The FED and IMF seem puzzled. Productivity, inflation and interest rates aren’t behaving correctly.
Let me start with a 9/25/17 quote from the Deputy Managing Director of the IMF: “What makes this slowdown <in productivity growth> more puzzling is that it comes at a time of significant innovation and technological change.” Janet Yellen, and the entire FOMC, has been puzzled for a while, too: By the FEDs measurement, inflation seems stuck at or below 1.5%. Finally, low interest rates seems to have puzzled just about everyone.
Let’s see if we can solve a few puzzles today.
Welcome to this week’s Steak House Index update.
If you are new to my blog, or you need a refresher on the SHI, or its objective and methodology, I suggest you open and read the original BLOG: https://www.steakhouseindex.com/move-over-big-mac-index-here-comes-the-steak-house-index/
The world’s GDP is about $76 trillion. At last count, our ‘current dollar’ US GDP is now over $19 trillion — about 25% of the total. No other country is even close.
The objective of the SHI is simple: To help us predict US GDP movement ahead of official economic releases — important since BEA data is outdated the day they release it.
‘Personal consumption expenditures,’ or PCE, is the single largest component of US GDP — about 2/3 of the total. In fact, the majority of all US GDP increases (or declines) usually result from (increases or decreases in) consumer spending. Thus, this is clearly an important metric to track. The Steak House Index focuses right here … right on the “consumer spending” metric.
I intend the SHI is to be predictive, anticipating where the economy is going – not where it’s been. Thereby giving us the ability to take action early.
If the SHI index moves appreciably -– either showing massive improvement or significant declines –- indicating expanding economic strength or a potential recession, we’ll discuss possible actions at that time.
Economists seem to be puzzled. For a number of years now, the usual and customary behavior of productivity, inflation, and long-term interest rates has been anything but.
On 9/25/17, the FED of San Francisco published an ‘economic letter’ with the title, “Demographic Transition and Low US Interest Rates.” Here is a graphic (modified by me as discussed):
(Source: Real short-term rates calculated as yields on short-term government securities with maturity less than 1 year minus realized CPI inflation. Shaded area shows the 90-10% range across countries. Sample includes Belgium, Germany, Finland, France, Greece, Iceland, Ireland, Italy, Japan, the Netherlands, Norway, Portugal, Spain, Sweden, United Kingdom, and the United States.)
‘Real’ interest rates behaved pretty much as expected until the late 2000s. But since that time (to the right of the RED LINE) — and thru today — rates don’t appear to be following the traditional script. And this is puzzling quite a few economists. Because it hasn’t happened before.
The SF FED economic letter suggests (1) lower population growth rates, and (2) aging populations in the developed world are the likely culprit. And they suggest this is a long, long-term trend unlikely to change in the near future:
“Changing demographics can affect the “natural” rate of interest. This rate, also known as r* (r-star), is the inflation-adjusted interest rate that is consistent with the full use of economic resources and steady inflation near the Fed’s target level. Thus, the natural rate of interest is the real federal funds rate consistent with stable inflation absent transitory business cycle shocks to the economy.”
Yellen and other FOMC members are taking notice. To a growing extent, they agree that R-star is important when considering monetary policy. It’s a bit of a “Goldilocks” scenario: Set the federal funds rate too high (COLD) relative to R-star for an extended period, and a recession may be triggered, causing GDP growth to fall below potential growth. Set the federal funds rate too low (HOT) relative to r-star for too long and the economy could over-heat, exceeding inflation targets. Somewhere between COLD and HOT is just perfect.
Especially when you consider the outcome of SF FED model:
“Setting the model parameters so that <US> population growth declines from 1% as of 1990 to 0.3% as of 2100, as projected by the United Nations. Life expectancy increases from 75 to 91 years over that period. We also assume an average retirement age of 65, which implies that the typical length of retirement rises from 10 to 26 years. We then assess the model-implied effects of this demographic transition on r-star between 1990 and 2016….” and they arrive at this graphic:
The ‘Baseline‘ reflects their interest rate forecast for r-star into the future — 2020 and beyond. Lower yet again.
Their conclusion: “Our model projections regarding the substantial effects of population aging suggest that future economic policy will have to adjust to operating in a low r-star world. In such an economic environment, interest rates would hover not too far above their lower bound. This implies that central banks could be more limited in their ability to further lower the policy rate to respond to recessionary shocks and stimulate the economy.”
Meaning, they believe the “right” FED funds rate level — one not too HOT and not too COLD — is quite low.
Of course, Janet Yellen added her own puzzling comments in her speech on Tuesday, about the mixed messages the FED is getting from current data: “My colleagues and I may have misjudged the strength of the labor market, the degree to which longer-run inflation expectations are consistent with our inflation objective, or even the fundamental forces driving inflation.” And assured us that “policy makers” have to remain agile.
