David Ross

What I think I learned last week #50

Last week, I had the pleasure of attending the Global Interdependence Center’s Central Banking Series in Madrid, Spain. The Global Interdependence Center provides a forum for experts (and in my case, definite non-experts) to discuss emerging economic, social and political issues. Below is some of what I think I learned from that conference.

The US economy has a lot of momentum and the Federal Reserve has met its dual mandate of price stability and full employment. However, there are some unusual features to the economy that make the outlook more difficult to predict. One feature has been, for the first time since the 1930s, the introduction of significant trade tensions in the global economy. The second feature has been the introduction of late cycle fiscal stimulus, which is the first time this has been attempted since the 1960s. These two economic experiments create additional uncertainty for policymakers and, especially in the case of the trade tensions, for business planning and investment.

It was noted among participants that historically in the US, unemployment does not “tick up.” If unemployment moves up, it moves up in a big way. In fact, history tells us that it seems rather impossible to hit a steady state of unemployment: it is either falling or rising, but it never sits flat.

There was a discussion on the “neutral rate” for Fed monetary policy. Typically, the Federal Reserve overshoots the neutral rate by 150 basis points, which inevitably kills off economic growth. However, in the past, the Fed was also fighting increasing inflation expectations. Currently, inflation expectations are low and showing no signs of increasing in the US, thereby lowering the pressure on the Federal Reserve to keep pushing rates above the neutral rate.

Regarding the trade wars, the economists in the group noted that the implementation of tariffs and trade restrictions has an effect similar to a supply shock, similar to the effects of the oil supply shocks of the 1970s. The impact of trade restrictions is to lower the productivity of the economy as the most efficient inputs become unavailable while at the same time overall costs and prices are increasing. Increasing prices and lower productivity is a recipe for a return to “stagflation” (again, something we have not seen since the 1970s in the US). Furthermore, monetary policy is ineffective in a supply shock situation; monetary policy is designed to impact the demand side of the economy.

One argument supporting the idea that fewer Federal Reserve rate hikes will be needed was the consensus opinion that the rest of the world is slowing and at the same time, the US dollar is strengthening. This will keep inflation expectations low in the US, and allow the Federal Reserve to avoid overshooting the neutral rate to suppress inflation expectations. The key concept to take away from this discussion was that as long as inflation expectations do not start to increase from current levels, the Federal Reserve can maintain a gradualistic approach to monetary policy normalization.

Finally, there was an emphasis on the dangers presented by Europe to the global economy. It is obvious that the 2017 growth burst of Europe is long gone and that the twin drivers of European economic growth, Germany and autos, have peaked. Both consumer and business confidence are stalling, and the future is creating much uncertainty. Obviously Brexit is an overhang, but the major worry among the conference participants was Italy. Basically, Europe has to make an example of Italy and its budget deficit, because if they don’t, they know it opens the door for Europe’s perennial budget-buster, France, to open the flood gates on deficit spending. A combination of Italy and France ignoring the rules would likely send the euro into a free-fall. The weaker currency would create inflation pressures, forcing the ECB to tighten, thereby pushing the Eurozone economy into recession. Add in the effect of tariffs, and one should expect that things will only get worse for Europe, leading to more success electorally for populists. So, in summary, prepare for another European crisis and then expect Europe to do what it does best: ignore the problem for as long as possible and then muddle through.

And that’s what I think I learned last week.