'll add my own analysis here from time to time. So watch for updates.

Reflections on NADA Week 2015, San Francisco

Ruggles based on a column in Wards
minor additions by Smitka

There was a lot going on in San Francisco in January. The week began with the American Financial Services Association (AFSA) conference. Following that, J. D. Power and Automotive News held conferences on the same day, while at the same time, NADA workshops were in session. There was simply no way to take it all in so I’ll only comment on the high points of sessions I attended.

AFSA:

Notably absent from the AFSA conference was the Consumer Financial Protection Bureau. I got the impression they weren’t invited and wouldn’t have come anyway. Last year, CFPB’s Patrice Ficklin addressed a packed room. Since last year’s event, AFSA commissioned a scholarly study, conducted by the highly regarded Charles River Associates, that isn’t kind to CFPB’s suspect methodology called Bayesian Improved Surname Geocoding (BISG) which CFPB uses to “prove” unintentional “disparate impact” discrimination. One gets the impression that zealots at CFPB see discrimination behind every tree and will stop at nothing to “prove” it. According to the Charles River study as summed up in an AFSA bulletin, “BISG estimates race and ethnicity based on an applicant’s name and census data. AFSA’s study calculated BISG probabilities against a test population of mortgage data, where race and ethnicity are known. Among the findings:

• When the proxy uses an 80% probability that a person belongs to an African American group, the proxy correctly identified their race less than 25% of the time.

• Applying BISG on a continuous method overestimates the disparities and the amount of alleged harm and provides no ability to identify which contracts are associated with the allegedly harmed consumers.”

To say that race and ethnicity is “known” in the case of mortgage data is a HUGE stretch as mortgage applicants are asked to “self describe” their race and ethnicity without any objective standard. For example, if a person is ¼ Native American, ¼ Asian, and ½ African American, what objectively is their race? People have a variety of motivations for how they will answer such a question. And with no objective standard, the margin of error is impossible to calculate.

Yet, no lender will stand and fight CFPB in court. CFPB knows they have an immense intimidation element working in their favor, and they leverage it at every turn.

Having said this, CFPB has done a lot of good in some areas. But attempting to prove discrimination where there is none is likely to cause a huge backlash that could overwhelm any good they might do.

MTV:

A highpoint at the NADA conference was a press conference presented by MTV. The attraction for me was that they stated up front that their research debunks the conventional wisdom regarding Millennials, who we are told are taking over the world. There is good reason to be suspect of research undertaken and then repackaged by people who know nothing about auto retail. We know that there are a LOT of Millennials out there. We know they will grow up and as they do, they will become more like the generations who came before them. And their children will complain about how stodgy they are.

One of the excellent points the MTV study makes is that there is a good reason Millennials tend to get their drivers license later than earlier generations. It has more to do with more restrictions imposed these days than in days past, not that Millennials have little interest in vehicles and are reluctant to drive. The study also showed that Millennials with both a drivers license and a vehicle drive a lot, in fact more than previous generations Baby Boomers and Gen Xers. So they'll need to replace their cars more often than other generations, good news for us in the business.

There are many who think Millennials are brats. The MTV study supported this, pointing out that this generation received a trophy for just showing up. “They want what they want when they want it,” said Berj Kazanjian, the Senior Vice President for Ad Sales Research for MTV. He said the study revealed a level of idealism on the part of Millennials. “They want things to be fair. They don’t want anyone to pay more or less for the same product.” I sat there thinking that this wasn’t sounding much different than what my own parents, who were raised during the Great Depression, sounded off about Boomers. Don’t idealism and being young go hand-in-hand?

