Friday, 23 March 2018

The Great Moderation is back

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  • Jonathan Rogers
With no sign of resurgent inflation and the technology revolution on the march, a return to pre-financial crisis conditions is under way, says Jonathan Rogers

Is the second round of the Great Moderation upon us? You will recall that this refers to the period from the mid-1980s to 2007, when the United States went through a period of low-volatility growth and low inflation. That period encompassed the longest period of economic expansion since the Second World War.

Numerous theories have been expounded to explain the Great Moderation, the foremost being a more incisive monetary policy than had been the norm in the previous decades. Former Fed Chairman Ben Bernanke, in a series of articles, has also ascribed the reason for the Great Moderation as to do with luck, plain and simple.

Many recall that period in connection with the Clinton administration, during which the US briefly achieved a budget surplus and when presidential adviser James Carville observed: “I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.”

That comment came as the new administration had to squash an early spending plan when long-end bond yields spiked.

It may seem odd in reflection, but the Great Moderation also encompassed the crash of 1987, so there is proof that long-term economic trends can easily survive the occasional market meltdown.

Looking to where we are now, it would seem to jar that another round of the Great Moderation could be upon us. After all, President Donald Trump seems the antithesis of the urbane, market-wired policy makers who dominated that era.

Government via the Bloomberg terminal certainly doesn’t seem to be coming back, unless former Goldman Sachs senior staffer Steven Mnuchin, now Treasury Secretary, is hiding his training lessons with President Trump from the public eye.

I’M NO TRUMP fan but I’m mindful of the fact that fiscal stimulus tends to be a game-changer in an economy the size of the US. I’m thinking of the mid-1980s Reagan tax cuts, which arguably paved the way for the Great Moderation which lasted until around a decade ago.

The bogeyman is the fear of a painful unwind of leverage from whichever source you care to name, from the Japanese bond market to the indebted balance sheets of local governments and corporates in China, or household debt from the United Kingdom to Singapore.

A principal enabler of that unwind would be the “normalisation” of US interest rates in the face of inflationary pressure. But I’m not convinced that pressure exists. Indeed, every time since the inauguration of Trump, when Treasury bonds have sold off they have just as quickly rallied back. It seems sensible to be of the opinion that the technological revolution has beaten back the kind of inflationary pressure that stymied the US economy in the 1970s.

A supply-side shock in the form of a spike in oil prices also seems highly unlikely and less likely to be the critical input it was 40 years ago, given the increasing reliance of global energy markets on renewables.

Modest inflation would be welcome at a point where entities borrowing in US dollars are still able to book relatively low coupons. If the Trump tax cut is to be partially funded out of US Treasury bond borrowing, the coupons the federal government will pay on that debt may look rather minuscule well before the debt matures.

IN THE MEANTIME, I suspect that the digital transformation which is happening globally may herald a period of sustained prosperity. All the various elements of that transformation, whether it be the internet of things, blockchain, e-commerce and artificial intelligence, are coming together rather nicely.

That transformation may, of course, contain the seeds of its own destruction. But I reckon the Great Moderation Part II is upon us and it’s time to run with it. Yes, the valuations of equities have never been more torrid. But then, apples are not really being compared with apples in that case; we have never had such a revolution occurring in the global economy, one which unlike railways or the telephone, will not run into a brick wall once the initial surge has played out.

When Donald Trump visits the World Economic Forum in Davos at the end of this month, it will presumably be to gloat about the health of the US economy and its markets. Maybe for once we should give the orange one his moment. And if this is a re-run of the Great Moderation, we may well be right in the middle of it without really knowing for many years to come.



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