R-star is going to “become an important market theme in the months ahead.”
So said Deutsche Bank’s Matthew Raskin who, in a February 9 note, suggested both markets and the Fed may be underestimating the natural rate due in part to the psychological scar tissue from the financial crisis. As Goldman’s Praveen Korapaty and William Marshall put it last week, “investors exhibit a strong recency bias and tendency to overweight Fed messaging when forming expectations” for r-star.
“We think the 2ppt drop in estimates of r-star following the GFC rests on shaky ground,” Raskin wrote. “Mechanically the drop is a product of the sluggish post-GFC recovery with short-term rates at the zero lower-bound, but a big part of that was household deleveraging and elevated risk aversion coming out of the GFC, which we don’t see as enduring features of the economy going forward.”
This is a critical discussion, and it doesn’t get enough attention, presumably because it’s often couched in unnecessarily esoteric terms. Economists tend to present it as an “inside baseball” debate — an important, but impenetrable conversation centered around academic arcana. That’s unfortunate, and especially so in the 2020s.
Consider the implications of a misestimated, unintentionally lowballed r-star in the context of the “structural” labor shortage Jerome Powell mentioned last week, and, more specifically, what a structural worker shortage would mean for pay and consumer prices — namely, very elevated wage growth in perpetuity and very stubborn services sector inflation.
Then think about the inflationary implications of geopolitical shifts and geostrategic realignments, and how inflation traders seem “blind” to those dynamics, as Zoltan Pozsar suggested+.
And also think about the extent to which societal trends and domestic political winds are turning against shareholder capitalism and against a return to the pre-pandemic disinflationary regime which, while serving to suppress consumer prices, was accompanied by lackluster growth outcomes in the developed world and widening inequality.
All of that’s inflationary and all of it suggests the voting public in advanced economies may no longer be willing to trade cheap goods and low measured inflation for lethargic growth, particularly in the US where, during decades of purported “price stability,” prices for things people actually need, like health care and education, were anything but stable.
Remember your Piketty: Wider inequality can be traced to returns on capital outstripping growth. The public now seems aware of the concept, even as voters surely haven’t read Capital. Reducing inequality means engineering hotter growth, lower returns on capital, a wealth tax, or some combination of those three things.
Central bankers are (understandably, for now) erecting a straw man every time they approach a lectern: Price stability is a prerequisite for a working economy, they say, and 9% inflation isn’t price stability. 8% inflation won’t work either, nor will 7%, and so on. But everyone agrees with that. The question isn’t whether we can live with 9% inflation in developed economies. The question is whether voters are willing to accept 3% inflation, or even 4% inflation, if it means a livelier economy, hot wage growth and better overall outcomes on Main Street.
If you’re inclined to scoff at that, I’d point you to the extensive discussion in my monthly letter+: Main Street in the US has been dying a slow death for the entirety of the low-inflation period. It’s (obviously) not that low inflation is killing everyday people. Rather, it’s that some (but not all) of the dynamics which enabled low inflation had unhappy side effects for the middle-class in advanced economies, even as those same dynamics decreased poverty dramatically around the world.
Of course, the low-r-star environment presented a number of vexing quandaries for central bankers, so a higher r-star isn’t necessarily a bad thing. But I’d suggest the circumstances outlined above, particularly to the extent they’re related to distortions brought on by a pandemic and a generalized “awakening” among everyday people to the fact that the last three decades haven’t exactly constituted a golden era for Main Street despite low measured inflation, aren’t necessarily what policymakers had in mind when it comes to mitigating a low r-star and/or “solving” the low-r-star “problem.”
Also, note that if r-star is higher than policymakers believe, then current monetary policy isn’t as tight as you’d be inclined to think. That could explain why the only parts of the US economy which seem to be responding to Fed hikes are those which are directly impacted by them (i.e., housing).
Everyone’s waiting around on the impact of legacy tightening (“long and variable lags”) to show up across the economy, but if r-star is materially higher than the Fed thinks, we’ll be waiting a long time — specifically, we’ll be waiting forever unless the Fed marks up its estimates for the natural rate and adjusts policy accordingly.
All of that to say this: At some point, the longer-run dots may need to move up. If and when they do, it’ll mark a sea change — an acknowledgment that we really aren’t in Kansas anymore, to quote Dorothy. And everything that means for policy, the economy and markets thereafter, good, bad and in-between.
“This issue isn’t yet in much focus, but if [US] growth and the labor market remain resilient, it will be,” Deutsche’s Raskin wrote. “This would have big implications for longer-run rates,” he added, noting that it’d “raise yields across the curve via the impact on expected short-term rates and by boosting term premium, given higher r-star would reduce the likelihood of hitting the ZLB and of future Fed QE to provide monetary stimulus.”
Wow! Really excellent post! I’m actually going to share it with my wife, who thinks I’m a bit of a wild man in regard to investing. Notwithstanding the partial truth of her assessment of my investing style, there’s nothing wrong with her being made aware of knowledge inputs that may inform my ongoing thoughts about investing and the investment environment.
