Market & Economic Outlook
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Crocodile Tears for the Phillips Curve
In 1958, William Phillips, an economist at the London School of Economics who briefly worked as a crocodile hunter in Australia, proposed the theory that as unemployment falls, inflation rises when employees are able to demand higher wages and prices adjust up to consumers’ increased spending. The thinking behind this inverse theory—known as the Phillips Curve--would guide Fed rate-setting policy for decades. Until now.
The Fed’s consignment of the Phillips Curve to the dustbin of history is a subtle but momentous policy shift. In recent weeks, Fed members have begun to discuss a new approach which may be further detailed at their meeting this week. Briefly, the new strategy will increase the Fed’s attention on achieving maximum levels of employment and decrease efforts to maintain inflation, defined as Core PCEat or below its long-term average of around 2%.
The Fed’s new marching orders were explained by Federal Open Market Committee member Raphael Bostic. Turning the Phillips Curve on its head, he said "as long as we see the trajectory moving in ways that suggest that we are not spiraling too far away from our target, I'm comfortable just letting the economy run and letting it play out." Fed policymakers are in agreement that the Fed should not raise rates preemptively as unemployment falls "unless you see inflation," Bostic added.
A Long Road Back
Part of the Fed’s challenge in steering monetary policy through the pandemic is the nature of this economic cycle. Typically, cycles follow a peak-to-trough gradual progression through the phases of expansion, decline and recovery. The Fed monitors early signs of economic growth to assess the pace of recovery and to consider a round of rate hikes to counter inflationary trends. A “U-shaped” recovery is the typical trough-to-peak cycle.
The current cycle, however, may be unlike any other the Fed has witnessed. The collapse in economic production and employment in the spring was swift and dramatic and prompted the Fed to roll out a wide range of programs to turn the tide. Now the question is whether signs of a return to normalcy—such as restaurant reservations back to 86% of pre-pandemic levels--will fade should a second wave of infections occur or progress on a vaccine disappoints.
Meanwhile, other indicators of growth remain stubbornly negative: the Transportation Security Administration logged a strong increase in airport screenings as the Labor Day holiday approached, but screenings remain nearly 60% lower than before the pandemic.And while unemployment declined to 8.4% as of the September 4 report, the number of jobs the Bureau of Labor Statistics (BLS) defines as permanently lost continues to rise--up 500,000 to 3.4 million.
Faced with conflicting and thus less-than-reliable indicators of economic recovery, the Fed has indicated that it is prepared to keep rates at rock-bottom levels and allow Core PCE inflationary growth to “run hot” and pass the former 2% red-line by as much as 50 basis points, even as it considers additional monetary stimulus measures. It would be unusual to see inflation surpass 2.5%. Core PCE inflation ticked above 2.4% a few times in 2006 and 2007, but the last sustained period took place in the early 1990s.
Not All Boats May Rise
While all industries show job losses for the six-months ending September 4 according to the BLS, job losses during that period were most pronounced in services, down 10.3 million, leisure and hospitality, down 4.1 million, and manufacturing, down 760,000.
We are concerned about the potential for what some investors view as a “K-shaped” recovery. In this scenario, certain areas of the economy—most notably those that rely on tech-savvy, white-collar workers, recover more quickly than blue-collar workers in the most affected industries such as services, leisure, and manufacturing. If workers in these sectors continue to face an uncertain employment future, increasing income inequality and social tensions may be the result.
The next several weeks, as the country moves towards an election complicated by responses to the pandemic, may see heightened market volatility. As always, we encourage clients to maintain portfolios structured for achieving long-term goals and to keep in communication with their advisors.
Economic and Market Perspectives is a publication of HighMark Capital Management, Inc. (HighMark). This publication is for general information only and is not intended to provide specific advice to any individual or institution. Some information provided herein was obtained from third-party sources deemed to be reliable. HighMark and its affiliates make no representations or warranties with respect to the timeliness, accuracy, or completeness of this publication and bear no liability for any loss arising from its use. All forward-looking information and forecasts contained in this publication, unless otherwise noted, are the opinion of HighMark, and future market movements may differ significantly from our expectations.
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