The US economy in 2015: Punch drunk, great DJ, but where is the Exit?

Fed Chairman William McChesney Martin once said  ( - apparently in a speech in 1955, and I paraphrase here), that that whole point of monetary policy should be to remove the punch bowl just as the party gets started". In the spirit of Christmas panto, and to continue the analogy, the drinks are now pretty strong (maybe shots?), and what's more, a talented DJ has just arrived and (s)he seems to really be dropping some great tunes and the party is beginning to look like it will roar!

The really interesting part to this story though, is what happens next? Does the host suddenly decide to hide the punch bowl and threaten to call the police to really put the dampers on things; or does the DJ run out of interesting tunes to drop because (s)he only brought a limited number of tunes; or is the DJ so good that it gets the neighbors involved to really spread the joy and make the whole party rock, with the distinct possibility that the police will show up in force, but only much later?

Those of you who know some economics will recognize the characters here: the DJ is the price of oil, the police represent inflation and the host is the central bank, with the punch bowl being accommodative monetary policy.  We all know that all 3 ingredients make the best parties - good drinks, often supplied by the host, no likelihood of police presence (perhaps because the neighbors are compliant and/or fun loving people) and a good selection of music to really get people in the right mood.

Now the economics.  OK, the precipitous fall in oil prices is good for most countries, and is even moderately good for the US, although it will definitely deliver some pain in some regions (like my own - South Texas).  But after watching an interview by the illustrious Simon Hobbs on CNBC, where he talked about signals that we are approaching the “end of the cycle” I got to thinking about whether Simon was correct, and whether the current oil price decline might soon sow the seeds of the end of the growth phase of the current business cycle.

So let’s look at some stylized facts:

i)   Business cycles typically last between 4 and 10 years;

ii) When the previous recession had, as it’s proximate cause the banking sector, research (by Reinhart and Rogoff) shows that the recovery is anemic;

iii) Central banks are pretty much exclusively focused on inflation and inflation targeting plus slack in the labor market these days; and

iv) Oil price rises tend to slow economies down.
So let’s see where we are on each of these stylized facts. 

First, given that these 4-10 year periodicities are roughly right, and I see no reason to believe that they are not, then as we recently passed the 5 year mark of the emergence from recession, we are definitely in the mid-stage if not heading into the late stage of the business cycle.

Second, the recovery from the previous downturn has been anemic, as anticipated, but this is partly due to the very tight restrictions on bank lending – these are now being relaxed, plus although the housing sector has not been wonderful of late, there are now signs that people are trying to move before the Fed increases rates sometime in 2015. Fanny Mae and Freddie Mac just announced a loosening of these lending standards, and the banks are already beginning to try to get better returns on their balance sheets.  

Third, central banks are expected to keep interest rates low for an extended period of time, principally because with falling oil prices inflation is not perceived to be a threat, at least if measured by core inflation, which excludes the effects of the volatile food and energy components of the CPI.  But in the US, the focus has been on the labor market and unemployment in particular.  So this points to a lagged reaction to accelerating economic growth by the Federal Reserve, and in other countries such as the UK and Canada as well.  Put another way, it means that the punch bowl might have been emptied but it has still not been removed, now that the party has got going.   Articles in the FT such as this obviously support this idea, and will likely bring forward some house purchases, while at the same time gearing investors up for a rapid rise in rates..

The figure below shows the current dislocation very clearly.  3 month T-bill yields are still almost zero, and yet growth is now above 2 percent. To state the obvious: in every business cycle except the current one, by this stage of the cycle interest rates have been higher.  

Fourth, when oil prices finally go up, they could rise just as fast as they have declined – and the fall in oil prices over the last few months has been dramatic (and the fall is likely not over yet). So if one believes that oil prices will first fall, because of lack of agreement on a coherent strategy in OPEC, then it stands to reason that at some point shale oil projects in the US will get taken offline as they will not be profitable at these low prices, and therefore supply will shrink to meet demand.  But at the same time, and no one really is talking about this aspect of things, lower oil prices mean greater demand for oil.  So in fact, although I would be surprised to see oil prices fall below $45, it would not be completely out of the question, as supply needs to shrink at the same time as plans in other industries reacts to the lower oil prices, stimulating demand. 

