An Update on Growth, Inflation and Regime Stability
The biennial debt ceiling dance is all over but for the shouting as the US House of Representatives has passed legislation to increase the limit on what the United States can borrow. The US Senate will vote to pass the legislation, President Biden will sign it, and the US Treasury can resume its normal course of operations and pay for spending the government of the United States has already committed itself to spend. The VIX, the index of the implied volatility of the prices of near-date options on the S&P 500 index of stocks, succumbed to exhaustion from quandariness and is currently trading at a level consistent with 'normality', down 20% from its two-week high, and down 11% since prior day's close.
The Regime Stability factor, along with the Economic and Inflation factors, largely drive activity in the financial markets. With the resolution of the debt ceiling debacle, this most proximate driver of price change has been relieved, leaving uncertainty about the direction and persistence of inflation, and uncertainty about the direction and rate of change of economic activity as the primary contributors to volatility. (The concern about the direction and change of interest rates is a derivative of these prior two drivers.) Let's take these two individually, and then ask where in the economic cycle we can locate ourselves.
US Growth Is Positive but Below Long-term Trend
The US Economy, the world's largest and most dynamic, has continued to chug right along despite the obvious impact of higher interest rates and slowing economic activity. Sixteen months into the current interest rate tightening cycle, the broader economy shows signs of weakening of demand--though that weakening has yet to translate to the labor market, which boasts a generationally-low unemployment rate of 3.4%, a level inconsistent with declining economic activity. When we talk about recessions, we're generally talking about labor conditions wherein not everyone who wants a job has one, or wage rates are insufficient to maintain a stable standard of living. As you can see in the chart below, the unemployment rate is quite low and consistent with the level it achieved in the runup to the Global Pandemic. Based on this measure, the economy is not currently in, nor poised to enter a recession.
Average Hourly Earnings of All Employees in the private sector will often fluctuate around its long-term average. Below we show the percent change over the prior period. Since the recovery from the pandemic, Average Hourly Earnings has consistently come in above average. This indicates that Labor has pricing power in setting the wage rate. When workers' wages grow, they have more spending power and are generally more confident in the economy. This leads to the consumption of goods and services, which comprises about two-thirds of economic activity in the US.
Ordinarily, these would be positive signs for an economy. Low unemployment and rising wages should indicate that workers--those most likely to spend--have jobs and are making money, and are therefore more likely to spend. The problem is that wage inflation, while an individual good, can be a social bad when it runs too hot. In order to meet those higher wages, corporations usually raise prices for consumers. This is how inflation becomes entrenched and why it is so hard and unpopular to fight.
Despite the inflationary pressure of too-fast wage growth, the economy continues to expand, albeit slowly. Average real GDP growth in the United States is typically around 2%; economic indicators suggest that the United States is growing at about 1% on an annualized basis--1-1.5% less than its postwar average. That's good, but not great. Long-run improvements in quality of life depend upon economic growth--and the higher, the better. It is possible that growth is muted due to the level of interest rates, and therefore the economy is struggling with Federal Reserve-imposed headwinds. Whatever the case, it is clear that economic growth, though positive, is not the picture of rude health.
Absent any exogenous shock, we anticipate that growth will continue to moderate over the course of the year. It is also our belief that the Federal Reserve's campaign to constrict the economy has yet to meet its conclusion, spelling further challenges for economic growth this year.
The Impact of Artificial Intelligence Is a Gamechanger
We've written before about how pandemic-unleashed technology adoption likely increased productivity. Relatedly, a new and larger potential exogenous (positive) shock is the impact that Artificial Intelligence has had and will have on the productivity of workers. It is far too early to measure or draw conclusions, but based on anecdote alone, people can get more done, and more important things done, using AI. This holds true, especially for knowledge workers. We believe that it is most likely that AI will augment worker productivity leading to the once-in-a-generation productivity boom that democratic capitalism engenders from time to time through its simultaneous advantages of capital formation, property rights, innovation, and intellectual freedom. This enhanced productivity may enable corporations to do more with fewer employees, employees to get more done while experiencing more leisure, and human wellbeing to flourish.
US Inflation Runs Too Hot, but Long-term Expectations Remain Anchored
Turning from Economic Growth to Inflation, the rate of inflation in the United States is still elevated relative to long-term trends. Prices adjusted for the volatile inputs of food and energy reveal that prices continue to climb at a rate of nearly 5% per year. Compare that rate with the definition of price stability as at or around 2%. As the Federal Reserve's favored inflation measure, the PCE, and especially core PCE, betray the Board of Governors' bias toward restrictive interest rate policy. Although the economy has slowed, and signs of economic contraction have begun to show up in the data, nevertheless higher inflation is now embedded in core prices, and will require the contraction of the economy--dampened spending and arrested wage growth--to curb its energetic bucking.
Although core inflation continues at too high a level, it hasn't impacted long-term inflation expectations. As we've discussed before, it's not what prices were that matters, but what the market thinks they will be. Therefore, belief about what prices will be in the future impacts behavior today. Looking out from one to five years, inflation expectations are higher than at any time since the period of recovery after the Global Financial Crisis, but declining. The general expectation, then, is for a reversion to normal rates of inflation over the next five years.
Based on inflation and growth expectations, and with the removal of uncertainty surrounding the debt ceiling mania that had seized hold of the Republican Caucus in Congress, we find it likely that growth will continue to muddle along, inflation will remain elevated, and the Federal Reserve to continue to raise interest rates to arrest growth and contain inflation.