From Janet Yellen Friday night:
Extreme economic events have often challenged existing views of how the economy works and exposed shortcomings in the collective knowledge of economists. To give two well-known examples, both the Great Depression and the stagflation of the 1970s motivated new ways of thinking about economic phenomena. More recently, the financial crisis and its aftermath might well prove to be a similar sort of turning point. Today I would like to reflect on some ways in which the events of the past few years have revealed limits in economists’ understanding of the economy and suggest several important questions I hope the profession will try to answer. Some of these questions are not new, though recent events have made them more urgent. Appropriately, some are addressed by the papers prepared for this conference. Pursuing answers to these questions is vital to the work of Federal Reserve and other economic policymakers, and the Fed is likewise engaged in ongoing research to seek answers.
The Influence of Demand on Aggregate Supply
The first question I would like to pose concerns the distinction between aggregate supply and aggregate demand: Are there circumstances in which changes in aggregate demand can have an appreciable, persistent effect on aggregate supply?Prior to the Great Recession, most economists would probably have answered this question with a qualified “no.” They would have broadly agreed with Robert Solow that economic output over the longer term is primarily driven by supply–the amount of output of goods and services the economy is capable of producing, given its labor and capital resources and existing technologies. Aggregate demand, in contrast, was seen as explaining shorter-term fluctuations around the mostly exogenous supply-determined longer-run trend. This conclusion deserves to be reconsidered in light of the failure of the level of economic activity to return to its pre-recession trend in most advanced economies. This post-crisis experience suggests that changes in aggregate demand may have an appreciable, persistent effect on aggregate supply–that is, on potential output.
The idea that persistent shortfalls in aggregate demand could adversely affect the supply side of the economy–an effect commonly referred to as hysteresis–is not new; for example, the possibility was discussed back in the mid-1980s with regard to the performance of European labor markets. But interest in the topic has increased in light of the persistent slowdown in economic growth seen in many developed economies since the crisis. Several recent studies present cross-country evidence indicating that severe and persistent recessions have historically had these sorts of long-term effects, even for downturns that appear to have resulted largely or entirely from a shock to aggregate demand. With regard to the U.S. experience, one study estimates that the level of potential output is now 7 percent below what would have been expected based on its pre-crisis trajectory, and it argues that much of this supply-side damage is attributable to several developments that likely occurred as a result of the deep recession and slow recovery. In particular, the study finds that in the wake of the crisis, the United States experienced a modest reduction in labor supply as a result of reduced immigration and a fall in labor force participation beyond what can be explained by cyclical conditions and demographic factors, as well as a marked slowdown in the estimated trend growth rate of labor productivity. The latter likely reflects an unusually slow pace of business capital accumulation since the crisis and, more conjecturally, the sharp decline in spending on research and development and the very slow pace of new firm formation in recent years.
If we assume that hysteresis is in fact present to some degree after deep recessions, the natural next question is to ask whether it might be possible to reverse these adverse supply-side effects by temporarily running a “high-pressure economy,” with robust aggregate demand and a tight labor market. One can certainly identify plausible ways in which this might occur. Increased business sales would almost certainly raise the productive capacity of the economy by encouraging additional capital spending, especially if accompanied by reduced uncertainty about future prospects. In addition, a tight labor market might draw in potential workers who would otherwise sit on the sidelines and encourage job-to-job transitions that could also lead to more-efficient–and, hence, more-productive–job matches.7 Finally, albeit more speculatively, strong demand could potentially yield significant productivity gains by, among other things, prompting higher levels of research and development spending and increasing the incentives to start new, innovative businesses.
Hysteresis effects–and the possibility they might be reversed–could have important implications for the conduct of monetary and fiscal policy. For example, hysteresis would seem to make it even more important for policymakers to act quickly and aggressively in response to a recession, because doing so would help to reduce the depth and persistence of the downturn, thereby limiting the supply-side damage that might otherwise ensue. In addition, if strong economic conditions can partially reverse supply-side damage after it has occurred, then policymakers may want to aim at being more accommodative during recoveries than would be called for under the traditional view that supply is largely independent of demand.
More research is needed, however, to better understand the influence of movements in aggregate demand on aggregate supply. From a policy perspective, we of course need to bear in mind that an accommodative monetary stance, if maintained too long, could have costs that exceed the benefits by increasing the risk of financial instability or undermining price stability. More generally, the benefits and potential costs of pursuing such a strategy remain hard to quantify, and other policies might be better suited to address damage to the supply side of the economy.
