When I was young, I thought macroeconomic analysis was about crunching numbers. I was envious of my peers that had greater faculty in using computers to crunch the numbers. After all, if “truth” lay in the numbers, those with the biggest and best mechanical crunchers would win the game.

As I grew older, I grew out of this cruncher envy, and became a “big idea” guy. The key to success, to my mind, became not in identifying patterns in data, but in conceptualizing changes in patterns of data. As I grew older still, I grew out of this obsession, too. While I recognized that it was hugely important to identify changes in data regimes, I concluded that success in doing so offers little help in defining the character of the new data regime.

So, at the moment, I’m infatuated with the notion that macroeconomic analysis is really but a game of playing solitaire with a deck of 51. You can’t win! No, I’m not depressed; quite frisky, actually. My new mantra is simply that there is no macroeconomic “truth,” only the search for it.

What Are They Thinking?

This axiom is serving me well in navel gazing about the New Economy. After many years of feverishly denying the possibility of a New Economy, the fraternity of “mainstream” economists now accepts the proposition, and is working feverishly to define the potential secular parameters of the New Economy — how low is the new lower “natural rate” of unemployment, and how fast is the new faster pace of structural productivity growth?

Indeed, even the Fed’s economists, who are congenitally mainstream in their thinking, now concede that the economy can run at a lower unemployment rate and a snappier pace than they thought possible just a few years ago. I must admit that, as a New Economy man long before it was cool, it is fun to watch the brethren debate the parameters of the new secular “truth.”

But in keeping with my new mantra that the search for truth has no destination, but only new horizons, I must admit that I am also bored by this debate. By definition, empiricism provides little guidance in defining new paradigms. All we can say with confidence, it seems to me, is that the New Economy will be more fully employed, with faster growing efficiency, than the Old Economy. We will be able to be more empirically precise only in the fullness of time, which will be etched in cyclical processes.      

Living in an (Implicit) Inflation Targeting World

Figure 1
Source: U.S. Commerce Dept., U.S. Labor Dept.

Thus, my axe to grind these days with the consensus of mainstream economists is not about the secular parameters of the New Economy, but about the cyclical transition to those new secular parameters. More specifically, I am befuddled by the consensus presumption that if the Fed tightens just the right amount to ensure a slowdown in demand, there will be a blissful cyclical outcome for inflation and corporate profits — a sweet soft landing! Everything I know about cyclical macroeconomic dynamics, which is presumably the same thing the brethren learned in academic days, says that the first cyclical landing following a secular productivity shock is highly likely to be sour, not sweet.

For those who would like to know why, I ask you to take a walk with me down academic memory lane. For those who can’t bear another academic discussion after last month’s treatise on NAIRU, I understand. Please skip to the last page, where I muse about what Chairman Greenspan might say in his upcoming Humphrey Hawkins testimony.

Labor Ain’t Stupid, but Rather Adaptive

One of the clichés of macroeconomic analysis is that monetary policy works with lags, which Nobel Laureate Friedman quipped are “long and variable.” Everybody knows that. Far fewer know the reason why: In cyclical time, productivity and prices are coincident, but wages lag .

Productivity and prices are coincident, such that: 

This is just another way of saying, of course, that:

In contrast, wages lag, such that:

This formulation asserts that the wage-setting process is backward-looking: Workers expect to be compensated for increases in productivity only after the fact, while also expecting to be “made whole” for trailing price inflation.

Common sense also supports this specification: Just think about your own negotiations with the boss about your pay!

Now, here comes the fun part of the analysis! Substituting (3) into (1), we get:

If the economy is experiencing a productivity shock, Productivity _today will be greater than Productivity _yesterday. And the result will be unexpected price disinflation, because the wages paid to produce today’s output are not reflecting labor’s productivity of today, but labor’s lower productivity of yesterday.

Alternatively, the positive productivity shock could show up in some combination of unexpected price disinflation and unexpected corporate profit margin expansion. Here’s the equation for that:

For Wall Street, it really doesn’t matter whether the positive productivity shock shows up in unexpected price disinflation, or unexpected profits. It is simply unalloyed good news, particularly for stocks: Either price disinflation lowers interest rates, pushing up P/Es, and/or profit margins expand, pushing up Es!

A positive productivity shock is also unalloyed good news for Main Street’s workers. They do not, to be sure, contemporaneously get their “fair share” of the productivity bonanza, but they are still better off: Either their real wages go up on the back of unexpected price disinflation, or their job security goes up on the back of their employers’ unexpected increases in profitability!

So What’s the Problem?

No problem so far, you say. Where’s the bad news? The bad news comes when the productivity shock has run its course, more specifically when productivity growth stops accelerating, and actually decelerates cyclically. At that inflection point, the backward-looking wage setting process, as represented by Equation 3, will still be “catching up” with the trailing acceleration in productivity.

