Panics, Crises, the Fed & the Labour Share

Once upon a time it was common to refer to financial market catastrophes as panics rather than the more modern terminology crises. So the panics of 1873, 1893 and 1907 gradually gave way to the crises of Asian crisis of 1997/98, the all-consuming crisis of 2008 and the Eurozone crisis of 2010.

I was discussing this development with the FT’s Gavin Jackson on Twitter last week. Neither of us had any special insight into why this change occurred. But I think it’s an important one nonetheless — a crisis and a panic imply very different things.

Some financial catastrophes do indeed lead to a crisis but I think the global stock sell off, oil rout and the all the rest of the past few months could more meaningfully be termed a panic.

John Authers identified no fewer than 12 (count them!) potential catalysts. Polemic Pain listed ten bears’ toys yesterday.

It really has been a “pick your narrative” kind of sell-off and there have been plenty of doom-ridden narratives available on the menu. But then, there always are.

There is of course the risk that these kind of events can become self-fulfilling, that through tightening financial conditions, a wealth effect and confidence effect a large sell-off in risk assets can tip the real economy into recession*.

For what it’s worth the world economy doesn’t like too bad to me at the moment. Assuming China isn’t about to fall off a cliff — and people who know far more about China than me and who’s opinions I respect assure me that is not imminent — then 2016 looks to be another year much like 2013, 2014 or 2015. A year of soggy and unspectacular global growth that is a far cry what we got used to pre-2008 but is also a long way from the kind of gut-wrenching crisis (and yes, crisis is the word) of 2008 or 2009.

The Eurozone looks set to put in another year of (by recent standards) decent growth, the UK economy has slowed but is ticking along and emerging market growth looks to be stabilising.

But the most acute concern in recent weeks seems to be focused on the US. A horrible print for Q4 GDP has sparked a host of commentary calling December’s 0.25bp rise in rates as a policy error.

Indeed many now expect the next move to be a cut. That seems to me to be highly unlikely because for all the talk of a US recession I simply don’t see it in the current data. The manufacturing sector is struggling (and it has outsized importance to both equity and credit markets) and the energy sector has obvious problems (and the hit to investment now seems to have played out whilst the benefit to consumers has much further to run). The rest though — and in particular the labour market — looks to be in decent health.

The more sophisticated critique of the Fed hike starts with the Wu-Xia shadow rate (which measures the stance of US policy including the unconventional as well as the conventional) rather than saying a quarter of a point on Fed Funds has tripped the global economy. It notes that the 0.25 was just the latest step in a large tightening of policy that began in late 2014.

But I look that this chart rather differently.

· The US stance tightened considerably in 2015 — by around 2.25% — and yet growth was (given this) very robust.

· If the Fed hiked four times in 2016 as implied on (the now infamous) dot plot this would be a considerably slower pace of tightening than in 2015.

Even if the US economy does turn down significantly from here, I’m still not at all convinced that December’s move should be termed a mistake — it seemed reasonable given expectations and forecasts at the time.

There is finally evidence that a tighter (and yes the participation rate suggests there is still slack) labour market is feeding through into wage gains. Econhedge’s view feels about right.

It would be hard to call a 0.25% move an obvious error if months later wage growth was at 2.8% coupled with low unemployment and decent GDP growth.

Of course, the UK labour market experience here suggests caution is needed — what looks like the beginnings of a strong pick up can fade.

The Fed minutes suggest, as Tim Duy notes, that the FOMC is aware of this and is moving towards a position of waiting for more direct evidence of inflation before tightening.

I think he’s right to argue that:

The Fed may be turning toward my long-favored policy position — the best chance they have of lifting off from the zero bound is letting the economy run hot enough that inflation becomes a genuine concern. That means following the cycle, not trying to lead it.

The potential policy mistake I worry about isn’t an early 0.25% last December, it’s a potential overreaction if inflation is above 2% and the Fed feels it has held rates low for too long.

The speed of the collapse of inflation across the West took many by surprise. The speed of its return may be an equal shock.

I keep turning to what Jared Bernstein has called his Rorschach Test.

The reaction should be “yay — finally some wage growth” followed by (the Fed’s favourite word) “gradual” tightening. But it could well prompt Tim Duy’s “scenario 5”:

Financial markets remain choppy in the first half of the year, pushing the Fed into “risk management” mode despite solid labor market activity. The Fed skips the March and April meetings. Officials’ delayed response calms markets and prevents a slowdown in activity, but they feel behind the curve and try to catch up with a steeper pace of hikes late in the year.

That, to me, would be the policy mistake -delaying for too long now and then over compensating with a steeper path in the face of inflation.

The Fed shouldn’t worry too much about falling behind the curve, as Paul McCulley wrote 18 months ago, there is strong case for letting inflation get above 2%.

Only in the later days of economic expansions — before they are murdered by anti-inflation Fed rate hikes (and/or the bursting of asset bubbles) — does labor gain sufficient pricing power to capture from capital a bigger piece of a bigger economic pie…

Achieving this outcome means that the Fed should — and thus, will! — remain “behind the curve” of the nattering nabobs for a long, long time after liftoff from zero… If a rising return to labor (which Wall Street insists on calling “inflation”) involves some pickup for price inflation to and beyond the Fed’s long-term 2% objective, so be it…

This scenario implies a slow but long grind up for bond yields in the years ahead. I do recognize that. But the Fed’s mandate doesn’t include a bull market in bonds.

Right now, I wouldn’t be at all surprised if a year that began with a deflation/growth scare ended with an inflation scare. The Fed would do well to look through both.