An American inflection: Corporate America and the Fed

  • Written by 

    Hans F. Olsen, CFA, November 2014

On September 18, 2014, Hans Olsen, Global Head of Investment Strategy, hosted a live webcast1 featuring Dr. Lawrence Lindsey, President and CEO of the Lindsey Group, Senior Advisor to Barclays, and a former Governor of the Federal Reserve System. In their free-ranging conversation, Dr. Lindsey shared his first-hand experience as a decision maker steering the future of markets and economies.

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The view from the front row

Dr. Lindsey has 33 years of experience as a government economic adviser. Most recently, he was assistant to President George W. Bush and Director of the National Economic Council. During the 2000 presidential campaign, he was candidate Bush’s chief economic advisor. From 1991 to 1997, he served as a Governor of the Federal Reserve System, and during the first Bush administration, he was special assistant to the President for domestic economic policy.

During President Reagan’s first term, he was staff economist for tax policy at the Council of Economic Advisors. For five years, he was a member of the Harvard Economics faculty, and at the American Enterprise Institute, he held the Arthur F. Burns Chair for Economic Research. He earned his A.B., magna cum laude, from Bowdoin College, and his A.M. and Ph.D. from Harvard University.

Hans Olsen:
It seems like, at long last, central bank policy is beginning to diverge between the United States and the ECB. I’m curious about your thoughts on the US Fed Reserve’s path. It seems as if they are casting about for a durable way to judge the appropriate policy rate. Can you give us your thoughts on what they are looking at, what they should be looking at and, do you think they will end up behind the curve in trying to get rates to the appropriate level?

Dr. Lawrence Lindsey: It seems like, at long last, central bank policy is beginning to diverge between the United States and the ECB. I’m curious about your thoughts on the US Fed Reserve’s path. It seems as if they are casting about for a durable way to judge the appropriate policy rate. Can you give us your thoughts on what they are looking at, what they should be looking at and, do you think they will end up behind the curve in trying to get rates to the appropriate level?

We are now at 6.1% unemployment which is only about three-quarters of a point from what the FOMC itself says is NAIRU,2 which is sort of the maximum sustainable rate of unemployment.3 With our unemployment rate dropping a tenth of a percentage point a month, sometime in the second quarter next year we’re going to be at NAIRU. Having a zero interest rate when unemployment is not signalling a need for economic expansion is just not what would be considered prudent policy.

While there’s a sense the Fed has to move away from existing interest rates, it also knows there’s going to be a lot of dislocation when it does so. The Fed is trying to do it in a slow, deliberate fashion to give markets time to adjust. So yes, they’ll be behind the curve – deliberately.

Hans Olsen:The ECB announced a new program of lending through TLTROs [targeted longer-term refinancing operations], which is outright quantitative easing through a program of asset-backed security purchases. Finally, the ECB is adopting a more aggressive approach to dealing with the deflationary pull that the currency bloc is experiencing. Do you think the ECB has done enough, or will it have to do more?

Dr. Lawrence Lindsey:  Money and finance is a great way to buy time, but it depends on what you do with the time. Devaluation is also a way of buying time, because it is true that when your currency goes down, at least internationally, everyone becomes more competitive. But of course, your costs also go up. Import costs are going to go up in Europe as well. And ultimately, you have made everyone in Europe poorer on an international basis as well. That’s why you gain a small competitive advantage, but you give up something.

There are no free lunches in economic policy. So TLTROs can’t be the final step, because although finance is a way of buying time, it is not a way of solving problems.

It’s very hard to have one monetary policy for all of Europe

Hans Olsen: So you buy the time and then you restructure?

Dr. Lawrence Lindsey: And then you restructure. Nobody thinks Europe is an optimal currency zone, that’s an economic phrase for countries that should have the same currency. Frankly, America is not an optimal currency zone: the California economy is very distinct from the New England economy.

Because of regional differences, it’s very hard to have one monetary policy for all of Europe, and that comes out at every ECB meeting, you see the various tensions. I think that is going to be very difficult for them to solve. Just looking at events, one really has to doubt whether Europe is going to get its act together in this next bout of buying time. Some of the major countries in Europe, France and Italy in particular, are in very, very difficult economic and fiscal straits.

Yes, I think the euro zone will hold together. But is it going to restructure? How is it going to work the differences out politically? How is it going to integrate monetary policy with fiscal policies? These are big questions, and these are going to take decades to resolve.

Hans Olsen: Since you started at the Fed, the US has had three recessions. The recovery period for getting lost jobs back has elongated in each successive recession, and for this one particularly. The 1991 recession was fairly short, and we recovered jobs in 12 or 13 months. The 2000 recession took about three years to regain lost jobs. A little more than six years afterward, we recovered jobs from 2007. (Figure 1) What’s the best way out this slow growth?

Figure 1: Job recovery demonstrated by our last three recessions

Dr. Lawrence Lindsey: It goes back to the quality of decision making. Let’s say I’m the government, and I take a dollar from you that costs me 5%. If I turn around and I put it in a 7% project, the country is better off, obviously. But if I turn around and I put it in a 3% project, the country is worse off.

Private sector-based decision making is better than the public sector’s because the private sector has an incentive to turn the 5% dollar into a 7% dollar. But if you take 5% dollars and turn them to 3% dollars, you end up not having any dollars left. There’s no such discipline in the public sector, which is pushing 40% of GDP, but there’s very little cost-benefit analysis involved in decision making.

Our political system is focused more on short-term results, not on long-term issues, which is going to lower the rate of economic growth. One of the worst parts about this recovery is just how awful productivity growth is. We had a peak, on an annual basis, of productivity of about 9.4% since 1989. We’re now down to 2.3%. (Figure 2) We’re going to have to start making decisions to make sure that each dollar is spent well.

