The Lens of Perception: Framing Effects in Inflation Measurement and Interpretation

 

The concept of framing, as elucidated in behavioral economics and cognitive psychology, plays a crucial role in the definition and calculation of various inflation measures. This essay will explore how framing influences our understanding and measurement of inflation, with particular emphasis on the Consumer Price Index (CPI) and Personal Consumption Expenditures Price Index (PCE), while also considering the challenges posed by phenomena such as shrinkflation and skimpflation.

Framing in inflation measurement begins with the fundamental question of what constitutes "inflation." The conventional definition—an overall increase in the prices of goods or services in an economy—already frames our approach to measurement. This framing leads to the creation of "baskets" of goods and services, which themselves represent a particular frame for understanding consumer behavior and economic activity.

The CPI, for instance, frames inflation through the lens of urban consumers, who represent 93% of the U.S. population. This frame, while comprehensive, inevitably excludes the experiences of rural consumers. Furthermore, the CPI's use of a fixed basket of 80,000 items presents a static frame that may not fully capture the dynamic nature of consumer behavior, especially in response to price changes.

In contrast, the PCE employs a different frame, using a chain-weighted index that allows for substitution between goods as relative prices change. This framing acknowledges the adaptability of consumer behavior but may understate inflation as experienced by consumers who do not or cannot substitute goods easily.

The distinction between "headline" and "core" inflation measures further illustrates the impact of framing. By excluding volatile food and energy prices, core inflation frames price changes in a way that may be more useful for policymakers but less reflective of the lived experiences of consumers for whom food and energy costs are significant.

Quality adjustments in inflation measures represent another crucial aspect of framing. The attempt to account for quality improvements in goods and services frames inflation not merely as a change in price, but as a change in value. This framing is theoretically sound but introduces subjective elements into what is often perceived as an objective measure.

The challenges posed by shrinkflation and skimpflation highlight the limitations of current framing approaches. These strategies by producers to disguise price increases—through package downsizing or quality reduction—exploit gaps in the frames used to measure inflation. While statistical agencies attempt to account for these phenomena, their effectiveness is limited by the very frames they employ to define and measure inflation.

Moreover, the different scopes of various inflation measures—such as the CPI's focus on out-of-pocket expenditures versus the PCE's inclusion of employer and government-paid expenses—demonstrate how framing can lead to divergent results. In June 2022, for example, the headline CPI indicated a 9.1% year-over-year increase, while the PCE showed a 6.8% increase. This divergence underscores how different frames can lead to markedly different perceptions of economic reality.

The impact of framing extends beyond measurement to policy responses. Central banks and governments base critical decisions on these framed representations of inflation. If the frames fail to capture important aspects of economic reality—such as the impact of technological change or shifts in consumer behavior—policy responses may be misaligned with actual economic conditions.

In conclusion, the definition and calculation of inflation measures are deeply influenced by framing effects. While current measures attempt to provide comprehensive and accurate representations of price changes, they are inevitably shaped by the frames through which we understand economic activity. Recognizing these framing effects is crucial for policymakers, economists, and the public to interpret inflation data critically and to develop more nuanced understandings of economic phenomena.

As we move forward, it may be beneficial to consider more flexible and diverse framing approaches to inflation measurement. This could involve developing new measures that capture different aspects of price changes, incorporating more real-time data, or creating composite indices that provide a more holistic view of inflation. By acknowledging and addressing the limitations of current frames, we can work towards a more comprehensive and accurate understanding of inflation in our complex, dynamic economy.

"Reframing Inflation: A New Paradigm for Monetary Policy in an Era of Global Upheaval

The traditional frameworks for understanding and measuring inflation, while valuable, are increasingly challenged by a confluence of global events and structural economic shifts. This essay argues for the necessity of a new framing paradigm in monetary policy, particularly in gauging inflation expectations, given the seismic changes in the global economic landscape.

The geopolitical tensions stemming from the wars in Ukraine and the Middle East have sent shockwaves through global commodity markets, disrupting supply chains and energy flows. These events have exposed the vulnerabilities of existing inflation models, which often struggle to account for sudden, externally-driven price shocks. The traditional framing of inflation as a primarily domestic phenomenon, influenced chiefly by national monetary and fiscal policies, is proving inadequate in capturing the complex interplay of global events and local price dynamics.

Concurrently, the unprecedented expansion of central bank balance sheets in response to the 2008 financial crisis and the COVID-19 pandemic has created a monetary environment with no historical parallel. The massive injection of liquidity into financial systems has challenged conventional wisdom about the relationship between money supply and inflation. This new reality demands a reframing of how we understand the transmission mechanisms of monetary policy and their inflationary impacts.

The issue of expanding government debt adds another layer of complexity. High debt levels can influence inflation expectations through various channels, including potential future tax increases or monetary policy actions. However, the current low-interest-rate environment has challenged traditional assumptions about the inflationary pressures of large public debts. A new frame is needed to understand the nuanced relationship between debt, monetary policy, and inflation in this era of secular stagnation and unconventional monetary tools.

The rise of China as an economic superpower and the concurrent decline in international trade growth represent structural shifts in the global economy that have profound implications for inflation dynamics. China's role as a global manufacturing hub has exerted deflationary pressures on goods prices for decades. However, as China transitions towards a consumption-driven economy and global supply chains reconfigure, these deflationary forces may wane. Traditional inflation models, often built on assumptions of stable global trade patterns, may fail to capture these evolving dynamics accurately.

Moreover, the decline in international trade growth, exacerbated by protectionist policies and geopolitical tensions, challenges the long-held view that globalization acts as a deflationary force. This shift necessitates a reframing of how we understand the relationship between global economic integration and domestic price levels.

