A message from Global electorates economics still matters
A standout chart from the US election was how the economy was key for 80% of Republican voters, second only behind immigration at 90%. This was despite unemployment rates close to record lows, annualized inflation rates around 2%, and interest rates on their way down from the peak. Incumbent administrations in the UK and France were similarly ushered from office, in part due to economic concerns.
It’s Prices Stupid - the pandemic price shock was not transitory
Despite Central Banks pointing to post-pandemic supply pressures easing, and inflation moderating, a common reprise during these elections was how voters were being negatively impacted by elevated price levels, and the inability of real wages to keep pace. In the US, the type of goods that households regularly purchase (food, drink, and gas) are some 28% above where they were in January 2020 and some 18% above where they should have been in a 2% inflation world (Chart CV1). In the U.K. the food, drink & energy index is 30% higher, while the ECB ‘Frequent Out Of Pocket Purchases (FROOPP) index is up 25% since the pandemic. It’s no wonder people are hurting. There are a number of lessons that may emerge from this economic data and the recent political outcomes, that are relevant for investors.
It could be time to shift from Taylor Rules to Woodford Models
Typically, major western Central Banks, appear to have set monetary policy with some reference to Taylor Rule models, adjusting policy rates depending on how far the economy was from the inflation targets, but also the amount of slack in the economy (sometimes proxied by unemployment rates) as an indication of future inflation risks. While these terms tend to be given equal weights, the recent elections suggest that electorates may be more focused on price stability than full employment. Given these election results, Central Banks might need to think about revisiting an alternative policy framework - price level targeting - as popularised by the economist Michael Woodford and others. In this framework, policy becomes history dependent, and by acting early to limit initial divergences, there are potential welfare gains for consumers. This contrasts with the current policy that celebrates the return 2% inflation after it has been missed for several years, without helping households to recover their lost real purchasing power. The discussion of these models also increased following the GFC, since some argued that if asset prices had also been included in the policy function there might also have been a positive impact in limiting financial instability as well. As the CEPR argue, it may be time for policy makers to revisit this discussion.
Headline inflation is more important than core
Another lesson from the recent elections is that while Central Banks target ‘core’ prices and inflation, voters seem to base their perceptions of the economy on ‘headline’ measures, i.e. policy is probably targeting the wrong variable. Central Banks may have more chance of influencing ‘core’ prices with traditional monetary policy tools, but by ‘looking through’ shocks in food and energy prices, Central Banks can appear detached from the prices that matter for the majority of society. It may also be the case that in a ‘small open economy’, such as the UK, if rates are kept low in the face of an external supply shock, and headline inflation accelerates, this can create downward pressure on the currency, further increasing imported price pressures. Perhaps, if policy makers had sought to stabilize post-pandemic prices earlier, by bringing demand and supply into equilibrium earlier, rather than just waiting for supply to catch-up, then we might have seen lower peak inflation, less price persistence, and less political turmoil.
Real wages and productivity faltered in the inflation targeting era
Also central to the recent rejection of incumbent governments is the fact that labour incomes have typically failed to keep-up with the increase in headline prices. Indeed, given the centrality of labour costs in core service sector inflation, it is clear that squeezing real labour incomes was a key part of the inflation targeting seen since 1997. At the same time, lower interest rates have favoured capital over labour.
Chart CV2 shows how, since Volcker started to bear down on inflation in the late 1970s, the benefits of productivity growth have tended to be captured by companies rather than labour. Also evident is how trend productivity has slowed since the start of the 1980s, despite the hope that inflation targeting would boost productivity through reducing inflation uncertainty for companies and encouraging investment. Investment and productivity also failed to respond to lower rates and QE when higher inflation was targeted, post GFC. Instead, companies responded with increased financial engineering to boost profits, not growth. They reduced investment spending and raised dividends and buybacks for shareholders.
Inflation targeting may boost income inequality and populism
This brings us to the final element of the story. Given that Central Bank inflation targeting has boosted capital relative to labour, it has also probably played a role in increasing income inequality. The incomes of wealthy, higher-income households have increased (due to dividend income) at the expense of low- and middle-income households (see Chart CV3). This widening income disparity has clearly played a role in the rise in populism across many western economies.
Conclusion: This was a vote to change monetary frameworks
The big lesson from recent elections is that the economy still matters. While unemployment may be low, elevated price levels mean that real wages have been squeezed for many households, fuelling discontent. Central Banks, and the politicians who set their mandates, need to recognise that whilst unemployment may impact an unfortunate few, high price levels impact every household. If politicians want to get re-elected, and Central Banks want to remain independent and relevant to society, it may be time for the politicians to re-visit these mandates. Tackling inflation earlier might also be good for both Bonds & Equities.
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