In turn, that outcome implies, by Equation 5, a stagflationary cyclical landing: Either corporate profit margins fall, giving birth to “stag,” and/or prices accelerate, giving birth to “flation.” What is more, and contrary to the consensus of mainstream economists, there is not a darn thing the Fed can do either to prevent or arrest this outcome. In fact, the cruel irony of it all is that the more that the Fed were to “fight” this outcome, the more nasty it could/will be. How so?

A productivity shock, as it is unfolding, is also an aggregate demand shock, as vividly displayed in Figure 2. Indeed, there are cynics who believe that the putative productivity shock in recent years has really been nothing more than an aggregate demand shock in drag; and that we won’t really know if there has been “structural” positive shock until a full aggregate demand cycle has unfolded. There is, actually, something to be said for that argument, though you won’t be hearing it from my (principled) populist lips!

Cyclical Fluctuations in Productivity
Are About Fluctuations In Demand

Figure 2
Source: U.S. Commerce Dept., U.S. Labor Dept.

But there can be no question that Fed tightening that fosters a deceleration in aggregate demand will also foster a deceleration in productivity, which will foster an acceleration in unit labor costs — the cyclical stuff of stagflation. Thus, it is beyond me why the consensus of mainstream economists preaches that all will be cyclically well, if only the Fed achieves an enduring slowdown in aggregate demand.

As I see it, a period of cyclical stagflation is a necessary final interregnum to the secular New Economy. The Fed should neither lament nor fight this outcome. It is the natural consequence of a backward-looking wage setting process, as labor’s share of the positive productivity shock “catches up” with capital’s share. Historically, such a shift in labor’s favor is always associated with accelerating inflation, as displayed in Figure 3.

Labor’s Share of GDP Moves Inversely
With Inflation

Figure 3
Source: U.S. Commerce Dept., U.S. Labor Dept.

But What About “Inflation Targeting?”

My deepest fear is that the Fed, as a result of some combination of faulty analysis and hubris, might conclude that it should try to preempt the un-preemptable. This is particularly the case now that the Fed is operating in an implicit “inflation targeting” regime. Theoretically, contemporaneous inflation is not supposed to “matter” in such a regime, as my colleague Lee Thomas wisely reminds me. To wit, an inflation-targeting central bank is supposed to act on its forecast of forward inflation , with the forecast incorporating the intervening effect of policy on economic growth.

Thus, if a central bank has (1) tightened sufficiently to ensure a slowdown in aggregate demand growth, which will (2) drive up the unemployment rate with a lag, and put downward pressure on wages/inflation with an even longer lag, it should (3) stop tightening, even if inflation is contemporaneously accelerating. Fed Chairman Greenspan played it precisely this way back in 1995, uttering in February at Humphrey Hawkins (my favorite Greenspan quote of all time!) that:

Yes, that’s the way the inflation-targeting game is supposed to be played! But back then, Mr. Greenspan had a disinflationary tailwind of a positive productivity shock behind him, even if he didn’t know it at the time. Now, he faces an inflationary headwind of labor’s “catch up” in real wages colliding with a slowdown in aggregate demand. Will Mr. Greenspan once again have the courage to stop tightening, even ease, “despite adverse price data?”

Theory says he should. But human nature screams to central bankers to tighten, whenever they hear cries that they are “behind the inflation curve.” In fact, the closer the Fed gets to explicit inflation targeting, the more difficult it becomes for the Fed to institutionally “ignore” rising inflation. Even for economists, who are taught from birth the importance of lags, it is difficult to accept that proof of the anti-inflation pudding is not cyclically in the eating thereof!

So What is Greenspan Likely to Say at Humphrey Hawkins?

I don’t know. I’d give the hubcaps off my VW Beetle to hear him say, “there may come a time.…” But that’s not going to happen, because Mr. Greenspan knows that such a speech would likely trigger an explosive rally in stocks (which he hasn’t got the courage to preempt with a hike in margin requirements!). No, what Mr. Greenspan is likely to do is preach the mainstream gospel that all will be well, if only the more productive American worker will resist asking for a raise commensurate with that higher productivity, out of fear that the Fed is going to put him/her out of work!

Okay, maybe that’s too cynical. But I’d love to hear Greenspan deny that’s an accurate statement of the FOMC consensus. Perhaps my best hope, for which I’d give the bud vase from my Beetle, is that Mr. Greenspan actually uses the word “stagflation.” The sheer use of the word would help mitigate what I call Greenspan’s “paradox of credibility”— the end of tightening to promote a soft landing triggers a stock explosion that paradoxically makes a soft landing more difficult to achieve. I think Mr. Greenspan would be doing himself a huge favor by simply admitting that a cyclical interregnum of stagflation could actually happen on his watch.

We’ll see. Meanwhile, I will continue playing solitaire with a deck of 51. You can’t win the game, of course. But recognizing that, while the consensus is in denial, is a path to avoiding the silly money-losing habits of the consensus.

Paul McCulley
Executive Vice President
July 1, 2000
mcculley@pimco.com