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The White Queen's Rule

Seven years after the financial crisis, the absence of any Fed rate hike seems surreal, and is reminiscent of the White Queen’s dictum in Through the Looking Glass: “The rule is, jam to-morrow and jam yesterday – but never jam to-day.” When Alice objects, “It must come sometimes to ‘jam to-day,’” the Queen retorts, “No, it can’t. It’s jam every other day: to-day isn’t any other day, you know.”

While justifying last month’s decision to push off a rate hike on the basis of “global financial and economic developments,” Fed Chairman Janet Yellen was at pains to emphasize “a U.S. economy that has been performing well.” Yet, for many months, ECRI’s research has shown this to be far from accurate – quite the contrary. Since the start of a rate hike cycle has historically implied an economy on a strong footing, this makes it a particularly inopportune time to begin raising rates.
At least until last Friday’s jobs report, many economists, including most policymakers, agreed with Ms. Yellen that, overseas weakness notwithstanding, “domestic developments have been strong.” Yet, a systematic examination of coincident indicators of U.S. economic growth has long contradicted this view.

The chart shows that year-over-year (yoy) growth in ECRI’s U.S. Coincident Index (USCI), having peaked in January, has declined to an 18-month low, while yoy payroll job growth has now declined to a 13-month low. Moreover, yoy growth rates for GDP, income and sales are at or near their lowest readings since 2014; and industrial production growth is close to its worst reading since 2010 (not shown).

Such a broadbased cyclical downturn in these key coincident measures is the essence of a growth rate cycle (GRC) downturn – hardly the hallmark of a “strong” economy continuing the revival from the weather-related weakness in Q1 2015 on which some economists remain fixated.

ECRI first flagged the “downturn in U.S. growth” nearly a year ago (USCO Essentials, November 2014), noting that, at the time, it was “being driven by a manufacturing slowdown.” While some economists are finally starting to recognize that the Fed may have missed its best opportunity to start hiking rates, it was at the beginning of this year – looking back at the GRC upturn in 2014 – that we asked the rhetorical question, “If not now, when?” (USCO Essentials, January 2015).
It is also worth recalling just how long the rate hike debate has been raging. Six long years ago (ICO, October 2009), it was so intense that we wrote, with the U.S. “recently exiting recession, the timing of the next … rate hike cycle is becoming a major issue” in the context of “sporadic pronouncements about the need for faster and more aggressive rate hikes.” Pushing back against the conventional wisdom at the time, we concluded that “it may be years before the central banks begin to hike rates, if past patterns are any guide.” Today, the timing of the first rate hike in nearly a decade is increasingly in doubt against the backdrop of a slowing economy.

Relatively recently, the consensus has experienced a succession of “aha” moments, belatedly arriving at conclusions we reached long ago. A case in point is our recognition more than seven years ago, prior to the Lehman Brothers collapse (USCO, August 2008), that U.S. trend growth had been in a declining pattern at least since the 1970s. A variation on that theme in the form of the “secular stagnation” thesis, introduced less than two years ago, is finally gaining wider acceptance.

In that context, the Fed last month further cut its estimate of long-term real GDP growth – pegged at 2.65% four years earlier – to just 2%. This is in line with our observation in May 2014 that “what is being gradually acknowledged – without any publicity or fanfare – is that long-term U.S. GDP trend growth … is converging towards its 2% stall speed. If so, almost every time GDP growth experiences a slowdown that carries it below trend, it will also fall below the recessionary stall speed” (USCO, May 2014).

That same month, we flagged one of the root causes of the decline in trend GDP growth – “the longer-term downtrend in productivity growth” (USCO, May 2014). As we also concluded, declining productivity growth was likely to exacerbate the ongoing multiyear slump in wage growth. These apprehensions have subsequently been highlighted by policymakers, including Fed Vice Chairman Stanley Fischer, and have more recently become a matter of broader concern.

In fact, low productivity growth has become a source of anxiety among policymakers, not only because of its long-term implications for the U.S. standard of living, but also because it implies a lower potential GDP that, within a Phillips curve framework, increases the urgency to hike rates. The Fed has yet to catch up with the reality that the inverse linkage between productivity growth and inflation “has broken down in recent years, with the price of imports increasingly becoming a critical driver of overall inflation” (USCO Focus, August 2015). It is notable, in that context, that Ms. Yellen argued last month that “an important reason” why the Fed was “way below our inflation target” had to do with the “declines in import prices.”

Today, the Fed’s analytical framework is once again struggling to catch up with the reality of the economic cycle. And the stakes seem to only be getting higher.

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