Figure 2: Tracking productivity growth over the last three recessions

Hans Olsen: Recent tax inversions have forced a rethink of the American corporate tax level. We have one of the highest tax rates of OECD [Organisation for Economic Co-operation and Development] countries. Will that be addressed?

Dr. Lawrence Lindsey: There’s a saying on Wall Street that cash is a fact, income is an opinion. Taxing income is a dumb thing to do: the US now has some very complicated IRS [Internal Revenue Service] codes just to define income. And FASB [Financial Accounting Standards Board], which sets accounting standards, has a different definition than the IRS. We should move away from defining income at both the corporate and personal level and move toward a cash flow basis of taxation. That’s the ultimate reform we have to move to.

Hans Olsen: In the US, the energy resource base comprises one of our competitive advantages. We actually now drill more gas than the Russians, but we don’t export. When will the US finally embrace a resource-competitive advantage and start to export unrefined product that would allow us to help our terms of trade, contribute to GDP growth, and perhaps change the geopolitical calculus? Will that ever happen?

Dr. Lawrence Lindsey: No, for an economic reason and a political reason. America is not energy-independent. We’re still importing three-to-four million barrels a day. The petrochemical industry definitely doesn’t want us exporting raw oil because it wants to keep the price of oil lower so it can export and be competitive.

If I’m a refiner, I’m going to go tell the senator, “Well, you want to export raw oil, that’s fine. Just be aware that you’ll be raising the price of gasoline for American drivers.” That’s likely to be a campaign ad in the next election. Fundamentally, exporting oil is not a path to a balanced trade for us, and politically, it’s going to be very difficult.

Hans Olsen: Has the Fed conquered inflation, or is inflation in a long-term coma waiting to awaken?

Dr. Lawrence Lindsey: Inflation is tame, in part, because we got a massive increase in global supply following the collapse of the Soviet Union, and the US and Japan decided to actively pursue policies to integrate China into the world economy. We’ve added 400-500 million people to the global industrial workforce, which takes a long time to digest. The immediate benefits in the 1990s led to a very rapid disinflation in spite of a boom. We still have a condition of global excess capacity, and I think globally that is a deflationary force.

I think inflation is in a coma and we’re going to stay asleep for a while. In this country, look more for the global excess capacity, and importantly, workers departing from the labour force, which will put a cap on growth more than be inflationary.

Hans Olsen: Do you see any bubbles forming or in existence?

Dr. Lawrence Lindsey: They’re most obvious in the credit markets. Credit is not being allocated based on risk. Look at the spreads between junk bonds and investable bonds. Look at the spreads between sovereigns in Europe. Countries like Italy, Spain, and France are having the lowest borrowing costs they’ve had in hundreds of years. (Figures 3 and 4)

Healthy systems have fear and greed. It’s all greed right now, but there’s no fear. It’s often called reaching for yield. But at this point, I think there’s definitely flashing yellow lights all over the place.

That’s part and parcel of a zero interest rate policy. The intent of that policy is to encourage investment. But we’re in a world of excess capacity. We’re trapped in a paradox; while our zero interest rate policy is urging us to invest, globally the marginal return on capital is very, very low.

So while there’s now plentiful credit for reinvestment, there’s no longer incentive to invest, because there’s no return. This is a very, very tough cycle to get out of – we’re stuck in a rut. We have yet to have an example in history where it ends well.

Figure 3: Comparative yield spreads between High-Yield and Investment Grade Bonds & Figure 4: Comparative yield spreads among European Sovereign Bonds

Hans Olsen: Are interest rate differentials helping the US Fed? The rest of the world is embarking on quantitative easing (QE) measures, and our bonds are more attractive on a relative basis. Is that keeping rates here lower for longer and enabling the Fed to accelerate its normalisation efforts?

Dr. Lawrence Lindsey: Yes. Low global rates certainly make it possible for the US to have lower rates than it otherwise would. But foreign exchange markets absorb most of the shock of differential policy between different countries. With the foreign exchange market, the currency moves to create interest equalisation. But I’m not sure that in any long-term sense, the Fed is helped or hindered by other countries’ policies, because any result from those policies would come out in the exchange rate.

Hans Olsen: Do you think the market is correctly pricing the timing of an interest rate increase by the US Federal Reserve? Is the market expecting lower rates than the Fed may have in mind?

Dr. Lawrence Lindsey: I think so, yes. The Fed has had a history of being a little bit more optimistic about economic results than what actually comes to pass, and market participants are sceptical that the Fed will ever get it right. But one of the interesting things about the September 17, 2014 meeting was the Fed brought down its economic expectations. I think it’s still a little bit rosy, but not as rosy as it used to be.

If I were the market, I would be very, very nervous about the numbers. Look at the data in the labour market – we’re in the sixth year of this expansion. The US economy’s capacity to continue to expand indefinitely is quite constrained by labour supply right now, coupled with low productivity and lack of investment. I would be quite nervous if I were a fixed income investor right now.

Hans Olsen: Historically, the US economy has grown at about 3%. Has anything changed that would prevent America from returning to that level?

Dr. Lawrence Lindsey: Oh, the US can get back there. The popular phrase is secular stagnation, the new normal, but the people who use those phrases the most are the people who have been in charge. And so, they look around and they say, “My gosh, I’ve been in charge and we’re getting lousy results. It couldn’t possibly have been me. It must have been secular stagnation or the new normal. It couldn’t have been my bad ideas.”

What makes economies grow? Having good decision makers where the decision makers bear the risks and rewards of the decisions they make. Nothing concentrates the mind better. We have moved far, far from that model, and we need to get back there, and when we do, I think you’ll see the US economy return to 3% growth.