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May 26, 2022

US macroeconomic anomalies and volatility; German producer prices; Sri Lanka cost-of-living crisis

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Julius Probst
Arnaud Lieugaut
Patrick Malm
Karl-Philip Nilsson
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US unemployment vs natural rate

A key building block of modern, neo-Keynesian macroeconomic theory is that the business cycle is symmetric: the economy fluctuates around the natural rate of interest and the natural rate of unemployment. Accordingly, output gaps should as a first approximation follow a normal distribution.

However, as our economist Julius Probst, PhD recently argued in a Mercatus research paper, the US economy seems to behave instead like Milton Friedman’s plucking model: the economy will follow trend output over time – that is, while there are no artificial booms that push the economy above trend, recessions do pull the economy below potential. Moreover, the steeper the initial decline, the larger the subsequent recovery.

Our first chart shows this inherent asymmetry in the labour market. Since the 1980s, the actual unemployment rate has remained above the natural rate estimated by the Congressional Budget Office (CBO) some 80% of the time. 

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US unemployment gaps

The distribution of unemployment gaps – the percentage point difference between the real and natural rate of unemployment - is highly skewed, as the histogram below shows. 

Since the 1980s, positive unemployment gaps – when the unemployment rate is higher than the natural rate – have occurred more often than negative ones. Moreover, they are also much larger in size, consistent with the plucking view of business cycles. For example, during the Covid-19 pandemic, the actual unemployment rate increased 10 percentage points above the natural rate.

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Growth and inflation volatility

Speaking of business cycles, it looks like we’re in the midst of a macroeconomic regime shift. The Great Moderation of decreased macroeconomic volatility from the mid-to-late 80s to about 2007 – which resumed after the end of the Great Recession – appears to be coming to an end. 

As the chart shows, volatility of both GDP growth and inflation has surged recently amid macroeconomic shifts and shocks triggered by the pandemic.

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Fed tightening cycle and policy rates

The next two charts use our slice analysis function to compare different historical Fed tightening cycles in one chart. 

In the first, we used market prices (Fed funds futures) to predict how the policy rate will evolve over the next couple of years. As you can see, despite surging inflation, it doesn’t seem likely that policy rates will rise too sharply or quickly during the current tightening cycle. 

We can certainly expect it to be less severe than during the Volcker shock (1980/1981), when then Fed Chairman Paul Volcker deliberately triggered a recession through a series of sharp rate hikes to crush rampant inflation. But perhaps not as benign as the post-financial crisis tightening cycle that started in 2015, which had to progress slowly lest it damage an already weak economy.

As such, markets are already pricing in some policy cuts in 2023/2024 – consistent with the idea that the US might face a substantial economic slowdown or even downturn in about a year.

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Fed tightening and unemployment

Looking at the tightening cycle and its current impact on unemployment, however, we can see some aberration. 

In contrast to previous tightening cycles – when the unemployment rate fell during the economic upswing – joblessness is now at a historic low, with the US labour market close to full employment. 

As the chart shows, the current cycle has started with an unusually low unemployment rate, which cannot go much lower. So, what will pay the price instead?

With the Fed funds market already pricing in rate declines in 2023, it appears bond market investors expect the US economy to slow down or enter a full-blown recession sooner rather than later. 

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German producer prices

The next chart looks at the impact of inflation on Europe’s biggest economy. 

As the heatmap shows, the price of goods sold by German manufacturers has risen sharply, driven by the higher cost of crude oil, gas, electricity and food. The Producer Price Index is up by more than 33% on a year-on-year basis. 

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Sri Lanka inflation

Inflation is hitting the pockets of people everywhere, but in some emerging markets, it’s leading to a full-blown economic crisis. 

In Sri Lanka, the inflation rate has jumped to more than 30% from just 5% a year ago, with food prices and transport (a consumer of energy) the biggest drivers. 

Meanwhile, tourism – one of the country’s biggest foreign currency earners – has collapsed in the wake of the pandemic. 

Little surprise then that Sri Lanka recently defaulted on its debt, given the insufficiency of foreign reserves to pay for imports. 

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Sri Lanka retail food prices

The next chart takes a closer look at Sri Lanka’s skyrocketing food prices based on high-frequency data collected by the country’s statistical agency each week. 

As you can see, prices of items such as bread, wheat flour, and tomatoes have swelled by at least 50% since January, leading to large declines in real incomes and a severe cost-of-living crisis that has sparked anti-government protests and rioting. 

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China and US 10-year yield gap closes

Our last chart this week shows the yield spread between US and Chinese 10-year yields. For the first time in more than a decade, US government bonds are offering a higher yield than those issued by China. 

This partially reflects the different business cycle dynamics of the two countries. In the US, the Fed is tightening policy to control inflation while in China, the government is calling for more monetary stimulus to cushion an economic slowdown caused by its zero-Covid policy. 

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