The new framing paradigm for inflation and monetary policy should incorporate several key elements:

1. Global Interconnectedness: A more nuanced understanding of how geopolitical events and global economic shifts transmit to domestic price levels is crucial. This includes developing models that can better account for supply chain disruptions, energy price shocks, and shifts in global trade patterns.

2. Expanded Balance Sheet Dynamics: The new framework must incorporate the effects of unconventional monetary policies and large central bank balance sheets on inflation expectations and price dynamics. This includes reassessing the relationship between money supply, asset prices, and consumer price inflation.

3. Debt-Inflation Nexus: A more sophisticated understanding of how high levels of public and private debt interact with inflation expectations and monetary policy effectiveness is needed. This should include considerations of potential fiscal dominance and its implications for central bank independence.

4. Technological Disruption: The new frame should account for the deflationary impacts of technological advancements, including automation, artificial intelligence, and the digital economy. These forces can significantly affect price dynamics in ways not captured by traditional models.

5. Changing Consumer Behavior: As demographics shift and consumer preferences evolve, particularly in the wake of global crises, the new framework should be flexible enough to capture these changes and their impacts on inflation.

6. Environmental Considerations: With the increasing focus on climate change and the transition to a green economy, the new framing should incorporate the potential inflationary impacts of environmental policies and climate-related disruptions.

In conclusion, the current global economic landscape, characterized by geopolitical tensions, unprecedented monetary interventions, shifting trade patterns, and technological disruptions, demands a fundamental reframing of how we understand and measure inflation. The Federal Open Market Committee (FOMC) and other central banks must evolve their analytical frameworks to capture these complex, interconnected dynamics.

This new framing should not entirely discard traditional models but rather expand upon them, incorporating a more holistic view of global economic forces. It should be flexible enough to adapt to rapid changes in the economic environment while maintaining the credibility and stability necessary for effective monetary policy.

The challenge lies in developing this new framework while maintaining transparency and clear communication with markets and the public. Central banks must strike a delicate balance between adapting to new realities and maintaining the consistency that underpins their credibility.

Ultimately, this reframing is not just an academic exercise but a practical necessity. As the global economy continues to evolve in unprecedented ways, the effectiveness of monetary policy—and its ability to maintain price stability and support economic growth—will depend on our capacity to understand and respond to these new realities. The time for a new inflation paradigm is now, and it is incumbent upon policymakers, economists, and researchers to rise to this challenge. 

Framing in Monetary Policy Decision-Making

The concept of framing, as articulated by scholars like Kahneman and Tversky, suggests that the way information is presented can significantly influence decision-making. In the context of monetary policy, the frames used by the FOMC to interpret economic data and formulate policy responses are crucial. These frames are typically derived from established economic models, historical precedents, and the committee's own past declarations.

On one hand, consistency in framing can provide stability and predictability, which are valuable in maintaining market confidence. The use of familiar frames allows for continuity in policy-making and helps in managing market expectations. This approach has been largely successful in maintaining price stability and fostering economic growth over extended periods.

However, the potential drawbacks of this consistent framing are significant and warrant consideration:

1. Anchoring Bias: The FOMC's reliance on past declarations and established models may lead to an anchoring bias, where new information is interpreted primarily through the lens of previous assessments. This could result in a slower recognition of structural economic changes.
2. Confirmation Bias: There's a risk that committee members might inadvertently seek out information that confirms their existing views, potentially overlooking contradictory evidence that doesn't fit within their established frames.
3. Model Risk: The economic models used by the FOMC, while sophisticated, are inherently based on historical data and assumptions. In times of rapid technological change or significant shifts in consumer behavior, these models may become less reliable predictors of future economic trends.

Structural Changes and Their Impact

The global economy is currently experiencing profound structural changes driven by factors such as:

1. Technological Advancements: The rapid pace of technological innovation, including artificial intelligence and automation, is reshaping labor markets and productivity in ways that may not be fully captured by traditional economic models.
2. Changing Consumer Behavior: The rise of the digital economy, sharing platforms, and shifts in consumption patterns (e.g., from goods to services) may alter the dynamics of inflation in ways not fully accounted for in established frameworks.
3. Globalization and Supply Chain Reconfiguration: The ongoing evolution of global trade patterns and supply chains, accelerated by recent geopolitical events and the pandemic, may have long-lasting impacts on price dynamics.
4. Climate Change and Environmental Policies: The transition to a greener economy and the impacts of climate change introduce new variables that may not be adequately represented in traditional monetary policy frameworks.

These structural changes pose significant challenges to the FOMC's traditional framing of inflation expectations and economic outlooks.

Balancing Tradition and Innovation

While acknowledging these challenges, it's important to recognize that the FOMC does not operate in a vacuum. The committee continuously updates its models and incorporates new data. However, the question remains whether these updates are sufficient to capture the rapid and sometimes discontinuous changes in the economic landscape.

A balanced approach might involve:

1. Diverse Perspectives: Incorporating a wider range of economic viewpoints and alternative models into the policy-making process.
2. Adaptive Framing: Developing more flexible frameworks that can quickly integrate new economic realities and shifts in the underlying structure of the economy.
3. Enhanced Data Analytics: Leveraging big data and advanced analytics to capture real-time economic trends that might not be reflected in traditional economic indicators.
4. Transparency and Communication: Clearly articulating to the public how the FOMC's frameworks are evolving in response to structural changes, thereby maintaining credibility while acknowledging uncertainties.

Conclusion

The challenge of framing in monetary policy is a delicate balance between maintaining consistency and adapting to change. While the FOMC's reliance on established frames provides stability, it also risks introducing biases that could hinder effective policy-making in a rapidly evolving economic environment.

