Jefferies

Economics and Strategy

The Fourth Turning of Disinflation (July 31, 2017)

— David Zervos, Chief Market Strategist

The U.S. CPI has missed market expectations on the downside for the last four months, crashing to a growth rate of 1.6% YoY most recently, from 2.7% YoY back in February. At the same time, core CPI growth has dropped back to 1.7% YoY, and core PCE price index growth has dipped to 1.4% YoY. Further, while the first cut of Q2 2017 real GDP growth came in at a reasonably strong 2.6% annualized rate last Friday, nominal GDP grew at only 3.6%. That left the implicit price deflator index for gross domestic purchases running at a meager 1% annualized growth rate over the last 3 months.

Of course, it is no secret that a rather sharp disinflationary trend has emerged in 2017. But the question is, why now? After all, employment measures suggest we are very close to full employment. And conventional Phillips curve-driven economic wisdom suggests that in the latter stages of a business cycle, as the labor market tightens, price pressures begin to appear. Now a well-trained Keynesian economist can always contort the Phillips curve so as to keep their version of reality alive in the face of incongruous evidence. But I want to argue today that the only contortion one should consider with a Phillips curve involves breaking it and binning it – not bending it. Understanding the 2017 inflation data and, actually, the entire post-crisis economic experience requires a supply-side lens, not one from the standard Keynesian demand side.

Now to be sure, soon after the Trump election win I began to argue that the forces of deregulation were setting up to unleash a large-scale positive supply shock in the U.S. economy, which would raise both potential economic growth and real rates of return on capital, while pressuring inflation lower. I dropped my pre-election concerns about populist trade and immigration policies and focused on a HIGHER real rate/positive supply shock outcome for the U.S. My concept of “secular stagulation,” introduced back on 3-Feb-17, best articulates the view. But follow-up notes such as “Stagulation rules, stagnation drools” on 5-Jun-17 and “The terminal funds rate” on 13-Jun-17, added more punch to the argument. In order to highlight the importance of this coming positive supply shock, I spent quite a bit of time in those notes reviewing the regulatory origins of the negative regulation-based supply shock that preceded it. Let’s just recap that discussion, since it is quite important as we tackle the outlook for disinflation.

There is no doubt that the post-crisis years were marked by significant increases in regulatory burden across almost all industries. This increased the overall cost of doing business and therefore shifted the aggregate supply (AS) curve. Thinking about this effect in terms of a traditional price vs. output chart from your Econ 101 textbook, each unit of output required a higher price so as to be economically viable. That translates into an AS curve that moves up and to the left – a negative supply shock. And of course this was happening just as we were (successfully) fighting off the large negative demand shock of 2008–09 with the introduction QE policies.

To see the actual numbers behind this supply shock, recall the data I put forth in the piece “Stagulation rules, stagnation drools.” The average annual growth rate of real GDP from 2008 to 2017 has been only 1.27%, a LOWER level than the 1.33% achieved during the depression decade of the 1930s. There was, however, a significant difference between the 1930s and the last 10 years. In 1930s there was deflation, -1.95% on average per year. But in the last 10 years inflation has averaged over 360bps more, at +1.62%. The ‘30s were all about a negative aggregate demand (AD) shock – a shift of the AD curve lower took both prices and output down. But the bulk of the post-crisis period was not characterized by adverse demand dynamics. We did of course see significant disinflation in the latter half of 2008 and into 2009, when demand-side forces were certainly in play. But as mentioned above, the introduction of QE countered that demand shock quite successfully by 2010.

Sadly, though, it was right around this time when this regulatory negative supply shock kicked into high gear. By 2011, U.S. CPI inflation was pushing up towards 4%, but employment and output growth were still soft. Traditional measures of the output gap remained elevated, and significant excess capacity seemed incongruous with a Phillips curve view of the world. How could we have maintained such robust inflation rates from 2010 onwards with so much excess capacity? The answer of course rests with a regulation-induced negative supply shock. Higher prices and lower output are 100% consistent with a shift back in the aggregate supply curve. All this talk of “demand deficiency” and secular stagnation was completely inconsistent with the data – in the end it was a “supply deficiency.” Looking back at the 2010 to 2016 period, the Phillips curve provided a cloudy lens through which to view the macroeconomic forces in play. We should have binned it long ago, and we should bin it now as the coming positive supply shock enters the fray.

