From time-to-time in the course of our regular research, we write what might be considered slightly random ‘thought pieces’ that seemingly don’t fit in the usual ‘flow’ of reports that we seek to produce. Sometimes these ‘ideas’ seem important at the time but never in fact become relevant to markets but on occasion - and often with a bit of luck - we can find that we have in fact stumbled onto something that will matter, even if we may not have fully appreciated it at the time.
One such random paper may have been a report that we compiled at the beginning of this year that looked at the US Phillips Curve. In this paper, we hypothesised that the Phillips Curve trade off between (wage) inflation and unemployment continued to exist at State levels – most of the individual States that we looked at still had quite defined and conventionally-shaped Curves - but that the national Phillips Curve relationship had weakened because US growth since the mid-1990s had been concentrated in a relatively small number of States – in effect there might have been 5 – 10 States in which the local economy was operating in the top NW quadrant (CA, WA, & TX) - but there were perhaps 20 or so operating in the lower SE quadrant. When the results of the different States were ‘averaged out’ into National data, the US Phillips Curve tended to become ill defined along most of its length, except at its extremes, i.e. when all the States were fully employed inflation would appear, or when there was a nationwide recession inflation would disappear.
Much of the media commentary covering Fed Chair Powell’s address to the Jackson Hole Conference this year has unsurprisingly focussed on his comments about average inflation rates and ‘how high inflation will have to be over the coming years’ in order to offset the undershooting of recent years. This is clearly of immediate relevance to both the short and the long ends of the yield curve, but we believe that the implications of Powell’s speech in truth went far beyond even this simple maths. To quote Mr Powell:
“this change (in Fed focus) reflects our appreciation for the benefits of a strong labor market, particularly for many in low- and moderate-income communities. In addition, our revised statement says that our policy decision will be informed by our "assessments of the shortfalls of employment from its maximum level (sic in these areas)"
Powell spent some time in his speech also emphasizing that the National Phillips Curve was no longer easily identifiably stable (although he did not seek to explain why) but he then continued in a way that echoed many of the comments of his predecessor at the Fed, Arthur Burns around the time of the Vietnam Conflict, to point out the potential benefits – and the need – to improve employment levels in the lower income states and amongst minority groups.
In short, he appears to be arguing that the authorities (rightly) perceive that there is a need to move the weaker states North-westwards along their respective Phillips curves so that the gap between unemployment rates in the prosperous regions (in which we have noted that there tend to be ‘clusters’ of successful industries) and the weaker states is reduced. In a practical sense, this would imply dropping the unemployment rate in the weaker States by 800 bp or more from where it is today, and by 100-200 bp with regard to their longer-term averages (i.e. cyclically adjusted). For Illinois, this would equate to there being a ‘target rate of unemployment’ of around 2.5%, while in Mississippi the target rate would be around 3%.
Our work for individual States suggests that these traditionally higher unemployment rate States would be experiencing wage inflation rates of circa 4% at these new target rates of unemployment, a rate of wage inflation that is to be some way above their historical rates of productivity growth. Hence, unless there were significant improvements in the supply side dynamics of these particular States in the interim, moving these regional economies to higher levels of employment would entail significantly faster rates of unit labour cost inflation.
Crucially, we must also remember that money is at a practical level always fungible. If the Fed has indeed committed to reducing unemployment in these States, then it will also be providing a boost to the more prosperous States (in fact, a larger boost since “money tends to follow money”) and it is likely that these economies would find themselves firmly in the NW quadrants of their Phillips Curves where they would be experiencing quite rapid rates of wage inflation that were not now being offset in the National data by weak wage inflation rates in other areas.
In practice, we suspect that the national Phillips Curve slope would indeed “start off” quite shallow as the recovery commenced (as Powell has suggested) but that, as the last 5 – 10 States finally began to participate in the recovery, it would be quite probable that the curve would become ‘almost vertical’ as virtually all the States moved onto the steeper left-hand parts of their wage / employment trade-offs.
Moreover, we further suspect that the sheer size of the stimulus that the Fed will need to impart to the system (most likely through continued heavy monetization of Federal spending, particularly in the weaker States) would imply that USD credit and funding conditions would remain extremely buoyant not just for domestic entities, but also the foreign sector as well.
In such a world, not only can the USD be expected to continue to drift lower, but the Fed would also in effect continue to fund the growth in some of the US’s own economic competitors, most notably China. China’s authorities may be attempting to wean their economy from its dependence on USD credit and external financing but if the Fed is destined to set policy according to the needs of its weakest States, then we suspect that China need not hurry to cut its own dependence on dollar funding.
The US has of course been making (loud) noises about cutting China’s access to funding and containing China’s growth through trade and capital account restrictions but while the Fed is intent on reflating all of the US domestic economy, it will be immensely difficult to contain China’s access to USD (thereby implying that Sino-US tensions may shift their focus back to conventional tariff & trade wars).
In such a World, the USD could certainly be expected to continue to drift lower against most currencies over the medium term, even the EUR. We have noted in previous notes that, in order for the EUR to survive the ECB also needs to set its monetary policy according to the needs of the electorate in the weakest nation state in its strange union. However, the ECB – probably because of the influence of the creditor nations in the union – seems less willing or able to embrace this logic, implying that the Fed – which ironically faces no such direct political threat to its very existence – may well continue to outperform the ECB in this regard. This, in turn, implies that the EUR may ‘win by default’, providing of course that the EUR project itself can survive the current slump.
Clearly, the gap between rich and poor in the US is something that should be addressed and morally needs to be addressed. The US does need some form of levelling up – just as the UK economy does – but we strongly believe that the way to achieve this is via supply side reform and investment in infrastructure, education and the building of ‘prosperity clusters’ around centres of learning (i.e. the Seattle model). This type of development usually requires effective cooperation between an enlightened public sector and a socially responsible private sector but, in order for sensible supply side policies to work, they usually need stable and predictable monetary conditions in the background.
However, instead of the latter, we find that the Fed is being pressed – ostensibly for good reason - into attempting to address the regional economic imbalances in the US through the incredibly blunt and singularly ill-suited tool of monetary policy. It is our sense that by attempting to use macro monetary policy to achieve micro aims, the central bank will fundamentally undermine the value of the USD both at home and abroad, while at the same time providing funding to the country’s geopolitical rivals.
In our period of economic consciousness there have so far been two major ‘moments’ in US monetary policymaking. The first being Volcker’s shift to a disinflationary stance; the second was Greenspan’s shift to underwriting markets and the creation of moral hazard markets; but we fear that we are now witnessing a third and equally important shift in the Fed’s stance. Because of policy failings elsewhere in the system, Fed policy will now be set according to the needs not of the average State but rather the weaker States, and as such the currency should start to reflect the productivity and position not of average America but the weakest parts.
In such a World, we suspect that bond investors should start to become a little nervous, although they will no doubt continue to take comfort from the fact that the Fed will be using their markets as a conduit for its monetary accommodation. For equity investors, the policy looks set to ensure that what we calculate to be the ‘largest credit boom in global monetary history’ will be able to continue for the foreseeable future. The USD may continue to lose value but USD-dependent risk assets should be able to continue their melt up until either the policy model changes, the plumbing inside the financial system fails (as it did in 2007), or there is by definition an unforecastable news event that is both so large and entirely ‘black swan-like’ that it cannot be ignored.
Risk markets may have lost touch with ‘reality’ but the Fed’s latest policy pronouncement looks set to underwrite the credit flows that have been propelling equities higher over the last six months. One day, the real and financial worlds will have to re-converge but this day of reckoning looks to be moving further away at this time.
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