What Investors Should Know about the Current State of the Economy
This week we are fortunate to share our interview with Mr. Kevin Kliesen, a business economist and Bank Officer in the Research Division at the Federal Reserve of St. Louis.
Mr. Kliesen holds an M.A. in Economics from Colorado State University and joined the bank in 1988. In his position as a business economist, Mr. Kliesen analyzes current U.S. macroeconomic and financial market developments and trends for the Bank president and staff economists prior to each Federal Open Market Committee meeting. He also reports on and analyzes economic conditions in the seven states of the Eighth Federal Reserve District. Another important aspect of his position involves speaking to the general public and professional groups about U.S. and Eighth District economic developments. Mr. Kliesen has written and published extensively and was instrumental in the development of the St. Louis Fed’s Financial Stress Index and the St. Louis Fed’s Price Pressures Measure. In addition to his responsibilities at the Federal Reserve Bank of St. Louis, he taught part-time on the Department of Economics at Washington University from 2006 to 2013. Professionally, he is a member of the American Economic Association, the National Association for Business Economics (NABE), and the Association of the Christian Economists. In September 2011, he was recognized as a NABE Fellow, one of the organization’s highest honors. In October 2015, he was designated as a Certified Business Economist by the NABE.
Disclaimer: The following represents the views of Mr. Kliesen. They are not necessarily the views of the St. Louis Federal Reserve or the Federal Reserve Board of Governors.
We asked Mr. Kliesen several questions about the current state of the economy. Let’s see what he had to say:
1. Why are interest rates currently low?
There are three key reasons why interest rates are low. The first reason is that inflation expectations are low. In very simple terms, if you think about the nominal interest rates or the interest rates that are reported in the Wall Street Journal or the New York Times on a day-to-day basis that is the sum of two components. First, you have the real interest rate component, which moves based on changes in the real economy, unemployment rates, etc. and reflects the performance of the U.S. economy. The second component is the expected rate of inflation that compensates holders of Treasury securities that are not adjusted for the changes in the prices. When you buy Treasury securities you make an implicit bet that inflation is going to come in at some level over the duration of the security that you are holding. It appears that financial markets on net are agreeing with the Federal Reserve numbers right now; this is the first inflation we are seeing and it is not going to persist.
The second reason why interest rates may be low is that the Federal Reserve is continuing with its asset purchase program, buying U.S. Treasury securities or mortgage backed securities. When it does that it tends to increase the demand for materials, so it bids up the price and lowers the yield or lowers the interest rates. This helps to keep interest rates lower or even lower than they might otherwise be in an environment where the economy is going strong and the Treasury is issuing a lot of debt.
The third factor is the fact that productivity growth over the long run is still expected to be around 1.5%. A low productivity growth economy tends to produce a low real (inflation-adjusted) interest rate over time as well. So, this combination of low-interest rates and the expectation of low inflation tends to be why you see interest rates low.
2. What is the near-term outlook?
The Fed recently came out with its economic projections, and I think the near-term outlook is exceptional in many ways. The median participant expects growth of a little less than 6% this year and if that happens, that will be the strongest growth rate since 1983. To paraphrase a song from the 1980’s, “The future is so bright, you have to wear shades”.
The strong growth reflects several factors. First, when you have a very big decline in economic activity like we experienced with the pandemic, there tends to be a sharp snap back in economic activity. During the pandemic, people saved a lot of money. When looking at the level of saving in the economy, it looks like there is still a little more than half a trillion above its pre-pandemic trend. This saved cash will be put to work by both households and businesses when they begin to spend more on travel, dining out, renovating their houses, etc. which will all boost growth.
Next, you have the contributions from the monetary and fiscal authorities. The Federal Reserve is still maintaining a near-zero interest rate target and Congress has passed several pieces of legislation that were signed into law by the president that has boosted incomes and expenditures by households, businesses, and federal and state and local governments. You might say that policymakers have pushed the “pedal to the metal.” The policy is very aggressive and conducive to the growth of output in employment and inflation. One of the trade-offs is that when there is fast growth, this tends to produce higher prices. For example, the press is full of stories of labor and material shortages which lifts the prices of materials and labor. This sort of feeds into the inflation dynamic I talked about earlier and can cause the possibility of the Fed having to raise its policy rate a little bit earlier than expected.
