Coronavirus and the End of Boom and Bust

Doug Nolan

The market week began with cases of the coronavirus jumping to 222, including four outside China. China’s National Health Commission confirmed human-to-human virus transmission. By Friday, more than 1,200 infections had been confirmed, with 41 deaths (8,420 under observation according to the Washington Post). China on Thursday suspended flights and travel out of Wuhan, a city of 11 million. The virus has quickly spread to Taiwan, Japan, South Korea, Thailand, Malaysia, Vietnam, Pakistan, Nepal, France, Australia and the United States.

China has moved to quarantine 13 cities involving an estimated 46 million, according to Bloomberg “the first large-scale quarantine in modern times.” From Bloomberg (Lisa Du): “‘The containment of a city hasn’t been done in the history of international public health policy,’ said Shigeru Omi, who headed the World Health Organization’s Western Pacific Region during the SARS outbreak in the early 2000s. ‘It’s a balance between respecting freedom of movement of people, and also prevention of further disease and public interest. It’s not a simple sort of thing; it’s very complex.’” Included in the 46 million are foreign nationals now unable to leave China.

A 1,000-bed emergency hospital is to be constructed in ten days in overwhelmed Wuhan, as 400 military doctors are deployed to support local providers. In Beijing and throughout the country, officials have cancelled “Year of the Rat” Chinese New Year’s celebrations. Beijing’s Forbidden City is closed to tourist until further notice. Across China, there is fear of going to markets, restaurants, movies and public events.

Nations around the globe have isolated ill patients awaiting coronavirus test results. That this scare is coming at the height of flu and cold season in the U.S. and other northern hemisphere countries adds further complication to a rapidly escalating crisis.

Florida Senator Rick Scott is urging the Trump administration to declare a public health emergency. Missouri Senator Josh Hawley has called for the administration to impose a temporary travel ban on flights from China. The coronavirus has the potential to turn highly disruptive to the Chinese economy, with wide-ranging effects on global markets and economies.

The Shanghai Composite dropped 2.8% in Thursday trading, and was down 3.2% for the week. Hong Kong’s Hang Seng index fell 3.8%, with the Hang Seng China Financials index sinking 4.9%. For the most part, Asian equities ended the week with modest losses. Financial stocks were under pressure around the globe.

My Bubble thesis views China as the marginal source of both global Credit and demand for commodities. Any development posing risk to China’s vulnerable Bubble rather quickly becomes a pressing global issue. It’s worth noting the Bloomberg Commodities Index dropped 3.1% this week. WTI crude sank 7.4%, while Copper was hit for 5.7%. Nickel fell 6.9%, Tin 5.4% and Zinc 3.6%. China’s renminbi declined 1.2% versus the dollar. In the face of notable investor optimism and attendant financial flows, EM currencies reversed lower this week.

Global safe haven bonds appeared to believe this week’s developments were a big deal. Ten-year Treasury yields dropped 14 bps to a three-month low 1.685%, and German bund yields fell 12 bps to negative 0.34%. The two-year versus 10-year Treasury spread declined almost eight bps this week to a six-week low 18.5 bps (after ending 2019 at 34bps). The market now prices in a 41% probability of a rate cut by the July 29th FOMC meeting, up from last week’s 29%. While on the subject of safe havens, gold bucked this week's commodities market selloff to gain 0.9% to $1,572.

U.S. stocks were under moderate pressure in early Thursday trading, but by the close the S&P500 was positive for the session and back near record highs. The situation turned more concerning by Friday. The S&P500 ended the session down 0.9%, with a loss for the week of 1.0%. The Bank index dropped almost 2% in Friday trading.

January 22 – Reuters: “U.S. home sales jumped to their highest level in nearly two years in December, the latest indication that lower mortgage rates are helping the housing market to regain its footing after hitting a soft patch in 2018. …Existing home sales increased 3.6% to a seasonally adjusted annual rate of 5.54 million units last month, the highest level since February 2018. November’s sales pace was unrevised at 5.35 million units… Existing home sales, which make up about 90% of U.S. home sales, surged 10.0% on a year-on-year basis in December. For all of 2019, sales were unchanged at 5.34 million units.”

Between the impeachment trial and the coronavirus, noteworthy housing data received scant attention. Housing and mortgage finance in 2020 will reemerge as prominent factors in U.S. Bubble Analysis, especially if global developments continue to pressure market yields (and mortgage rates) lower. While December Existing Home Sales (seasonally-adjusted) were the strongest in almost two years, more notable was the decline in available inventory to 3.0 months. This was down from November’s 3.7 months (and September’s 4.1) to the lowest level in the 20-year history of the data series. The chief economist for the National Association of Realtors stated, “America is facing a dire housing shortage condition.” Little wonder home prices have begun to accelerate.

January 17 – Bloomberg (Prashant Gopal): “U.S. home prices rose the most in 19 months in December, fueled by low mortgage rates and the tightest supply on record, according to Redfin. Prices jumped 6.9% from a year earlier to a median of $312,500, the biggest annual increase since May 2018… Values fell in just two of the 85 largest metropolitan areas Redfin tracks: New York, with a 2.4% decline, and San Francisco, down 1.7%... Some of the most-affordable cities in Redfin’s study had the biggest price gains, led by Memphis, Tennessee, with a 16% jump. The inventory of available homes for sale nationwide tumbled 15% from a year earlier. There were fewer properties for sale last month than at any time since at least December 2012…”

January 21 – CNBC (Diana Olick): “Homebuilding took a sharp turn higher to end 2019, but it is far from enough to satisfy the current demand. The U.S. housing market is short nearly 4 million homes, according to new analysis from Analyzing U.S. census data, the report showed that the 5.9 million single-family homes built between 2012 and 2019 do not offset the 9.8 million new households formed during that time. Even with an above average pace of construction, it would take builders between four and five years to get back to a balanced market. The shortfall today can be blamed on the epic housing crash of more than a decade ago… With loans available to even the riskiest buyers, builders responded by putting up 1.7 million single-family homes at the peak of the construction boom in 2005, according to the U.S. census. That was about 5 million more than the 20-year average.”

January 23 – Wall Street Journal (James Mackintosh): “The Davos consensus can be a powerful counter-indicator, but this year it is worrying me for all the wrong reasons. Two years ago the elite assembled for the World Economic Forum in the Alps strongly believed in global growth, and were completely wrong. A year ago they were concerned, and again entirely wrong as markets subsequently soared. This year the problem is that I find myself sharing the consensus view, justifying high stock valuations on the basis of easy monetary policy. It is a deeply uncomfortable place to be.”

Bob Prince, Co-CIO of Bridgewater Associates (in a Bloomberg Television interview from Davos): “2018 I think was a lesson learned. The tightening of central banks all around the world wasn’t intended to cause a downturn – wasn’t intended to cause what it did. But I think lessons were learned from that. And I think it was really a marker that we’ve probably seen the end of the boom and bust cycle.”

Bloomberg’s Tom Keene: “Is it the end of the hedge fund business in modeling portfolios off the guestimates of what central banks will do?”

Prince: “That won’t play much of a role nearly as it has. You remember the eighties when we sat and waited for the money supply numbers. We’ve come a long way since then… Now we talk 25 plus [bps Fed rate increase] – 25 minus. We’re not even going to get 25 plus or minus and we have negative yields. That idea of the boom/bust cycle – and that history that we’ve been in for decades – is really driven by shifts in credit and monetary policy. But you’re in a situation now where the Fed is in a box. They can’t tighten, and they can’t ease – nor can other central banks, particularly the reserve currencies. And so where do you go from here? It’s not going to look like it has.”

Bloomberg’s Jonathan Ferro: “Bob, you just said it twice – and I’m still surprised. And you said it before the interview started… It’s the end of the boom/bust cycle?”

Prince: “As we know it.”

Ferro: “There was a man called Gordon Brown, former Chancellor of the United Kingdom, a famous scene in Parliament of him standing up and saying, “It’s the end of the boom/bust,” and it was right before the financial crisis. It’s the end of the boom/bust cycle? What does that mean?”

Prince: “Cycles in growth are caused by the boom and bust in Credit. Credit expansion, Credit contraction. And those expansions and contractions of Credit are largely driven by changes in monetary policy. And so we’re in a situation today where with interest-rates close to zero and secular deflationary forces, you’re not going to get a tightening of monetary policy. They learned that lesson last year and got the unintended effects of that. You’re not going to get a tightening, and one of the reasons you’re not going to get a tightening is because they can’t ease. If you can’t ease you don’t want to tighten to cause a problem for yourself that you can’t get out of. Therefore, you’re in a box; you don’t tighten, and you don’t ease.”

Keene: “It sounds like you read (Ray) Dalio’s book.”

Prince: “We work together” (laughter).

Ferro: “…What are the investment implications…”

Prince: “The nature of the economic environment is changing. So, we are converging on something – a slow growth environment, I’d say close to stagnation – approaching stagnation. That’s why interest rates are at zero. That’s why real interest rates are negative – is because central banks have to make cash very unattractive…, but also they have to make bonds unattractive. Central banks have taken cash and bonds and they’ve made it a funding vehicle – not an investment vehicle. And they’re trying to keep that rate low so that money goes from bonds to assets.”

Noland: I’m always fascinated when highly intelligent market professionals say peculiar things. I’m still not over Ray Dalio’s concept of “beautiful deleveraging” from some years back. When I first heard Prince’s comments, I thought immediately of the eminent American economist Irving Fisher and his infamous, “Stock prices have reached what looks like a permanently high plateau” - just days ahead of the great 1929 stock market crash.