So how should we look at the (dis)inflation outcomes as deregulatory forces enter the U.S. economy? I suppose a 2.6% real GDP growth rate and a 3.6% nominal GDP growth rate (as per the release last Friday), along with a 4.4% unemployment rate, would be par for the positive supply shock course. Actually, those numbers might even represent a birdie. But in all fairness I think we need to widen the discussion on disinflation to allow for all the other forces at work. To that end I would like to argue today that we have four distinct disinflationary forces to consider. They are as follows:

  1. A tightening of monetary policy: There have been four rate hikes since Dec 2015, and the FOMC will begin balance normalization “relatively soon.” Monetary policy tightening shifts aggregate demand lower, thereby REDUCING price pressures.
  2. A slowing in labor force growth: While there is some debate on correlation versus causation, one of the most striking long-term relationships in macroeconomics is between inflation and labor force growth. Higher labor force growth associates strongly with higher inflation, and vise versa. With demographic trends pointing toward much slower labor force growth in coming years, a SLOWING in price pressures should also be on the horizon.
  3. An increase in automation: Much has been written over the years on technological advances driving production costs and therefore output prices lower. Some have even gone down the rabbit hole of the singularity hypothesis. Whether or not one believes in “matrix-style” technological advance in our future, the pressures from these secular forces have been and remain disinflationary.
  4. A movement toward deregulation: We have already spent most of this note discussing the disinflationary forces that are unleashed via deregulation. There is little need to discuss them further.

For me, the first three disinflationary forces have been with us for some time – and they are likely not going away anytime soon. But the fourth is a new one, and it is a sharp reversal of an inflationary force from the past. The momentum behind disinflationary deregulation policy is also likely to get much stronger in coming quarters. As I have argued in prior notes, new legislation is not required for us to see significant changes in the regulatory burden. Congressional legislation leaves much to various federal government agencies for interpretation and implementation. The new heads of the Departments of Commerce, Treasury, Labor, Interior, Health and Human Services, Education, and Transportation will have sharply different “interpretations” of the existing legislation than their predecessors. And on the financial side, at the Federal Reserve, someone like Randy Quarles will have a very different interpretation of Dodd-Frank than Dan Tarullo did. Unlike fiscal policy, regulatory policy changes do not require new legislation. I have largely rested my case for higher real rates and higher potential GDP growth on regulatory policy changes precisely for this reason. Waiting for fiscal policy to make an impact is simply too risky, given our broken legislative process.

All of this said, the most common question I get on the deregulation story is, how can we measure the size of its impact? People want numbers. They want empirical studies. They want to quantify the potential effects from deregulation. Well, I have spent an enormous amount of time looking through the work of academic economists on deregulation. I have also looked through the many studies on deregulation at prominent DC think tanks. And, as is to be expected with the economics profession, most of the work is dubious. The models are weak; the data are incomplete; and the authors typically allow their politics to drive their conclusions. I wish I had something more than survey data from the NFIB or a chart that shows increases in Federal Register pages. But I don’t. I do, however, believe that our prior analysis of the post-crisis period, which shows record-high corporate profits as a percentage of GDP and near-record-low productivity growth, is very consistent with a large increase in both regulatory burden and barriers to entry for new/small businesses. Those data suggest that regulation has had a major impact on the economy. And thus I feel comfortable arguing that unwinding regulation will have an equally large impact in the opposite direction.

I do wish there was something more concrete, but honestly it’s probably healthy for everyone to recognize the limitations of economic analysis. Even as a classically trained PhD student in economics, I see the field as an art not a science. The best economists, from my perspective, are heuristic storytellers, not frustrated mathematicians. We cannot expect precision in economics, especially macroeconomics. But hopefully today, with some acceptable storytelling, I have helped convince you that deregulatory forces from the supply side are going to add to the disinflationary trends that have already been in place for some time. There are four sharply disinflationary forces feeding through the U.S. economy at the moment. And the fourth one is just getting started.