A Few Concerns

We’ve begun 2014 with widespread expectations that economic growth will pick up. Growth last year was restrained by tighter fiscal policy. With that out of the way and the housing sector recovering, the pace of expansion is poised to improve. However, there are a number of concerns. Weak growth in real wages may limit consumer spending, which accounts for 70% of Gross Domestic Product. Long-term interest rates could rise too rapidly, choking off the recovery in the housing sector. A continued low trend in inflation, a major concern for some Fed officials, could weaken growth. Finally, matters regarding a number of countries have quickly coalesced into increased anxiety about emerging economies in general. None of these issues is likely to derail the expansion, but investors are likely to remain a bit nervous in the near term.

It’s been reported that President Obama will make income inequality a key theme in his State of the Union address on Tuesday evening. We’ve already had a preview in a speech Mr. Obama made in December. It’s unlikely that he’ll cover much new ground on the issue, but its emphasis in the State of the Union address is likely to make it a key political issue, especially as one looks ahead to November’s mid-term elections.

There’s been some debate in recent decades about whether income equality even exists, but the data have put that issue to bed. It’s real. Income gains have gone disproportionately to the top 5% (more disproportionately to the top 1%, and even more disproportionately to the top 0.1%). As Mel Brooks once said, “it’s good to be the king.”

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Consumer spending growth picked up in the second half of 2013, but that did not appear to be fueled by growth in wages. Average hourly earnings adjusted for inflation were unchanged over the 12 months ending in December. Note that you can still get growth in aggregate wage income as you add jobs.

The question then is whether income inequality is harmful for overall growth (and there is a growing body of research to suggest that it does contribute to slower growth), and if so, what to do about it. In March, we’ll see the English translation of Thomas Piketty’s book, “Capital in the 21stCentury.” Piketty, along with Emmanuel Saez, is well known for research into income inequality. The book, currently available in French, suggests that the ownership of capital becomes increasingly concentrated if the after-tax return on capital is greater than the growth rate of the economy. Implicitly, a simple solution to reducing after-tax returns on capital would be to increase tax rates. Not that this is likely to happen anytime soon, but the mere discussion could raise longer-term concerns for investors.

Incoming Fed Chair Janet Yellen will face some key challenges this year. In contrast to last summer, the financial markets appear to be relatively comfortable with the idea of the taper. While not on a set path, the Fed is widely expected to reduce the rate of asset purchases by $10 billion per policy meeting. The burden of evidence is on the economic outlook and financial market developments (to argue for a faster or slower rate of tapering). Long-term interest rates are expected to trend higher, but should not rise so rapidly that they derail the economic recovery. So far, so good. The 10-year Treasury note yield has fallen back to a moderate level.

Fed officials are also concerned that inflation will be too low. There seems to be little fear at the Fed of outright deflation (a decline in the overall price level), but a continued low trend of inflation means that debt burdens will be higher than they would be otherwise. All else equal, low inflation implies higher real interest rates and slower economic growth. Worries about low inflation are not unique to the U.S. central bank.

Fed tapering may be more of a concern for emerging economies. Many of these countries complained the Fed asset purchases were indirectly boosting capital inflows. Now they complain that the tapering is leading to capital outflows. During the financial crisis, global investors were not excited about putting money to work in the U.S. or Europe. The emerging economies had (and still have) a compelling long-term story. With developing middle classes, these countries are expected to account for much of the global economic growth over the next few decades. However, capital outflows, once they get going, tend to be reinforcing. As capital flows out, it creates more incentive for other global investors to pull out their capital.

Due to strict capital controls, China is less susceptible to such developments. However, China faces the prospect of slower growth this year. At the same time, its central bank is expected to rein in loan growth after the Chinese New Year celebrations, but the PBOC has little control of the shadow banking system.

© Raymond Jame s


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