A Look Inside The “Basket” Holding The “Market's Big Puzzle”
In a front page article, the WSJ takes aim at the “biggest market puzzle” of our times: the bizarre disconnect between growth and inflation, where on one hand government reports of strong, coordinated, global economic growth and tumbling unemployment (at least in the US and Japan) are offset by the complete lack of concurrent reflation. Some examples:
- The U.S. economy grew 3% in Q2, but in July CPI was up only 1.7% from the prior year;
- Eurozone inflation, similarly, remains stuck at 1.5% despite the bloc’s accelerated recovery.
- Japan’s economy grew 4% in the same quarter – its longest expansion streak since 2006 – yet inflation has failed to move above zero, where it has been stuck for the past two decades.
Aside from the now widely accepted reality that the Phillips curve is now broken…
… and the all too real possibility that either growth or inflation is being measured – and reported – incorrectly, whether accidentally or for political or market manipulation purposes, this disconnect suggests that something is very wrong with conventional economic theory: after all “when growth is strong, people demand more products and companies need to offer better pay to hire more workers, and so prices go up.” And, as the WSJ points out, if this relationship is indeed broken, “the consequences are vast for economic policy-making and financial markets.”
“There’s no question this is a very fundamental challenge to our knowledge and our policy making,” said Adam Posen, president of the Peterson Institute for International Economics.
It would also imply that the past 8 years of monetary policy has been based on a fallacy, as the growth-inflation relationship is the fulcrum of central banking: Central banks set an inflation target—usually around 2%—and then lower interest rates to help prices adjust whenever demand falters. If there is risk that excessive spending pushes inflation over the target, they raise rates to cool growth. Instead, what central banks have been doing, in addition to losing control over broad economic inflation, has been to spur asset price inflation, or as Bank of America put it, bubbles, and not just bubbles but “bubbly” bubbles…
… in the process destroying the entire capital allocation model that has defined so-called “efficient” markets since the advent of Finance 101.
The good news is that, despite broken markets overflowing with trillions in central bank liquidity, until now and for much of the post-crisis period, bonds and stocks have been going in the same direction. This year, the S&P 500 is up almost 10% while 10-year Treasury prices have gained 6%, pushing the benchmark U.S. bond yield down near 2%, a level typically associated more with financial distress than with improving growth. Of course, with everyone making money, nobody bothers to ask why.
Well, not everyone: some questions have emerged in recent weeks. Yesterday, Fed governor Lael Brainard said that “one simple explanation may be the experience of persistently low inflation”: Because inflation has been low and often falling for much of the past decade, households and firms now expect low inflation in the future as well.
Paul Donovan, chief economist at UBS Wealth Management, believes the bond market is giving the wrong signal about inflation. “Bond markets are rigged,” he said, by extraordinary demand for safe debt, created by an aging population, regulation and central-bank buying.
Other reasons for the chronic lack of inflation is a structural change in the labor market, coupled with the impact of globalization, the decline of labor unions and the rise of big multinationals holding down consumer prices in efforts to grab market share. Here we go back to the collapse of the Phillips curve:
Unemployment across the developed world has fallen to where it was before 2008, so in theory companies should be offering more generous pay raises to attract workers and increasing prices to offset the cost. Neither is happening. A partial explanation is that workers can’t demand pay raises. In its annual report in June, the Bank for International Settlements found a “positive and significant” link between wages and the strength of unions. Unionization has dropped by half over four decades.
This is certainly a factor, as we showed at the start of January 2015, when we demonstrated the startling difference in unionized vs non-unionized wage growth.
Then there is the hottest topic of our times: globalization:
Enrique Martínez-García, economist at the Federal Reserve Bank of Dallas, published research in July showing that globalization is part of why inflation has been low and unresponsive to growth. Companies can outsource production or import if the wage bill starts getting too high, rather than raise prices. China has flooded international markets with cheaper goods, ultimately pushing down prices.
Subsequent BIS data confirmed that it is indeed globalization that has kept prices low: in the U.S., 10% of the change in labor costs between 2006 and 2016 was determined by the price of labor abroad, compared with 2% between 1995 and 2005. For the world overall, it is 22%, up from 11%.
Others blame tech disruption and “superstar firms”:
“Inflation is not a leading indicator” of growth any more, said Didier Borowski, head of macroeconomic research at Amundi, Europe’s largest asset manager. He said “much more competition at the global level” is leading producers to price more aggressively. Indeed, the focus of many analysts is now on the market power of so-called “superstar firms,” especially technology giants such as Alphabet Inc. or Amazon.com Inc., rather than on traditional supply-and-demand explanations.
“When Amazon enters a market, it drives prices down,” said Jason Helfstein, a tech-sector analyst at Oppenheimer & Co. Chicago Fed President Charles Evans referred to Amazon’s purchase of Whole Foods Market Inc. as an example of “disruptive technology” that keeps inflation down.
What is unspoken here is the explicit role of the Fed to not only keep zombie companies alive courtesy of ultra cheap sources of funding, thus exacerbating deflation, but also boosting deflation-centric business models, such as all those to emerge from Silicon Valley over the past decade, in which massive losses are forgiven if they mean market share gains, while undercutting the competition on prices.
In any case, as the WSJ notes, what makes the conundrum difficult to solve is that inflation hovered around policy makers’ targets for more than two decades until 2008, after shooting up in the 1970s. “Central banks were then credited for subduing inflation by raising rates and cooling the economy, but many investors now doubt they can effect similar magic in reverse.“
Or maybe all of the above is wrong, and inflation is there, it is just not being measured accurately.
Indeed, a far simpler explanation behind the “lack of inflation” puzzle, especially since for most Americans not only are prices not declining, or “steady”, but rise with every passing month, especially for staples such as rent, food and education. is that what is really taking place is that inflation is most certainly present, it is just not being captured by the current CPI or PCE baskets.
In fact, some may be surprised to learn, that at this moment, services represent 75% of the measured inflation inputs that go into he Fed’s favorite inflationary metric, the PCE.
So instead of redoing policy based on the wrong diagnosis, it may be time to re-evaluate what Americans really spend most of their money on, which as of this moment is – at least according to the government – the following: