It’s looking more and more like the goldilocks economy the Federal Reserve Board (FRB) strives for. “The way it’s played out, we’ve kind of had an economy where we’ve had our cake and been able to eat it too.” Said Jonathan Millar, senior economist at Barclays.1 Inflation appears, if not fully tamed, certainly on its way to being controlled. “Core goods prices in the personal-consumption expenditures (PCE) deflator, the Fed’s favored inflation gauge, are down at a 2.3% seasonally adjusted annual rate in the latest six months.”1 The fear has always been that by killing inflation, the FRB would have to kill the job market. That has not been the case. Matthew Luzzetti, chief U.S. Economist at Deutsche Bank observed, “It was about as good of an outcome for the labor market as you could have hoped for in 2023.”1
How can the battle against inflation be over when the government printed so much money?
In a crisis, like COVID-19, there are two ways our government can minimize the economic damage. Congress can spend money (fiscal stimulus), or the FRB can increase the money supply. We did both! Money Supply (M2) in the United States averaged 5163.74 USD Billion from 1959 until 2023, reaching an all-time high of 21703.20 USD Billion in July of 2022.2 The fiscal stimulus was quite large as well. The federal government has provided about $4.6 trillion to help the nation respond to and recover from the COVID-19 pandemic. This increased our national debt to $34 trillion!3 This stimulus probably helped our economy avoid serious consequence. The risk is inflation. The definition of inflation is too much money chasing not enough goods. By borrowing money (fiscal stimulus) and increasing the supply of money (monetary stimulus) we avoided a great recession at the risk of potential sticky inflation.
Shouldn’t low unemployment also create wage-based inflation?
According to the economic theory put forth by William Phillips, lower unemployment will lead to higher wages. It makes sense. As the supply of available labor decreases, the cost or wages required to hire that labor will increase. The higher wage cost will be passed along to the consumer in the form of higher prices, or inflation. Central bank policy centers around this principle. The FRB is mandated to balance low unemployment with low inflation. You cannot have both. What is happening? According to the Bureau of Labor Statistics, unemployment sits at a low 3.7%.4 At the same time inflation is dropping, CPE is 2.3% as previously noted.
With increased money supply, increased government borrowing and low unemployment, why haven’t we had hyperinflation?
Some economists believe there is a lag effect before the higher wages are reflected in prices. Indeed, “…wages rose 4.1% in December…”5 Others believe that although unemployment is low, the labor participation rate is a better indicator for increased wage demands. “…the labor-force participation rate dropped sharply, to 62.5% from 62.8%...”5 While both observations have merit, we believe the substantial answer lies in worker productivity.
In our history there have been many innovations that have allowed workers to be more productive. The assembly line and the personal computer come to mind. However, there have been a handful of inventions that have revolutionized our economy. The internet was a game changing innovation that disrupted many industries, reduced inefficiencies and lowered the price of many consumer goods. The music industry, retail, entertainment, travel, and hospitality industries were completely dismantled and replaced with lower cost options for the consumer. It is generally accepted that widespread use of the internet began in 1993.
As our economy adjusted to the new reality, prices plunged. Inflation no longer became the FRB’s biggest concern. For the first time since the great depression, deflation became a greater concern. Interest rates cratered, but prices kept dropping. The economy expanded, yet prices remained under control. Workers could also produce more for the same pay.
We believe we are in the beginning stage of a similar transformation.
Artificial intelligence has the potential to increase worker productivity dramatically. In fact, we believe we are beginning to see some of those fruits in the latest reports. Clearly there are many concerns about AI and the effect it may have on humanity (see Doug’s article for more details). The benefit to the economy will be greater worker productivity and lower prices to consumers.
What will the Fed do?
The Federal Funds Futures market reflects a belief that the FRB will cut rates by 1.5% by December of this year. This would require six 25 basis point cuts. The most recent median projection from the Fed officials is a 0.75% reduction in the rate. So, the market thinks the FRB can cut twice as much as the Fed believes. In the long run, more cuts will be needed to get the Fed Funds rate to neutral. “The Fed now projects that the federal funds rate will be reduced by 250 basis points by the end of 2026 and implies a policy rate in the long run at 2.5%.”6
What should the Fed do?
In a goldilocks economy where inflation and unemployment are balanced, the FRB will seek a neutral interest rate. This rate would not encourage aggressive borrowing or suggest saving is the better course of action. The rate, like the economy, would be balanced. We believe the neutral Fed Funds rate is probably 2.5%, if inflation is 2%. This sharp reduction should take place slowly with an eye on the data to ensure the economy is still in balance. The new technology of artificial intelligence may allow the FRB to maintain a resilient job market and sound money, as it did in the late 1990’s with the advent of the internet. Time will tell.
1. Job Gains endure In Cooling Economy – Wall Street Journal 1/6/2024
5. The Markets See March Rate Cuts – Barron’s, January 6, 2024