This June marks the 10-year anniversary of the current U.S. economic expansion, according to the Business Cycle Dating Committee.[i] This post-Great Recession era has been characterized by massive international central bank stimulus, ultra-low interest rates for unprecedented lengths of time, bond purchasing, and other measures. In the “old days” pre-crisis, such stimulus would have surely caused robust economic growth and growth’s usual by-products, price and wage inflation. But strong consistent economic growth during this decade has been elusive with the recovery being described as “fragile” and “tepid”. This period has been referred to as the “New Normal”, a term made popular by economist Mohamed El-Erian during his time as head of PIMCO. The term stems from a belief that many of the old rules don’t apply any longer.
Some of the “old adages” of economic theory are being rethought. Let’s discuss a couple of them:
Low Interest Rates Cause Inflation
The relationship between interest rates and inflation has been the cornerstone of Federal Reserve policy since the abolition of the gold standard in 1970. Runaway inflation was dramatically brought to heed with sky-high rates implemented under Federal Reserve Chair Paul Volcker in the 1980s. Federal Reserve Chair Greenspan fought the last battle against runaway inflation in the mid-1990s. During this era, up until the financial crisis, a federal funds rate of about 3.00% would be low enough to stoke inflation of 4-5% or higher. Today, that relationship seems to be broken as years of the federal funds rate at or near 0% resulted in inflation hovering in the 1% range. A variety of factors have contributed to this “New Normal”: consumers’ access to information using technology and e-commerce, labor unions’ declining membership, employment dynamics (the rise of the “gig economy”), low oil prices because of supply abundance. We should soon see if the extended period of near full employment and low interest rates finally exhausts the “slack” in the labor market and results in long-awaited wage growth.
An Inverted Yield Curve is a Predictor of a Recession
A yield curve inversion occurs when longer dated treasury yields fall below short-term yields. This is a historic recession indicator as it can negatively affect the banking industry. Banks make profits by borrowing short-term and lending long-term. The inversion upsets that dynamic. Also, long-term bond yields are often a prediction of future growth, so low 10 year and 30-year yields are seen as a recessionary signal. Last week’s comments by Michael Schumancher[ii], Managing Director and Global Head of Rate Strategy for Wells Fargo Securities, reflected on another perspective. Schumacher’s analysis bifurcates the yield curve with separate metrics for short-term and long-term treasuries. He comments that the lower end is dependent on Federal Reserve moves (remember, the Federal Reserve controls short-term rates only) and the long end is reflective of a “risk off” strategy amongst investors. The “risk off” trade doesn’t necessarily predict a recession but instead is a flight to a safe haven during times of volatility. There are also technical factors in play such as large programmatic purchases of 10 year Treasuries related to hedging and the relative strength of the dollar.
History tells us that these adages are consistent prognosticators. Will they serve the same role in the future? Can we count on them as we have done so many times in the past? Only time will tell if these old adages still ring true in the “New Normal” or if new adages spring up in their place.