But there is an analytical framework behind Prince’s view worthy of discussion. I’m with him completely when it comes to, “Cycles in growth are caused by the boom and bust in Credit.” In a historical context, I can accept “those expansions and contractions of Credit are largely driven by changes in monetary policy.” I agree “you’re not going to get a tightening of monetary policy.” Prince says central banks are “in a box,” while I prefer “trapped.”

But it is as if Mr. Prince is suggesting there is now some type of equilibrium condition that precludes a boom and bust dynamic. I would counter that central banks are locked in a position of administering extreme monetary stimulus, fueling a runaway boom that will end in a historic bust. Markets clearly expect ongoing aggressive stimulus (QE) from all the major global central banks.

And I don’t buy into the “rates are near zero because of stagnation” argument. The Fed cut rates three times in 2019 due to market fragility and the risk of a faltering Bubble - that had little to do with U.S. economic performance. Global rates are where they are because of acute global Bubble-related fragilities and resulting extreme monetary stimulus. Low global market yields (and negative real yields) are more a Bubble Dynamic than a reflection of deflationary forces. A historic boom/bust dynamic has global bond markets anticipating enormous prospective central bank bond purchases (QE).

The critical question: Can runaway booms descend into busts without a tightening of monetary policy? The answer seems a rather obvious “absolutely”. I don’t believe the Fed’s timid tightening measures in 1999 and early 2000 precipitated the bursting of the Internet and technology Bubble. The Fed was cutting rates aggressively into 2002, yet that didn’t arrest the bust in corporate Credit. I would strongly argue the Fed’s even more cautious 2006/2007 rate increases were not the catalyst for the bursting of the mortgage finance Bubble. In reality, in the face of strengthening Bubble Dynamics, financial conditions loosened significantly as the Fed tiptoed along with its so-called “tightening” cycle.

The Fed emerged from the 1994 tightening cycle recognizing that contemporary finance – with its hedge funds, speculative leverage, derivatives and Wall Street securitized finance and proprietary trading– carried an elemental propensity for excess and instability. That was effectively the end of Federal Reserve policy tightening cycles. From then on, it was cautious little “baby steps” to ensure the Fed wouldn’t upset the markets.

The “tech” and mortgage finance booms were left to inflate free from central bank restraint. Uncommonly painful busts were inevitable. Today’s most protracted all-encompassing global boom has not only been left free to inflate, central bankers continue their multi-trillion spending spree to pressure nonstop inflation. I do agree: when this fiasco runs its course, it certainly won’t be boom and bust “as we know it.”

January 21 – CNBC (Yun Li): “Billionaire investor Paul Tudor Jones said the stock market today is reminiscent of the latter stages of the bull market in 1999 that saw a giant surge that ultimately ended with the popping of the dot-com bubble. ‘We are just again in this craziest monetary and fiscal mix in history. It’s so explosive. It defies imagination,’ Jones said… ‘It reminds me a lot of the early ’99. In early ’99 we had 1.6% PCE, 2.3% CPI. We have the exact same metrics today.’ ‘The difference is fed funds were 4.75%; today it’s 1.62%. And back then we had budget surplus and we’ve got a 5% budget deficit,’ Jones added. ‘Crazy times.’”

US economy: the Federal Reserve’s reality check

The US central bank’s events with small business and community leaders are beginning to influence monetary policy

Brendan Greeley in Washington

© Steven Senne/AP

In October, Jay Powell hosted guests at the Federal Reserve’s Marriner Eccles building in Washington. They sat at the boardroom table where the Fed’s Open Market Committee makes its decisions about interest rates and the Fed’s balance sheet. Silk-walled and chandeliered, the room served as a secure meeting place for UK and US military staff during the second world war.

After several hours of conversation, Mr Powell, chair of the Fed’s board of governors since February 2018, said: “We think our inflation is a little bit lower than we’d like it to be. But we realise for many people that sounds a little bit crazy.”

He explained to his guests — representatives of non-profits, community groups and small businesses — that if inflation falls too far, the Fed loses its power to encourage banks to lend more. Then, smiling a bit, he asked them: “Do you have any ideas on how to explain that to the public?”

The guests broke into laughter. “I think you’re going to need another three hours for that,” said one.

This summer, the Fed will release the results of an 18-month review of how it carries out and talks about monetary policy. While President Donald Trump has badgered the central bank to lower rates, the bank itself has been discussing something more fundamental: the tools at its disposal.

As part of that review, Fed staff organised 14 “Fed Listens” events, where they invited business and community leaders at least once to every regional Fed bank and the board of governors’ meetings in Washington.

Chairman Powell tours mHUB Chicago following a speech to the Economic Club of Chicago:
Fed chair Jay Powell tours workspace community mHUB after a speech to the Economic Club of Chicago © Federal Reserve Board

Mr Powell came to several of these events, and seemed to enjoy them — asking questions and taking notes. Over the past year the FOMC has lowered its policy rate three times by a total of 75 basis points, and indicated that it has no plans in 2020 to raise them again. The Fed eased for several reasons: it was concerned about a slowdown abroad and a lack of inflation at home. It also appears to have paid attention at its Fed Listens events.

