In what a prominent chief executive calls “one of the most puzzling” economic landscapes he has ever seen, the unusual is quickly becoming the usual – and few things demonstrate that better than the expectations surrounding the U.S. Federal Reserve meeting at the end of this month.
Central banks usually reduce interest rates to stimulate economies that are fading, but the Fed is now nearly universally expected to cut rates at its meeting July 30 and 31. Cutting interest rates would be a remarkable move at a time when the U.S. economy appears to be in the pink, with unemployment hovering around multidecade lows and stock markets hitting record peaks. The futures market sees a 69.5-per-cent chance of a standard quarter-percentage-point cut and a 30.5-per-cent probability of a more dramatic half-percentage-point chop.
The anticipated cut would speak to how radically thinking has shifted after a decade in which inflation has remained stubbornly low across the developed world despite declining unemployment. In Canada, for instance, the Consumer Price Index slipped to an annual pace of 2 per cent in June, notwithstanding one of the lowest unemployment rates since the mid-1970s.
The glaring absence of runaway inflation despite historically low unemployment adds to the evidence against the Phillips curve, the time-honoured model that used to guide central banks. According to the simplest version of the curve, wage inflation is supposed to go up as unemployment goes down. However, this relationship has essentially disappeared since the financial crisis.
If the Phillips curve is missing in action – something that Fed chair Jerome Powell more or less acknowledged in testimony before Congress last week – then central banks have good reason to embrace low rates. They can stimulate the economy, and encourage extremely low unemployment levels, without having to worry about paying a penalty in terms of higher inflation.
For investors, the apparent death of the Phillips curve suggests that rates are likely to remain at rock-bottom levels for longer than anyone expected even a few months ago. Whether this will extend the North American growth trend is anyone’s guess, but it adds to the uncertainties facing Canadian and U.S. businesses as they try to navigate an uncertain economic landscape.
It also adds to the challenges facing central bankers. They are the people who are supposed to control inflation. But it’s not clear what role they should be playing if their biggest lever – adjusting interest rates to raise or lower unemployment – has stopped having dependable effects on inflation.
Claudio Borio, head of the monetary and economic department at the Bank for International Settlements, the global organization for central banks, noted in a 2017 speech that the persistence of low inflation is a puzzle even for the people at the heart of the financial system. “If one is completely honest, it is hard to avoid the question: How much do we really know about the inflation process?” he said.
Many people have tried to explain the puzzle, but with less than satisfactory results. For instance, a report this week from the Federal Reserve Bank of San Francisco argued that global factors must be behind the decline of inflation across the developed world. The report stopped short, though, of speculating what those global factors might be, or how long they have to run.
Right now, the global picture is thoroughly muddled. Pessimists can point to the J.P. Morgan Global Manufacturing PMI, a purchasing managers index that tracks factory activity worldwide. It has sunk to its lowest level since 2012. In addition, bond yields have plunged around the world, usually a sign that investors are bracing for an abrupt slowdown.
On the other hand, actual economic data have been solid. In the United States and Canada, unemployment is still low and consumers continue to spend at a decent clip. The Bank of Canada said earlier this month that it expects Canadian growth to accelerate over the coming year.
“The present economic backdrop is one of the most puzzling I have experienced in my career,” James Foote, chief executive of U.S. railway operator CSX Corp., said on Wednesday after his company reported mildly disappointing results and announced it expected revenues to decline by as much as 2 per cent this year. In response, CSX stock dropped more than 10 per cent.
One factor in CSX’s downbeat guidance was the spreading effect of the U.S.-China trade conflict. The simplest way to view the Fed’s expected cut is to see it as insurance against a trade-driven slowdown. But unless inflation rises, interest rates could stay low for a long time.