A Framework That Provides Clarity

During periods of “low visibility,” confusion reigns: for every indication of one trend, there seems to be a countertrend. The key is to glean from the collective wisdom of reliable leading indicators a clear signal that the economy is headed for a turn.

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Aug 21 2014

Rate Debate Intensifies

At the Jackson Hole meeting this week, Chairman Yellen, speaking about labor markets, is widely expected to further justify the Fed’s dovish stance regarding rate hikes. It is no secret that she has serious concerns about the “underutilization of labor resources” – an issue we have emphasized for years.

Meanwhile, 4% GDP growth in the second quarter has cheered the consensus that firmly believes the U.S. economy is finally headed towards “escape velocity." And, with the recent inflation data coming in below consensus expectations, inflation worries seem to have been allayed.

However, as Japan demonstrates, real rates can remain low or even negative – a symptom of “secular stagnation,” as Larry Summers termed it last fall. The decline in trend growth since the 1970s, which stands behind such observations, is a phenomenon we identified precisely six years ago, the summer before the Lehman collapse. But it is only in recent months that this reality has begun to be accepted by prominent mainstream economists.

The most consequential of these is Janet Yellen, who had the following response last month to a question from IMF Managing Director Christine Lagarde: “[W]e’ve had recently many discussions of secular stagnation or the notion that for some period of time, whether it’s because of slower productivity growth or headwinds from the financial crisis or demographic trends, that so-called equilibrium real interest rates may be at a lower level than we’ve seen historically. And that’s one of the factors that I think will be important in determining how frequently a negative shock could push economies against the zero lower bound. So if it is correct that equilibrium … rates in the United States and globally may be lower going forward than they have been historically, I think we will have to worry about these episodes more often.”

This is a clear-cut summary of our “yo-yo years” thesis that the combination of lower trend growth and renewed cyclical volatility would lead to more frequent recessions in the U.S. and other developed economies in the years ahead.

And then there is the clear upturn in the U.S. Future Inflation Gauge, which now stands at a 71-month high. It would be surprising, indeed, if the debate within the Fed were not heating up.

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