Macro Factors and their impact on Monetary Policy, the Economy, and Financial Markets

The Business Cycle Is Not Dead

It seems that after years of expecting inflation to rise to its 2.0% target the Federal Reserve and many economists have concluded it’s just not possible. The reasons most often cited are the Amazon Affect, Artificial Intelligence, weak wage growth, years of excess capacity, and transitory factors like the mobile phone price war in March 2017. In September Federal Reserve Chair Janet Yellen said that the inability of inflation to rise to the Fed’s 2.0% target was “a mystery” and that the Fed clearly did not understand why. This is an extraordinary public admission by a Federal Reserve Chair but echoes the sentiments of private economists who have also been mystified by the lack of inflation after the unemployment rate fell to 5.0% in September 2015. It also explains why the Federal Reserve increased its 2018 estimates for economic growth, lowered the estimate for the unemployment rate, but left its forecast for PCE inflation and Core PCE inflation unchanged for 2018 and 2019.

One factor that certainly played a role in keeping inflation tame longer than expected according to the Phillips curve was the plodding nature of the recovery since it began in June 2009. Of the eleven economic expansions since 1949, the current recovery is the weakest, as measured by annual GDP growth during each expansion averaging just 2.0%. If GDP growth persists through the end of 2018, which seems very likely, this recovery will be the longest on record at 38 months. A number of the expansions since 1949 that registered much stronger annual GDP growth were also far shorter in terms of time. This occurred because much stronger growth contributed to a more pronounced business cycle leading to higher inflation and a response by the Federal Reserve that included higher interest rates and tighter monetary policy. In the shorter but stronger recoveries since 1949 the Fed stepped on the brakes too hard which led to the demise of the expansion and recession.

The 37 month expansion that ended in 1970 was preceded by an increase in the federal funds rate from 5.80% in November 1968 to 9.20% in August 1969. The Federal Reserve was responding to a late business cycle jump in CPI inflation from 2.5% in April 1967 to 4.7% in December 1968. The 37 month expansion that ended in 2001 was accompanied by a pick-up in inflation from 2.0% in June 1999 to 3.7% in June 2000 which led the Fed to increase the federal funds rate from 4.75% in June 1999 to 6.50% in June 2000. The 1970 recession was precipitated by an aggressive tightening by the Federal Reserve (a 58.6% increase in the fed funds rate (9.2 minus 5.8 / 5.8), while the 8 month shallow recession in 2001 was preceded by a far less aggressive change in monetary policy (36.8% = 6.5 minus 4.75 / 4.75) but was exacerbated by the unwinding of the tech bubble.

The lesson from economic history is whether an expansion was strong or long lasting eventually the business cycle matured to a point that ignited a rise in inflation that was sufficient to evoke an increase in interest rates and a tightening in monetary policy that led to a recession and a bear market in stocks. After years of slow growth since 2009 there is a risk that many economists have dismissed the concept of the business cycle and its role in creating inflation. The fiscal stimulus from the Tax Reform Act will make the economy more cyclical in terms of the business cycle than at any time during this recovery. Inflation has the potential of surprising the Federal Reserve and many economists in coming months since they have thrown in the towel in expecting inflation’s return.