The point here is that at some point oil prices could suddenly start to rise again, if for example OPEC suddenly agreed on a strategy to restrict output or if oil prices fell so low that they “overshoot” their new equilibrium value. In a way, this isn’t a bad thing, as the shale oil boom in the US has really gone too far, with drillers just everywhere in my part of the world – airborne pollution now a problem as well, and very little infrastructure to deal with the shipping and refining of these natural resource products.  So, as Schumpeter would say, some “creative destruction” is probably in order here, and lower prices will begin to better align oil demand with supply.  As of Friday, WTI oil closed at just about $63, so if this fall continues, some oil companies will soon definitely be cancelling future projects.

The chart below from BP shows some analysis of what we can expect in terms of the continuing fall in the oil price and how this will translate into lower upstream costs (the cost of oil exploration) down the road. The left panel shows where we are in terms of the fall in oil prices compared to previous rapid oil price declines. Previous declines have settled at anywhere between 50 and 70% declines, so we likely have further to fall yet until some kind of equilibrium is reached.  The period for oil prices to start rising again ranges from 5 months to 16 months, so we could be looking at lower oil prices persisting for a considerable amount of time. The right panel shows that in terms of costs, there appears to be a one year lag before costs fully reflect the fall in the oil price, as projects are cancelled and oil exploration is focuses on more certain and cheaper sources of oil.

How does this situation then potentially set us up for the next recession?  The problem here is that the fall in oil prices effectively stimulates the economy (like a good DJ can stimulate a party), by giving people more disposable income to spend, as filling their fuel tanks becomes a lot less expensive. At the same time, this accelerating growth will not show up as a problem at the Fed and at other central banks, as it gets excluded from their core measures of inflation, and they are still focused on labor market indicators (which are lagging indicators of economic growth).  So the Fed will likely be “behind the curve” when it comes to raising rates, something I believe we are already seeing, as they keep on pushing higher rates further into 2015.  

Moreover, given where government bond yields are, the Fed also appears to be very slow off the mark in terms of reversing QE – yields went up slightly when the bumper labor market statistics were released on  Friday Dec 5th, but came down again very quickly with a few other lackluster economic releases.  Market participants appeared somewhat surprised that bond yields had reacted so little – that in turn tells me that the Fed isn’t selling its bond holdings in any significant numbers, which is something I find quite alarming.

So that sets the stage for a medium term “foot on the accelerator pedal” to really boost growth in the oil dependent countries – notably the North American and European economies. The real problem occurs though when oil prices go back up. This will immediately slow growth, presumably when interest rates are higher, and the central bank meanwhile will be in no mood to be accommodative, as they will be busy trying to “normalize” monetary policy so as to fight any upcoming recession.  This situation though could be the trigger which causes the next economic downturn to occur.  To use the punch bowl analogy once again, this could create a great party, but the hangover could be serious, particularly if the party gets out of hand! 

What can wavelets tell us about long term US economic growth?

In this blog I always try and emphasize cyclical features of macroeconomic growth, as that is my main research interest right now. Given the extraordinary events taking place in the world of monetary policy in recent years, an important question to look at is where the long run US economic growth rate is going, as the argument has been made that the more fractured US labor market could lead to weaker economic growth going forward as US consumers are less willing to spend as they were before the great recession .

First, if you look at US economic growth, there has been a lot of talk about a decline in the long term US growth rate trend. What do I mean by this?  Recent (excellent) research by some economists at Fulcrum Investments highlighted in an FT article by Gavyn Davies (see here) used something called a "Dynamic Factor Model".  This research incorporated some tweaks in the overall model to allow it to "detect" where the long run US economic growth rate is headed.  Their results clearly show that long term US economic growth (and growth in other major developed economies) is heading downwards.  The figure below from their paper (which you can find here) shows the downward trend that they obtain for the long run US economic growth rate. In their paper the authors go on to repeat this analysis for the other major developed economies with very similar results.

Source: Antolin-Diaz, Dreschel and Petrella (2014), p21

Above the red line plots their long run growth rate, with the blue dotted lines showing 5 and 10 percent confidence intervals.  The black much more cyclical line shows the Congressional Budget Office's measure of the growth in potential output ( - the growth in the maximum output of the economy if all factors of production were employed).

On the face of it, the red line showing their measure of estimated growth looks pretty bad - it appears to move downwards over the 55 years plotted here.  But there are two points to bear in mind here though.

