Stephen Mnuchin, the incoming US Treasury secretary recently said he can’t see why the US economy cannot grow at 3-4% on a sustainable basis. Fiscal stimulus through tax cuts and infrastructure spending, deregulation and some renegotiated trade deals will unleash the US economy to growth levels not seen in years.
Global equities, currency and bond markets have bought in. Some market analysts are already suggesting Trump’s plan will be as positive to the American economy as Reagan was to it in the early 1980s. I would only say, that the starting points, both in terms of the economy and the markets are not even close.
Along with this expected stronger economic performance comes the risk of higher inflation. The long end of global bond markets and I would assume most central banks are starting to anticipate it. This outlook is based on economic models that rely on the Phillips curve that suggests that there is a trade off between inflation and economic growth. If an economy is growing faster than its potential growth, then there will be upward price pressure on resources and hence inflation. Potential output is the amount the economy can grow without putting undo upward or downward pressure on prices in the economy. Very simplistically, potential growth is based on the growth of the labour force and the productivity of that labour, how much more one worker can produce over that year. If the labor force grows at 1% a year and productivity grows at 1% a year, then the potential growth of the economy would be somewhere in the neighbourhood of 2%. If the aggregate demand is growing at 4% a year, the difference between this and potential growth of 2% is creating an output gap and pressuring prices higher.
In the case of the Trump’s team pushing aggregate demand of the economy higher, there is little being done to address the supply side of the US economy over the near term and hence the pressure on resources to meet the increase in demand will push up prices quickly and significantly. This move higher in inflation may even be enhanced if, for instance, the potential labor force is reduced as a result of moves against immigration. As well, if the new President decides to impose select tariffs, this too could impact inflation dramatically.
So how high and quickly will inflation increase? These measures are being introduced when the economy is already near full employment, as defined by the Fed. They have suggested that once unemployment gets below 5%, the risk to inflation rising increases. Unemployment is already well under that level at 4.6% and their favourite measure of inflation lies just below their 2% target. As I said before, just add a few tariffs and you very quickly get to higher levels.
Given the initial conditions of adding more stimulus to the economy with it already maxing out, the general belief would be we will see inflation picking up notably and soon. Unfortunately for Mr. Mnuchin, today’s economy is not built for sustained 3-4% growth. Dump your nominal fixed income products, buy inflation protected securities and brace for a flattening yield curve.
The framework suggests inflation. The economy will accelerate with the stimulus, the question about the ensuing upward pressure on prices lies on the supply side of the economy, or the economy’s “potential”. The issue is that this is an extremely difficult concept to measure. Demographics and immigration data allow economists to have a relatively good handle on labour input. The real problem lies with productivity. The trend in productivity for the last number of years has been poor. It is just not growing as it has in the past. Many believe that it is not being measured properly. Robert Gordon has written extensively on measurement problems while also giving us his downbeat views of productivity growth going forward. (If you don’t have anything productive to do, I would suggest reading his tome). However, despite a slowing down of potential growth as a result of a slowing in population growth and poor productivity growth, the accumulated excess supply of the economy amassed since the 2008 financial crisis has kept inflation at bay. Despite the kick the economy is going to get, we don’t know how large this excess supply gap and the time it will take to fully close.
Add to that, the underlying dynamics between output and inflation may be changing. Last week, the Governor of the Bank of Canada gave a speech entitled “From Hewers of Wood to Hewers of Code: Canada’s expanding service economy”. He said “in terms of economic models, it is worth considering whether the relationship between inflation and economic growth could change as the economy evolves. Certainly the concept of an output gap is gradually changing, as service capacity depends mainly on people and skills rather than industrial capacity…” He adds that the concept of investing is shifting away from plants and machinery toward human capital and that even the concept of inventories is changing. The digital age has altered the concept of capacity pressures on resources going up when producing one more “widget”. This suggests that as the makeup of the economy is evolving, so too is the relationship between inflation and economic growth.
So in addition to the implementation risk around the measures talked about by the Trump team, what if the potential growth of the US economy is higher than is currently perceived by the market (and the Central bank)? What if the relationship between inflation and economic growth are changing more than expected due to technology and the quiet shift to more service oriented economies in developed countries. What if inflation is more global in nature lessening the reliability of looking at a standard output gap framework that focuses on the domestic economy.
Since the end of the financial crisis, inflation has remained subdued and has continued to surprise people to the downside despite ongoing economic growth(albeit slow). There is little doubt that inflation looks poised to move higher in the US. It is doubtful that potential will reach a level that can sustain 3-4% non-inflationary growth. But there are also risks that the move to higher levels of inflation will be slower than the market currently anticipates with the ensuing ramifications both for Fed policy and the inflation premium demanded by bond holders.
Food for thought.
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