The Economy Is Weak Because the Economy Is Weak
We are all taught from the very beginning, from Economics 101 and even before you ever get to college that the central bank is central. Every time there is a question about the economy or markets, up pops the talking head of Mario Draghi, Jay Powell, or some such. A membership on the Federal Reserve’s Board of Governors, however one might arrive at it, confers almost legendary status.
What if it wasn’t true?
As part of the curriculum on central banking, we are also taught how this is supposed to work. Monetary scientists use the various levers at their disposal to reduce interest rates thereby assuring if not creating prosperity. It does operate in the other direction, too. Only going this way, by using careful doses administered in determined steps, rising rates are meant to do no more than slow things down when the economy is in danger of becoming uncontrollably inflationary.
Rising rates don’t kill prosperity, it is prosperity that brings rising rates!
After spending all of last year bragging and boasting of an economic boom in America, American officials this year are fixated on 241; as in, 2.41% the current effective rate for federal funds (EFF). They should be focused on that extra 1 bps; meaning, how EFF is that much still above IOER, which suggests two things already.
A single basis point doesn’t sound like much. In monetary history, though, seemingly small moves can be everything. That Panic of 2008, for example, began in earnest on August 9, 2007 when benchmark 3-month LIBOR surged by…12 bps. EFF jumped 14 bps that day. A little over a year later, the whole global financial system came crashing down. It hasn’t been the same since.
Second, IOER was repurposed last year to help make sure something like this wouldn’t happen. According to the central bank, it should act as a ceiling for federal funds, to keep the money rate around where officials want it to be. Therefore, even 1 bps through the ceiling disavows the notion; as does 243, how on March 29 EFF’s confounding misbehavior totaled three bps.
But that’s not what everyone is talking about. The formerly booming economy is in danger, they say, of becoming undone by 241 bps. An intensely strong expansion cannot stand more than 2% money rates?
This is the case that many are now trying to make. Primary among them is Larry Kudlow, the former CNBC personality and now the President’s chief economic advisor. Yesterday, he told Bloomberg how he doesn’t see rates increasing “again in my lifetime.”
As the President might say, this is huge.
At this moment, it doesn’t matter if you believe Kudlow or not. The fact that he made this statement even presumably as a lame excuse means something. I doubt that’s why he said it, though, or why just recently he demanded an immediate 50 bps rate cut. Economists have been talking about R* for some time now.
R*, or R-star, is the theoretical natural rate. It isn’t thought to be static, either. Through history, Economists believe, it moves around up and down. Currently, all the statistical models peg the US R* at a very low level. These are, of course, the same econometric equations which said, as late as summer 2008, more than half a year into the what would later be called the Great “Recession”, the US economy wasn’t in much danger.
What the natural rate means for monetary policy is the relationship of interest rates to the neutral rate. This other is the point at which short-term money rates are neither accommodative nor tight. In orthodox theory, the central bank wishing to “stimulate” can only do so if money market rates are brought down below the neutral rate.
That point relates to R* given what R* presumably says about economic potential. In times where the economy is naturally booming, actually expanding in a meaningful fashion, this would be denoted by a relatively higher R*. Given that, the neutral interest rate would be higher, too.
If, however, economic potential is being held back by whatever other factors, then R* would be unusually low. Therefore, the neutral interest rate must be, as well, too weak to handle even small increases in money costs. And if that is the case, and if the neutral rate is lower than anyone thinks, then a central bank wishing to go from accommodative to neutral might be at risk of blowing right past that point into unintentional, seriously strangling tightening.
That is the argument being made here. Economic potential is so weak and decrepit, 241 bps federal funds may have just killed the big boom.
You might already be scratching your head. Something doesn’t seem right, does it? How can R* be so low and the economy ever boom? It is a contradiction. Economic potential is so bad and yet especially last year economic growth was described as nothing other than strong. What are we missing?
Economic potential is not supposed to be a macro or cyclical factor. It defines, essentially, the baseline upon which growth can take place. Technically, then, you can have a boom with a low R* if you define a boom as the best that can be done at that given time. Quite naturally, a low-R* boom isn’t going to look anything like a high-R* boom; low potential, low-grade boom.
This is the part they (including Fed officials) never told you last year.
But to arrive at “the best that can be done” there must be indications which validate the R* calculation for potential. This is where the unemployment rate has been so important to this view of the economy. By falling, falling again, and then falling some more, this statistic has been the one key piece of evidence for “the best that can be done.”
Remember, overall output, as measured by any number of accounts starting with GDP, has been unusually and consistently low since, curiously, 2008. Therefore, the unemployment rate seems to validate that, yes, economic potential must be low because the economy drove to full employment even at a much-reduced level of output.
The unemployment rate demonstrates low R* which gives us a very low neutral rate, so Kudlow hates Jay Powell.
The unemployment rate, of course, requires validation, too. Or, more specifically, full employment in terms of the unemployment rate does.
If we are seeking to define the boundaries of potential, then full employment is the chief signpost for it. Briefly, this is the demographic shape of the labor force, how many Americans (or Europeans, Japanese, whatever) there are really available to match the demand for labor. Should economic potential be low, likewise the same for the labor force (especially since Economists are, in large part, making the case for reduced R* from Baby Boomer retirements and drug addicts).
When the Federal Reserve first began publishing the results of its econometric forecasting simulations back in 2012, these put full employment as somewhere between 5.2% and 6.0% unemployment. Based on that, expectations were for the unemployment rate to gently decline, aided in huge part, Economists believed, by QE’s three and four that same year.
