The New Economic Normal and the Impact on the Federal Reserve

A recent speech by Eric Rosengren, President of the Federal Reserve Bank of Boston, gives us a glimpse of what may lie ahead in the world that is the Federal Reserve.  In his speech, he outlines why it will be necessary for the Fed to implement one aspect of its new monetary policy ammunition and why this will be necessary.

As we all know, the Fed and its most influential peers have kept interest rates at historically low levels for the longest period in history as shown here:

Obviously, when the next recession hits, the Federal Reserve will have very little room to drop nominal interest rates, particularly when looking at how much rates dropped in the past as shown on this table:

In real terms (i.e corrected for inflation), the Federal Funds Effective Rate has been in negative territory for the longest duration since the 1960s as shown here:

Mr. Rosengren notes the following:

1.) with today's ultra-low short-term interest rates, there will be a limited buffer for monetary policy to respond to economic slowdowns (i.e. central banks have not got sufficient room to lower interest rates as they have in the past). 

2.) real short-term federal funds rates are likely to be negative more frequently.

3.) nominal federal funds rates are likely to reach zero more often (and in my opinion, may become negative).

The economic problem that the Fed has faced since 2008 is structural rather than cyclic in nature, that is, the functioning of the economy has transformed in a manner that is permanent.  In other words, very little of what the Fed has done since the Great Recession has been effective because the Fed's policies are designed to deal with cyclic (temporary) changes in the economy.

Here are two examples showing how the economy has undergone structural changes:

1.) Productivity Growth - Change in non-farm real output per hour:

2.) Civilian labor force growth rate (i.e demographic changes):

So, what's a central banker to do when the next recession arrives?   Here's a hint:

The world's three most influential central banks have massively increased the nominal size of their balance sheets because they discovered that, in the wake of the Great Recession and the nature of the post-recession economy, simply lowering interest rates were "...insufficient to rekindle economic growth..."

Here's the same data as a percentage of GDP showing how desperate the situation is for Japan, a nation that has undergone the most profound demographic changes:

Mr. Rosegren states that "...structural changes in the macroeconomy may necessitate more frequent use of large scale asset purchases during recessions.  This latter view hinges on the argument that the combination of low inflation, low rates of productivity growth and slow population growth may imply an economy where normal or equilibrium short-term interest rates remain relatively low by historical standards, even once the economy has fully normalized."

As I've noted in the past, central banks have painted themselves into a policy corner from which there is no easy extrication.  Never before in modern history have central banks acquired such a massive inventory of assets and never before have they faced divesting themselves of these assets.  No one understands the market implications of unloading and offloading trillions of dollars worth of bonds, and yet, Mr. Rosengren suggests that expanding central bank balance sheets is the only way to stimulate a contracting economy in a low interest rate environment.  Keeping in mind that the world's central bankers didn't see the looming Great Recession until it was on the doorstep, we should be concerned that the repercussions of their remaining monetary policy tool is unproven.

Let's close this posting with Mr. Rosengren's concluding remarks:

"While the extensive use of central bank balance sheets has been a distinguishing feature of the most recent downturn and slow recovery, I see it as quite likely that this tool will be necessary in future economic downturns. Unless productivity growth and demographic trends change, or monetary policymakers set a higher inflation target, the feasible reductions in short- term rates to combat recessions will not be sufficient. Thus, monetary policymakers are likely to need to use balance-sheet tools.

If monetary policy is to rely primarily on short-term interest rates to normalize policy, as seems prudent given the historical experience, in my view the Federal Reserve should adopt balance sheet exit strategies that reinforce the primacy of interest rate policy. Starting to shrink the balance sheet earlier – and doing so in a very gradual fashion – implies very little reduction in the degree of monetary stimulus coming from the U.S. central bank’s balance sheet. This, in turn, will allow policymakers to focus on gradual increases in the federal funds rate target as the primary mechanism for normalizing monetary policy and calibrating the economy." (my bold)

Good luck with that, Mr. Rosegren. 

Goodbye Mr. O'Leary

With the news that Kevin O'Leary has pulled out of the running for the leader of Canada's Conservative Party, I thought that it was a great time to post this parting shot of the "Real Kevin":

Goodbye Mr. O'Leary.  Don't let the door hit you on the butt on your way back to Boston.

What's Behind the Collapse of America's Manufacturing Sector?

As we are all aware, Donald Trump is on a mission to bring jobs back to the United States.  In large part, his plans include renegotiating trade deals that have led to job losses in what was once America's economic foundation; manufacturing.

Here is a graph showing what has happened to manufacturing jobs in the United States since 1939:

At 12.392 million jobs, America's manufacturers have shed 7.161 million jobs from the peak of 19.553 million in June 1979, a decline of 36.6 percent.  As well, since March 2010 when manufacturing jobs hit their post-Great Recession nadir of 11.453 million, the addition of 939,000 jobs is a very poor showing, particularly given the lengths that the Federal Reserve has gone to since 2008.

While there is no doubt that freer trade has led to offshoring of American manufacturing jobs, a study entitled "The Myth and the Reality of Manufacturing in America" by Michael Hicks and Srikant Devaraj at Ball State University strongly suggests that other factors are at play as you will see in this posting.

Let's start with a graphic that shows the U.S. manufacturing production index from 1919 to 2014:

As you can see, the Great Recession put significant downward pressure on national manufacturing production, pushing it well below the trend line.  Nonetheless, in real dollars (inflation adjusted), the value of manufacturing production continues to climb and, by 2014, it had recovered completely from the setback of the Great Recession. 