Two messages came through in particular. First, there is more “slack” than the Fed had thought — more people who could still come into the labour force, particularly in poorer areas. Second, most Americans are more worried about increases in the cost of housing and medical care than they are about low overall inflation. Unlike the Fed, in fact, Americans do not seem to be worried about low inflation at all.

The meetings took place at a time the Fed has been rethinking the nature of the post-crisis economy. Evidence from the Fed Listens events has also crept into the standardised language that Mr Powell and his vice-chair, Richard Clarida, use to describe the state of the economy. That language, in turn, sends a signal to markets about the future path of interest rates. This means that long before the Fed finishes its review, the events have already become a tool for the Fed’s “forward guidance” — hints about what’s coming in monetary policy.

Graphic showing the hierarchical structure of the Federal Reserve system, including a list of the 12 Federal Reserve banks.

“People who live and work in low- and middle-income communities tell us that many who have struggled to find work are now finding new opportunities,” Mr Powell said at his press conference in December. “These developments underscore for us the importance of sustaining the expansion so that the strong job market reaches more of those left behind.”

After the laughter died down in the Fed boardroom, Denise Scott, from the Local Initiatives Support Corporation, a non-profit that identifies investments in poorer areas, agreed with Mr Powell’s point — that higher inflation would help to stimulate growth in the long run.

“But for many of our communities, the distance to the long term, we don’t — we just don’t survive that, that’s part of the problem,” she said. “The business closes. People don’t get to make the choice, say, for higher education. Families just can’t buy the milk today. I think that’s the challenge.”

All of the Fed’s monetary tools are intended to work on the same basic principle: to create economic growth, the central bank pushes down rates for a time, making loans more attractive. For the last several years, though, the Fed has been increasingly worried about the effectiveness of its tools.

A graphic with no description

The “natural rate” — an estimate by the New York Fed of what commercial interest would be without any central bank action — has been dropping steadily for years. The Fed cannot undercut something that is already on the floor.

Another way to accomplish the same thing would be to generate more inflation, reducing inflation-adjusted interest rates. But that’s been dropping, too. Since the Fed set its inflation target of 2 per cent in 2012, it has only reached it once, in the summer of 2018.

The Fed has a ritualised process for gathering data before its policy meetings, but the Fed Listens events have already begun to supplement this process and help define new areas of policy research. And according to the minutes of the Fed’s December meeting, some policymakers said they would like the events to continue, something Mr Powell has also suggested will happen.

What could have been a feel-good part of a one-time review, then, has become a serious research habit.“The individual reserve banks will continue to do these type of events,” says Robert Kaplan, president of the Dallas Fed. “But I think it’s a good thing for the Fed in a more formal, organised way to be doing these Fed listens events on some regular basis.”

Governor Brainard moderates a panel at the
Federal Reserve governor Lael Brainard moderates a panel sponsored by the Chicago Fed © Federal Reserve Board

“I’ve been pleasantly surprised at how meaningful they were,” Neel Kashkari, president of the Minneapolis Fed, says.

It’s not quite fair to say the Fed had never encountered regular people before. As well as running a nonprofit group, since early 2019 Ms Scott has served as chair of the New York Fed’s board of directors. But there are two novelties about her conversation with Mr Powell. First, it took place not at a regional Fed bank but in the boardroom of the Eccles building, in front of three governors. Second, they were not talking about how to boost local community development. They were talking about the policy decisions of the Fed’s rate-setting committee.

“There’s always been an aspect of the Federal Reserve that has been tied to community,” says Claudia Sahm of the Washington Center for Equitable Growth. “It has not ever been a part of monetary policy.”

Federal Open Market Committee (FOMC) participants gather at the Marriner S. Eccles Building in Washington, D.C., for a two-day meeting held on January 29-30, 2019. Please note: Confidential documents seen in this photo have been obscured.
FOMC participants at the Marriner S. Eccles Building, which was also used for the 'Fed Listens' events © Federal Reserve Board

The Federal Reserve has several jobs. It carries out monetary policy. Like the Bank of England, the Bank of Japan or the European Central Bank, the Fed has to keep prices stable. Uniquely among them, however, it’s also required to pursue “maximum employment” — it defines this as making sure that anyone who wants a job can get one, hence the focus on slack in the US economy.

The Fed also makes sure that banks are lending without prejudice and to encourage growth within their own cities, a function it calls “community development.”

The trained economists at the Fed have tended to stay cloistered in their own departments, separating the macroeconomics research that guides monetary policy decisions from work on community development. Ms Sahm, who ran consumer and community research at the Fed’s board of governors until October of last year, says the community development research staff had seen early warnings of the financial crisis, but did not know how to package what they had seen for policymakers.

“They had absolutely no way to convey that to the FOMC. And [former Fed chair Alan] Greenspan didn’t want to hear anything about it,” she says. “How do you take a thousand anecdotes and turn it into a boardroom briefing?”