The key lies in fostering an approach that respects the value of established frameworks while remaining open and adaptable to new economic realities. This might involve a more dynamic and diverse approach to framing inflation expectations and economic outlooks, one that can swiftly incorporate structural changes in technology, consumer behavior, and global economic patterns.

Ultimately, the effectiveness of monetary policy in the coming years will depend on the FOMC's ability to strike this balance – maintaining the credibility and stability that come from consistent framing while developing the agility to reframe its approach when faced with significant structural economic shifts.

Navigating the Labyrinth: Strategies for an Impending Global Financial Odyssey

The global economic stage is currently set against a backdrop of foreboding projections, each statistic a harbinger of potential tumult. Insights unveiled by the UN Conference on Trade and Development (UNCTAD) paint a picture of deceleration, with global economic growth poised to dwindle to a modest 2.6% in the looming shadow of 2024. This figure, teetering precariously close to the conventional recessionary threshold of 2.5%, is not a solitary omen; rather, it resonates with the ominous echoes of forecasts echoed by the World Bank's "Global Economic Prospects" report, which anticipates a subdued growth rate of 2.4% in the same year, with a marginal uptick to 2.7% in 2025.

Among the myriad challenges that lie ahead, persistent sluggishness looms large, marking the third consecutive year of growth trailing below pre-pandemic levels. The average growth between 2015 and 2019 stood at a robust 3.2%, a stark contrast underscoring the urgency of achieving Sustainable Development Goals by the decade's end. However, this trajectory is not merely hampered by economic stagnation; geopolitical uncertainties cast their ominous shadow over investment and economic progress, with conflict zones disrupting global supply capacities and potentially igniting inflationary pressures.

At the heart of this economic tapestry lies China, a linchpin of global commerce, navigating its own labyrinth of challenges. With growth poised to ebb to a modest 4.5% in the current year, the slowest pace since 1990, the deceleration poses risks for economies closely entwined with Chinese trade. Meanwhile, European banks, overseen by the European Central Bank since November 2014, exhibit resilience in the face of recent shocks, yet remain vulnerable to the tremors of the global pandemic and geopolitical conflicts.

The tide of interest rates, after a prolonged dance with negativity, now embarks on a journey of reversal, presenting a conundrum for fragile credit-rated developing economies. As policies aimed at national security potentially hinder global trade recovery, concepts like "friend-shoring" and "near-shoring" necessitate careful calibration. However, amidst these challenges, investor confidence remains relatively stable, albeit tinged with underlying concerns that could precipitate sudden reactions.

Inflation, historically subdued by monetary tightening, now presents a Gordian knot of complexities, with balancing targets against economic stability emerging as a delicate task. Rapid repricing of assets looms as a specter, capable of reshaping inflation trajectories and monetary policy expectations with the flick of a geopolitical event or supply chain disruption.

Beyond these macroeconomic musings lie tangible concerns within specific sectors. The real estate market teeters on the edge of uncertainty, with borrowers in feeble segments struggling to refinance existing loans, potentially triggering defaults and exerting pressure on lenders. Similarly, the high-tech sector, once the vanguard of economic resilience, now grapples with high inflation, elevated interest rates, and global uncertainties, precipitating a softening of consumer spending and market capitalizations.

In the realm of riskier credit markets, default rates surge across jurisdictions, while banking institutions confront the aftermath of pronounced interest rate fluctuations against a deteriorating economic outlook. Enhanced mechanisms for bank resolution emerge as imperative amid the fog of uncertainties.

In conclusion, as we navigate this intricate economic labyrinth, vigilance becomes our guiding beacon. Prudent policymaking, coupled with resilience across financial systems worldwide, serves as our compass in charting a course through the stormy seas of the impending global financial odyssey.

Navigating the Nexus of Geopolitical Crises: Implications for Global Financial Stability

The current geopolitical landscape, marked by escalating tensions in the Middle East and the Russian invasion of Ukraine, presents formidable challenges to global financial stability. As military conflicts disrupt financial markets, trade, and energy supplies, the intricate interplay of factors necessitates a multifaceted approach to risk management and policy coordination.

The Russian aggression in Ukraine has not only heightened regional instability but has also reverberated across global financial markets. Heightened uncertainty has eroded investor confidence and triggered capital flight, exacerbating volatility in asset prices and currency markets. Of particular concern is the disruption in energy supplies, notably natural gas, which has led to a surge in European gas prices. The ripple effects extend to households, businesses, and energy-intensive industries, compounding inflationary pressures worldwide.

Geopolitical tensions further strain global trade dynamics, causing supply chain disruptions that impede cross-border flows and challenge export-dependent economies. As counterpart risks escalate, financial institutions grapple with diminished market liquidity, amplifying the vulnerability of the financial system to shocks.

Amidst these challenges, policymakers confront the imperative of balancing energy security with climate imperatives and mitigating market fragmentation risks to ensure financial integration. The role of the US dollar in asset allocation warrants careful scrutiny, especially as tighter financial conditions and heightened portfolio outflow risks loom large.

China's vulnerabilities, compounded by property stress and COVID-19 outbreaks, underscore the urgency of coordinated fiscal support for affected businesses and households. Emphasizing risk management and transparency, policymakers must institute robust stress tests and contingency plans to bolster financial institutions' resilience.

Internationally, a paradigm shift towards rule-based policy coordination is imperative. Western countries must synchronize responses to geopolitical risks, collaborate on trade policies, and eschew arbitrary sanctions that undermine international trade and prolong hostilities. Clear communication from central banks and governments is paramount in managing market expectations and averting destabilizing speculation.