First, this measure does not use the official definition of economic growth, which is percentage change in real GDP per capita, as it is measured here as percentage change in real GDP.  In fact most economists do not either, as getting population estimates by quarter is extremely difficult and even if you do, they are only estimates as we only really take a proper guage on the US population every census year.  In other words, the figure above doesn't account for the change in population growth. This is important, as in all developed countries there has been a decline in the population growth rate, so some of this fall in the percentage change in real GDP would be expected.  Now the authors do attribute some of the fall in the growth rate to the fall in population growth, so this is not a fault with their analysis, but rather something that one would be expect to be reflected in the figure above, thus tending to support a fall in the long term growth rate.

Second, I would argue that their definition of "long term" is not correct.  To me, long term means something that is measured over several business cycles, not just over one business cycle.  Just looking at the graph above, I would argue that for the period 1970 to 2000 their long term measure of the economic growth rate was actually pretty stable, but that their measure clearly turns downwards well after 2000. So their measure really drops decisively below 3% only in 2004 or thereabouts, only 10 years ago, and therefore not even a complete business cycle ago. To my way of thinking that is not a change in the long term growth rate, as it has only happened over the last business cycle.  Why does this matter?  Well it could be (as we all know from the Reinhart and Rogoff research) that the recovery from the last recession was weak because the last recession was caused by a systemic banking failure - something that takes a lot longer to recover from than a "regular" recession.

Often it is good to get a robustness check on the results from doing an exercise like this by looking at what alternative methodologies reveal about the fluctuations in economic growth that the US has experienced. So here I introduce another approach known as wavelet analysis.  This type of analysis operates in what scientists call the "time-frequency" domain, as it assumes a certain degree of (regular or irregular) cyclicality.

So let's first start with what wavelet analysis does.  It basically takes the data and extracts cycles that can be detected by the technique over different ranges of frequencies. This is done in certain preset ranges, and these ranges are dyadic ( - they increase in terms of powers of 2).  So for example the most basic cycles in a quarterly data series can be extracted at the 2 to 4 quarter cycle, then at a 4 to 8 quarter cycle, an 8 to 16 quarter cycle etc. When you run this type of wavelet analysis ( - technically it's called multiple overlap discrete wavelet analysis), you have to specify the maximum length of cycle you want to extract.  Here I specify a 16 year cycle to be the maximum cycle, so that means that we have 5 series of what are called "crystals" which include the different ranges of cycles up to a 16 year cycle. Then anything left over after cycles up to 16 years long are extracted, is also put into what is called the "wavelet smooth".  It contains any trend in the series plus any cycles in the data that can be detected that are longer than 16 years in length.

So what does this look like for US economic growth?

Source: Calculations by author

In the chart above I have broken down the fluctuations in US economic growth by cycle range, so lyd1 (the dark blue line) represents 2 to 4 quarter fluctuations in growth, lyd2 (the bright red line) represents 1 to 2 year cycles in growth etc.  The light brown line which is labelled lys5 represents everything left in the growth series after all the other cycles have been extracted, so it contains cycles longer than a 16 year duration and any trend left in the series. Following the wavelet literature, I will call this variable (lys5) the "smooth".

What I find is very different from the Fulcrum Investment research. It is clear that from around the late-1960s onwards the growth rate has fallen to a lower level than it was prior to this date. But from around 1983 we see another phenomena emerging in the data - that of the so-called "great moderation", which saw high frequency fluctuations (lyd1, lyd2 and lyd3) dampened down, but at the same time a more vigorous longer term cycle emerging, particularly in the "smooth". In a paper with Andrew Hughes Hallett (available here) we show that in fact there was likely volatility transfer from this more high frequency (shorter) cycles to the low frequency (longer) cycles. I will write more about this paper and it's implications in a future blog.

But what is clear is that the longer term trends shown by the wavelet smooth do not indicate a significant decline in the long term economic growth rate. In fact, quite the opposite: it shows that i) the longer term smooth has been falling for cyclical reasons, as it has rebounded nicely since the great recession, but also ii) the longer term trend (also captured by the smooth) is in fact moving upwards quite rapidly, signifying that the economy is still on a long cycle upswing right now. In fact it may indicate that there is a longer cycle in growth lurking in the data.

Of course which methodology is right will affect a whole lot of other variables in the economy - such as the stockmarket, the bond market, incomes and expenditures.

So which method is right?  Both methods have their advantages, but both also have disadvantages and statistical flaws. Probably the honest answer is that only time will tell!