The Federal Reserve: Between Scylla And Charybdis

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Douglas Adams


  • The release of the July FOMC minutes underscores the dichotomy between a tightening labor market and quiescent levels of inflation in the greater economy.
  • Wage and salary growth hit 2.5% YOY through the end of the 2nd quarter while labor productivity fell 0.4% over the same period.
  • Stimulating demand by creating higher supply via fiscal policy could provide a needed bottom-up approach to sustainable economic growth.

The Federal Reserve continues to be stuck negotiating safe passage between Scylla and Charybdis on monetary policy and the July FOMC meeting minutes, released on Wednesday (17 August), did precious little to alter the perception in the minds of investors large or small, domestic or international.

The labor market did indeed tighten in the six weeks between the June and the July FOMC meetings. The civilian labor force increased during the month of July which caused an uptick in the labor participation rate of 0.2 of a percentage point year over year, leaving the national unemployment rate unchanged at 4.9%. Wage and salary growth through the end of the 2nd quarter increased at an annualized rate of 2.5%.

Yet US worker productivity has been dismal, falling 0.4% year over year through the end of the 2nd quarter. That non-residential and equipment investment has fallen in the past three consecutive quarters is perhaps a conspicuous reminder that economies of scale and workplace efficiency technologies do not count as top corporate decision-making priorities of late. On a brighter note, household spending had a strong showing in the first estimate of GDP growth for the 2nd quarter.

The biggest dichotomy of all: Even with a tightening labor force, increasing wage growth and an unemployment rate of 4.9% - core PCE inflation remains quiescent at 1.4% year over year through the end of the 2nd quarter, well below the Fed's 2% target. Both survey-based market expectations and FOMC forecasts on inflation project core PCE hitting a 2% plateau by the end of 2018, little changed in recent months.

Prices for goods were up 1.8% year over year in the greater economy while service prices were up 2.2% over the same period. The difference continues to be the strength of the dollar in international currency markets which largely determines the price and demand for US products in world markets. With international demand weak and the US dollar strong, import prices fall in dollar terms as foreign exporters gain comparative market advantage on price.

This puts downward price pressure on domestic competitors on goods priced for the US market. With worldwide surpluses of crude oil and most recently large build-ups of refined products such as gasoline in the US continuing to depress prices in the greater economy, price inflation remains subdued. Final demand goods declined 0.4% in July with the fall of both food and energy prices during the month.

Year over year, final demand goods have fallen 0.2% as the toxic mix of weak global demand and a strong dollar continue to apply downward price pressure on goods. On the service side, price inflation is more visible as the service economy lacks the downward price pressure of imported goods from abroad. Services that sell almost exclusively into the domestic market are by definition less exposed to the strength or weakness of the dollar. Accordingly, domestic service providers have much more pricing power in the economy.

While the headline emphasis continues to focus on the labor markets, it is the underlying economic realities that keep inflationary risk well anchored, allowing the further tightening of the labor market to continue without triggering a federal funds rate increase. Further, the natural rate of unemployment is still yet to be achieved.

FOMC participants saw little of the volatility in asset pricing created by the UK vote to leave the EU being exported across the Pond. The expedited party appointment of Theresa May to the office of Prime Minister and the decision of the new government not to seek an immediate electoral mandate removed much of the political uncertainty that hung over the economy as a result of the vote.

While the triggering of Article 50 of the Treaty of Rome is highly unlikely before 2017, further action by the Bank of England (BOE) at its early August meeting saw the launching of an aggressive response to the downward pressure on sterling-denominated assets in the aftermath of the vote with a 25-basis point reduction of its main lending rate, the launch of a new asset purchase program that includes a corporate debt component and a bank loan program for banks - a spending level of about 7% of current GDP.

Given the current environment, the July FOMC minutes saw many participants coming to the conclusion that it was appropriate to wait on additional data to confirm the direction of both labor market and inflation. Several participants went further in their assessment saying that current conditions would likely afford the Committee ample time to react to any spike in inflation that rose quicker than currently anticipated.

Market expectations after the release of July's FOMC minutes captured a 4% probability for such a move in September, a 10% probability for an October move, a 16% probability for a November move and a 30% probability for a December move on the federal funds rate. The probability of a move on the federal funds rate at the beginning of the 2nd quarter was negative.