Against this backdrop, reforms to the global financial architecture are indispensable. Enhancing the IMF's role as the central institution entails recalibrating its quota formula to ensure equitable representation and bolstering lending facilities to effectively address crisis situations. Strengthened surveillance and early warning mechanisms are vital for detecting vulnerabilities in member economies, while macroprudential policies must be rigorously enforced to forestall financial crises.

Crucially, the financial architecture must align with sustainable development objectives, ensuring that financing for development prioritizes policies benefiting all segments of society. Coordinated efforts to address global imbalances and assess systemic risks are pivotal for fostering inclusive and balanced growth.

In navigating the nexus of geopolitical crises, steadfast commitment to comprehensive oversight, prudent risk management, and collaborative policymaking is imperative to safeguard global financial stability and advance sustainable development goals.

Global Depression and the Phillips Curve -- Is Fed Using the Right Tool?

The probability of a sharp global growth downturn is increasing by leaps and bounds, not only because of the international trade wars, including the Brexit, and US government shutdown, but also mainly due to the global increase of economic imbalances that are exerting their downward impact that may end in a depression. The  slowdown in Chinese economy that grew by 6.6 percent last year, which is China's slowest growth pace in 28 years is but one of the signifiers of this  emerging recessionary and perhaps depressionary tendency. The IMF's global economic outlook presented at the World Economic Forum in Davos, Switzerland, on January 21st, lowered the agency's global growth estimates for  2019  by 0.2 percentage points to 3.5%, which is perhaps far too optimistic. According to the  White House estimate, the economic impact of the government shutdown, which has left about 800,000 government employees either furloughed or working without pay, reduces growth by 0.13 percentage point per week, that should be added to the other signifiers such as the recent decline in the US existing home sales which had their worst month in more than three years this December , and the recent downward sloping trend in the stock price the leading indicators of a recession.

However, according to the most recent report of the US Labor Department, the  economy added 312,000 jobs in December, 77 percent more than the number that was previously expected. This increase, of course,  appears to be positive for consumption, which has been stimulated by the 2018 tax reductions. But  would the consumption, that is fuelled by debt and deficit  prevent the recession?  The  Federal Reserve Chairman,  Jerome Powell, recently announced that the central bank will be patient in raising interest rates. Nevertheless, in a speech in the Economic Club of Washington he understandably expressed concerns  about the ballooning amount of the US debt, that is a harbinger of upward pressures on rates. As well, Mr. Powell,  has also said that the Fed's balance sheet will be reduced significantly from where it is now, which  according to the old macroeconomics textbooks, would be much the same as a leftward shift in the LM curve, which also would be exerting upward pressures on rates, thus reducing the GDP growth.

In short, the Fed's Chairman has  talked about  the strengths of the economy but also has signaled that the monetary authority would remain flexible in its management of interest rates. He has  opined that the link between unemployment and inflation may be loosening  rather than poised for a revival. However, this link, which is in fact a Phillips curve type relationship,  usually becomes operative at the long-term full-employment level of output, that  corresponds to the long-term minimum efficient scale of aggregate production. In this note, I would argue that the US economy is not, and has not been, operating at this scale level, and the current quasi-full-employment level of output  corresponds to the short-term scales, associated with optimizations along the aggregate short-term aggregate average costs.    A failure to realise this fact would result in a costly error.

In fact, the current Phillips curve relationship is the theme that Mr. Powell has developed last October in his speech to  the National Association for Business Economics,in  Boston, Massachusetts, where he stated:

 [The] dynamic between unemployment and inflation is known as a Phillips curve relationship, and at times it can pose a fundamental tension between the two sides of the Fed's mandate to promote maximum employment and price stability. Recent low inflation and unemployment have some analysts asking, "Is the Phillips curve dead?"  Others argue that the Phillips curve still lurks in the background and could reemerge at any time to exact revenge for low unemployment in the form of high inflation.

Mr. Powell attempted to spell out  "how changes in the Phillips curve help account  for the somewhat surprising but broadly shared current forecasts of continued very low unemployment with inflation near 2 percent," and while admitting that   "no one fully understands  the nature of "  changes in the Phillips curve explanatory components "or the role they play in the current context, "  nevertheless,  maintained that;

 I do not see it as likely that the Phillips curve is dead, or that it will soon exact revenge. What is more likely, in my view, is that many factors, including better conduct of monetary policy over the past few decades, have greatly reduced, but not eliminated, the effects that tight labor markets have on inflation.   

In this note I would propose to examine these claims and to suggest that the framing of the unemployment-inflation relationship in terms of the Phillips curve, in abstract, as a guide for monetary policy would be a grave mistake, as there are ample evidence that the macroeconomic imbalances  emanating from the drastic developments  in both the supply side, and the demand side of the economy, operating under uncertainty, have generated a short-term  local equilibrium configuration, well below the long-term full-employment equilibrium. As we argue, again, the recent declines in the jobless rate are in fact due to the rises in contingent employment, and as such cannot be regarded as genuine inflationary pressures derived from a Phillips curve.   

Firms in the supply side have changed their production strategies in response to the various prevailing sources of uncertainties. In fact, an inflation targeting of about 2%  that had necessitated a very low real interest rate of close to zero, or even a negative  rate,  arising from a leftward shift in the aggregate demand in conjunction with the recent unconventional monetary policies have been creating a quasi-equilibrium that in the dynamic literature is known as local equilibrium. This type of equilibrium, as opposed to the global equilibrium, which is stable and can provide an Augmented Expectations Phillips type relationship, is unstable and any resulting pattern of inflation-output gap from it would be sparious.   As we have argued in the past, in recent years  firms,  in response to the prevailing levels of uncertainty, were  shying away from productivity enhancing (putty-clay) investment strategies and aimed at utilizing  various short-term contingency (putty-putty) technologies, in order to satisfy any temporary upticks  in the  aggregate demand. One such uptick in 2018 was emanating from the  tax reductions that was not perceived by businesses  as sustainable over the medium to longer term -- particularly with the crowding out impact of the debt and deficit. As well, the $500bn repatriation of offshore dollar holdings by US companies responding to Mr Trump’s tax reform, does not appear to have had a material impact on the US capital formation, however it has drained the dollar funding markets in Europe and Asia, squeezing credit, which would adversely affect the US external trade balance in its GDP.  .

