Rising stock dispersion does not mean investors are ignoring macro risks

Eric Lonergan   27/02/2017   Comments Off on Rising stock dispersion does not mean investors are ignoring macro risks

Earlier this year, Matthew Klein at FT’s Alphaville, made a typically punchy and well-argued case for abandoning a cornerstone of the current macro policy framework – the NAIRU.

This inelegant acronym (“Non-Accelerating Inflation Rate of Unemployment”) refers to the rate of unemployment which is consistent with stable inflation. It is one of a set of similar concepts prevalent in macroeconomic policy. The ‘output gap’, an attempt to measure spare capacity in the economy, attempts to play a similar function at the aggregate economy-wide level. If the output gap is zero, we might expect inflation to be stable, if there is a shortage of capacity, inflation rises.

The current sensible and pragmatic consensus is that these are useful concepts, very useful pedagogic devices, and a reasonable way to frame policy. Dissonance emerges because the output gap and NAIRU are perceived to be extremely hard to measure – perhaps too hard to be of any use. That position can be accepted by those who still believe in output gaps and NAIRUs.

Simon Wren-Lewis in his response to Klein, perhaps exemplifies this perspective – he believes there is a NAIRU and an output, they are extremely difficult to measure, but the framework is broadly accurate and can be useful. He sees intelligent ways of dealing with the measurement problem. For example, he suggests, quite reasonably, that the US Federal Reserve Board should wait until inflation is rising, and the NAIRU has been demonstrably breached, before significantly tightening policy. Jo Michel also outlines a more nuanced, and critical perspective – with an useful link to exchange with Klein on points of agreement and dissent.

I have adhered to this broad framework of thinking about the macro economy since I first learnt economics at university. One of my earliest personal economic influences was Professor Ken Mayhew  at Oxford, one of Britain’s leading labour economists, and a periodic co-author with both Richard Layard and Steven Nickell who first introduced the ‘NAIRU’ in 1986.

The objective of demand-management – either through fiscal or monetary means – is to target the level of aggregate spending consistent with an economy fully utilising its resources. A zero output gap is a proxy for this. Concepts of unemployment consistent with stable inflation are somewhat subtler, because they focus on the institutional features of the labour market – reducing unemployment is not just about aggregate demand, improvements in labour market efficiency, either by reducing search costs or improving the matching of skills – can all reduce the rate of unemployment without negative trade offs – such as higher inflation.

Like much of modern macroeconomics, this entire framework really originates with the problems of stagflation in the 1970s and with the Philiips Curve framework of the 1960s – which Wren-Lewis refers to, and I have discussed before.

That is also its weakness. I am going to suggest a completely different structural description of how the current economy works, in stark contrast to the structure that prevailed in the 1970s and early 1980s. In the world I will describe, the NAIRU is not useful – in fact it is highly misleading. Not because it cannot be measured – but because it does not exist. This, I think is a far stronger position than the most vociferous critics outside of the Austrian school have so far made. And I will go further – policy based on the NAIRU will be damaging.

Here goes: Let’s assume that product markets are highly competitive, in the textbook sense that firms are price takers. Let’s assume the same is true of labour markets. To be clear, I am not assuming that prices and wages are symmetrically “flexible” – that model is empirically false – I am only requiring that firms and individuals lack market power, and specifically lack the power to determine their prices and wages. This is not an extreme position, in the sense that there will obviously be “negotiations” even in non-unionised worker-employer relationships, where the costs of retraining etc., are reflected in a ‘bargain’ between worker and employer. But that is not my point, I am simply assuming that the broad wage-determining process, is determined by demand and supply for the skill set.

Now, how do expectations fit into this view of the economy? I am also assuming the Greenspan definition of price stability prevails. In other words, inflation is sufficiently low and has been sufficiently low for long enough that people (‘economic agents’) don’t really pay any attention to it. Put more accurately, I am assuming a world where almost all the information is in relative price variance not aggregate price variance. In other words, when wages for a given skill set fluctuate, or prices of goods and services fluctuate, participants do not assume anything about aggregate inflation, they draw a conclusion from the price signal about their specific circumstances. Price and wage variance has relative price information and there are no relevant aggregate “inflation expectations”. If people are asked, what do you expect inflation to be they reply, “don’t know, don’t care.”