The Q&A lasted long after the presentation officially ended and eventually turned into a spirited discussion. I mentioned my own “surveys” when I asked roomfuls of Millennials if they think 10% is a fair dealer gross profit on a new car. The consensus answer is that 10% is “fair.” This coincides closely with TrueCar’s survey which shows consumers think 8% is fair. But when I ask the same room if a $3000 profit is “fair,” the tone of the room changes instantly and I hear comments about car dealers being cheats and liars. The MTV presenters thanked us for “keeping them honest.” While I think their research shows interesting results I do think they need to enlist the input of someone who understands automotive retail to frame questions in a way relevant to the industry, and thus translate what customers mean in our context as opposed to the words they utter as general principles.

At least it seems that MTV isn’t interested in selling their advice to dealers on a consulting basis like many who conduct self serving research. They just want to sell some advertising. They may not feel it's worth their trouble to restructure their survey on our behalf, but we benefit from their not trying to spin the data to drum up our business.

Oil Economics:

It is always interesting to hear economists provide their SAAR predictions for the coming year. There was a lot of talk about oil economics and how the current low price of fuel at the pump will impact the mix of vehicles sold. It seems apparent that small vehicles will need to be heavily incentivized to keep the assembly lines running and to minimize CAFE fines. This will reduce residual values on those vehicles. There were some estimates on how long the moderate fuel prices will last, up to 24 months. As someone who was raised in the oil patch to an oil company family I have watched OPEC curtail its own production to maintain price equilibrium. In fact, they produce about the same amount of oil today as they did 40 years ago when the population of the earth was half what it is today and consumption much less than today. This is despite the fact that OPEC had 5 members then, and 12 today. However, OPEC has on occasion allowed the global market price of oil drop to drive out high cost competitors. They are the low cost producer and Saudi Arabia is sitting on around $700 billion in dollar reserves. I recall distinctly the oil glut of the mid 1980s. The economies in oil patch states took major hits. There were huge numbers laid off from various oil companies during that era. Just last week Schlumberger announced a layoff of 9000 workers.

It is hardly a surprise when a cartel acts like a cartel. Frackers, sand and shale producers, ethanol producers, EV car manufacturers, battery makers, etc. will take a hit. With the world market price of oil below the cost of production where would Keystone get the traffic it needs to pay its debt service?

The issue in the U.S. has NEVER been our dependence on foreign oil. The issue is our dependence on the global market price of oil as controlled, or at least heavily influenced, by OPEC. Does anyone think an American oil company would sell its oil to American consumers for less than the global market price? In fact we know the answer, because when we tried price caps in the 1970s, the response of the industry was to leave oil in the ground.

Oil is a fungible commodity. It makes little difference from a price standpoint if the fuel we put in our cars came from a foreign country. Yes, it is always nice to keep money at home, and with all things being equal, the transportation advantages means a lot of domestic oil stays home. But that doesn’t have a major bearing on the price.

Saudi Arabia finds itself in an interesting position. The Sunni Saudis aren’t fond of their Shiite Iranian OPEC partners. Through their policies they cooperate – though that is likely not their primary motive – with the U.S. Government in its sanctions against Iran for its nuclear program as well as its financial support of terrorist groups in the region. Their policies likewise support the Administration in its desire to curtail the oil revenue of ISIS. Their policies, intentionally or otherwise, reinforce our sanctions on Russia over its Ukrainian incursion. The low price of oil doesn’t help Venezuela either, something that might please the Administration. Low fuel prices will give the U.S. economy a real shot in the arm and it could carry through the next election cycle. The EU may avoid another recession, which also helps the U.S. At the same time, the Saudis are accomplishing what they wanted to accomplish all along, which is to force high cost producers to fall by the wayside. As production wanes, the global market price will rise on its own. It will take time for it to come back online. During previous periods of “glut, many ethanol plants went bankrupt. It may well happen again.

The Administration will have to bite its tongue as their alternative fuel initiatives will become less interesting. There will be less conservation. CAFE might have to be revisited. There are rumors of EV inventory piling up. Of course we find an emphasis on fuel efficiency in the policies of Europe, Japan and China. That leaves pressure on American producers, from Toyota to GM, to engineer and make fuel efficient, and hence often small, cars and light trucks. They would really like to add US volume to spread their cost base. So there are lots of tensions building.

