Goldilocks Narrative, The U.S Economy And Some Policy Conundrums
“Financial conditions are near their easiest since 2009 even after four rate hikes as evidenced by falling bond yields and credit spreads, record levels in stock markets, and a weaker dollar. In fact, the Federal Reserve has inadvertently given a double portion of porridge! This liquidity needs to find a home, boosting flows into global stock and bond markets.” (Prashint Bhayani, Is the economy too hot, too cold or just right? July 26, 2017)
A Goldilocks economy is often described as not too hot to cause inflation nor too cold to fall into recession. In fact, while there is no precise definition of a Goldilocks economy, it is generally characterized as having low unemployment, increasing asset prices (stocks, real estate, etc.), low interest rates, steady economic growth and low inflation. In many respects, the U.S. economy in 2017 seems to fit this narrative.
Looking more closely, however, one can see that the U.S. still has some significant economic problems. One of the more worrying concerns is why wage and price inflation hasn’t picked up in response to low unemployment?
In terms of the low inflation conundrum, many “one off” factors are frequently cited, particularly the role of falling oil prices. Other “one offs” include globalization, de-industrialization, imports from low wage countries and America’s large current account deficit.
With respect to the low wage aspect of all of this, American firms seem to have no difficulty in finding workers who will accept extremely low wages even in the nearly fully employed economy. These same firms seem to be willing and able to manage the high job turnover rates associated with paying low wages.
Then there is the apparent conundrum that the Phillips curve (the inverse relationship between declining unemployment and increasing wages) may have broken down, if only temporarily. In other words, the historical inverse relationship between unemployment and inflation seems to have flattened out.
Of course, what is often missing from the reporting on the flattening of the Phillips curve is the importance of inflationary expectations – which itself is extremely low, and certainly lower than 2%.
Also complicating our understanding of what is actually happening due to monetary policy is the observation that financial conditions in the U.S. have eased this year, even though the Fed has raised interest rates four times since the recent bottom. In fact, U.S. financial conditions are at their easiest levels since August 2014, in large part due to tighter credit spreads in the financial markets.
This latter conundrum is expressed in the following chart which shows that the Chicago Fed’s National Financial Conditions Index (NFCI) has declined this year. (Keep in mind that positive values of the NFCI indicate that financial conditions are tighter than average, while negative values indicate financial conditions are looser than average.)
Finally, it is rather likely that the Fed will soon begin its process of balance sheet normalization (or shrinkage) before delivering another interest rate hike in December.
Hopefully by this year’s end much of the uncertainty surrounding the American debt ceiling will have dissipated.
The U.S. National Financial Conditions Index Tilts Towards Easing In 2017
Disclosure: None.