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When Standards No Longer Apply

Way back in the day when I was first learning about inflation and where it comes from, the distinction that was highlighted was between core and headline inflation. I came to understand that headline inflation is driven primarily by relatively more volatile food and especially energy prices. I also came to understand that core inflation is driven by relatively less volatile wages and housing costs. Fundamentally very straightforward concepts, but time and technology has a way of shifting the sand under the feet of even the most fundamentally straightforward concepts. Prime example being the Taylor Rule, but that's another discussion for another day.

When reading the April 2018 edition of the Federal Reserve Bank of San Francisco's FedViews, I came across a chart that highlighted a nuanced distinction between the correlation between wages and inflation pre 1985 which had a factor of 0.946 versus post 1985 which has a factor of 0.289. The composition of inflation measures did not change from before 1985 compared to after 1985, so that leaves the determinates of wage growth. The period stretching from the late 1970s to the early 1990s was plagued by a combination of high unemployment and high inflation, otherwise known as stagflation. The macroeconomic shift that was occurring during that period was the death of the manufacturing industry and the simultaneous emergence of the service industry as the dominant sector in the American economy.

The Fed also began actively targeting inflation levels towards the end of the 1980s in response to the stagflation during the period. The thing that threw off the balance was the shift in the US economic base from manufacturing to services. Inflation metrics were based on baskets of manufactured goods even though labor trends and by extent inflationary pressures began/are leaning towards the services sector. Services typically require relatively less labor and productivity can be enhanced with capital investments in technology. This simply means that the cost of new technology has a higher weighting than the cost of labor in determining the final cost of providing a service.

Unfortunately for workers in service-based economies, technology tends to evolve exponentially while costs tend to fall in a linear fashion. The exponential growth in technological efficiency means more workers are being displaced everyday than the day before, while the linear drop in cost means overall cost-of-living is falling relatively slower than real incomes. In other words, the skillset of the typical American worker is becoming obsolete; their bargaining power for wages is diminishing while consumer prices are being driven by factors outside the purview of the labor pool, with the shortfall being covered by personal debt.

The world has evolved and unfortunately not everyone has been willing or able to evolve with it, specifically the Baby Boomer generation. Fortunately, the millennial generation was born and raised in times of uncertainty and constant change, so we are native to creative destruction and rebirth. This is what the world looks like when standards no longer apply. We've got it from here.

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).

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.

Ricardian Trade Theory and U.S. Total Factor Productivity

Total Factor Productivity which is defined as the economy-wide effects of innovation indirectly as the residual part of productivity growth that cannot be explained by other factors. Basically, the extra bit of efficiency that accumulates in an economy when  everybody is becoming more efficient. According to a February 2018 Federal Reserve Bank of San Francisco Economic Letter titled, "The Disappointing Recovery in U.S. Output after 2009", quarterly growth in Total Factor Productivity is beginning to slowdown. The Economic Letter also highlights that the slowdown began before the Great Recession and coincided with a peak in labor force participation.

What the analysis featured in the Economic Letter ignores is the fact that the U.S. economy has not been growing its Total Factor Productivity in a vacuum. When the U.S. economy began reaping the benefits of the shift from a manufacturing base to a services base by the early 1990s, Total Factor Productivity increases manifested. Being a high capital economy, able to take advantage of economies-of-scale, the U.S. economy had a comparative advantage over its trading partners in services. The advantage compounded through the 1990s and culminated with the bursting of the dot-com bubble. During the formation and inflation of the dot-com bubble the U.S. dollar appreciated as foreign investment capital flooded in and the U.S. grew the capital account surplus.

By the turn of the millennium, labor force participation was peaking as the baby boomers began their exit from the labor market. Within five years the slowdown in Total Factor Production became apparent, just in time for the Great Recession. But after pressing its advantage in services from about 1985 to about 2005, the U.S. economy began experiencing diminishing returns. Data moves more freely around the world now more than ever before and has been doing this for decades. Simply put, other countries have the internet now. Open trade has allowed other countries to buy, learn from, and develop upon U.S. services and technologies. They too can grow their Total Factor Productivities. The good news is if we keep trading with countries that are getting more and more efficient, it will keep import prices low which benefits consumers.

U.S. Yield Curve and Risk of a Liquidity Trap

The Fed, after its most recent meeting reiterated its plans for the front end of the yield curve for the remainder of the year and into next year. Barring some unforeseen disaster in one form of another, of course. Market participants can expect at most three interest rate increases this year. Since the unwind of Quantitative Easing began, the Fed has been loosening its grip on the longer end of the curve, which has allowed for a clearer dissemination of market expectations through pricing data. My regression analysis of the last year's price of the 10-Year U.S. Treasury Note Futures, suggests a period of stable to rising prices in the medium-term. Stable to rising prices for 10-Year U.S. Treasuries means stable to falling interest rates for that segment of the yield curve. Pair that with the raising interest rates on the very front end of the curve, the trend of yield curve flattening that has been unfolding in bond markets is set to accelerate.