In the economy I am describing, people simply do not have “inflation expectations” (nor are they represented by entities, such as trade unions, which have inflation expectations), but they do have knowledge about when demand for their skills (or their products) is strong or weak.

I also need to be absolutely clear that this is not a world without recessions, or collapses and shortfalls in demand – it absolutely is. I have no problems with the idea that firms and workers can be price takers and there can be brutal recessions. Accepting that labour and product markets are competitive by no means assumes that they always “clear”. Rigidities, balance sheet problems, coordination problems, errors, animal spirits, credit conditions – none of these potential sources of recession or depression have gone away – they exist in my model.

Ok, so how does the NAIRU fit into the world I am describing? It doesn’t. What happens in the economy that I am describing when unemployment falls to extremely low levels is relatively unpredictable, but not particularly harmful nor requiring any policy response. I am happy to let the system sort it out. Labour shortages may take time to be addressed – there may be a need for more training, there may be a need for more migration, there may be need for firms to substitute capital for labour. I don’t mind – the market system can sort that out, and smart policy-makers can facilitate it with micro-policies. It may be the case that profit margins get squeezed, and a lengthy process occurs of lower return on capital, lower investment, and ultimately lower demand for labour occurs.

This is also a world where variance in certain market prices – commodities being a striking example – and sectoral credit cycles, are the main source of moderate cyclical variance. Something Frances Coppola has astutely suggested. I think it is highly plausible that idiosyncratic sectoral shocks, for example in autos, segments of housing, and the commodity sphere have been far more relevant since the financial crisis to the US economy than monetary policy. And this is the norm.

What I am describing is a world where monetary policy – and specifically the level or overnight interest rates – is really not very significant. Other relative price signals, sectoral shocks and credit cycles, sort themselves out. And credit conditions are determined far more by the behaviour of the financial system and private sector demand for credit. Again overnight interest rates are relatively peripheral. Market shifts in risk premium and the regulatory backdrop dominate the pricing of credit and finance, too.

It is again important to stress that is not a naive Panglossian market-clearing world view of the world. This is definitively a world where sufficiently large, correlating, aggregate shocks occur – the financial crisis and Eurozone austerity being recent examples. And I have long been advocating the need for profound and effective counter-cyclical contingency policies.

Conclusion: Rethinking economics

Increasingly, these are the lines along which I think we need to rethink our economic structure – macro-theory may itself be regime and structure dependent. The framework of the 1970s – of rational expectations, NAIRUs, and ultimately interest rate setting central banks managing demand – is a regime of relevance to some parts of the world (perhaps economies such as South Africa, Brazil and Turkey, with higher initial-condition real interest rate structures), but no longer to the developed world.

I am conscious that, to some extent, I am overstating my case. There is considerable institutional variance across developed countries. But I am increasingly of the view that the standard inflation expectations/output gap/NAIRU framework is more profoundly flawed. The concepts are useful pedagogic devices, but given the current micro-structure of the developed world, they may be  significantly redundant, and worse, a hindrance to policy-making.

Central banks may need to accept that changes in overnight interest rates really don’t matter very much. Absent very large shocks to demand, there is nothing for them to do, and when they are needed, they will need new tools. Periodically there is a desperate need for aggressive stimulus of demand – such as in the Eurozone currently. Where Simon Wren-Lewis and I are fully in agreement, is that we need independent central banks with proper counter-cyclical policy tools. My concern is that a deeper overhaul of the entire conceptual framework may be needed to get them there.


About the author, Eric Lonergan

Eric Lonergan joined M&G in 2006 as a member of Dave Fishwick's multi asset team. Eric is currently manager of the M&G Episode Defensive Fund, launched in September 2012, as well as co-manager of the M&G Episode Macro Fund, launched in 2010. Prior to joining M&G, Eric was managing director and head of macro research at JP Morgan Cazenove. He has a BA in politics, philosophy and economics from Pembroke College, Oxford, and an MSc in economics from the London School of Economics.