Here is a graphic showing the value of all manufacturing as well as nondurable goods (those used for less than a year) and durable goods (those used for more than a year) from 1987 to 2014:

While the real value of nondurable goods (in light blue) has been static for more than a decade, the real value of nondurable goods (in dark blue) continues to rise.  As well, you can see that the real value of all manufacturing goods continued to climb throughout the two and a half decades with short interruptions during recessions.  This clearly shows us that manufacturing is still a very important part of the U.S. economy.  In fact, while the total value of manufactured goods fell by 11.5 percent during the period from 2006 to 2009, rose by 32.9 percent over the period from 2009 to 2013, leaving us with overall growth of 17.6 percent from 2006 to 2013.

Now, let's look at how productivity has changed in key manufacturing sectors.  Here is a table showing how the average product of labor changed between 1998 and 2012 and the GDP growth for each sector over the same timeframe:

As you can see, when adjusted for inflation, productivity grew for all sectors over the period from 1998 to 2012, ranging from a low of 6 percent in the nonmetallic mineral products sector to a high of 829 percent in the computer and electronic products sector with an average of 90 percent for all manufacturing sectors.  This compares to overall production value increase (i.e. GDP growth) of 32 percent for all sectors.

What caused this substantial increase in productivity?  The authors note that the increase in productivity is largely related to the adoption of automation and information technology.  The authors focused on the period from 2000 to 2010 when the U.S. economy experienced the largest decline in manufacturing employment in history as shown here:

In January 2000, there were 17.284 million manufacturing jobs in the United States, by the beginning of 2010, this had dropped to 11.46 million, a decline of 5.824 million.  The authors  calculated the total number of employees needed to produce the 2010 levels of production using the 2000-level worker productivity levels.  Had the economy kept the level of productivity from the year 2000 and applied that to the 2010 production levels, manufacturers would have required 20.9 million workers rather than the 12.1 million that were employed in the sector. 

The study then examines the job losses in manufacturing that are attributable to trade, changes in domestic demand for goods and changes to productivity.  The authors found that losses in productivity and trade varied by sector but, overall, the share of job losses in manufacturing were relatively small when it came to international trade (13.4 percent of jobs lost) compared to losses related to increases in productivity (87.8 percent of jobs lost).  This means that only 750,000 of the jobs lost in manufacturing during the period between 2000 and 2010 were related to international trade compared to job losses of over 5 million that were related to increased productivity (i.e. the adoption of automation and information technology). 

From what we can see in this study, very little of the job losses in the manufacturing sector are related to international trade.  It appears that, unless America's domestic manufacturers are willing to forgo the productivity gains made by adopting automation, the U.S. economy will find it increasingly difficult to create significant numbers of manufacturing jobs.  Gone are the glory days of the factory worker no matter what Donald Trump may want. 

The Impact of Lowering American Corporate Taxes

With the Trump Administration moving towards lowering the corporate tax rate from its current 35 percent, a look at a study by Jane Gravelle at the Congressional Research Service is timely.   As almost people are aware, Corporate America likes to complain about the "uncompetitiveness" of the current rate particularly when compared to corporate tax rates in other nations, a factor that they claim is leading to slower economic growth in America.  In the study by Ms. Gravelle, she examines the impact of a 10 percentage point drop in the corporate headline tax rate of 35 percent and how this impacts key economic factors including corporate tax revenue, job creation and output.

There are three types of corporate taxes as follows:

1.) the statutory rate - the rate in the tax statute which, in the case of the United States, is a maximum of 35 percent.

2.) the effective rate - the tax rate paid divided by profits - this rate capture the tax benefits that reduce the taxable income base relative to profits.

3.) the marginal rate - the tax rate calculate from the share of pre-tax return that is paid in taxes.

Additionally, in the United States, corporations must pay income taxes at the state level which raises the statutory rate to 39.2 percent from 35 percent.  

Let's look at a table which shows the various corporate tax rates for the United States and its OECD peers:

As you can see, the effective corporate tax rate in the United States is roughly in line with its OECD peers.  Several other studies show similar results with U.S. effective corporate taxes being similar to those in the world's 15 largest economies including China and Brazil.

Here is a table showing the historical statutory tax rates for the United States and its OECD peers with the weighted column showing the average tax rate weighted to the size of the economy:

Now, let's look at the impact of a 10 percentage point decrease in the statutory corporate tax rate in the United States, a move that would bring U.S. corporate taxes into line with the weighted average of the OECD.  Here are the most significant impacts:

1.) Tax Revenue - over a decade, corporate tax revenues would decline by between $1.3 trillion and $1.7 trillion.  

2.) Economic Output and Wages - a one-time increase of approximately 0.62 percent at the maximum.  Some studies show that the impact on output and wages could be as low as 0.18 percent.

It is interesting to note that, even though corporate tax rates in the United States are higher than in other jurisdictions, total corporate tax revenue as a percentage of GDP has dropped substantially since the 1950s as shown here:

By way of comparison, corporate taxes as a percentage of GDP is around the 3 percent level for other developed economies.  

One of the issues that seems to develop when the United States lowers its corporate tax rate is that other jurisdictions follow the American lead.  This was the case in the period between 1986 and 1988 when the U.S. lowered its corporate tax rate from 48 percent to 35 percent as shown on this graphic:

When one nation cuts its corporate tax rate, it attracts capital from other nations, however, if all nations cut their corporate tax rates, no nations gain capital and all nations lose tax revenue.

As you can see from this analysis, the idea of reducing corporate taxes in the United States is far from a clear cut win for the U.S. economy.  While Corporate America loves to tout the advantages of a lower headline statutory corporate tax rate, this analysis shows that the economy will gain very little at the cost of much-reduced tax revenues.  As well, in our "monkey see, monkey do" world, other jurisdictions may simply follow the lead of the United States, lowering their own corporate tax rates in a move to attract business investment.  The race to the bottom will clearly lead to a situation where there are no winners except for the corporate world which will see its profits expand.