This article recalls for me Bernanke’s approach to tightening when he raised the Fed Funds rate 17 times over the course of two years, from 1.0% to 5.25%. I recall at the time he just kept on tightening, mostly in 0.25-point increments for a long spell, though some were in larger increments. At the time I did not understand his mojo. It was kind of aggravating to me because each quarter point move suggested the process was still incomplete. Then it remained elevated into 2007, after which we enjoyed about 15 months of a more reasonable economy when the market actually crashed in a big way at the end of 2008. What a nightmare! But the world was (eventually) a better place thereafter.
We’re staring down the barrel of a deflationary cannon. In 5 years, we’ll look back and think it was crazy that some people were worried about structural labor shortages. Certainly not all services will be replaced by AI, but enough will be that once again, the working class will be the ones taking the brunt of the cannon shot.
Companies are salivating at the idea of replacing more people with the reliable (unless the servers go down), cheap labor of AI. Fast food restaurants already practically force people to use their phones to place orders. Airlines make you jump through hoops to get to an agent. AI will only hasten that trend and help it spread to other areas of the economy.
Inequality will get worse, but maybe that’ll free up labor in areas like healthcare since the boomers will need care when they reach old age. Then again, maybe a nice, friendly chat with AI will give them the companionship so many people in nursing homes could use? Maybe that’s a bit dystopian, but if you’ve ever visited a relative in the nursing home, the experience for many residents is incredibly isolating and depressing.
Sorry, I know I keep banging the drum for AI, but the implications of what’s coming will reach across society and the economy. For what it’s worth, I think the natural rate will stay near 0 with occasional blips, especially as the world’s population growth slows.
Maybe the vast majority of companies are holding off investing in AI: https://hbr.org/2023/01/stop-tinkering-with-ai.
Maybe you’re correct that in unlike the promise of biotech in the late ’90s, AI will revolutionize economies across geographies and scales in just five years, causing a “deflationary cannon.” Or maybe in two or three years we’ll wonder why we didn’t expect the CRB and WTI to double from current levels and uproot current inflation perceptions and theoretical expectations in a completely different way. I don’t know.
The advice for how to approach AI in that article is sound, but it’s already outdated. The publicly-available AI tools will reduce investment costs for companies to deploy AI by orders of magnitude. The main issue right now is the amount of computing power required (which is no small issue), but that’s where I think we’ll see substantial investment in data centers. Other than that, companies should absolutely take heed of what the article is saying.
Also, I should clarify that I don’t expect that this will create a dystopian hellscape where no one can find work because AI does everything. My expectation is that it’ll be enough where we won’t need to worry about labor shortages in the services sector which will limit wage pressures. On the flip side, the winners will be the knowledge workers who figure out how to use AI to dramatically increase their productivity.
Going back to the natural rate and inflation, I do believe that housing costs will continue to rise. Ezra Klein had a good op-ed recently about how construction isn’t getting any more efficient. AI won’t be able to build houses (although they might be able to draw up the blueprints) or navigate local zoning rules any time soon.
DJ. I agree with Dave, well said. I apologize if I’m wrong about this, but it seems you have recently joined our merry band on HR. I have really enjoyed your thoughtful comments. I look forward to more, especially on AI.
Well said, DJ. I’ve documented relatively simple AI programming, and it’s very powerful stuff. We’re just breaking the ice with it. A flood of AI is coming. The Chinese will be right there with us, or a little bit behind us. But competition will be exercised in business and in tools for international one-upmanship, and conflict, which will drive more rapid AI proliferation.
R Star. I had to visit the dictionary. An education in every post.
So, we’ll be revisiting this one.
“ the longer-run dots may need to move up. If and when they do, it’ll mark a sea change”
And the sea change will manifest. . . how, for example? Hotter, more equitable economy? Will we be measuring the change with geologic time?
Thx, again!
I agree. Excellent piece.
Excellent piece for sure and the 3-4% “target” for inflation as long as real wages (aka Main Street) benefit would be a positive and likely outcome if there remained an absence of political interference. However, I fully expect the Republicans to weaponize inflation as soon as it comes back driven by the higher natural rate. It will be their “reason” for crashing the federal government and global economy. I doubt we make it out of the year before that happens. At this point I put the chances of a government shut down at better than 50/50 and an intentional default at 10%.
Things have been silly for the past decade. We’re about to enter the ludicrous decade. The good news is all of this is normal for epochal societal shift driven by new dominant communication paradigms. Thing get better after the ludicrous decade.
First, it seems to me your drawing/inages have taken quite a pretenatural feel, almost Assisted? (please keep sliding in the classic photo art too!)
Second: great piece as macro is Investing (vs Trading). Demographics are History (watch China) and the US is definitely starting a post Boomer age (hastened by Covid). It will be interesting if 2024 punctuates the change from Boomer in Charge to ?
It’s unclear to me that if (smaller high demand workforce) wages go up, but technology (solar, batteries, robotics, AI) deflates costs, do we really have inflation? Maybe predictably yes if commodities are the artificial mechanism to extract rents…
I loved your down- trending graph of rates. That chart is the mirror of the rise in my portfolio for the same period. I bought nothing but seasoned discount USTs, mostly on 60% margin for 10 years before I finally bought my first core stock, AT&T (pre-breakup). I’ve continuously held 60-70% fixed income since then (25% tax-exempt). It still earns more than equities.
Home run.