The field of play
Risk of secular stagnation
As a long term investor I try to understand the broad economic framework. I think of it as the field of play. Using a football metaphor, it’s like developing a deep understanding of the different zones on the field. In some zones offense takes place. In others, defense. Some have danger, and so on.
My investment process has developed by reading and trial and error. With my long term focus I don’t have to have any view as to how the economy will unfold in the next year or two. I don’t need to worry about whether there will be a recession over the next twelve months. That is irrelevant. I don’t need to interpret the tea leaves of inverted yield curves.
I do need to understand the big picture. I want a plausible view or even a likely view as to how the economy will unfold in the next five or ten years. I need this because when I’m thinking about the stocks in our portfolio, I need context to understand their businesses and potential pitfalls over the long term.
50 years of inflation
In the last 50 years inflation in North America has averaged about 4% a year. But the average is misleading. The 1970s and 1980s saw inflation well over 4%. In the early 1980s I was paying over 20% interest on a loan I took out to buy a real estate limited partnership. Somehow the economy and our family survived very high inflation and very high interest rates.
The period post 2000 was the complete reverse. Alan Greenspan was chair of the U.S. Federal Reserve from 1987 to 2006, some 18 years. He noted that post 2000 globalization seemed to be exerting a disinflationary impact on the U.S. economy. Disinflation is a lowering of inflation. Deflation is an actual drop in prices.
He wrote: “By 2003, however, the economic funk and disinflation had gone on so long that the Fed had to consider a more exotic peril: a declining price level, deflation. This was the possibility that the U.S. economy might be entering a crippling spiral like the one we’d seen paralyze Japan for thirteen years.” (Alan Greenspan The Age of Turbulence, 2007) p228 (Emphasis added)
We can update the Japan situation. That country’s battle against deflation and stagnation has now gone on for 30 years. Japan is the only developed country to not be raising interest rates because it has minimal inflation to fight. Its 10 year government bonds yield zero interest.
U.S. secular stagnation
For the 20 years prior to 2020 the U.S. was facing secular stagnation. In the early 2000s this term was popularized by Larry Summers, an economics professor at Harvard who served as the U.S. secretary of the treasury from 1999 to 2001 and as director of the National Economic Council from 2009 to 2010. The idea is that “slow growth and limited opportunities for productive capital investments in turn depress the demand for investable funds, lowering the neutral rate of interest.” According to Summers, secular stagnation is the “result of fundamental forces that likely will persist.” (Ben S. Bernanke, 21st Century Monetary Policy, 2022) p.91.(Emphasis added). Bernanke was chairman of the Federal Reserve from 2006 to 2014. In 2022 he received the Nobel Prize in Economics.
The neutral rate of interest is an economics term that is worth defining. It is the rate of interest that prevails when the economy is at full employment with stable inflation.
Economists also hypothesize that the neutral rate of interest has been declining over the last 25 years because of a combination of factors: globalization; technology; slow growth in productivity; and, a glut of global savings driven by worldwide income growth in an aging population. (Bernanke, 2022) p.92. Japan fits this description perfectly. It has a wealthy aging population, a real demographic problem. Japan’s problem started with the bursting of a massive bubble in the late 1980s and has never let up.
Readers will remember that prior to Covid, in the period leading up to 2020, nominal interest rates in many countries were essentially zero. That meant that with inflation hovering around 1.5%, real (inflation adjusted) rates were negative.
The need for inflation
The Federal Reserve’s job is to keep inflation in check and do so in a way that keeps unemployment as low as possible. It has three basic tools: the first is through setting interest rates; the second is by managing inflation expectations through its messaging (called forward guidance); and, the third is the use of unconventional tools such as quantitative easing and quantitative tightening.
The main tool, interest rate setting, is a bit like operating a car. When a car needs slowing down, a tap on the brake is called for. To speed up, the accelerator does the job. The economy goes in cycles. At risk of oversimplifying, the economy sometimes over-heats and interest rates need to be raised to act as a brake. When the economy is in a funk, a recession, interest rates need to be lowered to step on the gas.
