Stocks are running up record high after record high. One of the big impulses of these new records is the expectation that the new government will embark on a host of reflationary policies that will tilt economic growth, and hence corporate earnings higher.
Whether that scenario plays out depends on a host of elements. For instance, one might wonder whether the Republican dominated congress really wants to embark on a program that could very well blow up the public deficit, and by extension, the public debt.
Another doubt people might have is whether the reflationary program will actually be so reflationary. If most of the tax cuts go to corporations and the wealthy, and are at least in part paid for by reductions in public spending on welfare programs, it shifts income from low to high savers, and its economic impact could very well be muted or even deflationary.
Other doubts surround the supposedly big infrastructure bonanza. Since the election, we haven't really heard all that much about it anymore, and if it mainly (or even exclusively) takes the form of tax deductions, it's doubtful whether it will lead to all that much additional spending (as to offering tax cuts for projects already approved or in progress).
Then there are those who argue that the economic impact of any reflationary program will not be felt before well into 2018, simply because it takes time to draw up programs, get them through Congress, implement them, and then taking effect.
One could also have some doubts if the incoming government will remain without mishaps before this "well into 2018," when the reflationary program is supposedly taking effect. We think of specific mishaps on the trade front, where the government is liable to do something that could very well affect growth negatively, and so negate much of its reflation even before it has really started.
Again others argue that any reflationary program, especially one that exists mainly of big tax cuts and some public expenditure increases (defense, infrastructure) will blow up the deficit and lead to substantially higher bond yields, and the Fed and the dollar could very well follow. This could sniff out much of the reflation even before it has taken effect.
The next hurdle
But, for a moment, let's just assume these real-world problems away and assume that the incoming government is indeed embarking on a reflationary program that will take economic growth higher. We then have another possible hurdle to climb, which is called the labor market.
If the labor market is close to full employment or, more technically, close to the level where inflation takes off (the so-called NAIRU, or non accelerating inflation rate of unemployment), then the reflation efforts could well result mostly in higher inflation, rather than higher growth and employment.
The President himself obviously thinks we're nowhere near, so it's probably no concern of the government or something they're taking into consideration when designing the program and policies.
Trump has argued that the real unemployment rate is much higher, and on other occasions he has even argued 95M Americans are unemployed and the true unemployment rate is 42%. This 95M is indeed the number of people of working age who are not, at present, looking for a job.
But of those 95M, most actually have good reasons not to look for a job:
Basically they're voluntarily unemployed, because they're too old, following education, disabled, looking after family, etc.
Of course, that doesn't mean that there are no unemployed out there, willing and able to work but not able to find a job. An economy always has a certain amount of unemployment, like:
- Frictional unemployment - the labor market is complex as it's very heterogeneous; there are always people between jobs as adjustment takes time.
- Structural unemployment - economies are subject to structural change which changes their sectoral makeup. Some sectors are shrinking and shedding workers, while others are growing and hiring, but there can be a large mismatch in required skills and geographical location between growing and shrinking sectors.
Then there are, of course, those discouraged workers, laid off during the financial crisis and the big recession in its aftermath. We know from similar experience in Europe that the labor market tends to suffer from an effect called hysteresis.
This describes the phenomenon that after a big shock, economic variables are whacked out of sorts, but do not necessarily return to their previous ("equilibrium") values when the shock subsides.
It's not terribly difficult to imagine how this can happen in the labor market. The longer people stay unemployed, the more they tend to lose relevant skills and motivation, and the more likely they're going to be discriminated against.
Effectively, these hysteresis effects produce a decline in the growth of labor supply, resulting in a higher NAIRU if other things remain the same. In this light, it's somewhat odd that the unemployment rate has declined as much as it did without leading to much of a notable uptick in inflation.
But labor market hysteresis is likely to have been accompanied by other hysteresis effects, most notably on investment. The big recession and the fairly mute subsequent recovery produced a situation in which a substantial output gap persisted for a lengthy period of time.
A large output gap discourages building new production capacity, and this eats into the quality and quantity of the capital stock. We see some of this in the disappointing productivity and capital formation figures, and these reduce the rate at which the economy can grow without producing an uptick in inflation.
And there might also be more secular factors at work that have declined the rate of investment like the advent of shareholder capitalism, and the emergence of capital 'light' business models.
In the light of all this, it's curious that there are no bigger inflationary pressures, also as the labor supply itself is growing less rapidly, now that baby boomers are retiring en masse.
In an excellent article, SA contributor Ed Dolan produced the following figure:
The U3 is the current headline unemployment rate, the NEI is:
Based on the work of Hornstein, Kudlyak and Lange, the NEI includes all nonworking members of the labor force, from the short-term unemployed to the retired, but weights them according to their transition rates. Accordingly, the short-term unemployed get the highest weights, marginally attached workers a lower weight and retired people a lower rate still.
Transition rates refer to the chances of finding a job in the next month for different categories of people (with different attachment to the labor market). Nolan derived three conclusions from this; two of which are relevant here:
- The NEI shows the pool of available labor is larger than indicated by the U3.
- Both the U3 and the NEI are close to historic lows.
The latter especially shows that, unless the US embarks on retraining programs on a large scale, the labor market is already rather tight.