Finally, in an article entitled “Is there a risk of snap-back in long-dated yields?,” the Head of Research for the Bank for International Settlements (BIS), Hyun Shin, considers the puzzling conundrum of ultra-long bonds:
“The holding of ultra-long bonds by German insurance firms has quadrupled since 2008. In turn, yield-chasing may affect market dynamics to lower long-term rates, sparking even greater demand for long-dated bonds. To an outside observer, it would appear as if market participants’ preferences were changing with market prices themselves.“
Remember, the longer the duration of a bond, the greater the value loss if rates rise significantly.
Why, then would German insurance companies quadruple their holdings of ultra-long bonds, at a time when long-term rates are at generational lows, if they were concerned rates will be rising, soon or significantly, thereby significantly reducing the market value of their holdings? The simple answer: They would not.
The graph below is a bit tricky. The left-hand side (Lhs), the right-hand side (Rhs), and the bottom are all defined. The bottom shows the duration (time to maturity) of the bonds.
The Lhs shows how many billions of euros German insurers held in 2013 (pink) and, also, 3-years later in 2016 (blue) for each duration segment shown at the bottom. The Rhs shows the total amount of bonds outstanding — again, for each duration segment shown.
Here’s the interesting take-away: While the quantity of bonds in every duration segment greater than 5-years shrunk during this 3-year period, German insurance companies dramatically increased their holdings. Meaning they purchased a much larger share of the total quantity outstanding. Again, this is not the behavior of an investor concerned about rising interest rates. It’s the behavior of an institution seeking to lock-in low yields … hoping to match future returns with their vision of future rates. This is the behavior of an investor who believes long-term interest rates will be very, very low for a very, very long time.
Many economists are puzzled by today’s unique conditions. People, institutions and data are not following the typical recovery trajectory. By this time in the economic cycle, most economists would tell us, productivity, wages, interest rates and inflation should be rising. Yet they are not.
We’ve discussed the “why” in many prior blogs … so I won’t cover it again today. But it’s refreshing to see a bit more acknowledgement from our economic leaders that maybe, just maybe, something is different today.
Are things different today at the steakhouse? How are the priciest of eateries doing this week? Is Mastros fully booked? Let’s take a look.
Well, yes, it appears our super-expensive steakhouses are more popular this week. With this week’s SHI reading at negative <-10>, the spread between the SHI from one year ago is only 8 points. As you’ll see in the longer-term trend analysis below, this is definitely an improvement.
My long-term readers will recall we began our SHI experiment on March 2, 2016.
In that first blog, I introduced you to the “Big Mac Index” — built by The Economist magazine in 1986 — and then crafted the Steak House Index, and “Steakonomics” in a similar fashion. But instead of measuring currency values, the SHI was intended to serve as a predictive barometer for consumer spending. Has it fulfilled its intended purpose? That has yet to be determined, even though we’ve been chewing on the SHI for more than a year and a half. But pretty soon, we’ll know if the SHI is ‘USDA Prime Beef’ … or just gristle. 🙂
Remember, about 70% of the US GDP is the result of ‘consumer spending.’ Which means, far and away, consumer spending/consumption is the single most important economic indicator – one that bears close scrutiny if you’re trying to gauge how the economy is doing – now and in the near future.
And so we built the SHI on the presumption that human are, for the most part, rational beings. Thus, collectively, our behaviors are rational. Meaning, when faced with danger, we tend to pull back…away from the danger. When faced with ‘financial’ danger, we do the same: we adapt our behavior to avoid risks.
For example, if we –- or our company (for those of you on a company ‘expense account’) –- are feeling financially ‘pinched,’ are we going to take a party of 4 people to an expensive steak house for dinner on a Saturday night? Not a chance. Conversely, if we’re feeling flush, sure, we’ll go to Ruth’s Chris Steak House on Saturday night and spend $300 or $400 for dinner for 4.
Since that time, I’ve repeated the SHI process every week – on Wednesday – to create our SHI.
Each of our four (4) costly eateries, selected over a year and a half ago, offers 14 possible time-slots — for a total of 56 possible reservations each week. Granted: The restaurant sample size is small, but I felt the large number of possible reservation combinations would create the framework for a meaningful outcome.
Lately, I’ve had a few folks suggest that while the SHI concept is quite fascinating, they feel it is geographically constrained. Meaning, they would feel better about the predictive value of the SHI if the SHI tracked expensive steak-eater behavior in more major cities across the US. So, at the suggestion of one persistent and knowledgeable “Steak House Index Disciple,” I’m considering expanding the SHI to include 15 cities across this great country of ours.
What do you think? Good idea? Please share your thoughts!
– Terry Liebman