Strategy & economics

Playing a mean game

23/05/2016

Richard Jeffrey

Richard Jeffrey

Chief Economist

‘Disappointing’ seems to be the most common epithet attached to the word ‘growth’. This is as true for the US as it is many other developed and developing economies. Being disappointed, of course, has to be measured against an expectation of what you hoped or anticipated would happen. Welcoming the evening’s clientele to the Kit Kat Club, in the musical Cabaret, the master of ceremonies tells people, ‘Leave your troubles outside. So, life is disappointing? Forget it!’ Maybe that is what central banks should be saying to financial markets; that, rather than wallowing in disappointment, markets should be adjusting their expectations. But that would require a type of leadership from central banks, including the Federal Reserve (the Fed), that is sorely lacking at the moment.

At issue here is the way that markets form their expectations. Inevitably, this has considerable reference to what has happened in the past. In this context, we still seem to be hankering after the sorts of growth rates that were recorded prior to the ‘great’ recession. After all, growth at an average (or mean) rate of 3% per annum seemed such fun. A mean of 2%, on the other hand, feels distinctly unexciting. Nonetheless, I would argue that, as dull as it may seem, 2% is safer and more sustainable than 3%.

But this is not the message that has emerged from the Fed. It has persistently guided market expectations towards anticipating growth rates that have been significantly higher than those eventually achieved. Looking at the forecasts made for each of the years from 2012 to 2015 at the end of the previous year, the Fed has been meaningfully above the eventual outturn. So, the history of the past four years appears to have been one of underachievement. Hence, disappointment.

Will it be any different in 2016? The Fed’s central forecast for growth started out at fractionally under 3% (conventionally, projections are for the year-on-year percentage change in the fourth quarter). But that was two and a half years ago. By December last year, the forecast had been dropped to 2.4% and it has subsequently come down to 2.2%. This looks much more realistic. Certainly, compared to both 2014 and 2015, the Fed has cut its estimates much earlier – on which basis it would now seem to be outlining a more achievable growth profile, both for the current year and for 2017 and 2018.

In itself, this suggests that the Fed is doing its best not to repeat past errors. However, there is another feature of its forecasts that is problematic. While growth has been weaker than forecast, job generation has been significantly stronger, and the unemployment rate has fallen more rapidly. As in other western economies, the ‘problem’ has been with the pace of productivity improvement which has been unexpectedly slow compared to achieved rates during previous cycles. Indeed, productivity growth has been so poor, that even 2% as a medium-term trend growth rate looks a testing objective.

With the US labour market now looking very tight, the implication is that the re-ignition of inflation could happen at significantly lower GDP growth rates than would historically have been the case. This is not something that the Fed is anticipating. However, we are now beginning to see more obvious signs of rising wage inflation. Later during the year, the rate of increase in labour costs is likely to become incompatible with the Fed’s inflation target. At this point, its policy credentials will come under more intense scrutiny.

At the start of 2016, the Fed outlined a very credible plan for beginning to normalise monetary policy. This incorporated four 0.25% rate rises over the course of the year. But, following a period of volatility in financial markets, this plan was reassessed, reducing the planned four increases to, perhaps, two. In my view, this has placed the Fed in an invidious position – in essence it has made financial markets the arbiter of the timing of the tightening process. Given recent developments in labour markets, it may be evidence that inflation is becoming less well anchored that forces the Fed to reassert its control over the scheduling of policy changes. At this point, the focus of the policy debate is likely to shift to whether the Fed has allowed itself to fall behind the curve – something that could cause even greater anxiety in markets.

This article is issued by Cazenove Capital which is part of the Schroder Group and a trading name of Schroder & Co. Limited, 12 Moorgate, London, EC2R 6DA. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. 

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