Just a couple years ago, the notion of “secular stagnation” was a favorite topic of conversation in the tea salons of the chattering classes. Secular stagnation is the idea that structural forces are at play pushing the growth rate of the global economy ever farther away from what we call “historical norms” (which really means “average rates of growth since the end of the Second World War”). Former Treasury Secretary Lawrence Summers was a leading proponent of the secular stagnation theory, pointing to widespread evidence of reduced levels of business investment and subdued consumer demand. Secular stagnation offers a different explanation of economic performance than the usual ups and downs of the business cycle. It suggests that the very idea of “historical norms” is meaningless: the world, and the world’s economy, has changed in profound ways since the 1950s and the 1960s, and there is no point in benchmarking current trends off those prevailing sixty and seventy years ago.
Hit the Mute Button
Secular stagnation lost quite a bit of mojo in the immediate aftermath of the 2016 election and the brief infatuation with the “reflation-infrastructure” phenomenon that was supposed to happen when the incoming administration turned on the full force of corporate tax cuts and deregulation. Although the tax windfall did arguably give a momentary sugar high to GDP growth rates, it didn’t have much of a sustained effect on business spending levels. And it had absolutely no effect on inflation. The chart below shows the long term inflation trend (core inflation, excluding food and energy) along with the corresponding ten year Treasury yield. The data go back to 1990.
There are a couple noteworthy things about this chart. The first is that inflation really has been a non-factor in the US economy since the mid-1990s. Core inflation has not risen above three percent since 1996. Through up cycles and down cycles, inflation has been – to use the word that is now embedding itself into the working vocabulary of the Federal Reserve – muted. And of course, in the recovery that began in 2009 core inflation has never even come close to the three percent level it last flirted with at the height of the manic real estate boom of 2006.
The second thing to observe in the above chart is the subduing of long term interest rates. We have talked about this in recent weeks, but here we focus on the 10-year yield as a barometer of inflationary expectations. One plausible reason for the persistence of the low benchmark yield – even after the Fed stopped buying intermediate term bonds as part of its QE programs – is that bond markets bought into the structural nature of muted inflation long before the Fed did. When the FOMC’s January 30 communiqué seemed to make official the Fed’s view of lower-for-longer inflation, one can picture the bond market replying thus: Thanks for telling me what I already know.
Alvin Hansen Gets His Day
And with that, a long-dead economist may finally have his life’s work recognized in formal monetary policy. Alvin Hansen was the originator of the term “secular stagnation,” way back in 1938. That was a grim year. Six years after the peak of the Great Depression, monetary authorities gingerly attempted to tighten policy and prevent the recovering economy from overheating. Things went south quickly, and policymakers realized that the economy was still too fragile to withstand traditional medicine.
Hansen’s secular stagnation theory seemed on the money at the time. Fortunately for the country, if not for Hansen’s own posterity, the theory quickly went out the window when the economy reflated onto a war footing as the Second World War broke out. Now that’s an infrastructure-reflation event! And dormant the theory lay until resurrected by Dr. Summers et al in the mid-2010s. We may still be one or two FOMC meetings away from calling it the dominant interpretation of today’s economy. But barring some genuinely massive exogenous shock to reflate the economy, the pattern of core inflation suggests that “lower for longer” is indeed what the world is going to have to get used to.
Where’s the inflation? That question has lurked behind most of the major headline stories about macroeconomic trends this year. Jobless rate falls to 4.3 percent. Where’s the inflation? GDP growth revised up to 3 percent. Where’s the inflation? The Fed has an official dual mandate of promoting price stability and the maximum level of employment achievable in a stable price environment. By all available measures, our central bank policymakers would appear to be living up to their mandate in spades. Inflation has remained subdued for pretty much the entire run of the recovery that began in 2009. Over the same time, unemployment has come crashing down from a post-recession high of 10 percent to the gentle undulations of 4 percent and change from month to month. And therein lies the problem, or rather the riddle that neither the Fed nor the rest of us can answer convincingly: why hasn’t a robust jobs recovery reignited inflation?
Math, Models and Markets
Those of us who do not hold Ph.D. degrees in economics from the nation’s most prestigious universities at least have one advantage over those maven economists on the Fed Open Market Committee: we can freely speculate about the perplexing absence of inflation. Here at MVF we have our own views, largely proceeding from the larger issue of long term growth that has been the central subject of our in-depth research for much of the past three years. The catalysts that drive growth over successive business cycles – productivity and labor force participation – have both chronically underperformed for many years. Quite simply, we may have reached a point of diminishing returns on the commercial innovations that powered a historically unique run of growth through the middle and mid-late portion of the last century. Without that growth, we shouldn’t expect wages and prices to do as they did before.
Which is fine for us to say, because – see above – we are not doctorate-level trained economists. But Janet Yellen is, and so are most of her colleagues. And unlike us, they do not have the freedom to brainstorm and speculate about what’s keeping inflation from showing up. All they have are models. Models with months, quarters and years of data providing quantitative insights into the relationship between the labor market and consumer prices. Models written in beautiful mathematical formulations, the legacy of giants who inhabited the “freshwater” (University of Chicago) and “salt water” (MIT and Harvard University) centers of economic research in the years after the Second World War. Models premised on the hyper-rational choices of economic actors, models that do not actively incorporate variables about capital and financial markets but that assume that money is just “there.”
Follow the Dots…Not
The models say that a higher uptrend in inflation is consistent with where the labor market is. Accordingly, the “dot plot” predictions by FOMC members continue to assume one more rate hike this year (most likely December) and three more next year. This despite the fact that the core personal consumption expenditure (PCE) rate that the Fed uses as its inflation gauge remains, at 1.4 percent, well below the Fed’s 2 percent target. Fixed income markets, though, continue to largely ignore FOMC dots (despite some of the usual post-event spasms after Wednesday’s press release). There remain about 100 basis points of difference between what the Fed thinks is a “normal” long term trend for the Fed funds rate (closer to 3 percent) and what the bond market thinks (closer to 2 percent).
In a nutshell, the bond market, and analysts such as ourselves, look at inflation trends and say, why rush? The Fed says, because the models say we have to act. If the models are right, there could be some very nasty shocks in fixed income markets that spill over into risk assets like equities. But for the rest of us, with our parlor game speculations about how the relationship between prices and jobs today may simply not be as statistically robust as it used to be, it is difficult indeed to spot the hard evidence supporting a major bout of inflation on the horizon.