To a Man With a Hammer, Everything Looks Like a Nail

This FT piece by Gavyn Davies is getting some attention. He makes the case that the upturn in growth we are currently seeing is likely not a secular shift from possible stagnation, but a (welcome) cyclical burst. He references San Francisco Fed President Williams recent paper concluding that the equilibrium real interest rate (r*) is likely to remain much lower than in the past. Briefly, r* is derived by reflecting on an ex post realized output gap relative to the Feds policy stance. If the Fed sets policy rates at what they think ex ante are very accommodative real interest rates relative to the estimate of neutral rates at that time, and yet over the forecast horizon growth doesn’t respond, they conclude that they haven’t been as easy as they thought. They then mark down what the neutral rate must have been, and then judge their current policy stance in relation to the new neutral rate. The effect of this is that in the Feds mind, policy rates at 0.5% could go from being thought of as very easy, to not that easy, if growth didn’t respond.  Even though the principal author of secular stagnation Larry Summers is clear that it is a hypothesis, this is lost on the commentariat who treat it as a gospel fact that we are doomed to live out as Japan for the medium to long term.

But is It true? Is it relevant for the future? How much weight should one put on the whole premise? To our eye it’s an exercise in false precision. These are the issues as we see them.

  • The output gap term, the difference between potential and actual GDP. GDP is notoriously difficult to measure even with the benefit of hindsight and particularly so in real time. This Charlie Bean piece from last year is good reading for an overview of the issues. The short version is that GDP is a measure better suited for an economy that grows crops and produces widgets than today’s economy. By way of example – he notes that in Q4 2008 the UK financial sector recorded its fastest growth on record, as financial services get measured on a loans * spreads framework. Spreads blow out on panic – GDP goes up!
  • Potential GDP takes the same measurement concept and tries to ascertain an ‘operating at full potential level’ based on full employment and all capacity being utilized. These are unknowable in advance, and get messy in modern service economies where operating leverage is hard to pin down, and messier still when you start extrapolating that forward a decade.
  • Using real rates introduces another set of issues, implicitly overweighting low inflation as demand side. The collapse in commodity prices hits this whole exercise in a couple of ways. First in pushing inflation rates down, and therefore real rates up, as it bleeds through the economy and second as GDP suffers a direct hit in the commodity sectors. This hit was real – but it doesn’t make sense to us to assume the low r* necessarily continues just because GDP was temporarily weak due to a cartel break in the Middle East.

If we were to replace the GDP based output gap and did a NAIRU based output gap (which admittedly has its own issues of understanding) you would get a different picture of policy efficacy – where the Fed were too optimistic on the forecast horizon expectations for GDP growth, they were too pessimistic on employment. Are things that bad when the hardest of date – jobless claims – are at 40 year lows? One could note that it looked at first reading that productivity recently had been low, but not that the US is spending the next 20 years as Japan. The bottom line is that nobody, including and especially voting FOMC members, should care too much about today’s GDP reading.

The models work by assuming an economic reaction to lower rates based on past responses. This introduces a small sample size problem – there just aren’t that many easing cycles and recessions to draw from – much less those that come about in such a severe recession coupled with systemic banking freezes. It is hard to draw conclusions about the long term state of the economy when basing the reaction in the post crisis period on reactions from the 2001 recession – far milder, impacting fewer people, and without a breakdown of credit. The impacts of crises aren’t linear. The damage done in the recent crisis was different. Adding in the differences around fairly major deficit reduction in the US in the post crisis period, regulatory regime changes, lending standards and animal spirits makes this all the more complicated. One can’t infer secular stagnation based upon economic responses under very different circumstances – and certainly need to be careful predicting this forward as a fait accompli. As former Fed Chairman Bernanke was at pains to point out – monetary policy is not a panacea, and isn’t the only game in town. Concluding we are Japanese from this period is a stretch too far – particularly when we have an incoming administration that is looking to reverse much of the regulatory framework and tax increases that have arguably hampered growth in the post crisis period. Trumponomics looks to be dedicated to the proposition of big stimulus to generate faster job growth and wage growth. Whatever one might have thought about the ideal interest rate path over the next three years amid Clinton and gridlock, it is almost certainly much higher now amid all GOP control of Washington. Zero r* and secular stagnation? It used to be a messy description of the ongoing reality, with all the caveats and problems described above. There was a risk that it would persist for a long while. It now appears to be either masked or ended via major stimulus in the short run. And what happens in the long run, for at least the next few years, will be largely irrelevant. At this point one can’t know with any certainty what changes the economy will undergo. This Blanchard paper  is fascinating and echoes something we’ve thought for a long time – that talking down the economy has consequences, maybe as much as 1% a year of GDP. Caution begets caution. As I write, I see a headline that Trump may call for a return to manned missions to moon. It is lost on nobody that Kennedy did the same thing to galvanize the US to aim higher. The opposite of caution begets caution is animal spirits.