Ms Sahm says the Fed Listens events, and Mr Powell’s commitment to them, had sent a signal to the career research staff, mostly PhD macroeconomists, about what is important. “Economists don’t trust anecdotes,” she says. “But anecdotes can also spawn an, ‘Oh, I should look at that in the data.’”

Chart showing the type of inflation that people care about. US consumer prices rebased (2000 = 100) showing figures for tuition and childcare, Medical care, rent and the overall figures.

At the Fed’s December meeting, for example, as part of a presentation on findings from the events, Fed research staff presented results from a model that incorporates “heterogeneity” — the possibility that the same economy has different effects on different people. In the model, the assumption that some people cannot borrow money produced sharper downturns, particularly when the policy rate is already close to zero.

“What’s new now is attempting to hear from these voices in a way that’s more directly related to the monetary policy front lines,” says David Wilcox of the Peterson Institute for International Economics. “The division of community affairs was hearing from these voices, but it was one step removed from the monetary policy process.”

Mr Wilcox ran the research and statistics division at the board of governors from 2011 to 2018. He says stories, often underestimated by macroeconomists, are important, because policymakers do not make decisions in a simplified, graduate-school environment.

“Decisions are made under profound uncertainty”, he says, “and if you better understand the consequences, you’ll better understand the risks.”

Federal Reserve Chairman Jerome Powell, right, says he doesn't see elevated recession risks, during a visit to a class of students and faculty, at historically black Mississippi Valley State University in Itta Bena, Miss., Tuesday, Feb. 12, 2019. Powell says that many rural areas have not benefited from the national prosperity and those areas need special support. Powell visited the school as part of his speaking before a rural policy forum at the school. (AP Photo/Rogelio V. Solis)Powell, right, during a visit to Mississippi Valley State University last year © Rogelio V Solis/AP

The Fed does its work within a complex institutional arrangement, an early 20th-century compromise to pacify southern and western US banks that were reluctant to let anyone back east tell them how many loans they could make. A central bank in all but name, the Federal Reserve System balances the Washington-based board of governors, appointed by the White House, with 12 regional Fed banks, each controlled in part by commercial banks in their own districts.

Contact with local workers and businesses has tended to take place through the regional Feds, whose presidents keep a regular schedule of meetings and speeches with business and civic groups. Regional Fed research staff also compile a quarterly Beige Book, a record of conversations, mostly with business leaders.

More recently, Fed bank presidents had begun taking the board of governors for visits to poorer communities in their own districts. Eric Rosengren, president of the Boston Fed, took former chair Janet Yellen to Chelsea, an industrial, majority Hispanic town across the Mystic river from Boston. Robert Kaplan of the Dallas Fed took Mr Powell to Dallas’s fifth ward.

Mr Rosengren, Mr Kaplan and Mr Kashkari say the Fed Listens events have been bolted on to existing processes and relationships they had in their own districts, both for community development and for data gathering.

What’s new, says Mr Rosengren, is that the Fed banks are not just heading out to learn about the economy, but also to ask about policy. “If you were somebody working at the carpenters’ union, we’d be asking, ‘How do you see the labour markets?

How would you see what’s happening in construction in Boston?’” he says. “But we wouldn’t really talk about monetary policy and how it affects their membership.”

FILE - In this Jan. 7, 2020, file photo, men hold up signs at a rally outside of City Hall in Oakland, Calif. California's Gov. Gavin Newsom said Wednesday, Jan. 8, 2020, that he is seeking $750 million to help pay rent for people facing homelessness, among other purposes, in the most populous state's latest attempt to fight what he called a national crisis. (AP Photo/Jeff Chiu, File)
The Fed learnt that Americans were more worred about increases in the cost of housing and medical care than low overall inflation © Jeff Chiu/AP

During the Fed’s December meeting, research staff laid out what they had learnt at the events.

In keeping with what Ms Scott had told the chair in Washington, inflation “elicited fewer comments at these events and were generally seen as posing less of a challenge than labour market conditions”, according to minutes of the meeting released last week. Guests at the events, Fed staff explained, were worried about the rising cost of living and thought that low inflation was a good thing.

Fed staff also noted that guests at the Fed Listens events had said that the economic expansion had not yet reached their neighbourhoods in a way that national statistics might suggest. Policymakers, according to the minutes, heard at the events a confirmation that the longer the expansion continued, the more likely it would “reach more of those who, in the past, had experienced difficulty finding employment”.

