Regime Change: Inflation

With the nomination of Jerome Powell for Chair of the Federal Reserve Board, we hear much speculation about whether a change in Board members will alter the course and conduct of US monetary policy.  Strong Chairs, including Paul Volcker and Ms. Yellen, have managed to guide policy in times of dramatic change in the economic landscape. Mr. Volcker reshaped America’s future by breaking the wage-price nexus of the 1970s. Ms. Yellen will be remembered as the architect of extricating the Fed from the extraordinary policies undertaken in the aftermath of the Global Financial Crisis. Mr. Powell faces a much less tangible challenge that he and the Board are in danger of missing altogether. Namely, the world has changed dramatically over the past three decades, and the analytical tools underpinning monetary policy have not evolved in tandem. Economists often refer to such transformations as “regime changes”, and the challenge will be to develop new tools that fit the new world order.  In short, central bankers are flying blind and are in need of upgrading their radar systems. For that matter, so are other policymakers, planners and anyone else who must use projections as a basis for their judgments and decisions.

At the top of the list of the causes of regime change are globalisation and technology, which tend to be catch phrases that subsume many possible causes but nonetheless are over-arching phenomenon that have changed the way the world works. Other sea changes including the saving patterns of aging populations, China’s meteoric industrialisation, Asia’s saving glut and a widening gulf in wealth inequality also have contributed to the breakdown of old economic norms. To be sure, many of these forces are interrelated and mutually reinforcing. What matters to investors are whether these changes are long-lasting and hence might somehow justify current lofty valuations.

Let us focus on three regime changes that in my opinion are critical to addressing prospective risks and returns. First, the longstanding inverse relationship between inflation and economic slack seems to have weakened dramatically. If so, investors would no longer need to fear that excess demand would cause inflation to rise as much as it did during past cyclical peaks. Second, the norms for real interest rates have declined and now hover close to zero. Central bank bond purchases surely have contributed to this aberration, but so have changes in saving behaviour and in wealth distribution, neither of which seems likely to change anytime soon. Third, business investment has been persistently weak despite record profits, a hoard of excess cash in corporate coffers, unprecedented access to cheap financing, and near-record longevity to the current business cycle. New business models do not require as much bricks and mortar as the old industrial expansions and that begs the question of what will sustain full employment once central banks remove their stimulus.

I will focus on the first of these regime changes in this commentary because price and wage determination underpin the other two conundrums as well. My message is that technology and globalisation have fostered a dramatic rise in returns to scale and thus to monopolistic pricing. In many sectors, prices are set as a mark-up over unit costs that often decline or are flat as sales increase. That real-world framework runs contrary to the assumptions of competitive capitalism that are deeply embedded in our economic psyches and forecasting models. That ideal world no longer exists, if indeed it ever did.

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