This Week’s Economic Update, February 20, 2023

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Not to share how old I actually am, but I was in school at the time before holidays were celebrated on Mondays allowing for a three-day weekend.  That meant in February we had two days off of school, not just one.  We all celebrated Abraham Lincoln’s Birthday on February 12.  A mere ten days later we were let loose for George Washington’s Birthday.  During that time, we would recite the Gettysburg address and typically had something to do with Cherries to celebrate.  Now, two score and twelve years later, I cannot tell a lie, I still miss having two holidays as well as celebrating both of these Great Leaders.  Sadly, the celebration now seems to have more to do with retail sales than our past leaders.

An eye opener to be aware of.  Built into the 2017 tax law is a change that may be devastating to many companies.  First of all, Section 174 of the tax code has allowed companies to directly deduct all research and experimentation expenses at the time of the expense.  That deduction changed at the end of 2021.  Now firms have to capitalize the expense over a period of five years.  For 2022 that means the R&E expenses spent in 2022 will be amortized over the next five years.  It gets worse, this first year you only get 6 months depreciation.  A firm that spent $250,000 on R&E this past year will be allowed only $25,000 in expense this year.  If they had not planned correctly, they would be looking at an increase of $225,000 in net income over prior years.  If their tax rate is 45%, they are facing an increase in their tax bill of $101,250.  This is going to be devastating to many manufacturing and other firms that have become accustomed to the immediate deduction of these expenses.  Start talking to your clients and your accountants to fully understand what the cash ramifications are of this massive change.  It could easily crash firms across the nation unless Congress acts.

The consumer price and producer price indexes both reflect a world where high inflation is becoming baked into the economy.  On the consumer side the month over month core inflation number was .5%.  This equates to an annual rate of 6%.  The past month saw the price of energy turn around, rising again after everyone thought China was returning to normal and would soak up the surplus oil, it didn’t.  Food prices continued to rise in January.  Rent and mortgage costs rose in the past month.  This increase has a good chance of being reversed later this year.  However, for now there is nothing on the horizon that indicates we will see a spike or any softening in prices. 

The core producer price index also popped back up after holding at .3% over the past few months.  At .5% it mimicked the consumer price increases.  The overall index, which includes food and energy, rose .7%.  Supply issues and labor issues all seem to be creating a floor on the inflation level.

Consumer spending continues at a tear at 3% month over month.  Pulling out auto sales, the level was still up 2.6%. Typically, the period immediately following Christmas is soft as buyers are out of cash, facing higher credit card bills and await their tax refund, if one is coming.  Because these numbers are not adjusted for inflation, the consumers actually outpaced inflation for the month by a considerable margin.  The increases came from food service, drinking places, auto sales and furniture stores.  No categories saw a decline.

This brings us to the adage, between a rock and a hard place.  The economy, including the employment numbers, continue to hum along.  It appears after two years of interest rate increases that we are no where near the economic downturn that was expected.  Historically there is a lag time between the rise in rates and the economy responding.  This lag time has been between 12 and 18 months for its full effect.  After 24 months it appears that the moves by the Federal Reserve have had limited impact on slowing either the economy or inflation.

In order to effectively fight inflation, interest rates have to be higher than the rate of inflation.   Based on history, with the level of embedded inflation we are currently seeing, the Fed funds rate should be close to 9% not 4.5%.  Those hurt the most by higher interest rates would be borrowers.  The largest debtor on earth right now is the US Government.  Chairman Powell is truly between a rock and a hard place.  

Have a great week.



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