The Fed Listens events represent a way to give policymakers, particularly from the board of governors, the same message, says Mr Kashkari. “For a couple of years I’ve been travelling around the district, meeting with community groups,” he says. “I’ve been hearing these messages about ‘there’s still slack’ literally for four years.”  As well as informing policy, the events may be serving another purpose: helping the Fed explain what it does, in plain English, to people who do not follow financial markets.  In September, Fed governor Michelle Bowman met the St Louis Fed’s advisory groups. She heard from Josh Poag, chief executive of Poag Shopping Centers in Memphis, Tennessee.  “I will admit in the four years I've been here I think this is the most robust conversation we’ve had,” he told Ms Bowman. Employers in the St Louis Fed’s real estate advisory group, he said, were searching for workers, and thinking about bringing on convicted felons and ignoring evidence of marijuana use, for example.  Mr Pogue added that any kind of transparency is good for the Fed, and that people who do not understand how monetary policy works may be more likely to trust what they learn on YouTube. “The smarter the Fed sounds, the less trust it will have. That’s a scary thought. But I think it’s accurate.”

Expect the Unexpected When It Comes to Inflation

Most policy makers and economists forecast inflation will stay low in the year ahead. But predictions don’t always come true.

By Justin Lahart

The days when worries over the danger of too-high inflation were a regular feature of economic commentary are long gone.

That doesn’t mean the possibility of inflation running hotter-than-expected should be dismissed entirely.

The Labor Department on Tuesday reported that consumer prices rose 0.2% in December from November, falling shy of the 0.3% economists surveyed by The Wall Street Journal expected and putting them 2.3% above their year-earlier level.

Prices excluding food and energy items—the so-called core economists watch to track inflation’s trend—rose 0.1% on the month, putting them up 2.3% from a year earlier.

Since the Federal Reserve’s preferred inflation measure, from the Commerce Department, runs cooler than the Labor Department’s, it is likely that inflation once again finished the year short of the central bank’s 2% target.

Fed policy makers’ projections show that on balance they don’t expect inflation to reach 2% until next year.

Just because economists have been struggling to understand why inflation has been so low doesn’t mean that inflation can’t pick up. Photo: David Paul Morris/Bloomberg News

It is a remarkable turn, given that the unemployment rate, at 3.5%, is well below the 4.1% Fed policy makers believe is sustainable.

With the traditional, inverse relationship between unemployment and inflation seemingly broken, many officials, and economists, too, have defaulted to an expectation that inflation will remain persistently cool.

But Federal Reserve Bank of Boston President Eric Rosengren struck a lonely chord in a speech Monday, suggesting that there remains a danger inflation could accelerate. Wage growth, while still moderate, has been picking up, he pointed out, and with corporate profit margins under pressure lately, companies’ ability to absorb rising labor costs without raising prices may be limited.

Moreover, just because economists have been struggling to understand why inflation has been so low doesn’t mean that inflation can’t pick up. Instead, their struggle to forecast inflation may simply show that inflation is hard to predict, and might end up doing something unexpected. Indeed, in the early 1960s inflation was running even cooler than it is today. Policy makers assumed that would continue and rather suddenly found out they were wrong.

None of that means inflation is about to become a big problem or that forecasts that it will stay low won’t come true. But investors should be open to the possibility that inflation might not do what everyone thinks it will.

The Changing Face of Economics

Economists necessarily lack evidence about alternative institutional arrangements that are distant from our current reality. The challenge is to remain true to empiricism without crowding out the imagination needed to envisage the inclusive and freedom-enhancing institutions of the future.

Dani Rodrik

rodrik168_mlenny_getty images_teacher

CAMBRIDGE – Responding to pressures from within and without, the economics profession is gradually changing for the better. Not surprisingly, the populist backlash sweeping advanced democracies in recent years has produced some soul searching in the discipline.

After all, the austerity, free-trade deals, financial liberalization, and labor market deregulation that caused it rested on the ideas of economists.

But the transformation extends beyond economic-policy tenets. Within the discipline, there is finally a reckoning with the hierarchical practices and aggressive seminar culture that have produced an inhospitable environment for women and minorities.

A 2019 survey carried out by the American Economic Association (AEA) revealed that nearly half of female economists felt discriminated against or treated unfairly on account of their gender. Nearly a third of non-white economists felt treated unfairly based on their racial or ethnic identity.

These failings may be related. A profession that is less diverse and less open to different identities is more likely to exhibit groupthink and hubris. If it is to generate ideas to help society achieve inclusive prosperity, it will have to start by becoming more inclusive itself.

The new face of the discipline was on display when the AEA convened for its annual meetings in San Diego in early January. There were plenty of panels of the usual type on topics such as monetary policy, regulation, and economic growth. But there was an unmistakably different flavor to the proceedings this year.

The sessions that put their mark on the proceedings and attracted the greatest attention were those that pushed the profession in new directions. There were more than a dozen sessions focusing on gender and diversity, including the headline Richard T. Ely lecture delivered by the University of Chicago’s Marianne Bertrand.

The AEA meetings took place against the backdrop of the publication of Anne Case and Angus Deaton’s remarkable and poignant book Deaths of Despair, which was presented during a special panel. Case and Deaton’s research shows how a particular set of economic ideas privileging the “free market,” along with an obsession with material indicators such as aggregate productivity and GDP, have fueled an epidemic of suicide, drug overdose, and alcoholism among America’s working class.