When we forecast, we have a baseline forecast that we look at and make projections from, but there is always risk in forecasts. There are known risks that we talk about and then there are other unknown risks, such as when we were in the thick of last year’s pandemic. We try to factor in all of these things into our forecast.
3. Let’s talk about uncertainty. It seems that COVID-19 and the political arena have been driving uncertainty, but one of the common indicators - lowered stock prices - hasn't tagged along. Is this a new paradigm of uncertainty, and if so, how can investors take advantage?
The measure of uncertainty I look at is the Baker-Bloom-Davis Economic Policy Uncertainty Index. [Here is the FRED link: https://fred.stlouisfed.org/series/USEPUINDXD] This measure of uncertainty has declined markedly from the record-high levels of last year. During the Pandemic, uncertainty spiked. Obviously, there was a lot of fear in markets and among households and businesses about future direction of the economy, whether firms will survive, and whether people will lose their jobs, so that uncertainty was natural and expected. Since then, uncertainty has come back down but remains slightly above the long-run average. So, in this sense, we may be in a new regime of higher uncertainty; we will just have to wait and see.
Typically, uncertainty falls when economic growth is high. There is more certainty about the path of the economy so we will have to see if it begins to fall forward. If not and this regime of higher uncertainty persists, it may eventually have long-run implications for the economy.
One of the things we do know, and I’ve done some work in this area, is that when uncertainty picks up, there tends to be more of a precautionary view among households and firms. For example, if you are a household and are more uncertain about your employment prospects, you tend to spend less and save more; in other words, precautionary saving goes up. It is the same thing with firms; if firms are uncertain about the future, they may not purchase a piece of capital equipment because they cannot reliably estimate the long-run rate of return on it, or they may not hire a new individual because the hiring process is costly.
We are in an environment where the thrust of monetary and fiscal policy is just so far outside of what we have seen before. The question is will this re-normalize at some point or will it persist going forward. We will just have to wait and see what happens.
4. Are there any important forecasts from the Fed that it’s possible investors don’t give enough credence to?
Good question, I am not sure. I think private forecasters and sophisticated investors look at the same data and also know what the Fed looks at. Remember that the Fed is fallible; I’ll be the first to admit it. My job is to forecast the U.S. economy, which is a tough job and a tough business to be in. We are not right all of the time by any stretch of the imagination.
I think one of the complications is that the Fed has this new framework. They are banking on us to run a very hot economy and sort of raise the tide that lifts all boats in terms of improving employment prospects. But there is a trade-off there, which is the possibility of higher inflation.
Congress has given the Fed a dual mandate of price stability and maximize employment. We will just have to see what happens, but I think financial markets and sophisticated investors know what the Fed is looking at and will act accordingly to achieve its dual mandate.
5. Does the end of COVID-19 indicate any significant policy changes?
A while ago, my boss, Jim Bullard, commented that an improving economy and an end of the pandemic could signal some tapering action by the Fed. And this appears to have come to pass according to remarks made by Chair Powell in the latest Press Conference. But I think the more general rule is that as the economy begins to return to a path of growth, inflation, and employment that is consistent with the fundamentals, the Fed will adjust its policy to reflect this economic state of affairs.
I do not believe the mechanics of monetary policy nor the fundamentals of monetary policy have changed. The Fed has a dual mandate and is going to react accordingly if one or both of those mandates are threatened. The worst possible scenario would be that we find ourselves back in the 1970s where both inflation and unemployment are going up. There may be some people out there forecasting that outcome, but I am not one of them—nor do I know of any Fed forecasters or private sector forecasters who are doing so..
I think the Fed will eventually return to a policy where it is, first, not expanding its balance sheet and, second, has set the policy rate at a level that is consistent with its view of the long-term growth rate of the economy and inflation at its target. That is “Traditional Central Banking 101.” Now, the big question is when we will get there – which brings us back to the uncertainty issue. There is still a fair amount of uncertainty about the future direction of the economy and fiscal policy.
For more about Mr. Kliesen and his research, visit his Federal Reserve of St. Louis webpage.
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