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After releasing the minutes from the Federal Reserve meeting last week, new Fed Chairmen Powell testified in front of congress yesterday. While most of you were likely glued to your T.V. sets watching, in case you missed it here’s a summary of what he said and our interpretation of what it means.
Powell will continue to follow a similar monetary policy as his predecessor Chairwomen Yellen. What’s interesting to us is the Fed’s insistence that they alone have the ability to determine what the inflation rate will be. “The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee reaffirms its judgment that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate.”
This seems a bit arrogant to us. For starters, the Fed has not been able to achieve their desired 2% inflation rate in the last 10 years. They remain well below it. We are not dismissing monetary policy as a factor in determining inflation, but it’s not the most important factor in today’s world. Globalization and technology are bigger factors and they have worked to drive down inflation, and therefore interest rates, over the last 40 years.
The Fed acknowledges that their forecasting models have been “prone to error” during recent history, consistently forecasting higher inflation than we end up experiencing. They don’t acknowledge that there may be something wrong with their models. A simplified version of the Fed model is the Phillips curve. It states that as unemployment drops, wages must rise. It’s a basic supply and demand curve. Since there are fewer unemployed workers, employers must pay more to attract or retain workers. Wage inflation then leads to general inflation. The problem is the Phillips curve hasn’t worked in the last 20 years.
It’s more than coincidental that traditional models for forecasting inflation stopped working at the same time the world became connected through the internet. Globalization is not to be confused with immigration. While not every domestic job can be performed overseas, many can. Foreign workers no longer need to immigrate to the United States to create an increase in our domestic workforce. A call center in India or a programmer in China can perform work in real time for a company domiciled in another country. That’s why domestic unemployment rates are far less significant today. The available workforce is global, and there is plenty of capacity left. We believe this explains why strong economic growth has not led to more inflation, despite the Fed’s forecast that inflation will rise.
The good news for corporations is that growth is increasing faster than labor costs, this means record revenue and earnings. While inflation and interest rates will likely rise too, we don’t see them increasing at a rate that will undermine the economy. That day will come at some point, but as of today we have higher growth with modest inflation and low interest rates. That’s a great recipe for stock markets.
The GreenPort Team