When the Fed raises short-term interest rates in a healthy economy, with growth on its horizon represented by a steepening yield curve, the rate increase transmits throughout the entire curve and pushes down all bond prices. In normal financial markets, investment capital would flow out of bonds and into stocks, raising equity prices and further reflecting expected economic growth. Apparently, we don't have a healthy economy, with growth on its horizon, or normal financial markets. With the Quantitative Easing unwind well underway and the now-apparent fact that the U.S. economy cannot support equity prices at current levels on its own, stock markets around the world are revaluing. Now for a bit of normalcy, falling stock prices will result in investment capital flowing into bonds. More specifically, the 10-Year U.S. Treasury Note for its perceived safety and liquidity, which will push the price up and interest rates down.

As the Fed continues along its intended course of interest rate increases, inflation expectations of market participants and businesses will continue to remain subdued. This translates into lower prices of inflation hedges like gold, and even lower input costs starting with oil. From the position of businesses, even with shortages of qualified labor, they don't have enough of an incentive to raise wages because they don't anticipate significate or continuous price increases in the near future.

My expectation is that as losses mount in U.S. equity markets, investors will have to liquidate foreign holdings, putting continued pressure on global equity markets, both developed and developing. In addition to liquidating foreign holdings, U.S. investors will repatriate cash to cover margin calls and rebalance leverage ratios by selling foreign currencies and buying U.S. Dollars. Dollar inflows will become exacerbated if the selling in equity markets accelerates and triggers a flight-to-safety reaction in market participants. In this scenario, the Fed will be forced to divert the course of monetary policy. And, if as the flattening yield curve suggests, a slowdown in U.S. economic growth or even a recession is pending, then the Fed does not have very much room to maneuver before they're back to a Quantitative Easing policy. The real definition of a Liquidity Trap.

What The US Dollar is Telling Me About the Global Business Cycle

As of December 28, 2017 the one-day, one-week, one-month, one-quarter, and one-year regression slopes of the Dollar Index are all negative. Looking further back, the five-year and ten-year regression slopes are positive, but this reflects the recovery from the Great Recession over the past decade.  Because the one-year regression slope is the longest of the short-term measures that has turned negative, tells me that the almost decade long rally in the US dollar came to an end in 2017. The apparent reversal in the mid-term trend of the US dollar is a signal of a return to normalcy in global financial markets, and international capital flow.  

When searching for context, I like to look at my longer-term charts out to twenty-years. What stands out is the period from mid-2001 to mid-2008, and the economic narrative of the day.  From the early 1990s through to the early 2000s the US economy, and by extent the global economy was is a long-term expansionary period. The growth that was experienced resulted from the US economy going through the finally stages of transitioning from a manufacturing dominant economy to a services dominant economy. A process which started in the late 1970s, and manifested as stagflation in the 1980s.

For the duration of the expansion during the 1990s, the US dollar appreciated against wide baskets of it trading partners. This appreciation reflected international investment capital flowing into the US to participate in the tech bubble and the broader US equities market. By mid-2002 the Dollar Index was making lower lows in conjunction with lower highs, which signaled the start of a downward trend. The trend in the dollar continued until mid-2008, by which time global financial markets had become aware of an underlying problem with the US financial system. During that same period, the US consumer was left to do what they do best, which is borrow and spend, and that they did. There was economic growth driven by appreciating housing prices and deepening household debt, and even a recovery in the US equities markets after the dot-com crash. The US dollar depreciated from 2002 through to 2008 for the same reason why it will depreciate from 2017 through to 2022 and maybe into 2023.

There have been trillions of dollars in value created in US equities since the lows of 2009. For the recovery part of the business cycle, the US economy was the biggest and safest game in town, while the rest of the world ‘sorted through their financial affairs’. Now that we are in the expansion part of the business cycle, risk appetite is returning to global financial markets. With (tepid) growth ensured in the US, market participants can move their profits from the US equities market into international markets to better leverage the synchronized expansion we are currently experiencing around the world.

If global economies keep expanding in sync with each other, monetary policy will remain on a path of tightening around the world. However, consumer price inflation will not return in a synchronized manner, which means US interest rates should rise relatively slower than world averages. This should lead to further dollar depreciation in the face of further economic expansion, which should continue to support the US equities market.