Last week, we published Neil’s thoughts on the disappearance of the Phillips Curve over the past twenty-five years. This development has had profound ramifications for workers, wages and inflation. It has also driven down interest rates and the risk free rate of capital with attendant positive implications for asset prices, both equities and bonds.
In tandem, however, lower wages for workers and greater levels of wealth for asset owners, have amplified inequality and undermined the mainstream political status quo. Now that the political backlash is underway, David McWilliams, in New York, asks whether we are about to see the return of the Phillips Curve?
The presidential campaign has poisoned America. I have never seen the country more divided, angry and ill-at-ease with itself. Five years into a recovery, even with unemployment at a very low level and with asset prices booming, there is a palpable sense of angst and insecurity. This national anxiety is stoked by a daily diet of incessant fear mongering, amplified by the tickertape of saturation TV coverage, social media feeding frenzies and the relentless battle for the attention of the average American – all of which is designed to sell him something or other.
This time last year, in Letter from America, I highlighted the fact that an increasingly unequal America – an inequality driven in part by zero bound rates – was likely to lead to a political problem for the centrist parties. This dilemma has come to pass and is made flesh in the bouffant toupee of Donald Trump. You have to ask yourself, if Trump is the answer, what the hell is the question?
Whether you like it or not, this is the ridiculous position in which America finds itself.
For many voters, it is a choice not between good and bad, but between bad and worse. Anger and rage are not the solution, but both can feel good in the ballot box. Lashing out is a bit like telling your boss where to stick his job; you know it’s not good long term, but the very act of insubordination is satisfying and profoundly self-affirming, if ultimately self-destructive.
With the nation in this mood, I am not going to try to predict who will prevail on November the 8th. Instead, let’s view the presidential jamboree as being the consequence, not the cause of America’s travails. Therefore, any efforts to rectify the problem will have to go beyond the personalities and will entail medium-term implications for policy and for asset prices.
From dishwashing to central banking
I am in an Uber driven by Sadique who is from Bangladesh and at college by night, driving by day. We are avoiding potholes, heading uptown on 3rd Avenue towards 125th Street in Harlem, the new Times Square. Sadique has only been here for three weeks. I remember a time when you needed to know New York to drive a cab. Like London cabbies of old, you needed the knowledge, an exam and a permit. Today, all you need is a car and a smart phone with Google maps.
Many years ago as an itinerant economics student, I too worked here. I washed dishes on Bleeker Street. Had Uber been around then, I’d have probably been an Uber driver. But would I have been heading to Harlem in the mid-1980s? I doubt it!
New York has changed – and so too has America.
Every time I visit, a new nationality is driving cabs or running corner shops. From month to month, some new app revolutionises the way something is done, from music, to journalism, to travel. Each disruption enriches some and impoverishes others. Just think what Uber is doing to taxi drivers! What was once permanent is now transitory, what was once secure is now fragile and what was once a full-time income is now a part-time top-up.
Geographically, the place is in a constant state of flux. Every few months some neighbourhood is being spruced up and sold on to hipsters – the hirsute prodigal sons of investment bankers. Old tribes move on, new ones move in. All the while, asset markets go ever higher, helping the rich, who own assets, get richer, while those who depend on wages become relatively poorer and more insecure.
This bubbling witch’s brew of change, immigration, disruptive technology and winners and losers simmers away, unnoticed until suddenly it spills over to scald the US political mainstream.
This may not always be apparent, but in the same way as Irish teenagers washing dishes in the 1980s told us something about Reagan’s America, the Bangladeshi lad driving the Uber tells the story of Obama’s country.
Yet all this could change.
The old enemy, inflation
Back in the 1980s, when I was toiling away in the kitchens of Manhattan earning expensive dollars to bring back home to Ireland, the Federal Reserve was right in the middle of its war on inflation. The strong dollar was an essential part of this offensive.
Beginning with Paul Volcker in 1981 and for two decades thereafter, the Fed fought a campaign against inflation called ‘opportunistic disinflation’.
The Fed welcomed recessions when they inevitably happened, because the downturn would compress wages and prices through unemployment. A corollary of this thesis was that the Fed should pre-emptively tighten in recoveries, prompted by leading indicators of rising inflation, rather than rising inflation itself.
