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Thursday, April 19, 2018

FIFO Monetary Policy and the Business Cycle

With all the talk of Yield Curve flattening and recession forecasting in the U.S., see U.S. Yield Curve and Risk of a Liquidity Trap ; it occurred to me to consider the interest rate structure of other developed economies and also juxtapose the economic narratives. Developed economies are generally experiencing low unemployment rates paired with low wage growth, healthy housing markets paired with available credit, and overpriced equity markets paired with geo-political uncertainty.

The common theme of shrinking spreads between long-term interest rates and short-term interest rates suggests that many developed economies are on similar positions on their business cycle. It stands to reason as Central Banks synchronized their response to the Great Recession, and monetary policy accommodation during the recovery and expansion stages of the business cycle. When the Federal Reserve embarked on its current monetary policy tightening cycle, they all but ensured that the U.S. economy would once again lead the world economy into its next recessionary cycle and out the other side.

By tightening monetary policy, which is inherently short-term, the Federal Reserve is accelerating the pace of yield curve flattening. As they drain liquidity from financial markets by selling short-term bonds, the Fed pushes up short-term interest rates. The loss of liquidity means less money is available to keep pushing up the price of equities so stock markets fall too. And finally, as stock prices fall investors buy long-term bonds for safety, pushing prices up and long-term interest rates down. This shift represents a change in market participants expectations about the trend in economic growth over the duration of the yield curve. Long-term rates falling relative to short-term rates is interpreted as future growth is expected to fall.

Central Bank policy and crisis response is generally backward-looking, so they only respond to  recession after it is underway even if they are the technical cause. That being said, the first economy to go into a recession will have its Central Bank modify policy, and will be the first to cycle out of recession and onto recovery and expansion. First In First Out (FIFO).

Friday, April 6, 2018

Baby Boomers + Labor Market = Low Wage Growth


The one thing that has been consistently missing from this otherwise textbook recovery that was engineered by the US Federal Reserve is sustained wage growth. The one thing that has been consistently ignored in the narrative of the recovery has been labor force participation. The trend has been one of declining participation ratios, and this can only be expected to accelerate. The acceleration in the rate of decline of labor force participation is predominantly driven by the Baby-boomer exit from the labor market.

In terms of a lack of sustained growth in real wages in the last almost two decades, again the burden lies with the Baby-boomers. Wages grew while the Baby-boomers entered and matured in the workforce, including the macro-introduction of women into the labor market. Now we are at a point where Baby-boomer wages have increased for decades and now on aggregate are at their caps. Paired with Fed-backed low inflation expectations, employers on average have no reason to increase wages. However, as the Baby-boomer retirement trend accelerates, and their share of the labor pool shrinks, employers would have to increase wages on aggregate to keep or attract younger talent.

All-in-all things seem to work themselves out. Millennials get to experience sustained wage growth over some period congruent with experience and education, and long-term employers see their average wages fall as the boomers retire. Now let's take this slice of relative tranquility on the labor side of the Fed Mandate and overlay it with the pricing side of that same mandate.

The unwind of the Fed's Quantitative Easing  policy and effective tightening of monetary policy, along with similar positions being adopted by other Central Banks means financial and other inflation sensitive assets will continue to reprice lower.  Simultaneously, President Donald Trump is pursuing a trade policy that in one way or another will lead to higher consumer prices in the U.S. through higher import prices. U.S. households look to be caught in a full pincer maneuver. From one side they will be hit with falling financial asset prices which reduces the value of their savings, from the other side they will be hit by increasing consumer prices stemming from trade disputes, and finally from above with demographic pressures keeping wage growth subdued.

Long story short, when U.S. discretionary spending starts contracting a recession will soon follow.