Since the election, significant segments of the financial markets have been re-priced. Notably, interest rates are higher and the U.S. dollar is stronger.
In our view, the recent uptick in bond yields reflects a shift in market expectations with regards to growth and inflation. In and of itself, this gives the Federal Open Market Committee the flexibility to officially affirm this upward shift in market rates by increasing the Federal Funds Rate at their December meeting. Beyond that, the reduction of the unemployment rate to 4.6% in the most recent employment report provides an economic data point to support taking this action.
Yet which will we ultimately see: growth or inflation? Here at Roosevelt, we understand that the future is inherently uncertain and believe prognostication to be a fool’s errand. However, there are a few signs we are watching to get a sense of which the direction the economy might take.
In that regard, we start with the two textbook components of economic stimulation: demand side versus supply side. Attention typically goes to the demand side, or Keynesian models, with their emphasis on “aggregate demand”. In this view, consumer spending, industry spending on capital goods, and net exports are all supplemented by government spending – which is seen as an intervention to assure desired levels of employment and growth.
In contrast, while a Keynesian would think that demand for goods and services are the critical economic drivers, the supply side view is that producers and their ability to create goods and services are what set the pace of economic growth. The logic continues that if a producer can create products, then jobs are created because they will hire people to help produce. At the core of the supply side view are tax and regulatory policy, due to the incentives and disincentives that they generate. In reality, the truth is that governments always do a bit of both, so it’s not necessarily one or the other, but the mechanisms tend to work very differently.
If anything is clear to us post-election, it’s that the next chapter remains a bit foggy. Given the recent run up in infrastructure stocks, it appears the market is assuming that the federal government could spend significantly in that space – leading to job creation, and subsequently additional demand for goods and services from those with jobs. This is the traditional demand side formula for economic stimulation. Yet with unemployment below 5%, which is in the neighborhood of what economists generally view as the non-inflation accelerating rate of unemployment, workers may be starting to get scarce. Under that thinking, a substantial federal demand stimulus program would simply push up the demand for labor, and consequentially wages. Wage inflation has the potential to trigger broader economic inflation, the possibility of which is not lost on the financial markets.
On the supply side, driven by the potential for reductions in tax and regulatory burdens, markets are already pricing in some level of disentanglement from bureaucratic red tape. Typically, supply side inducements have the ability to be less inflationary and more productive. This can be true if reshaping the rules and the tax regime does not create other disincentives. With the new administration already starting to talk about tax policy and regulation, this could indicate a greater emphasis on supply side stimulation. That has many investors thinking a bit more about the possibility for growth rather than inflation.
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