Politics & Policy

The Yield Curve Is Outnumbered

This is a Schumpeterian expansion with legs.

A debate has opened on Wall Street regarding previous Federal Reserve rate hikes and their likely influence on the growth outlook. Those who are generally bearish on the outlook point to the fact that the Fed has hiked rates 17 straight times, with nearly every maturity on the Treasury yield curve now priced to yield less than the prevailing fed funds policy rate. As such, the bear camp argues that the Fed already has overshot and that a significant growth slowdown (or even recession) is on the way.

 

Standing in stark contrast, however, are several important market and economic indicators that suggest the Fed remains accommodative: near record commodity prices, relatively low real short-term interest rates, rising monetary velocity, tight credit spreads, and robust growth in business loans.

 

In other words, the yield curve is outnumbered.

 

I continue to believe that the growth (and profit) outlook is being underestimated and that the Fed’s expectation of sub-trend growth and receding core inflation will not come to pass.

 

The headline consumer price index is up 4.3 percent year-to-year while the “core rate” has risen 2.6 percent. While year-to-year trends in core inflation could still be considered “low,” core CPI advanced at a 3.7 percent pace during the last four months (annualized, not compounded) — the fastest since 1995. Prices of non-energy services have increased at an annualized rate of 4.5 percent during the last three months and 3.5 percent year-on-year. Moreover, headline inflation rates tend to lead the core rates by 6 to 22 months. So the still-wide gap between headline and core inflation (1.7 percentage points) suggests that core inflation likely will be headed higher during the next year.

 

While this ultimately could set the stage for a Fed overshoot in 2007, I continue to believe short rates are far from a level that would disrupt growth. Prior to the last two recessions, the real fed funds rate (using the GDP price deflator) rose well above 4 percent. This would require the equivalent of a funds rate at 7 percent or more given today’s current inflation trends, so rate hikes above the 5.25 percent level shouldn’t prove as disruptive to growth and investment as widely assumed.

 

In his critique of the Marxian model, late economist Joseph Schumpeter argued that capital accumulation was driven by profits and bank credit, the wellspring of entrepreneurial capitalism, innovation, and wealth creation in the dynamic capitalist system. With profits standing at an all-time record relative to GDP in the U.S., and bank credit expanding at a two-digit pace, I continue to expect the industrial economy (which expanded 6.6 percent at an annual rate during the second quarter) and non-residential investment spending to continue to advance at a robust pace. Record profits and productivity growth also should help boost labor demand and incomes, since these variables are all co-integrated over time.

 

In fact, the low level of initial jobless claims suggests that unemployment rates will remain low and that wage rates will continue to rise. It is also worth pointing out that non-supervisory production worker wages advanced at a 4.6 percent annual pace during the second quarter, the fastest since late 1997 (which was the beginning of the labor-market boom, not the end). While non-supervisory wage growth remains below the CPI inflation rate on a year-to-year basis (3.9 versus 4.3 percent), it isn’t below it by much — despite the fact that headline inflation rates remain nearly two standard deviations above their two-decade trend. The 4.5 percent annual growth in average weekly earnings surpasses inflation any way it’s measured. In my view, this says something about the tightness of the labor market.

 

Further Fed policy firming is not only appropriate, it will help push non-supervisory wages back above headline inflation. In addition, any reversion to the mean regarding profit/productivity and labor compensation should limit the severity of the consumer “slowdown” now underway, meaning above-trend growth should continue absent some unforeseen policy error.

 

This Schumpeterian expansion — built on the back of low tax rates on capital, record profits, and strong bank credit — continues to have legs.

 

– Michael T. Darda is the chief economist and director of research for MKM Partners, an equity execution and research boutique located in Greenwich, Conn. He welcomes your comments here.

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