My best guess is we will see moderate oil prices for 24 months or longer barring anything unforeseen.

The Current State of Leasing and Residual Based Financing

Ruggles, February 2015

According to the most recent Manheim Market Report, “Lease originations exceeded 3.5 million for the first time since 1999. It will take only a slight increase in 2015 to push new leases above the all-time high reached in 1999.” This is largely the result of Auto OEMs attempting to counteract the negative impact of long term financing, which is also reaching new highs. Both initiatives are efforts by the OEMs to maintain volume and production in the face of rising MSRPs and transaction prices. Increasing finance terms take consumers out of the market for extended periods of time and dramatically decreases the chance the consumer will return to the same dealer and/or manufacturer for their next vehicle.

The new vehicle market is increasingly skewed to high income households. This increases the importance of the late model pre-owned vehicle market. The pre-owned market is currently running at a 42 million unit rate. Compared to selling rates from the depths of the Great Recession, new vehicle volume is up by 42%. Preowned selling rates only dropped by around 20% at the height of the Recession, showing considerably less volatility than the new vehicle market. Despite dramatic volatility in certain segments caused by sudden spikes in fuel prices, the absolute change in residual values over the last 19 years is 3.5% as measured by the Manheim Index. That fuel price volatility has proven to be temporary as consumers adjust to higher fuel prices in a few months. According to Tom Webb, Manheim’s Chief Economist, the change residual values in the last three years has only been 2%. That’s stability.

Is there any real danger in the recent dramatic lease percentages? Most experts agree there is absolutely no danger and considerable upside. There is still considerable pent up demand in both the new and pre-owned markets. Less affluent households, and those consumers who are interested in the greatest value, gravitate to the pre-owned side as evidenced by the explosion in Certified Pre-Owned numbers, which set new records every month. Increased new vehicle short term leasing and/or residual based financing is required to provide the inventory to fuel these increases.

There are many who regard pre-owned vehicle leasing, especially in the CPO area, as the greatest untapped area of opportunity in the auto retail business. There are some who claim the residual based payments on pre-owned aren’t enough less than subventions on new vehicles to justify a consumer to go with the pre-owned. A careful study of this theory shows that is the exception, not the rule. There are many credit unions and other lenders around the country offering residual based programs that dramatically reduces the monthly payment while still shortening the term. The truth is, dealers who are not offering their customers such a program probably aren’t aware of their existence or are held hostage by their own pay plans, which incentive F&I departments to continue to extend term while adding in rate participation. This is short term thinking at its worst. Dealers need to wake up and recognize that this short term “gain” carries with it long term penalties. Scot Hall, Executive Vice President of Swapalease.com, a leading auto lease facilitator is a big proponent of leasing/residual based financing on pre-owned. He says, “Those cars are generally going to be serviced to a high degree and reconditioned to a high degree, so setting up, say, a short three-year lease on those — or maybe even a two-year lease on some of those cars — I don’t think there would be a lot of risk, if it’s done correctly. I think it would benefit the consumer, and especially as more and more leases are coming back off the new end, this would be another avenue to help dealers and manufacturers move those off-lease vehicles from a remarketing perspective.”

For credit unions and other lenders offering a pre-owned residual based program, their yield is considerably higher due to the higher daily balances. This is particularly important in today’s margin compressed environment. Further, there is really no competition allowing for somewhat higher interest rates to be charged while still maintaining the short term low payment objective. They get their borrower back more often while both dealer and lender achieve the objective of retaining the consumer and doing business with them more often.

So what is the future of auto retail? Longer terms with lower volume or shorter terms, higher sales, more pedigreed pre-owned inventory for dealers, more customer loyalty, and ultimately higher profits? After all, it is more expensive to find a new customer than to retain the ones you already have.