Therefor, due to various  uncertainties, in fact,  the short-term aggregate supply curve in an  inflation- output space has shifted to the left.  Moreover,  the planning horizons for capital expenditures have shortened dramatically.  As well, firms' choices of technique have shifted towards the  less capital-intensive technologies.  In other words, businesses have been relying on part-time workers to operate more intensively with the existing machinery and equipment, and instead, of investment in new smart technologies,  were introducing more labour overtime, and upgrading the existing production lines with repaired or used equipment. 

Against such background, firms have been utilizing tactical contingent factors of production instead of investing strategically in productivity enhancing technologies. This would imply that the underlying cost mechanism, which determines the short-run aggregate supply curve,  in a price-output space (as opposed to inflation-output space),  was determined by the short-term average cost curve. In a nutshell, the output capacity in the current circumstances  does not reflect  the minimum efficient scale of production, that is  the weak observed  inflation rates corresponds to the Klein (1960) and Berndt and Morrison (1981) definitions of capacity  that are determined by the short-term aggregate average cost curve.  Such an upshot is corroborated by the recent weak commodity prices. In fact, the S&P GSCI (formerly the Goldman Sachs Commodity Index) is more than 7% below its level around 2014, and copper price, often used as bellwether for the global economy due to its wide-ranging industrial applications, is more than 10  per cent lower over the same period.

On the demand side, the recent tightening of  the credit and money markets,  that have shifted the LM curve to the left,  have caused a flattening of the yield curve. At the same time the high level of consumer and corporate indebtedness, the changes in international trade, particularly with respect to trade wars, and the precarious state of the global finance are adversely impacting the various components of the IS curve (i.e. C+I + [G-T]+[X-M]).  Given that the wealth gap have been expanding in recent years it is clear that  the consumption component of GDP  cannot be relied upon to prevent the buildup of recessionary forces, particularly when most of the new employment is of the contingency nature.

The Treasury High Quality Market (HQM) Corporate Bond Yield Curve
Monthly Average Par Yields, Percent

Wealth Gap

Source: Federal Reserve

An  illusion of a buoyant market was created by the January Labor Department report; in which unemployment fell more than forecast in September, to 3.7 percent. This was the  lowest since December 1969. As well, average hourly earnings climbed 2.8 percent from a year earlier.  However,  the fact that the U-6, or underemployment rate, edged up to 7.5 percent from 7.4 percent, despite  a 48-year low jobless rate, provides a powerful verifying evidence for the contingency nature of the recent rise in employment.  Note that the U-6, includes part-time workers who would prefer a full-time position and people who want a job but are not actively looking.

Unemployment Rate and Core Inflation Rate  

In his October speech,  Mr Powell,  contrasted the two very different periods i.e., (i.)  the period 1960 to 1985, which in the literature is known as the Great Inflation era, and (ii.) the period from 1995 to today which includes both the Great Moderation and the distinctly immoderate period of the Global Financial Crisis and its aftermath, as depicted in the above charts.  He argued:

There is a dramatic difference in the unemployment-inflation relationship across these two periods. During the Great Inflation, unemployment fluctuated between roughly 4 percent and 10 percent, and inflation moved over a similar range. In the recent period, the unemployment rate also fluctuated between roughly 4 percent and 10 percent, but inflation has been relatively tame, averaging 1.7 percent and never declining below 1 percent or rising to 2.5 percent. Even during the financial crisis, core inflation barely budged. As a thought experiment, look at the right panel and imagine that you could see only the red line (inflation), and not the blue line (unemployment). Nothing in the red line hints at a major economic event, let alone the immense upheaval around the time of the global financial crisis.

This breakdown of the Phillips curve relationship into two periods clearly demonstrates  that the current full-employment output does not correspond to the long-term minimum efficient scale, since  had the economy was operating close to its global potential output,  Phillips curve would have become operative over the later period. 

Showing the results of  Fed's estimates of the coefficients of Phillips curve, based on a  rolling 20-year-sample, that starts  from 1965 to 1984 and ends at 2017,  Mr. Powell  maintained that:

 "during the Great Inflation samples, the value of coefficient of the lagged inflation rate was near 1, meaning that higher inflation one year tended to translate almost one-for-one into higher inflation the next."   

This is of course  what econometricians call nonstationarity inflation series, that  stems from rational expectations. The Fed's estimates show that the so-called Phillips curve coefficient on the lagged inflation rate has  declined to about 0.25, "meaning that roughly one fourth of any rise or fall in inflation carries forward".   As we have argued  the reason that inflation has become stationary in the recent times,  is precisely due to the fact that the aggregate  output gap does not currently corresponds to the aggregate minimum efficient scale of production. That is to say, the recent inflation rates were the results of the offsetting of deflationary pressures  by unconventional monetary policies. 

The Fed's estimated coefficients of the labour market slack in the Phillips curve (defined as the unemployment rate minus the current estimate of the natural rate of unemployment at each point in time)  have also declined. This coefficient drops from 0.5 percent to near zero.  Thus the  Phillips curve  that, in Mr. Powell's words, was "relatively steep in the Great Inflation samples" is nearly flat in the most recent sample.  Thus, according to him:

The baseline forecasts of most FOMC participants and a broad range of others show unemployment remaining below 4 percent for an extended period, with inflation steady near 2 percent. I have made the case that this forecast is not too good to be true and does not signal the death of the Phillips curve. Instead, the outlook is consistent with evidence of a very flat Phillips curve and inflation expectations anchored near 2 percent. 