How likely is that a significant uptick in inflation will spoil any reflationary party of the new administration? Let's sift through some evidence. On the latest jobs report - here is Bloomberg:
The news on wages was less bright. The gain in average hourly earnings over the 12 months ended in January was less than the 2.7 percent median forecast, despite any possible boost from minimum-wage hikes at the start of 2017, and followed a revised 2.8 percent gain the prior month. Compared with December, worker pay increased 0.1 percent. Overall wage gains were depressed by a 1 percent drop in pay in financial industries.
The unemployment rate even notched up to 4.8%, and labor market participation actually increased.
Well, things are getting pretty heated here - from Bloomberg:
The U.S. cost of living increased in January by the most since February 2013, led by higher costs for gasoline and other goods and services that indicate inflation is gathering momentum. The consumer-price index rose a larger-than-forecast 0.6 percent after a 0.3 percent gain in December, Labor Department figures showed Wednesday. Compared with the same month last year, costs paid by Americans for goods and services rose 2.5 percent, the most since March 2012.
Now, this looks worse than it is as half of January's rise is due to higher gasoline prices as we're coming off the lows of the previous years. But still, a host of other goods and services are rising as well, the trend is clearly up, as it is in much of the rest of the world.
What's more, stagnating wages and rising prices leads to...
This is actually a good test for the state of the labor market. If we're close to full employment, wages will tend to creep up as employees have a better bargaining position in the face of higher inflation.
Another element that might spoil the reflationary party is the Fed. Here is how close the unemployment rate is to what they think will set off higher inflation:
However, it should be noticed that estimates of this variable have been revised downwards at the Fed several times already - from the Center for Financial Economics:
This process is illustrated by the last 4 years of FOMC estimates of the longer-run normal rate of unemployment as reported in the Survey of Economic Projections. From Dec. 2012 to Dec. 2016, as the unemployment rate fell but inflation did not rise, the FOMC steadily lowered its estimate of what must be normal. The upper bound of the central tendency for the normal rate fell on average more than 2 tenths of a percentage point per year, the lower bound fell a bit more slowly.
In fact, the NAIRU is nice in economic textbooks, in as a practical guide to policy, it's fairly useless.
First, the markets seem skeptical about the path of Fed rate hikes, from Business Insider:
But there are signs that financial markets don't believe the central bank this time. For one, traders aren't pricing in the next interest rate increase until June. The way things are moving in Washington these days, who knows what the economy will look like by then. More notably, big Wall Street banks are already second-guessing the Fed's recent guidance about the number of rate hikes that are likely this year.
It's not hard to understand why, inflationary expectations are still muted:
Jabaz Mathai, head of US rates strategy at Citigroup, and his team point out that inflation expectations as measured by the gap between inflation-protected bonds and regular Treasury notes, which are seen as a harbinger of future price rises, may not be recovering quickly enough for the central bank's liking. In a policy statement last week following its decision to leave rates on hold, the Fed said, "Market-based measures of inflation compensation remain low; most survey-based measures of longer-term inflation expectations are little changed, on balance."
This is, of course, why the equity markets are on a tear, pricing in an expected reflation effort whilst seeing little in the way of an inflationary threat that might stop the reflation in its tracks.
But market expectations can change on a dime, and one has to take into consideration that the Fed has a tendency to act preemptively. Here is Janet Yellen herself (from Economic calendar):
"I think that allowing the economy to run markedly and persistently "hot" would be risky and unwise," Yellen said in prepared remarks at the Stanford Institute for Economic Policy Research in San Francisco. She added that waiting too long to raise interest rates could cause inflation expectations to rise uncontrollably, driving actual consumer prices higher. The combination of persistently low interest rates and a strong labor market could also lead to other financial imbalances that will be difficult to control.
And not all market indicators see such a benign inflation picture - from Reuters:
A measure of U.S. inflation expectations rose for a second straight month in January to its highest level since mid-2015, according to a Federal Reserve Bank of New York survey released on Monday that reinforced the view that interest rates would keep climbing. The survey of consumer expectations, an increasingly influential gauge of prices for the U.S. central bank, found that year-ahead inflation expectations increased to 3.0 percent, from 2.8 percent in December and 2.5 percent in November.
Another variable to consider is the anti-immigration and increased deportation policies, which can easily reduce the labor supply, and hence constrain the labor market and growth further in an already increasingly tight labor market.
There are quite a few firms which have turned against the executive order for a temporary ban on immigrants from seven predominantly Muslim countries as it has caused some disruptions for some of their employees.
The equity rally is remarkable, given that it's at least in part based on pricing in the expected benefits from a reflationary effort by the new Administration taking growth higher. While we enjoy a good party as much as the next guys, we think this is a little premature.
There are numerous hurdles to climb before higher economic growth sets in, if it indeed does. The effects of any stimulus, if indeed felt with the vigor the markets seem to assume, might very well not be forthcoming until next year.
There are also multiple possible spoilers on the way, like wages and prices creeping up, Fed hikes, a bloating public sector deficit, a significant bond selloff, a rising dollar, and that's not even mentioning the usual suspects in the form of Chinese capital outflows, eurozone instability or any self-inflicting trade policy wound.
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.