When inflation is too low and when the neutral rate of interest is too low, stepping on the gas through rate cuts doesn’t work. That’s because rates are already so low that they can’t be lowered enough to make a difference. And, at some point, lowering them further would take them below zero.
This is essentially why central banks today target bringing inflation to 2% and holding it in that range. It gives them scope to either hit the brakes by raising rates or hit the gas by lowering them. By targeting 2% central bankers not only want to sometimes lower inflation. They also sometimes want to raise inflation.
Prior to Covid
In the U.S., prior to Covid, the Fed had effectively been in an inflation raising mode over the previous ten or more years. Prior to Covid, this had had little effect.
Bernanke suggests that prior to Covid economic policymakers had recognized that “the neutral interest rate had continued its long decline; that the economy had become better able to sustain very low levels of unemployment without spurring inflation; and, indeed the behavior of inflation was itself fundamentally changing.” (Bernanke, 2022) p.204. (Emphasis added)
Immediately prior to Covid inflation was too low. Today, in 2022, in spite of dramatically raised interest rates over the last six months, low unemployment and job vacancies that are going unfilled continue. It seems to be caused by an aging population leaving the workforce.
But, in this new normal prior to Covid, there was not enough inflation which meant that interest rates were not high enough for the Fed to step on the gas in recessionary times.
In 2019 the Fed had begun a strategy review to see whether the target rate of 2% should be increased. Such an increase would have increased the neutral rate and given the Fed more tools to step on the gas in a recession. In August 2020 the Fed announced that if inflation ran below 2% (as it had for most of the time pre-Covid since the Great Financial Crisis and recession) the Fed would allow inflation to run “moderately above 2 percent for some time.” (Bernanke, 2022) p.270.
The Federal Reserve has all the tools it needs to bring inflation back to target. It also has the will. There is no higher bound on raising interest rates other than howls of pain from borrowers this would hurt. Quantitative tightening is available to raise longer term rates. Although the Fed loses money with QT. And forward guidance is also being used effectively. Ten year U.S. gov’t bonds currently yield 3.7% which suggest the long end of the bond market believes the Fed will succeed.
The Fed and other central banks will get inflation under control in the next year or two.
Here’s the long term outlook
Long term secular trends affecting inflation, labor market and interest rates such as technology; increasing investment in intangibles and decreasing investment in tangibles; slow growth in productivity; declines in the size of the workforce as populations age and leave the workforce; and, a glut of global savings driven by worldwide income growth in an aging population will remain. Globalization may as much be morphing into friendshoring as into reshoring. Friendshoring may have the same impacts as the original globalization.
If there are no changes to these long term secular trends (which I don’t see happening), I have to believe that over the next five or ten years the risks of a Japanese type secular stagnation remain for the U.S. economy. The Fed is currently engaged in a fight to tamp down inflation. I suspect the Fed is quietly hoping that some of our current inflation and inflation expectations stick so as to raise the neutral interest rate back to around 4% or even 5% rather than the estimated 2.5% that existed prior to Covid.
This post has been about long term secular trends and possible Japanese type stagnation. I find it useful to learn about this stuff because I need context to understand the companies in our portfolio, their businesses and potential pitfalls over the longer term.
The companies we invest in are all well positioned to deal with the current inflationary environment. They are not particularly exposed to increased interest rates. Some companies such as REITs and utilities (which we do not hold) are exposed. Our portfolio is not especially vulnerable to a recession, even a sharp one. The companies are also well positioned to deal with risks from some form of secular stagnation that might follow a sharp recession. As for stock prices, volatility is quite normal on this field of play.
Readers wishing to read deeper into this subject can check out the Motherlode Chapter 8. The Economy and the Stock Market – Cycles and Trends
And particularly Sections:
8.02 Industry or sector cycles
8.04 Animal spirits and economic cycles
8.07 Underheated economy – recession
8.09 Declining prices of commodities
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