3 Powerful Forces Transforming the Economy

December 27, 2016

3 minute read

The Fed's faulty assumptions

Some of the factors limiting US growth also hold the key to its future says Steve Malin. This includes ineffective Fed policy, rising populism and transformative technology that policymakers and businesses must take notice of or risk missing the wave.

by Steve Malin, Allianz Global Investors

Throughout most of the post-crisis period, the US Federal Reserve argued that the United States' weak economic growth, productivity and capital spending were caused mainly by insufficient aggregate demand. In response, the Fed implemented aggressive monetary accommodation to stimulate spending—and, for a while, it succeeded. However, GDP growth soon decelerated and business investment stayed subdued, which indicated that the economic theory the Fed relied upon had proved to be faulty.

Consequently, several Fed officials in 2016 wrote extensively about how structural changes in the US economy had been interacting with ultra-low interest rates and tougher regulations on banks to make interest rate targeting difficult, reduce the target level of policy rates and restrain real economic growth. Among their key findings:

Precautionary savings rose, causing real consumption to not keep pace with real disposable income.
Persistently low interest rates encouraged households to postpone consumption and build up precautionary savings.
Regulations raised hurdle rates on prospective business investments.
The mix of regulatory and economic policies encouraged capital spending outside the US rather than within it.
Low interest rates encouraged corporate leverage—not to finance productive investment, but to finance share buybacks and dividend distributions.
Federal Reserve ownership of Treasury securities removed collateral from the repo market used to finance day-to-day operations of businesses.
Low interest rates strained pension funding.
Mortgage financing became more difficult.
Banks chose to restrict some forms of lending in order to protect their equity from potential loan losses.

The modern industrial revolution

The Fed's policies and unforeseen structural changes have not been the only factors causing sluggish US economic growth. Growing populist movements are set to at least partially shape a new wave of fiscal intervention into economies—and monetary policy must account for these new influences in the years ahead. These movements reflect a combination of globalization, technological changes, political stalemates and geopolitical crises that have resulted in lower inflation-adjusted incomes and widening of income and wealth disparities.

Moreover, the inexorable development, marketing and implementation of a range of new technologies have already reshaped how businesses are organized—and arguably altered every aspect of economic activity. This chain reaction of technological progression will continue to generate enormous upheaval and opportunity. Not only have modern technologies become disruptive, but they have reduced the need for material inputs, enabled production at a zero marginal cost, made the entirety of human knowledge accessible via the cloud, and made knowledge available to anyone in the world at virtually no cost. These are new technologies that now "crowd-in" knowledge and understanding instead of crowding it out.

Clearly, the pace of adoption of new technologies has never before been so pervasive and rapid. As a result, all households, businesses and governments must adapt to and change with this new, modern industrial revolution or else risk their economic and financial well-being, now and in the future. This has significant implications for the Fed and other central banks: Failing to master the implications of this industrial revolution will not only cause them to miss their policy targets, but push them toward setting the wrong targets.

The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Forecasts and estimates have certain inherent limitations, and are not intended to be relied upon as advice or interpreted as a recommendation.