The US Personal Income and Outlays report for June 2019 came out this morning. It showed personal income increasing 0.4% and wages and salaries increasing 0.5% last month. These are good numbers. And in conjunction with a lot of other data we have seen recently, it should put to rest worries we have seen about an imminent recession.
But, over the medium-term, it makes sense for economists to worry about a potential downturn, especially given the weakening growth we have seen in Europe, China, and Japan. The big question is this: what should policymakers do? The tried and true approach of lowering interest rates hasn’t been as effective as anticipated, either in sparking real economic growth or inflation. What gives?
Below are my thoughts on what’s happening and what I believe will occur at the policy level going forward.
Economists’ View of Inflation
I read an interesting article on the inflation side of this in the Wall Street Journal this morning. Here’s what the Journal was saying:
For decades, mainstream economists have seen inflation as determined by slack—that is, spare capacity—in labor markets and the broader economy. Too much slack should cause lower inflation; too little should drive up prices. This is captured in the Phillips curve, which shows an inverse relationship between unemployment and inflation.
Recent studies have shown prices in some sectors—such as housing—do indeed rise faster when growth is in full swing, unemployment low and markets frothy. But a large chunk of the economy, from health care to durable goods, appears insensitive to rising or falling demand.
The upshot of this alleged interest rate insensitivity is that it lessens the effectiveness of interest rate policy as a policy tool.
A lot of people have focused on increased industry concentration giving some firms more wage supplier and consumer pricing power. But, I wrote about this two years ago from the Baumol’s disease point of view. And what I was saying then is that there are large sectors of the economy that are interest rate insensitive because a lack of productivity gains is driving up costs. Healthcare is one of them. And what this effectively does is increase inequality by raising prices for less wealthy people where things like healthcare costs are a disproportionate percentage of income a lot more than it does for the rich. This is especially true for seniors.
The Journal article focuses on the other side of things though – where prices are not rising as much as one would anticipate, rather than too much.
Take college textbooks, for instance. For more than three decades, their prices rose faster than overall inflation. They only stopped rising in 2017, a few years after Rice University engineering professor Richard Baraniuk launched a philanthropically-backed initiative offering more than 40 textbooks, ranging from pre-algebra to microeconomics, free over the internet.
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Disruptive technologies, government policies and global trade have had similar effects in other markets.
But, either way you look at it, it’s the imperviousness to rate policy that matters here. It says that rate policy is less effective.
Combatting slowing growth
So, when growth slows, the trusted method of central bank rate cuts won’t work to raise nominal growth rates via inflation. And I believe it won’t work to raise nominal growth through an increase in real GDP either. Here’s why.
Interest rates as a policy tool are very distinct from fiscal policy. Whereas fiscal policy can put money in people’s pockets when the government deficit spends, interest rate policy operate only through various interest rate channels. That means it adds stimulus only to the degree that the extra spending of people who are benefit from interest rate relief outweigh the people who are hurt by a loss of interest income. There is no ‘net’ addition to private sector wealth as there is with fiscal policy and deficit spending. You simply have winners and losers due to a gain of interest payment relief and a loss of interest income.
When central banks have cut rates in the past, they have eased financial conditions in several distinct ways. First, they lowered the discount rate of future income, which lifts the value of asset prices based on a stream of future cash flows. Second, they allowed households to refinance their mortgages at lower interest rates, freeing up cash for spending. Third, they allowed corporate borrowers, particularly those with interest payment stress and in fear of default, to lower their interest burdens. Fourth, they have lowered the attractiveness of dollar assets relative to assets in other currency areas, making exports cheaper. And fifth, lower rates tend to steepen the yield curve, which allows banks, which lend long and borrow short, to breathe easier during a period when their balance sheet is under stress from increased loan losses.
When the economy is in a serious state of stress, this relief can be tremendous in helping to kickstart the economy. And it overrides any loss of interest income the private sector may receive. But, how effective rate cuts are depends on the strength of those factors versus the loss of interest income. And I would argue non of those factors is especially true right now in the US, Europe or Japan.
For example, in the US, mortgage rates have been this low in the recent past. Lowering rates a quarter percent won’t kickstart a wave of mortgage refinancing. Also, corporate debtors are not stressed as default rates are at cyclical lows. Moreover, corporations are not redeploying capital into investment. Instead, they are buying back shares. So lower rates won’t boost the economy there either.
Even more importantly, in my view, is the fact that, with inflation expectations falling, yield curves are flattening, not steepening. That is no help to banks. And this is particularly problematic in the eurozone, where the European Central Bank is effectively taxing banks with negative interest rates. A larger tax won’t help restore balance sheets. It will worsen them. And it will do so in an environment where European banks need more capital, and where the economy is much softer than it is in the US, potentially dipping into recession, as it already has in Italy.
Of course, lower discount rates are good for equities. And so, it makes sense that Goldman Sachs is projecting an S&P500 2019 year-end of 3100 and 3400 for 2020.
So, the long and short of it is that financial conditions are easing with a rate cut. And that helps asset prices. But that doesn’t necessarily translate into real GDP growth or inflation.
The future
I think a lot of what I just wrote is off the radar screen for most policymakers. Their view is still very much the binary one of “lowering policy rates is stimulative and raising them is anti-stimulative”. Moreover, they don’t see the big contrast between fiscal and monetary policy as relevant because of the still virulent anti-deficit bias in policymaking circles, particularly in the eurozone.
So I expect that, if any advanced economies weaken, the policy response is likely to be mostly monetary in nature, lower interest rates and central bank asset purchases. None of this is going to be effective. In fact, because of the interest income channel, it could work to impede growth and lower inflation expectations.
So, I see yields continuing to come down in advanced economies, more at the long end of the curve than the short, with Anglo-Saxon countries like the US having more room to run than places like Switzerland and Germany, where most government bond yields are already negative.
Unless governments show a willingness to tackle income inequality, lifting spending by those with the greatest marginal propensity to spend, I think this is the paradigm we’ll be living in until the next global recession.