Capitalism is no longer delivering, and economics is, at the very least, complicit.

A panel called “Economics for Inclusive Prosperity” (EfIP), organized by a network of the same name which I co-direct, discussed several strands of new thinking taking over the discipline. One is the need to expand economists’ focus from “average” levels of prosperity to distributive aspects and to non-economic dimensions that are equally fundamental to wellbeing, such as dignity, autonomy, health, and political rights.

How economists talk about, say, trade agreements or deregulation may well change when they take such additional considerations seriously. This will require new economic indicators. One proposal that goes part of the way is for government agencies to produce distributional national income accounts.

As Samuel Bowles and Wendy Carlin argued in a paper presented in the same session, every policy paradigm embeds a set of ethical values – about what the good life entails – along with a view of how the economy works. Neoliberalism presumes individualistic, amoral individuals and a free market that delivers efficiency, thanks to complete contracts and a relative paucity of market failures.

What we need, according to Bowles and Carlin, is a new paradigm that integrates egalitarian, democratic, and sustainability norms with a model of the economy as it really operates today.

This paradigm would place community alongside the state-market dichotomy and would include policies such as wealth taxes, broader access to insurance to reduce risk exposure, workplace rights and voice, corporate governance reform, and substantial weakening of intellectual “property rights.”

Speaking in the same session, Luigi Zingales faulted economists for foisting their own preferences on the body politic. This happens because economists tend to place greater value on certain outcomes (such as efficiency) than others (such as income distribution), and because they fall prey to groupthink and fetishize particular economic models over others.

Part of the solution is to value diversity and exhibit greater modesty. Another part, according to Zingales, is to pay more attention to research in other social sciences, including history, sociology, and political science.

The implication of all these perspectives is that economics must be open to institutional alternatives and to institutional experimentation. Fostering such thinking is one of the major aims of the EfIP network. The institutional basis of a market economy is largely indeterminate.

We can stick with institutional arrangements that sustain privilege and restrict opportunity. Or we can devise institutions that, in the words of Bowles and Carlin, are consistent with the pursuit of not only shared affluence but also an expanded concept of freedom.

Empirical methods – especially of causal inference – will help, and they have become much more central to the profession in recent decades. This is a very good thing insofar as real-world evidence, with all of its necessary messiness, displaces ideology.

But the focus on evidence also risks creating its own blind spots.

Evidence about what does and does not work can be obtained only from actual experience. We necessarily lack data on alternative institutional arrangements that are distant from our current reality.

The challenge for economists is to remain true to their empiricism without crowding out the imagination needed to envisage the inclusive and freedom-enhancing institutions of the future.

Dani Rodrik, Professor of International Political Economy at Harvard University’s John F. Kennedy School of Government, is the author of Straight Talk on Trade: Ideas for a Sane World Economy.

The Limits of Germany’s Economic Outreach to Russia

By: Ekaterina Zolotova

German Chancellor Angela Merkel was in Moscow on Saturday to meet with Russian President Vladimir Putin.

Over more than three and a half hours they discussed the situations in Syria and Libya, the Iran nuclear deal, the Nord Stream 2 gas pipeline project and implementation of the Minsk agreement regarding Ukraine.

This was Merkel’s first visit to Moscow since 2015, an indication that both Russia and Germany needed serious dialogue.

In recent months, there have been several signs that Germany is interested in improving ties with Russia.

This coincides with an ongoing slowdown of the German economy. Despite existing Western sanctions, Russia remains one of Germany’s key trading partners. Any meeting between Berlin and Moscow may mark the beginning of deeper cooperation.

And this possibility always garners attention, because in the past when the two countries have gone through periods of rapprochement, it didn’t last and often ended in conflict or a significant strengthening of the Russian economy. Neither outcome would please the West.

The German economy is teetering on the edge of recession. Germany’s real gross domestic product fell by 0.1 percent in the second quarter of 2019 compared to the previous quarter, and rose by just 0.1 percent in the third quarter.

German industrial orders unexpectedly fell in November because of weak external demand and the lack of major contracts. German car manufacturers also significantly reduced their output in 2019.

The German Association of the Automotive Industry announced recently that during 2019 only 4.7 million passenger cars were produced in German automobile plants, 9 percent less than a year earlier and the worst output since 1997.

Car exports fell by 13 percent, and to reduce costs, Daimler, Volkswagen and Continental have been forced to make workforce cuts. Volkswagen, for example, plans to cut between 5,000 and 7,000 jobs over the next five years.

What’s more, Germany, which derives almost 50 percent of its gross domestic product from exports, does not expect demand among its largest trade partners to bounce back anytime soon.

A drop in demand from China, one of the main markets for German carmakers, was especially impactful. German automobile sales to the Chinese market fell by 11 percent from January to October 2019.