The December 2012 Greenbook, for example, given that view of full employment thought that the unemployment rate would slowly improve from around 8.3% where it was to about 7.4% by the end of 2014. Instead, by the middle of 2013 it had already reached that level.
By December 2014, the unemployment rate had actually dropped to 5.5%, well beyond anyone’s wildest computational imagination. It went so low so fast, that the Fed’s models had to constantly revise the view of where full employment must be.
In March 2017, for the first time the actual rate moved below what was considered to be the surefire level. The statistical lower bound (central tendency) for full employment had already been reduced to 4.7% and yet the actual unemployment rate in that month was 4.5%.
Ever since, that’s the way it has been. The actual unemployment rate has been consistently less than what’s thought to be the guaranteed, no-way-it-could-anything-less level of full employment – even as that estimate itself creeps lower and lower through time. As of the latest modeled simulations, the Fed now thinks full employment is almost definitely (lower bound) 4.1%. The unemployment rate has been below that figure for each of the pasteighteen months.
Again, output never actually accelerated during these years. Therefore, either that corroborates the R* view or the whole thing is wrong, the unemployment rate like the economy faulty. With so much time having passed, there are no other options left.
To validate the unemployment rate there must be inflation, in wages if nowhere else. Full employment isn’t just a numerical assignment. As a concept, it is the point at which all those willing to work have been hired or rehired (if laid off during the prior cyclical contraction). There are few spare workers (outside of natural economic frictions) left, or what’s called “slack.”
Slack is a macro related factor, not one consistent with potential. If the economy has reached its potential, then slack has been fully absorbed leaving businesses to fight over the few standby workers available. Competition for them means rapidly rising wages, increased labor costs which are then, as they always are, passed on to consumers in the form of broad-based consumer inflation (the Phillips Curve).
This is what Jay Powell, Mario Draghi, and all the rest have been talking about the last four years – more emphatically and intently the last two. You can already sense how this was emotion rather than rational, honest analysis: give us those wage increases and rising inflation so that it might authenticate R* and therefore let every central bank off the hook for persistently low output.
If R*, then truly it was the best that could have been done by anybody.
Except; no inflation, no wages. Employment pay, overall, has been increasing, of course, but still at historically depressed rates. Better than 2010 isn’t the same as full employment. They are not even close. Every single major wage or labor statistic shows the same thing (many of which I’ve cited consistently and repeatedly over these same years).
When the Federal Reserve surrendered in January with this Fed “pause” it did so on far greater terms than has been discussed in public. It wasn’t just that officials at the central bank may have come to agree with Larry Kudlow about the neutral rate, derived from R*, they went even further. Several FOMC members are openly questioning the whole thing.
This is what they meant by “muted”; as in, inflation pressures should have been monumental last year given what the unemployment rate said. The labor market, by its reckoning, was exceptionally, historically tight. Competition must’ve been fierce for the few spare workers left in an economy with no slack (the media played along by publishing innumerable stories about a LABOR SHORTAGE!!!, stories that have curiously disappeared since 2019 began).
In January, though, the FOMC completely changed its view. Inflation pressures are now judged to be “muted.” How can that be? What are we missing?
You could make the case that the language is disingenuous. In order to calm markets, the Fed needed an excuse for its “pause”, which wouldn’t have been consistent given the case for inflation they were trying to make all throughout 2018. To justify the pause, policymakers had to kill these inflation expectations at least in their official communications.
But the Federal Reserve’s Vice Chairman Richard Clarida admitted this week what many are already thinking; what we are really left to only think. Speaking in Minneapolis on Tuesday, here’s howReuters summarized Clarida’s evolving thoughts:
“The traditional tie between falling unemployment and rising inflation has clearly weakened, Clarida said, and the recent influx of workers returning to the labor force indicates there may be more “slack” in the economy than the headline 3.8 percent unemployment rate indicates.”
If that’s true, and there is more slack, that’s macro not potential. All the evidence points to this conclusion, an overwhelming consistency that forces the occasional Economist and central banker to speak rationally now and again. This R* story is incredibly tortured logic. Again, emotion not analysis.
The economy isn’t living up to its potential, meaning R* probably isn’t unusually low which means the neutral rate likely isn’t either. Counterintuitively, the only reason the unemployment rate fell as far and as fast as it did was because of this slack! Potential workers have been excluded from the official definition of the labor force, therefore the denominator of the unemployment rate (the participation problem).
This is why as the official level of unemployment dropped output never increased – which, by every natural instinct, it would have if the unemployment rate were anywhere close to accurate. Ironically, this is the message that Candidate Trump used to secure his place as President Trump.
The economy sucks because the economy still sucks; this “expansion” is entirely too uneven, there are only a few decent quarters here and there, the somewhat good ones, like Q2 last year, being outliers. Conversely, bad quarters and downside risks are our baseline. Macro baseline, not actual potential.
EFF 241 bps cannot mean what Kudlow wants it to mean. It’s not those first 240 that are now the problem, he needs to really take a hard look at that last one.
They are all missing something. The economy is clearly missing something. If neither R* nor the neutral rate are what policymakers think, or they have no idea how to find them, then how would they ever square monetary policy with the last decade? We don’t need to know R* to tell how us badly it was performed in 2007, 2008, and 2009 – the same years, curiously, when R* is thought to have collapsed.
What if central banks are not central?