Of course, the Chairman warns  that such forecasts are rarely come to pass, and this is why  the FOMC

"takes a risk management approach, which has three important parts: monitoring risks; balancing risks, both upside and downside; and contingency planning for surprises".  

Based on our analysis, we argue that the possibility of an emerging recessionary dynamics emanating from the current imbalances are quite real, and any risk management that relies on monitoring of lagged data on inflation expectations and wage settlements may not be of much use.  In fact, such monitoring-based risk management would be similar to Messrs  Greenspan and Bernanke's idea  that   'monetary policy  tools would be  far more effective in cleaning up the mess after bubbles burst'! which proved to be quite a disaster.

 In fact, Mr. Powell has offered three examples of  risks: First;  the possibility that inflation expectations surge again? Second; the "revenge of the Phillips curve" scenario, or the possibility that inflation pressures move up more than expected in a hot economy.  Third, the possibility that the natural rate of unemployment to be lower than expected. Our old textbook models of the Expectations  Augmented Phillips Curve  suggests that all these three risks are exactly of the same origin, in the sense that they are all emanating from  similar shocks on the various components of the Phillips curve. Given that short-term aggregate average cost curve is incapable of generating a stable Phillips curve, these risks need to be evaluated in a more sophisticated framework.

The Fed's risk-management  for the  first two of these  cases include  monitoring survey- and market-based proxies for inflation expectations  as well as monitoring of a wide array of wages and compensation data.   The monitoring aim is to look for a material shock on inflation expectations  and/or wage costs. As for the possibility of a lower natural rate the chairman  believes that it would be the flip side of the "revenge of the Phillips curve" risk, which would be manifested through lower inflation rate.   Thus, to balance these risks the Fed is opting for  a  path of gradually removing accommodation, while closely monitoring the economy. "As always, there is no preset path for policy," Mr. Powell has stated. "And particularly with muted inflation readings that we've seen coming in, we will be patient as we watch to see how the economy evolves." As we have  argued if the economy is indeed exhibiting a local equilibrium corresponding to the aggregate short-term average cost, the monitoring of inflation expectations will not provide any useful information, because the Phillips curve would not be operative over the various local optima.

Slope of the Fed's Estimated Phillips Curve

The shaded area is the 70 percent confidence interval. 

Source: October 02, 2018 Monetary Policy and Risk Management at a Time of Low Inflation and Low Unemployment, Chairman Jerome H. Powell Speech At the "Revolution or Evolution? Reexamining Economic Paradigms" 60th Annual Meeting of the National Association for Business Economics, Boston, Massachusetts

As the above Fed chart shows, the slopes of the Phillips curve in recent years, based on the Fed's rolling 20-year-sample estimates,  have been very close to zero. Of course, given the somewhat chaotic nature of post-financial crisis one may have certain doubts about the accuracy of such estimates. Nevertheless, and more importantly, the hypothesis of a recession (i.e., a negative slope) cannot be rejected at 95% confidence level (note that the shaded area in the above chart depicts only the 70% confidence level). In fact, given the enormous expansion of the Fed's balance sheet the appearance of such low  estimates of the coefficient of the Phillips curve since 2012,  are  another evidence for the fact that the economy has been operating below the measure of the full-employment output gap -- that is associated with the long-term  minimum efficient scale. In other words the quasi-vertical aggregate supply curves associated with different short-term aggregate average cost curves are not the real long-term aggregate supply curve that  is determined by an  optimal capital formation trajectory.

The US  historical Phillips curve  type inverse relationship between the unemployment rates and wage  inflation rates;
2009-2018  

As the above chart shows, the employment cost inflation has increased with the decline in unemployment rate over the past 10 years . However, this increase in the employment cost represent the rise in short-term average cost. In the normal circumstances and in the absence of uncertainties,  with increased capital formation of putty-clay type and new firms entry, the theory suggests that, the average short-term cost would be shifting down along a U-shaped trajectory of the long-term average cost curve, and towards the minimum efficient scale.  Such a shift still  is still absent in the data.

As we have argued, instead of investing in productivity enhancing capital formation, the recent data shows that firms are resorting to share buybacks. For instance, from 2015 to 2017 the restaurant industry spent 140 percent of its profits on buybacks, meaning that it borrowed or used its cash balances  to purchase its own shares. The corresponding percentages for retail and food-manufacturing industry  have been nearly 80 percent  and 60 percent of their profits respectively. All in all, public companies across the American economy spent roughly three-fifths of their profits on buybacks in recent years.

Shares of gross domestic product: Gross private domestic investment

Real Gross Private Domestic Investment: Fixed Investment: Nonresidential: Equipment
Percent Change from Preceding Period, Quarterly, Seasonally Adjusted Annual Rate  

As well the extremely low levels of the real interest rates have distorted the capital allocation across industries in favour construction industry. Growth rate in the construction employment at 4.9% from October 2017 to October 2018 was nearly triple the 1.7% increase in total nonfarm payroll employment. In fact, investment in construction rose at annual growth rates of between 11% to 14% over  2012 -2015,  7% in both 2016 and 2017, and  3% in 2018, reflecting the impacts of the imposed tariffs on steel, aluminum, and   lumber, and some other imported construction materials.

To be prepared for a global depression there is an urgent need for a global coordinated response.

How deep would be the recent plunge in the stock market and how far the slowdown would last ?

