What next for the Goldilocks economy?

On the face of it the Fed has achieved the perfect equilibrium. A Goldilocks economy! Inflation is at 1.9% (almost right on target), GDP growth is seen running at around 2% this year, right on the trend rate dictated by labour force growth and productivity, and unemployment is at 3.8%, full employment by anybody’s measure. The Fed duly confirmed yesterday that it is on hold indefinitely with the Funds rate at 2.5%. And, conveniently, that rate is just about what the Fed now views as the neutral rate (2.5-3%) according to the dots plot from the FOMC materials. If it seems too good to be true it probably is.

The economy follows a dynamic cyclical process so it wont stand still. The question is what happens next. One line of thought is that it will continue to decelerate. GDP growth in Q1 appears to be running at only about 1-1.5%, based on tracking estimates using high frequency data. It is possible that there is more slowdown already baked in, or that new shocks (a breakdown of trade talks with China or a new front opening with Europe perhaps) will make it slow further.

What seems more likely is that growth will firm up enough to meet the 2% forecast for this year and next but that inflation will prove more troublesome than expected. So, first, why will growth firm up? The slowdown in the last 6 months is substantially due to weakness in China and Europe, together with lower oil prices affecting investment in fracking in the US. The stock market wobble at the end of last year worried consumers adding to general concern. On the policy front the trade war with China and the government shutdown did not help, while fears over Brexit may have occasioned caution too.

But all these seem to be transitory. Most importantly, China is stimulating again and already there are signs of a pick up which should be evident by mid-year. Both sides in the trade dispute want a deal so, while there may yet be last minute stand-offs, I expect a deal to emerge. The stock market has recovered and, with it, consumer confidence. Ahead of a recession consumer confidence normally falls for several months but that’s not happening at the moment, at least not yet.

That said, a return to the 3% growth rate achieved for a while in 2017-18 looks unlikely because there wont be a major new fiscal stimulus, though I wouldn’t rule out some stimulus just ahead of the 2020 Presidential elections.

The question then becomes, if GDP growth putters along at 2%, right on target, will wage growth stay contained or continue to move up? The Fed’s forecast materials suggest they are worried about this because the FOMC materials put full employment at 4.3%, above where we are now. A simple Phillips curve view suggests that wage growth will continue to accelerate. To my mind, this is the greatest risk to the upswing because it will eventually force the Fed to raise rates. The good news is that the problem of rising wage growth is not likely to be viewed with urgency by the Fed for at least 3 good reasons.

First, wage growth is not likely to surge the way it did in the 1970s. International pressures and the lack of union power and indexation will keep it muted. And GDP growth running at 2% is less risky for wage growth than growth running at 3%. Wage acceleration is a function of the level of unemployment relative to full employment AND the pace of the economy.

Secondly, there is a chance that productivity growth will run at a higher rate in the next year or two than for most of this upswing. In the year to Q4 output per hour achieved a 1.9% rise, the highest rate for some years. Of course some of this strength may have reflected more rapid growth itself. But productivity should be able to hold up with the help of rising capacity use and high investment. This should mean that companies can absorb higher wage growth without raising prices too much.

Thirdly, the Fed has indicated that it will not panic if core inflation ticks above 2%, as I expect later this year. The Fed will likely emphasise that inflation has mostly been below target in recent years. The bond market won’t like this and I think we will see the 10 year yield retreating to the 3-3.5% range in due course.

This upswing wont go on for ever. But, barring a disaster in the next few weeks it should saunter through June and become the longest on record. I think it has 2-3 years left to run and am pencilling in 2021-2 for the next recession. As always keep watching the leading indicator index which has been flat now for 4 months. Any significant fall here would be a worry. A rise by mid-year would confirm my expectations that the upswing is intact. For now.