Back to economic normality?

Investors who are beginning to talk about a return to normality after the financial crisis should realise that things have changed, believes Keith Wade.

Global activity is recovering and investors are beginning to talk of a return to normality for growth and interest rates, but the economy which is emerging from the ashes of the financial crisis is likely to be very different to the one which went into recession a decade ago.

There can be no doubt that economic activity is improving, with business surveys such as the widely followed purchasing managers indices, strengthening alongside an upturn in global trade. Consumer confidence and spending have picked up and although there are still questions about how much of the upturn in the surveys (the ‘soft’ data), will feed through into actual ‘hard’ data such as Gross Domestic Product, global growth prospects are looking their best for some time. Inflation has also picked up and, although much of this reflects the increase in energy prices, the world economy appears to have moved on from the secular stagnation concerns which have dogged markets since the financial crisis.

As activity improves, investors are asking whether we still need the ultra-loose monetary policy which has supported growth through the crisis. Why should we have emergency interest rates when the world is getting back to normality? In this context, the US Federal Reserve (Fed) has already started to withdraw stimulus by first ending asset purchases (quantitative easing) and then raising interest rates. But the level of rates remains very low by past standards: policy rates are negative in the Eurozone, Japan, Switzerland and Sweden, while the European Central Bank (ECB), the Bank of Japan and the Riksbank are still engaged in asset purchases. UK interest rates are positive, but at 0.25% are at their lowest level since the Bank of England came into existence in 1694.

One way of gauging the stance of monetary policy and where interest rates should be as the economy normalises is to compare the level of rates with different economic indicators. For example, our analysis based on the Taylor Rule (which calculates policy rates from indicators of the output gap and inflation) suggests that US rates should be 2.5%, some 150 basis points above current levels (figure 1). On this measure, US monetary policy is very loose for an economy which is close to full employment and has inflation near to its 2% target. Although this makes a case for the US Central Bank to tighten more quickly, interest rate models of this type have been signalling that policy is too loose for the past four years. If we were to fully read into the Taylor Rule’s modelling, then we should have seen a boom in activity and a significant rise in inflation.

Clearly there are constraints on the economy, which are preventing loose policy from feeding through into activity. It is these headwinds that Fed Chair Janet Yellen and her colleagues have been mindful of, as they have slowly moved interest rates higher in the US. Similar considerations have weighed on policymakers at the Bank of England and ECB, where this type of analysis suggests that interest rates should also be higher, even though recovery has been less advanced than in the US. On the demand side, the focus is on the unwinding of the debt bubble and tightening in bank regulation, which have weighed on the growth in bank credit. This legacy of the financial crisis has constrained the strength of consumer spending, thus limiting the impact of loose monetary policy. It is the gradual unwinding of these headwinds that is allowing the economy to get back to normal.

For example, after a long period of de-leveraging, household borrowing has begun to pick up again (in the US, UK and Eurozone) as balance sheets have been repaired and banks have eased credit conditions (see figure 2). On the corporate side we have seen debt growing for some time with increases primarily coming through the corporate bond markets, which have disintermediated much of the banking system.

There has been another feature of the recovery which has prevented loose policy from feeding into stronger activity and inflation. Wage growth has remained subdued and stable despite the tightening of labour markets. Even with record levels of employment and an unemployment rate of 4.7% (the lowest for 42 years), underlying UK wage growth was 2.3% in February. In the US the employment cost index was running at 2.4% y/y in the first quarter of 2017 with an unemployment rate of 4.7%. The last time unemployment was running at this rate, wage growth was more than a percentage point higher.

This combination of falling unemployment but subdued wage growth is often referred to as the ‘flat’ Phillips Curve (see figure 3) and has had two effects. Firstly, it has limited the pick-up in real income growth which normally accompanies an economic upswing and the feed through into stronger consumer spending. Secondly, it has limited the increase in costs and hence inflation, which in turn has kept central banks comfortable with their easy monetary stance. Thus, rather than rising real wages and increasing consumption, the economic recovery in this cycle has been sustained through a persistently loose monetary policy stance accompanied by low wage growth and low inflation.