On Wednesday, December 19, the Federal Reserve announced a 25 basis-point rate hike. In response, the Dow Jones Industrial Average and other major indexes tumbled. This development prompted several of my students to reach out, asking for an update on my July note, in which I had written:

“Based on theoretical considerations, the probability of a sharp economic slowdown has increased by an order of magnitude. There are reasons to believe that the short-term aggregate supply curve, as well as long-term potential output, have begun shifting to the right. At the same time, due to ‘borrowing from the future’ and the persistence of large budget deficits, aggregate demand is expected to shift leftward. The result would be the onset of recessionary forces whose amplitude could surpass those of the 2008–09 downturn.”

I must confess that last February—contrary to my broker’s advice—I decided to exit equities. As markets continued to climb, I had to endure his frequent complaints about my supposedly unwise decision. Yet in this note, I wish to reaffirm my argument: we are on the verge of a major and unsettling correction in the Dow, potentially down to the 14,000 level, which could herald the emergence of another financial crisis.

It should be emphasized, however, that markets rarely move in straight lines. Some short-term reversals of recent declines are to be expected, since—as the old saying goes—even a dead cat will bounce when dropped from a great height. More broadly, the economy may drift sideways for years, and we may well be facing a stagnating market through 2026, and perhaps beyond.

 

Dow Jones - 10 Year Daily Chart

To be sure, the Fed has been under scrutiny in recent months for its efforts to normalize monetary policy.  It had kept its benchmark interest rate anchored near zero for seven years, and in numerous occasions,   in these notes, we have discussed the futility and the risks of the QEs which have been exacerbating the global imbalances.   We have argued for a new global financial order based on a meaningful restructuring of global debts, and a fundamental rebalancing of the global imbalances.  Of course, we have been aware  that the Quantitative Easing policies (QEs) had provided some artificial support for the stock market, keeping it aloft, and we have been expecting that  with the onset of  Quantitative Tightening policies (QTs) we would  be seeing some opposite effects. However, these effects would pale in comparisons with the dramatic correction to be expected in response to  a rapidly deteriorating structural imbalances, associated with  high levels of governments and corporations debts, inflated central banks balance sheets, and trade conflicts.

It would be a misguided argument, drawn from a conventional stabilization policy analysis, to maintain that a correctly formulated set of QTs could somehow prevent the danger of the upcoming financial crisis. We  have argued that the impacts of conventional stabilization policies, including the unorthodox QEs and QTs  in a disequilibrium context, in which the equilibrium conditions in virtually all markets have been highly distorted, are not easily quantifiable. We have argued that the conventional methodology for calculating the output gap would be misleading in the current situation  in which, due to the prevailing  uncertainties, firms investment strategies  are focused on the utilization of contingent labour and contingent capital.

Unfortunately, the appearances, from time to time of,   quasi- equilibrium conditions, which have been local and highly unstable, have been misinterpreted by many analysts, including the policy makers, as the long-term global equilibrium. Although  such short-term equilibria, arising from agents' optimizations, under obstreperous QEs, had provided the illusive dynamics of a healthy growth, with the associated  increase in employment and consumer confidence, in reality they  were based on highly unstable supply and demand functions. Expectations of a soft-landing, in such a flimsy circumstances are a wishful thinking that always, and to a large extent,  aggravate  the severity of a crash. 

The Fed rate hike came in a background of  softening global growth,  relatively low inflation and  volatile stock market, with the monetary authority  expecting two more rate hikes in 2019,  as compared to their previous forward guidance of three increases next year.  Also, the Fed statement sounded  slightly more nervous, as it did not include  the qualifier 'some' in its previous statement, stating:

“The Committee judges that some further gradual increases in the target range for the federal funds rate will be consistent with sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective over the medium term.”

Moreover, Chairman Jerome Powell said that he would keep reducing Fed's balance sheet by up to $50 billion per month. It should be noted that since the beginning  of the QT  process in October 2017, the Fed has trimmed its dangerously  inflated balance sheet by  a meager $365 billion to $4.14 trillion, relative to what is really needed, which is a virtually impossible to attain reduction of some $3 trillion.  According to the chairman:

“We thought carefully about how to normalize policy and came to the view that we would effectively have the balance sheet runoff on automatic pilot and use monetary policy, rate policy to adjust to incoming data. I think that has been a good decision,”

Total Assets of the Federal Reserve ($million)

  

Year-on-year change in  the Federal Reserve balance sheet ($000)

 Some analysts were quick to blame President Trump for this sorry state of affairs. According to CNBC;

The end of 2018 makes clearer every day that the president himself represents a fundamental problem for America's economy and national security alike. Trump's erratic behavior and weak leadership have unsettled Wall Street and Washington alike — and there's every reason to expect things will get worse. :

While, I am not certainly a fan of president Trump's shenanigans and at times his irrational behaviour, nevertheless,  I find this kind of accusation bordering to nothing more than a cheapshot. On the other hand it is hard to understand  Treasury Secretary Steven Mnuchin's declaration on the weekend of December 22, that markets have enough liquidity for lending. Yes, it is true that according to Goldman and Sachs data the large Banks have now 39% more liquidity as compared to 2010, and the comparative rates for trust banks and regional banks in the US are 73% and 71% respectively. However, in  a world with close to $1.3 quadrillion of financial debt instruments, including derivatives, and a global GDP of close to $90 trillion these percentages would be meaningless, particularly  in the event of a major financial crisis, when the Fed balance sheet has increased close to 500 percent, and the US public debt has increased by about 63% over this time span.