Such pre-emptive strikes would ‘lock in’ the cyclical disinflationary gains wrought by the preceding recession. Each recession squeezed relative wages downwards, so that when workers finally got back up following a recession, they started each new upswing at lower wages. Therefore, each recession was seen by the Fed as an opportunity to squeeze a little bit more inflation out of the system. All the while, the working man lost out as wages fell and the corporate man gained as profits rose. Such a massive switch from labour to capital underpinned the massive bull run we have seen in asset prices over the past 25 odd years.
The cyclical disinflation process was boosted by two huge secular events that drove inflation permanently lower and stocks higher: the emergence of China and NAFTA – now two bête noire’s of the Trump campaign.
Both the emergence of China and the implementation of NAFTA pitted the American worker not against the American capitalist but against poor third-world workers as US companies outsourced.
The political cost of these developments has been the gradual erosion of the working man’s wages and the marked amplification of inequality. With workers’ incomes held down by China and Mexico, a much bigger percentage of American value-added went to profit, not wages, rewarding asset owners as opposed to wage earners.
Last week, Neil wrote a wonderful piece about the disappearance of the Phillips Curve. In short, this has happened because the relationship between inflation and unemployment evaporated as the American labour supply expanded enormously. Corporate America could drive down American wages with the help of Chinese and Mexican workers.
Back in the US, only through increased personal indebtedness could US consumption be maintained, which is exactly what happened. However, the social cost of so much personal debt, is a heightened level of economic insecurity.
Ultimately, the Fed won its hard fought war on inflation but at a cost – the greater social inequality which would come back to dominate this presidential campaign.
The Great Moderation, crashes and liquidity traps
On the policy front, once the war of inflation was won, not only did the strategy of ‘opportunistic disinflation’ die, but so too did its companion strategy ‘pre-emptive tightening’. This new period became known as the Great Moderation.
But the Great Moderation also coincided with the Great Bubble and the Great Crash. My generation of central bankers (and I write as a recovering central banker), obsessed by fighting inflation, took their eyes off the ball and allowed the greatest debt bubble in modern history to build right under their noses.
Once it burst, balance sheets imploded and a liquidity trap was sprung. The only policy response was the one we have experienced since 2008, which Paul Krugman refers to as ‘enlightened irresponsibility’.
If your balance sheet is broken, you can either fix it by defaulting on the liability side of the balance sheet or reflating the asset side of the balance sheet. The former is what Victorian moralists would have liked, the latter is what the Fed adopted – and it has worked.
But while capital gains may have repaired wealth and balance sheets crushed by sudden deleveraging, income – which comes largely from wages for the average voter – still remains subdued. The contrast between wealth and income has left us with two dilemmas, one financial and one political.
The big question financially is whether those capital or wealth gains earned in the past eight years of the Obama Boom are sustainable. The second question, the political conundrum, is whether those gains are sustainable if politics, post-election, moves to solve the redistributive or ‘share of the pie’ problem in the US. This problem stems from the fact that American workers and voters don’t get enough of the upside from their own economy on the way up, but suffer most of the downside on the way down.
In a nutshell, if inflation rises, driven up by rising wages as demanded by the electorate, do asset prices have to fall, driven by falling margins, as feared by financial markets?
When markets are pitted against the electorate in such a clear fashion, elevated valuations may well suffer the consequence.
Up until now, low inflation, imploding balance sheets and deep structural changes in the economy such as Uber, pushed down the ‘neutral’ rate of interest towards zero. This is what became known as the ‘new normal’. This is important because if you feel that the neutral rate of interest is close to zero, then asset prices can’t be profoundly overvalued because the central bank is not being overly accommodative.
If you believe that inflation is always present and just around the corner, your estimate of the ‘neutral’ rate of interest will always be relatively positive. But if you believe that the fundamental changes to the US economy like immigration policy, outsourcing and disruptive technology, means that something permanent has happened to inflation then the ‘neutral’ rate could be closer to zero.
If you believe the latter, as I do, then you may need to redefine your framework.
Speaking of frameworks, one thing that has always perplexed me is the way most central bankers (my former colleagues) still see the world. They appear like generals fighting the last war. Maybe they don’t get out enough.
For example, much of the central banking tribe still believes in something called the Taylor Rule.
The Taylor Rule, as befits its 1990s origins, suggests that if inflation is at the Fed’s 2% target and if the economy is at its full employment potential, then the ‘right’ level for the Fed’s policy rate would be 4%. This is the targeted 2% inflation plus Taylor’s assumed 2% real rate that is ‘constant’.