The lack of wage growth in the face of ever lower unemployment has proved to be a puzzle to economists. As well as the US and UK, it is also apparent in Japan and Germany. Local factors will have played a role, but the international nature of the phenomenon suggests broader explanations. Global factors are becoming more important than local with the opening up of labour and product markets to greater international competition, effectively increasing available resources and economic capacity. Others have pointed to the decline in trade union representation and the fall in worker bargaining power. Technology and increased automation has also played a role in displacing workers and keeping real wages subdued.

When combined with well anchored inflation expectations and central bank credibility the IMF has suggested that the inflation dog has been muzzled (IMF World Economic Outlook, Spring 2013) Whatever the explanation, the slowdown in real wages is reflected in the deceleration in productivity growth. In the long run real wages and productivity tend to move together and the period since the financial crisis has seen a deceleration in trend US output per head from 3% in 2007 to just over 1% in 2017 (see figure 4). The story is similar if not more dramatic in the UK, where productivity growth has collapsed to almost zero. The causes are the subject of active debate with some pointing to the misallocation of resources in the run-up to the financial crisis and others arguing that technological progress has stalled. Nonetheless, it does suggest that the jobs created during the recovery have been less productive and less well paid than those which have been lost.

Until recently we would have been tempted to conclude that this is what ‘back to normal’ will look like. Interest rates may
be slightly higher, but essentially we will still have a low-wage, low-growth economy, characterised by stagnant real wages and low productivity growth. Central banks will have to continue to keep policy loose to support global activity and there will be no sudden break out in activity and earnings. However, such an explanation does not allow for politics and the emergence of populism. The stagnation of real wages is fuelling widespread dissatisfaction with the economy and government policy. The US and UK have been good at creating jobs, but not good at creating well paid, secure jobs. In response, voters are searching for alternatives to the mainstream parties, leading to a shift toward populist alternatives. The UK Brexit vote and the election of Donald Trump as US President are the obvious examples. More recently, Europe has appeared to resist populism with the elections in Holland and France delivering centrist governments. However, alternative parties continue to draw considerable support, with the populist Five Star Movement currently leading the opinion polls in Italy, for example.
What might we expect from a world economy run by populists? Recent analysis of 22 countries finds several common themes amongst what might be called populist parties (The Politics of Rage, Barclays Equity-Gilt Study 2017). These are the demand for the return of sovereignty, restrictions on immigration and barriers to trade. Such factors could be summed up as being ‘anti-globalisation,’ with many of those who support populist parties seeing themselves as losers from the rapid increase in free trade and immigration of the past 40 years. Many envisage a world economy with far more restrictions on trade and labour mobility.
In such a world, we would expect global trade and growth to be weaker, as barriers cut off opportunities. Rather than reaping the benefits brought by specialisation and economies of scale, industries would shrink back to their domestic economies.
Productivity, which has benefitted from the opening up of competition, would slow even further. Inflation would be higher, as firms become constrained by local resources. The UK, for example, would have seen inflation pick up significantly had it not been for its ability to tap into migrant labour and increase imports during periods of booming demand. By effectively expanding the capacity of the economy, globalisation has helped economies extend their cycles. By limiting migration, the UK and the US economies are at risk of losing this important safety valve. It could be argued that reducing migration will spur innovation, as firms will find technological solutions to the fall in labour supply.

This is possible, and more generally as the scars from the financial crisis heal, we would expect more risk taking and innovation. However, it is hard to escape the conclusion that politics is taking us in a direction where we experience higher inflation, shorter cycles and more active central banks. Interest rates and financial markets would be more volatile as investors demand a higher risk premium to compensate for increased uncertainty. This suggests a more difficult prospect for the world economy and markets. In this respect, a return to normal does not mean getting back to where we were before the financial crisis.