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That was then, this is now…

October 14, 2019

ref: - "The world economy's strange new rules”, The Economist, Leader and Special Report

 

We are just going to point you towards the Economist, which this week puts an examination of how the economic rules have changed front and centre… figuratively and also literally in the case of the hard-copy magazine. It's not exactly revelatory… Uncle Tom Cobley and all have been talking about this for years now, but such attention from the Economist almost makes it all seem "official" and besides, it's useful to see things laid out in black and white. Even now, the evidence that some things are changing (or have changed) so fundamentally still comes as a bit of a shock.

 

You'll need to find a few moments of quiet time to run through the Special Report (though we would urge you to do so), but the leader gives us a pretty good flavour of what they're on about.

 

In essence, governments are tasked with promoting growth and a strong jobs market. If successful, that would have the felicitous effect of improving the chance of re-election, but more to the point the common wisdom has always been that it would also increase upward pressure in inflation. It's then up to central banks to keep inflation under control. Remember William McChesney Martin, long-standing head of the Federal Reserve (1951 - 1970), and his oft-quoted description of his job? He said that he was the guy who had to take away the punch-bowl just as the party was getting going. In other words, governments should be in charge of fiscal policy and central banks handle monetary policy. In years gone by that wasn't exclusively the case but in more recent times that has been the understanding.

 

But now? Politicised central banks running out of firepower are urging fiscal action from governments, and politicians are blatantly interfering with the "independent" monetary policy decision-making of central banks. Yes, things are certainly changing.

 

Understandably, much of the report (but certainly not all) centres around inflation and what drives it… and we know how those dynamics have changed. Inevitably, that brings to mind the "Phillips Curve", the economic theory named after the Kiwi economist that depicts the inverse relationship between levels of unemployment and inflation -- as unemployment goes up, the rate of inflation comes down, and vice versa. For all its adherents, the Phillips Curve always had a chequered record. It cannot tally with the period of stagnation -- stagnant economic growth, high unemployment BUT ALSO high inflation -- in the 1970s. More recently, after a very brief and kneejerk dose of deflation, inflation ROSE in the aftermath of the financial crisis with most of the "rich" world still in recession. And patently the Curve theory is not working right now: headline US unemployment is at 50yr lows (3.5%) while inflation runs well below target at 1.4%.

 

The traditional drivers of inflation have been overwhelmed by factors that suppress it: Technology, Globalisation, Demographics, a Savings Glut and lack of both corporate and governmental investment -- not to mention a pretty low price of oil. Even if it's hard to be precise about cause and effect, the world has largely got its head around all that now. But the attraction of the Phillips Curve theory has been hard to shake -- and that's probably because it has seemed so utterly logical. It makes perfect sense that when more people are in work and earning, demand should rise and prices increase. Ah, but that was before it all got complicated by factors that were not previously considered (or even imagined).

 

You know, one could argue that there's still been an element of Phillips Curve thinking even comparatively recently -- and amongst some fairly heavy hitters, too. Just less than a year ago, US 10yr Treasury yields had climbed above 3.20% and some very famous bond gurus were predicting that they would continue higher to 3.5, 4.0 or even 5.0%... as it turns out, we've recently been below 1.50% (last at 1.73%). Part of their rationale will have been that Donald Trump's tax cuts and simultaneous promises of increased spending had to necessitate more borrowing… i.e. more issuance of bonds. But perhaps more importantly they may have been assuming that the strong growth and low unemployment engineered by the President's measures would be bound to prove inflationary. Inflation, as we know, is very bad for bonds, pushing prices down and therefore yields higher.

 

Despite all the modern evidence, there must be some who still believe that the old rules may have been modified but still apply in some form. If we're absolutely honest… and strictly between us, mind … because of the apparent logic behind Phillips we can understand that line of thinking even though it's clearly flawed. That's why it's important to keep reading articles such as these, in case one lets old preconceptions rather than modern reality colour one's judgement. But it would be fascinating to know whether there can ever still be a point when growth leads to jobs, which lead to demand, which leads to price rises. Sadly, we're not likely to find out anytime soon. For a myriad of reasons, some of them self-inflicted, the global economy has put on the brakes and may in places slip into recession. Right now, the momentum is in the other direction and fighting the prospect of deflation may prove more pertinent than worrying about inflation.

 

 

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