But why should a real rate of interest be constant? Hasn’t the world changed since the 1990s?
Surely structural changes might reduce the real rate of interest? Could the neutral rate in the past few years have been much lower? Of course!
Now think of politics.
If the electorate now demands limits to immigration and barriers to trade, could inflation reassert itself? Yes it could. If and when inflation does return, the neutral rate of interest will also have to rise.
What about markets?
Why is this important for asset prices?
Well, if the discount rate that investors use to value assets has to rise, two things will happen. The first is that asset prices would be driven down to a lower plateau and second, as short-term interest rates become less stable, market volatility will increase.
Over the past few years, due to extremely powerful internal and external forces, the neutral rate has been closer to 0% than 2%. This has had huge implications for the fair value of stocks and bonds because one thing leads to another.
The most basic, and intrinsically most powerful, framework for valuing stocks is, for me anyway, the Gordon Model, which incorporates the ‘risk-free’ long-term real interest rate in discounting profits/dividends.
Accordingly, if that rate is a function of the central bank’s ‘neutral’ real policy rate plus a term premium, then it should be clear that a structural reduction in the neutral rate should have a profound upward impact on the fair valuation of both bonds and stocks.
Thus, current valuations for either bonds or stocks don’t have to be ‘artificial’. They are not cheap, but their relative expense is because they have been discounting a lower equilibrium Fed Funds rate for quite some time. Just because prices are high doesn’t mean they are automatically ridiculous. Granted, there are some clear elements of froth in both markets, particularly in specific sectors. But on the whole, if the neutral equilibrium rate of interest is lower, because of structural flexibility in the US economy, then asset prices can correspondingly be higher.
But here is the rub: this tautology only holds if inflationary pressures and wages stay low. Here is where the Main Street versus Wall Street showdown being played out in the presidential campaign, but rarely defined in such terms, becomes really interesting.
New politics, new policy
Because we are so used to disinflation being the objective, it is difficult to get our heads around the following: if American politics shifts to address middle class insecurity and inequality by introducing tighter immigration, protectionism and moves to higher wages, then inflation will become not just the unintended consequence of policy, it will become policy itself!
In short, the Phillips Curve would return and this time, its policy!
This implies a totally different stance on the part of the Fed. In basic economic terms, curbs on immigration and trade, shift the American supply curve upwards, meaning that for every level of output, the rate of inflation will be higher. This may lead to the rebirth of Phillips Curve that Neil wrote about last week. Such a development would feed into the discount rate for valuing assets. And, if the long-term discount rate rises, the next five years of asset prices looks very different to the past five years. That doesn’t mean that an appropriate investment strategy can’t make you money – but it does mean a more challenging market backdrop, for passive strategies in particular.
Remember the US wasn’t always open. There have been long periods when America closed its doors. For example, in the 1850s and 1860s in response to massive Irish immigration, a nativist movement called ‘The Know Nothings’ agitated and secured significant curbs on immigration. Again in the 1920s, in response to the mass movement of Italian, Jewish and again Irish, American immigration laws were tightened significantly. Even more recently, the period from 1950 to 1980 saw reduced legal immigration into the US relative to historical norms. So it can happen.
In terms of rates, at the moment, its seems to me that the pressure for immediate rate rises is overdone, but further out, an expansionary fiscal policy, immigration curbs and the threat of protectionism means a totally different policy outlook than anything we’ve seen in half a lifetime.
Although Hillary Clinton promises more of the same, that will not stem the groundswell of American public opinion that has driven the Trump phenomenon, and she knows this. Even a Clinton Presidency, much hoped for on Wall Street, will have to listen to Main Street.
Trump, although he might not put it quite this way, is a neo-Phillips Curve agitator. So too is Clinton. This is the 1970s all over again.
As we pull up to 125th street, Sadique is still talking cricket – a game alien to the locals. The fare is docked virtually. No money changes hands and, in the process, another faceless middleman, this time, the old-fashioned bank employee, loses out.
But the downsized bank teller is not just a number. In a fractious democracy, he is another disgruntled voter, another voice for change and another frustrated ballot-box warrior demanding a new direction.
As I head towards Harlem’s famous Apollo Theatre, Sadique is already answering his next Uber client. I wonder does this intrepid young Asian have any idea the impact he, his iPhone and his ambition, is having on America and how it could all be about to change, and change utterly?