Peak Uncertainty - EconVue June 2022

posted by Lyric Hughes Hale on June 10, 2022 - 12:00am

In spite of our reputation as the technology capital of the world, last month the US witnessed its greatest fall in productivity since 1949. This might be a symptom that the US is lagging in the type of innovation that leads to economic growth. According to Peter Coy at the New York Times, based upon data shared by the Hamilton Center on Industrial Strategy, the US has a definitive lead in only one tech sector: information services.

China has more or less matched the United States in terms of the two nations’ shares of world output in seven high-tech sectors: pharmaceuticals; medicinal, chemical and botanical products; electrical equipment; machinery and equipment (from engines to office gear); motor vehicle equipment; other transport equipment (mostly aerospace); computer, electronic and optical products; and information technology and information services.

Inflation, another drag on the economy, is being blamed on a wide cast of characters, from Vladimir Putin to Jerome Powell. Its persistance has been surprising to many economists in a world where demand is in a long-term structural decline due to slowing demographics. Yet we have found a way to push up prices after the effects of Covid have faded.

On her mea culpa tour Treasury Secretary Janet Yellen admits she was caught by surprise by inflation. Economic models failed us she says, or as Larry Summers claims, measurement of key data such as the CPI is inadequate to capture our current reality.

These and other negative factors, from lack of innovation to excess fiscal stimulus could be contributing to slower growth, but will they lead to recession? The Sahm Rule is a useful tool to predict recessions, based on changes in employment figures. “It is currently -0.1 percentage point, which is well below the 0.5 percentage-point trigger of being in a recession” writes economist Claudia Sahm in her newsletter We Are Not in a Recession Nor is One Inevitable.

Sahm believes that the biggest risk could be a policy error. She concludes what we can all see with our own eyes, we are not in a recession.

Consumers are spending. Businesses are hiring. The unemployment rate is low. That doesn’t mean everything is good. Inflation is high. But that’s not a recession.

The Fed is committed to bringing inflation down. But to do so, they need us to swap one hardship for another. Less consumption for less inflation. But that’s not the only way. More supply—whether it’s more workers to hire or more stuff to buy—would reduce inflation too. That’s the better way but more uncertain and beyond the Fed.

The best would be if inflation came down and it was not due to the Fed. The worst would be if it were all due to the Fed. And in between is some mix of the two. Regardless inflation’s coming down. Recession or not. Preferably not.

So the path forward is not clear. We live in a world where previous assumptions have been replaced with uncertainty and rapid shifts in geopolitics. However, despite all these co-morbidities, I think that a prolonged period of unpredictability is what could eventually give the economy a heart attack.

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Uncertainty about the future incurs a high cost for both people and businesses. Last month here in Chicago, the CME MSRI Prize of Innovative Quantitative Applications was awarded to Nancy Stokey, a distinguished professor of economics at the University of Chicago. In 2009 she wrote “The Economics of Inaction.” Here is a very brief summary of one of her theories:

In economic situations where action entails a fixed cost, inaction is the norm. Action is taken infrequently, and adjustments are large when they occur. Interest in economic models that exhibit ”lumpy” behavior of this kind has exploded in recent years, spurred by growing evidence that it is typical in many important economic decisions, including price setting, investment, hiring, durable goods purchases, and portfolio management.

We are indeed living in “lumpy” times which make it harder for both investors and companies to ignore sunk costs. It is also difficult to assess risk accurately enough to incur new expenditures. Volatility in equity prices, as measured by VIX is about twice as high as it was pre-Covid. All over the US employers are hitting the pause button. From Coinbase to Olive AI, a unicorn health IT company in Ohio, hiring freezes have begun for high-skilled jobs. Low-skilled jobs remain unfilled, with many citing health concerns as the reason for their withdrawal from the workforce.

Wall Street awaits CPI data which are to be released this morning. Median rents in the US, now more than $2000 a month, were not directly impacted by higher food and energy costs, supply chain disruptions, or interest rates. My guess is that landlords are making up for lost revenues during COVID, taking advantage of the fact that mortgage rates are increasing…due to Fed rate hikes. There is a lot of seepage in monetary policy.

Almost any business owner would agree that it is preferable to have higher taxes and expenses that are fixed rather than unpredictable inputs. The measures of inflation that can be affected by monetary policy are already trending downwards. Housing sales are slowing, and supply shocks are righting themselves, as Target’s inventory drawdown reveals. Corporate America is doing its job but is cautious.

One example: oil companies. Although their profits have rebounded since the dip in 2020 when the major energy firms lost tens of billions of dollars, they are not planning to increase investments. Why? In the face of higher prices and ESG investors who shun carbon fuel, they are also being targeted by politicians. Unsure of where this might lead, they are spending their money paying down debt and rewarding shareholders who stayed with them during the lean years. There is too much risk, and not enough policy support to entice them to make long-term investments.

So the central question is, will we see slower growth, or will we bump our heads on a nasty recession? This points to the biggest risk of all—policy mistakes which would not confine themselves to the US economy. An overcorrection by the Fed could have worldwide humanitarian ramifications, particularly in emerging markets. Forward guidance does not solve this.

Robert Solow was quoted in the New York Times in 1979 saying “To try effectively to wipe out hard core inflation by squeezing the economy is possible but disproportionately costly. It is burning down the house to roast the pig.”

We will see how markets react to what is expected to be a large increase in the CPI today. It could be that inflation is successfully tamped down by the real economy sooner than expected, that Janet Yellen was right in the end, and that the peak economic uncertainty that we are experiencing now is as fleeting as peak oil was years ago.

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