There are political problems, too. Beijing has threatened Germany with retaliatory measures if Berlin bans China’s Huawei from participating in the buildout of the German 5G communication network, while Washington is implementing sanctions against the Nord Stream 2 natural gas pipeline between Russia and Germany.

The United States also in October imposed tariffs of 10 percent on large civilian aircraft and 25 percent on some agricultural goods from Europe.

Washington is also still holding out the threat of higher tariffs on European cars, which would disproportionately hurt Germany.

Finally, it is far from clear what the future holds for the EU-U.K. trade relationship after Brexit.

Germany has few other trade partners whose demand could pick up the slack.

In theory, Russia could be one of them. In the past, Russia-Germany relations have oscillated dramatically; their swings from confrontation to cooperation have been one of the main axes upon which European history turns.

Before World War I, Germany was among Russia’s main trading partners, accounting for a third of Russian exports and almost half of Russian imports, while Germany (along with France, Belgium and the United Kingdom) was one of the main investors in Russia. In the interwar years, with the German military crippled by the tough restrictions of the Treaty of Versailles, Germany turned to the Soviet Union for military-technical exchanges.

As part of their military cooperation, the Soviets and Germans set up a joint flight tactical school near Lipetsk and a joint tank school near Kazan, both in Russia. In the early 1970s, Germany again assumed a leading position among the Soviet Union’s main trading partners, partly as a result of a long-term contract on the supply of Soviet pipes and other equipment for the construction of a gas pipeline to Western Europe.

Today, the Russia-Germany economic relationship remains pragmatic, though political relations are far from good since Germany opposes Russia’s position in Crimea and Donbass.

The European Union – mostly Germany – accounts for more than half of Russia’s foreign trade, while Germany is among the major direct investors in the Russian economy, an especially appreciated fact in Russia at the moment.

The volume of trade between Russia and Germany in 2018 reached $60 billion, higher than at any point since sanctions were enacted over Crimea in 2014.

In 2018, German companies’ investment in Russia, at about 3.2 billion euros ($3.6 billion), was near its peak since the collapse of the Soviet Union and a record for the past 10 years. In the first quarter of 2019, the Russian economy received 1.76 billion euros of net direct investment from German firms, which is a third more than at the same point last year. Direct participation by German businesses in Russian companies and Russian debt instruments is not decreasing either.

Volkswagen is one of the largest foreign investors in the Russian automotive industry and owns a plant in the Kaluga region. In 12 years, the Volkswagen Group has invested 1.83 billion euros in Russia, and it is planning to invest another 600 million euros over the next five. Siemens supplies Russia with a wide range of products, such as industrial and medical equipment as well as high-speed electric trains.

Small wholesale supermarket Metro Cash & Carry has 89 shops in 50 Russian regions (and one in Crimea); Henkel has nine Russian factories; and Wintershall has already invested 600 million euros of a planned 950 million euros in Nord Stream 2 and established the Achimgaz joint venture with Russia’s Gazprom to develop the Urengoy field in Siberia.

There is some statistical evidence that German companies are continuing to leave the Russian market because of sanctions; according to Deutsche Welle, at the end of 2019, 4,274 companies worked in Russia, compared with 6,300 in 2011. But it’s hard to prove that those German businesses that have left have done so completely or permanently.

In addition, the number of companies leaving Russia tells us nothing about those companies’ size, and thus the scale of business leaving. According to the latest survey by the Leibniz Center for European Economic Research, Russia is the most attractive emerging market for German family businesses because of its tax system, the availability of educated workers and its low energy costs.

Despite the harsh criticism of Russia and ongoing sanctions, and their differences on issues including Crimea, Berlin often calls for open dialogue with the Kremlin over several international issues. In the near term, however, the German government finds addressing its economic problems more pressing than other areas.

The Russia sanctions have already cost German businesses several billion euros, according to the German-Russian Chamber of Commerce. German businesses do not want to give up their positions in Russia because of new U.S. sanctions. On Nord Stream 2, for example, Germany would like to complete the pipeline so that it can get rid of the extra costs paid to transit countries and thereby purchase cheaper energy, which will give a jolt to its economy.

But greater Russia-Germany cooperation could significantly help Germany’s economic performance only if Russia provides high demand for German goods and sanctions are lifted. Neither is realistic. The Russian economy itself is slowing down and unable to deliver the higher levels of demand that German firms seek.

There are reports from Russia daily about declining consumption levels and falling disposable incomes. And sanctions are unlikely to be lifted without a stable peace in Ukraine, and in any case it's not a decision solely for Berlin to make – a veto from Berlin on extending the EU’s Russia sanctions would cause more political problems in the EU than it would be worth, not to mention the disruption it would cause in the much more important relationship with the United States, the main destination for German exports.

This is why the key task for Berlin now is to maintain its position in the Russian market and get a return from its huge investments in the Russian economy. Germany and Russia will certainly continue their economic cooperation, but sanctions will limit their actions.

At least in the short term, the German economy won’t find much respite from its eastern neighbor.