The decision by the Fed to hold rates seems to have met with renewed sighs of failure from many observers. In their minds, interest rates need to normalise to prevent the (continued) build-up of asset bubbles (which cheap money is creating) and bring the Fed back to the curve (which it is ever behind), reducing overheating risks. Their view remains that inflation will invariably rise with such a tight labour market, holding faith in the resurrection of Phillips curve.
The reality could not be further from the truth. Headline unemployment may have fallen below levels previously thought to be “full employment” or below the NAIRU rate, for want of another term. But there is ample evidence of remaining labour market slack, from the U6 rate (which is a better measure of broader underemployment) to the still elevated numbers of long-term unemployed (those out of work for over 27-weeks as classified by the BLS).
The story is equally grim looking at the activity data (which the Fed glossed over when assessing current economic health). Industrial production has been on a downward tear ever since the Fed first hiked last December. Retail sales growth continues to fall; advance sales rose at just 1.9% y/y in August in nominal terms. Meanwhile, inventories continue to build, suggesting further adjustments are needed. Housing activity looks to be stagnating. Imports are down. Exports are down even more. Investment remains weak, and that stands even after you strip out the effects of the collapse in energy.
And alongside all this, wage growth has continued to be tepid. In fact, in real terms wages are now falling as inflation has inched up (as oil prices drop out of the annual comparisons).
On the structural side, the problems of low productivity remain. The effect of that is that even with moribund wage increase unit labour costs are rising rapidly. So it’s worrying to see weakness not just in corporate profits but also sales. Against such a backdrop any acceleration in supply driven wage growth would be self-defeating. Businesses would be more likely to try and sweat a smaller headcount (i.e. start firing) than increase the total wage bill, thus further eroding profits. There is a good relationship between declines in profits and investment and recessions.
The only good data is the jobs data. And that has a terrible track record of predicting future growth. If it gets to a point where the labour market is flashing red you’ll probably find the economy has already been in recession a good nine or twelve months. Labour data gets heavily revised, smoothing this lag over time. But initial unrevised data is very revealing. Indeed, by March 2009 (when the stock market based) the headline non-farm payrolls number had undercounted the jobs lost to that point of the downturn by 2.7mn. The true scale of the loss was only becoming evident in early 2010 when BLS revisions or the revisions arrived.
What is more relevant now seems to be growth. That constantly disappoints the market but in reality has been above the Fed’s estimates of long-term growth for the past five years. And that estimate continues to fall, the median down to just 1.8% in the September summary of economic projections, down from 2.0% in July. It has fallen in lock-step with the Fed’s long-term interest rate dots. It’s difficult to square the idea that monetary policy is too loose if trend growth is also slowing. Year-on-year GDP expansion peaked in March 2015 and has slowed in every single quarter since then. It stood at just 1.2% in Q2 and that was only because consumers dipped into savings to spend.
Yellen has finally conceded this point. Monetary policy is now only “modestly accommodative” in the eyes of the FOMC, and that comes from a board that has persistently overestimated the neutral level of interest rate. The door remains open to a December hike (data dependent), but one and done might be a more realistic assessment of where policy is heading beyond that (rather than four and more the market was pricing at the turn of 2016). It’s highly doubtful the Fed could deliver more without tipping the economy back into the abyss.
Perhaps the time has come for central banks to change tact entirely, embrace the structural forces (demographics, over capacity – which comes through via falling good prices – and the legacy damage inflicted by both the credit bubble and ensuing “great recession”, for example) that are creating low inflation and low growth and allow markets a freer hand in setting prices.
Deflation should be seen as complementing the adjustment process (helping remove excess capacity). Rekindling some creative destruction seems to be the only way to address these problems and create the foundations for the productivity driven recovery that we really need. Productivity after all determines living standards. Until that nut is cracked any effort to tighten policy will be self-defeating. What’s needed now is not dissimilar to the adjustment Volker kick-started; there was an acceptance of the need to repair structural damage and an acceptance that there would be a cost to this process. Unfortunately that seems to be missing from today’s debate.