The Myth of a Goldilocks Outlook, No Recession, Low Inflation, and Positive Growth

CommentarySince the assertion by the chairman of the Federal Reserve, Jay Powell, echoed by Secretary of Treasury Janet Yellen, there is already a common (market) belief that the U.S. Goldilocks economic outlook is highly likely. Although this is not theoretically impossible, there needs to be a more understanding of the rationale behind it or such a conclusion will become a kind of religious belief. It seems those who uphold this belief are based largely on the experience of stagflation in the 1970s; in fact, the current inflation ups and downs can match well with those in the old days.History rhymes rather than repeats exactly. The 1970s was an outcome of severe supply shock where oil prices rose six-fold—from $25 per barrel before 8/1973 to $150 by 1980, but it was still far below the oil price peak in 2008. Although there were wars in both eras, with an extra global pandemic in the recent one, the inflation peak was still lower than those in the 1970s. That says, if merely comparing the supply shocks across both periods, the recent one was mild. But speaking of monetary accommodations, the relative strength is reversed.Despite there was a U.S. dollar delinking with the gold system in the early 1970s, rate hikes in due course were never lacking. Throughout both uncontrolled inflation periods in the two oil crises, the Fed funds rate tracked closely to the inflation level such that the real interest rate was, in fact, floating around zero rather than deeply negative. This time, however, is different in that the real rate had been negative too much for too long over the past 15 years and was only reversed very recently (2023Q2). There has been too much abnormal easing for too few abnormal days.It turns out that the demand stimulus seems to have overridden the temporarily adverse supply shock. Both Powell and Yellen unilaterally accept the positive effect of monetary easing yet deny the side effects. Whether such a claim is true can be judged from a simple chart. U.S. Aggregate Quantity and Price Growth. (Courtesy of Law Ka-chung)The accompanying chart shows both U.S. real GDP year-over-year (YoY) growth and core PCE YoY inflation (using core to remove unnecessary fluctuations). For pure demand effect, quantity (GDP YoY) and price (YoY inflation) should move in the same direction. Failure of such implies there is either a supply shock or too much money (high inflation expectations). Were there adverse supply shocks, we should see skyrocketing energy prices and logistic costs. This was the case 2-3 years ago, but clearly not in the past year. There remains “too much money.”More ArticlesConsecutive rounds of high inflation in the 1940s and 1970s were separated by a few years. It is way too early for the Fed to declare victory. The recent inflation ease and bond yield decline are “temporary,” following the Fed’s wording (previously used in describing inflation). We do not have to bet against the market and the Fed when bond yield and policy rates are coming down. But we should neither bet against economic theory by ignoring the inflationary effect of prolonged easing.KC Law, Ka Chung

The Myth of a Goldilocks Outlook, No Recession, Low Inflation, and Positive Growth

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Commentary

Since the assertion by the chairman of the Federal Reserve, Jay Powell, echoed by Secretary of Treasury Janet Yellen, there is already a common (market) belief that the U.S. Goldilocks economic outlook is highly likely. Although this is not theoretically impossible, there needs to be a more understanding of the rationale behind it or such a conclusion will become a kind of religious belief. It seems those who uphold this belief are based largely on the experience of stagflation in the 1970s; in fact, the current inflation ups and downs can match well with those in the old days.

History rhymes rather than repeats exactly. The 1970s was an outcome of severe supply shock where oil prices rose six-foldfrom $25 per barrel before 8/1973 to $150 by 1980, but it was still far below the oil price peak in 2008. Although there were wars in both eras, with an extra global pandemic in the recent one, the inflation peak was still lower than those in the 1970s. That says, if merely comparing the supply shocks across both periods, the recent one was mild. But speaking of monetary accommodations, the relative strength is reversed.

Despite there was a U.S. dollar delinking with the gold system in the early 1970s, rate hikes in due course were never lacking. Throughout both uncontrolled inflation periods in the two oil crises, the Fed funds rate tracked closely to the inflation level such that the real interest rate was, in fact, floating around zero rather than deeply negative. This time, however, is different in that the real rate had been negative too much for too long over the past 15 years and was only reversed very recently (2023Q2). There has been too much abnormal easing for too few abnormal days.

It turns out that the demand stimulus seems to have overridden the temporarily adverse supply shock. Both Powell and Yellen unilaterally accept the positive effect of monetary easing yet deny the side effects. Whether such a claim is true can be judged from a simple chart.

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 U.S. Aggregate Quantity and Price Growth. (Courtesy of Law Ka-chung)
U.S. Aggregate Quantity and Price Growth. (Courtesy of Law Ka-chung)

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The accompanying chart shows both U.S. real GDP year-over-year (YoY) growth and core PCE YoY inflation (using core to remove unnecessary fluctuations). For pure demand effect, quantity (GDP YoY) and price (YoY inflation) should move in the same direction. Failure of such implies there is either a supply shock or too much money (high inflation expectations). Were there adverse supply shocks, we should see skyrocketing energy prices and logistic costs. This was the case 2-3 years ago, but clearly not in the past year. There remains “too much money.

Consecutive rounds of high inflation in the 1940s and 1970s were separated by a few years. It is way too early for the Fed to declare victory. The recent inflation ease and bond yield decline are “temporary,” following the Fed’s wording (previously used in describing inflation). We do not have to bet against the market and the Fed when bond yield and policy rates are coming down. But we should neither bet against economic theory by ignoring the inflationary effect of prolonged easing.

KC Law, Ka Chung