Expert Commentary

A Falling Star: The U.S.A. and Deflation

You wouldn’t know it by looking at the stock market, but there’s been a subtle, multi-decade decline in the U.S. economy.

After the Great Depression of the 1930s, economics became increasingly model-based and mathematical as people sought to quantify every relationship in a bid to understand what was going on (and avoid a repeat of the depression). Up sprang econometrics as the math-based branch of economics which became popular with eggheads all over the world. Cue academic research and books containing models with thousands of equations and esoteric symbols for all economic variables (and the source of much frustration in my undergraduate days!). Over the past couple of decades, many of these models have been found wanting and a growing number of economists are realizing that yes, indeed, economics is a SOCIAL science and therefore belongs alongside the likes of psychology, not mathematics.

Nevertheless, one esoteric-sounding econometric symbol has somehow found its way into the market zeitgeist over the past couple of weeks. R* (or R-star) stands for the natural rate of interest. This is the real interest rate that is expected to prevail when the economy is operating at full tilt. If the economy is expected to be very strong, R* will be high, but it will be low if the economy is not operating at its full capacity. Many market participants are surmising that R* cannot be very high given the slack in the U.S. economy. Given the flattening of the yield curve and the downturn in the term premium (a measure of how risky it is to hold long-dated Treasuries), the bond market is skeptical about the Fed tightening monetary policy too soon. As one strategist put it, “(The Fed) won’t be able to go very far before inflation and growth hit a speed limit, pushing yield expectations after the initial hike lower”. In other words, the secular deflationary trend is still alive, and the biggest reason for this is the massive debt burden which is acting as an anchor.

There’s also a subtle, but huge, divergence between some measures of the U.S. economy and the stock market. Industrial Production, for example, at an index level of 99.86 in May 2021 is still below the 102.47 high it reached in 2007. With interim peaks in 2014 (103.67) and 2018 (104.17), we could say that Industrial Production in the U.S. has essentially stagnated for 14 years!

Then there is Capacity Utilization. This is the extent to which a firm or nation employs its installed productive capacity. It is the relationship between output that is produced with the installed equipment, and the potential output which could be produced with it, if capacity was fully used. As the chart below shows, in the late 1960s, the U.S. economy was operating at around 90% capacity. Almost all of its potential was being used. Now look how that number has slowly but surely declined over the past 50 years. The U.S. economy currently operates at around 75% capacity having, in 2020, made a new low below that of 2009. Now, someone might say that this is not that relevant because the U.S. economy has become much more service-based, rather than manufacturing-based, over the past 50 years. That is true, but the decline in Capacity Utilization still paints a picture of stagnation.

This chart is a reminder that, under the hood of the U.S. economy, the engine is sputtering.

Capacity Utilization Total Index