The problem is that with the imminent appearance of a severe recession the policy makers may decide to resort to another round of QE, which unfortunately would be even more ineffective than the previous rounds. Furthermore, with the federal funds rate target at a range of 2.25 percent to 2.5 percent, the Fed will not simply have enough ammunition for an effective interest rate response. The fact is that the discussion about the level of neutral rate at this juncture is a red herring. Nobody  can predict the new long-term equilibrium conditions before the cleansing of all excesses.

Economic growth, has already exhibits a decline from its 4.2 percent rise in the second quarter, and it is clear that it will be slowing  dramatically in 2019, as not only the impacts of artificial boosters such as tax cuts and spending increases wanes, but more seriously as the global uncertainty that is flared up already, triggered by Brexit,  European financial situation, debt overhang in China, massive global corporate debt  and the trade war exerts its impact.  These impacts could be magnified by the rise of artificial intelligence-driven electronic trading as it accelerates  financial transactions, allowing them to be conducted across multiple markets at the same time. Thus, a possibility of an emerging sudden deflationary dynamics cannot be ruled out.

The European Saga

According to the European Financial Stability Review, November 2018;

The euro area financial stability environment has become more challenging since the publication of the previous Financial Stability Review in May. On the positive side, a growing economy and improved banking sector resilience have continued to support the financial stability environment in the euro area.

As for the Brexit, the Bank of England has already warned Britain would be tipped into a recession worse than the financial crisis in the event of a no-deal disorderly Brexit. The Bank's analysis of various EU withdrawal scenarios, shows that in the event of a disorderly Brexit, Britain's GDP could fall by 8%. The Bank of England has also investigated the impact of an stress scenario on the British financial institutions.  The scenario assumes, gross domestic product would fall by 4.7 per cent in the UK and 2.4 per cent worldwide, while residential property prices in the UK would fall by a third and the BoE’s base rate would rise to 4 per cent.

Under this relatively optimistic  scenario, British lenders would be able to withstand a global recession more severe than a disorderly Brexit.  The test indicates that British banks would be able to keep lending to customers even if there were a major financial crisis, while continuing to pay billions of pounds in fines and compensation to address wrongdoing.   “The test shows the UK banking system is resilient to deep simultaneous recessions in the UK and global economies that are more severe overall than the [2008] global financial crisis,” the BoE wrote in the introduction to the stress test results. Despite, the fact that the results appear to have been presented to appease the bickering Brexiteer politicians,  still  the Bank's efforts are more encouraging than those of the Fed, which perhaps being worry of provoking President Trump's wrath  has been resistant to conduct broad-based, macro stress tests on its systemically important financial institutions (sifis).

Some central bankers are more vocal with regard to their  concerns about the upcoming financial crisis. For instance,   Bank of France governor Francois Villeroy de Galhau  has stated: “To measure the global impact of shocks, we need in particular to have macro stress tests of liquidity, including for investment funds."   In France, where national debt is set to hit 98.7 percent of GDP in 2018, president Macron, who thought pursuing a Gerhard Schröder's type of more business-friendly reforms,  would be improving its long-run growth potential suddenly faced with the so-called ‘yellow vest’ protests. Outraged by his wage and welfare reducing policies, under a highly skewed distribution of income in favour of rich, Gilet June  protesters torched cars, attacked shop windows and clashed with police. The president was forced to deliver a much-watched mea culpa in mid-December to mollify protestors, and offered a handful of concessions; raising the minimum wage and slashing some taxes that would push next year’s fiscal deficit well beyond the EU-mandated threshold of 3.0% of GDP.  The French government has warned of slower economic growth as a result of the protests and Bruno Le Maire, the country's finance minister,  has stated that the current protests would cost France 0.1 percentage point of quarterly economic growth. France growth  rate was a meager 0.4 percent in the third quarter from the previous quarter.

With large French and German banks owning billions of Italian sovereign debt, including BNP Paribas  €9.8 billion, BPCE   €8.5 billion and Crédit Agricole €7.6 billion, at the end of 2017, the chronic financial problems of Italy is the prime trigger for a financial crisis that could spread across the EU. These problems include  Italy's huge accumulation of nonperforming loans on its banks’ balance sheets, amidst of the efforts by its populist government to spend money, that it doesn’t have, to improve the country's long lasting lethargic growth  Rome's debt is more than  €2 trillion and 131 percent of its GDP, the second highest in the EU after Greece.

And Finally China's Slowdown

In China a weaker credit growth, slowing global demand and higher U.S. tariffs on Chinese shipments  are affecting its investment and export prospects, and thus its GDP.  Her GDP growth slowed to 6.5 percent in the third quarter, the weakest pace since the global financial crisis, and with the recent data  showing softness in November factory output and retail sales, it is quite clear that the economy is already slowing down. China's official Purchasing Managers' Index (PMI)  fell to 50, from its previous level of 50.2. A reading below 50 indicates that an economy is contracting. The last time China saw a no-growth headline figure was in July 2016:

China's  domestic  economic imbalances are serious.  The country's regional banks are heavily incentivized to keep loss-making companies alive. To avoid  the appearance of  loan losses, the banks extend loans to zombie firms,  allowing them , in the short term, to maintain an illusion of profitability.  The asset quality of many banks  are quite poor, and  they rely heavily on interbank borrowing as source  of funding, which can dry up fast when it is most needed during a financial crisis. For instance,  according to  data from 244 Chinese lenders,  the share of deposits in total liabilities at regional banks fell from 73 per cent to 64 per cent between 2013 and 2017.   Once banks levering up through non-deposit sources, the cost of funds increases and the odds for an interest rate shock or a liquidity shock rise substantially.

The country's debt levels are soaring  from 140 percent of GDP in 2008 to more than 260 per cent now. Despite  four reductions to banks' reserve requirements, tax cuts and increased construction spending, lending remains tight and money supply now sits near record lows.