Market reaction was largely subdued with the S&P and the Dow Jones Industrial Average both up slightly on the day. Gold and the US dollar both rose slightly as did the price of US crude. The yield on the 10-year Treasury fell slightly as investors took advantage of yet another market respite from an imminent uptick in the federal funds rate.

Perhaps we should step back for a moment and ask the simple question: After the tsunami of central bank liquidity that has washed up on the shores of the developed world, are we further along the path toward achieving sustained economic growth, or achieving price stability or maximum employment? Perhaps there is a better way, a different path.

Robert Gordon in his controversial book The Rise and Fall of American Growth puts forth the bold if pessimistic proposition that American technological innovations that revolutionized the workplace and boosted the living standards of generations past - are just that, past. Electricity, the automobile, the assembly line, the telephone, the airplane, the computer, the internet all were discoveries that provided quantum leaps in society's ability to produce goods, to communicate, to travel, to process and store information. Productivity soared. America has simply entered a fallow period where productivity declines are merely carving out a reflective "new normal."

Lawrence Summers offers a rather different assessment and approach, resurrecting an idea first put forth by Alvin Hansen in an address before the American Economic Association in December 1938. The looming backdrop of Hansen's remarks was the Great Depression where secular stagnation-infused recoveries produced checkered levels of economic sustainability, leaving a hardcore army of unemployed in its wake.

Of course, Hansen's thesis was destined for the dustbins of history with America's entry into World War II. Summers' resurrection of the Hansen thesis has found new resonance in the wake of the Great Recession of 2007. The focus is fiscal policy - using government as the lender of last resort and infrastructural spending as the means to create demand in the greater economy.

The payoff of such spending is the stimulation of private sector supply channels of design work, raw materials and local jobs while at the same time activating the Keynesian multiplier effect in the targeted areas of construction that over time migrates through the general economy.

Stimulating demand by creating higher supply from the bottom up is a very different approach from monetary policy that creates the top down investment environment with the hope of creating demand by lowering borrowing costs across the economy. In the new world where $12.6 trillion in sovereign and corporate debt carries negative yields, rather than stimulating borrowing and spending saving rates in Germany, Denmark, Sweden, Japan and Switzerland are at all-time highs, according to OECD data.

The anecdotal evidence here is one of fear: People and businesses borrow when they are reasonably confident of future economic return on funds invested today. Low inflation, declining energy prices, and aging populations all offer up strong incentives to save - not to spend.

The counterproductive embrace of austerity measures throughout much of official recovery at the governmental level in much of the developed world has limited the scope of private sector investment in the greater economy which has only been exacerbated by the precipitous decline in energy investment due to the falling price of crude.

Borrowing costs have reached historic lows as companies race to issue debt largely to fund stock buyback programs and enhanced shareholder dividend payouts - hardly the intent of central bankers in lowering borrowing costs across their respective economies. Large-scale asset purchase programs have indeed lifted the price of assets throughout the economies of the world - from stocks to bonds to houses to dollar-denominated commodities.

Plunging yields have likely distorted the ability of investors to price risk which cuts across the breadth of the economy as insurance companies to pension funds to healthcare providers face down the risk of not being able to match today's contractual promises with the necessary yield to meet future liabilities. Secular stagnation if structurally based simply eats away at the floor under interest rates rendering monetary policy largely ineffective.

If current productivity levels are structural, future income streams and supporting lifestyles will likely be much reduced. Asset purchase programs largely pull future income streams forward. If those streams do not create current economic expansion, future growth will be necessarily stunted.

This article was written by

Douglas Adams profile picture
Douglas Adams specializes in macro-economic research and turning theory into practical portfolio applications for clients over the past seventeen years. Mr. Adams recently formed Charybdis Investments International based in High Falls, New York where he is the managing director of a fee-only investment advisory practice with clients throughout the United States. As an author, Mr. Adams has commented widely on a diverse array of topics from Brexit to monetary policy to forex to labor productivity and wage growth. He holds an undergraduate degree from the University of California, a master’s degree from the University of Washington and an MBA in finance from Syracuse University.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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