Further research is not much needed. Several hundred years of economic observation, theorising and modelling is enough. What stands in the way of appropriate policy is not a lack of rigor or understanding, it is ideology, systematic distortions and interests.
We more or less know why this downturn has proven so destructive to supply side economics. It’s a number of inhibitors to demand – demographics, debt and inequality, combined with supply-side impacts from de-industrialistion and technology – that have capped demand and promoted production excessive. The response by authorities to avoid all pain to society has only made that worse by preventing the cleansing of bad debt, mis-allocated capital and inefficient production that usually sets up the next cycle for productive expansion.
And so, as Janet Yellen couches this discussion as an academic mystery, for the investor it is not the unknown that matters so much as it is the entirely predictable. Yellen’s next step is not a change of path from that which the FOMC has been on for eight years. She still wants inflation to bail out the indebted, spread income more widely to increase demand, and push capital out the risk curve. But it is potentially a big change to the relative winners and losers of that inflation. The “high pressure economy” swings inflation away from financial assets and towards labour income.
That leaves us with two questions. Is Janet Yellen in control of the Fed? And, if so, what will her “high pressure economy” do to markets? The answers are interrelated. From Tim Duy:
Federal Reserve hawks face an array of labor market data that threatens a key pillar holding up their policy view. That pillar is the assertion that monthly nonfarm payroll growth over roughly 100k will soon force unemployment far below the natural rate, thus placing the US economy in grave danger from inflationary forces. By this view, the decline of unemployment long ago justified further rate hikes. Hawks failed to anticipate that the unemployment rate would flatten out at 5 percent despite steady payrolls growth. This outcome does not fit in their worldview. Fundamentally, they were supply-side pessimists. The recent strength in labor force growth suggests their pessimism was sorely misplaced and undermines their argument for immediate rate hikes. The key elements of the FOMC – the permanent voters – now stand as supply-side optimists and are prepared to hold rates at current levels through the next meeting, and perhaps even longer. A December rate hike is still not a foregone conclusion.
The Fed’s “supply side pessimists” argue that hikes are needed now to prevent many more hikes later. They are wrong given the amount of shadow slack still in the US labour market but broader US inflation is going to rise in Q4 so they’ll get a lift anyway. They could still ambush the doves.
But I still think not. Yellen’s doves are in control of the Fed so inflation is going to be let run. What will the “high-pressure economy” do to markets then? The following:
- shift corporate profits to labour income;
- steepen the yield curve as an anchored short end is overtaken by a long end with rising inflation expectations;
- this will interplay with both Europe and Japan which are also steepening the yield curve, and
- all three will hurt global equities as the risk-free rate rises and pulls down price multiples. Especially at risk are yield-based equities (defensive yield as it is called).
In short, the “high-pressure economy” suggests a firmer economy but both bond and equity bear markets. Equities especially look troubled given even if the Fed’s hawks win through then rate hikes will achieve the same end.
This is both a potential positive evolution and disaster for Janet Yellen. It’s possible that a shift from corporate to labour income can transpire without a business cycle accident as increased spending helps boosts profits to offset the declining price multiple for shares.
But it’s unlikely to be smooth. And if it gets really volatile then the negative wealth impacts will undermine the demand-side boost and tip both equities and the economy towards recession. Perhaps at this point it would be helpful to inject some co-ordinated fiscal support, which also appears to be coming thanks to America’s anti-globalisation election.
For MB allocations there are no changes then but a shift in texture:
- the downside for long-dated bonds is clearer than before, all the more so given BoJ move, China’s emerging inflationary shock and possible ECB tapering;
- the short end is still worth buying on the dips for Australia given more rate cuts are ahead;
- ‘sell the rallies’ on equities is morphing into an outright short;
- commodities normally benefit from asteepening yield curve but base metals and bulks are still exposed Chinese restructuring so remain a no-go;
- forex is unchanged with ongoing upwards pressure on the USD from inflation rising ahead of elsewhere, and a concomitant grind lower in the Aussie dollar, and
- gold is still ‘buy the dips’ on very slow monetary tightening and European disintegration risk but beware that a steepening yield curve will increase volatility.
Overall, a high distribution to cash is warranted given the high-pressure economy brings with it more financial market volatility and opportunity.
