A “double dip” in the global economy suggested by monetary trends appears to be playing out, with weakness likely to intensify into late 2023.
The global composite PMI new orders index – a timely coincident indicator – continued its decline from a May peak last month. A relapse had been suggested by a fall in six-month real narrow money momentum from December 2022 – see chart 1.
Chart 1
The year-to-date low in real money momentum occurred in April but there was little recovery through July and another decline is possible. The suggestion is that the PMI will fall further into Q4 and remain weak into early 2024.
As expected, the composite PMI fall is being driven by services converging down towards weak manufacturing – chart 2. The August decline in services new business reflected a plunge in demand for financial services and a further consumer slowdown, with a partial offset from a minor recovery in business services after a larger July drop – chart 3.
Chart 2
Chart 3
The ending of the services mini-boom, which fuelled recent employment gains, suggests a faster loosening of labour markets. Unemployment rates have reached 12+ month highs in the US, France, the UK and Canada, while a rise appears to be under way in Japan – chart 4.
Chart 4
Previous posts suggested that a bottoming out of the stockbuilding cycle would support manufacturing new orders later in 2023. The cycle downswing, however, could be extended by delayed inventory cut-backs in the Eurozone: stockbuilding bounced back in Q2 as final demand contracted sharply, with recent adjustment lagging far behind the US / UK – chart 5.
Chart 5
Eurozone / UK July money numbers offer further support to the assessment here that ECB / Bank of England policy tightening has been excessive and – unless reversed swiftly – will cause unnecessarily severe economic weakness and a medium-term inflation undershoot.
The latest releases are astonishing in several respects.
Six-month real narrow money momentum hit a new low in the Eurozone in July and is even weaker in the UK despite a recent boost from falling six-month CPI inflation. Readings are much worse than elsewhere and historically extreme – see charts 1-3.
Chart 1
Chart 2
Chart 3
Broad money has followed narrow into nominal contraction. The preferred broad measures here, i.e. Eurozone non-financial M3 and UK non-financial M4, fell at annualised rates of 0.8% and 0.9% respectively in the three months to July – charts 4 and 5.
Chart 4
Chart 5
Broad money declines are rare: since 1970, the Eurozone / UK three-month changes were negative only for a brief period around the GFC, with the falls of similar magnitude to recently.
Money leads the economy while credit is coincident / lagging. Bank lending to households and non-financial firms is starting to contract, consistent with recessions being under way – charts 4 and 5.
A further notable feature of the Eurozone data is a widening divergence between still-rising bank deposits in Germany and falls elsewhere – chart 6.
Chart 6
A similar core / periphery monetary divergence in 2011 warned of an escalating Eurozone crisis. The driver then was capital flight from the periphery, reflected in a ballooning of national central bank TARGET deficits / surpluses.
The Bundesbank’s TARGET surplus has fallen recently. Rather than capital flows, the relative resilience of German broad money is explained by less pronounced weakness in bank lending – chart 7.
Chart 7
So money / credit trends suggest that economic prospects in the rest of the Eurozone are at least as bad as in Germany.
Eurozone six-month CPI momentum, meanwhile, continues to track a simplistic monetarist forecast based on the profile of broad money growth two years earlier – chart 8. Six-month headline momentum was unchanged at 3.3% annualised in August but core slowed further to 4.0%, a 17-month low.
Chart 8
The suggestion is that six-month headline momentum will reach 2% next spring, with the annual rate following during H2. A subsequent significant undershoot is indicated unless recent monetary weakness is reversed.
Why have global government bond yields picked up over the summer despite weakening PMIs and neutral / favourable inflation news?
The rise is attributed here to a further deterioration in the global “excess” money backdrop driven partly by unexpected output strength as an easing of supply constraints has allowed firms to work off order backlogs. Output is expected to realign with weak / falling incoming demand during H2, suggesting a reversal of liquidity tightening.
The rise in nominal yields has been driven by the real component with inflation expectations little changed.
Changes in real yields have been inversely correlated historically with changes in global “excess” money momentum, as measured by the differential between six-month rates of change of real narrow money and industrial output – see chart 1.
Chart 1
This differential has been negative since early 2022 but was expected to narrow as monetary tightening fed through to weaker economic activity and slowing inflation lifted real money momentum. Instead, industrial output growth rose to a seven-month high in June while nominal money weakness has offset a disinflation boost to real momentum – see chart 2.
Chart 2
Production resilience was signalled by a recovery in the global manufacturing PMI output index, which crossed 50 in February on the way to a May high. It moved back below breakeven in June / July, however, with August flash results suggesting a return to the December 2022 level or lower – see chart 3.
Chart 3
Covid-related supply disruption resulted in the PMI output index lagging the new orders index in 2021 / H1 2022, but the position has reversed over the past year as production bottlenecks have eased, allowing firms to fulfil outstanding orders.
With the PMI delivery speed index – an inverse indicator of bottlenecks – hitting a 14-year high in May, the supply catch-up is probably ending, suggesting that the PMI output index – and hard production data – will converge with weaker new orders. At the current level of the latter index, this would imply output contraction.
The real narrow money / industrial output momentum differential, therefore, is likely to narrow unless nominal money data weaken further and / or consumer price inflation rebounds (unlikely). While G7 tightening is still feeding through, stable / easier monetary policies are expected to promote money growth recoveries in EM.
Commentaries here have suggested that the monetary / economic backdrop would favour quality stocks in 2023. The MSCI World quality index is 7.1% ahead of MSCI World in price terms year-to-date (as of yesterday’s close). This mainly reflects a high weighting in tech, but the sector-neutral quality index (which imposes MSCI World sector weights) is also now outperforming the main index and has reversed its relative weakness in 2022 – see chart 4.
Chart 4
The recent relative gain is striking against the backdrop of rising Treasury yields, with which the style has been inversely correlated historically, as the chart shows. The divergence is reminiscent of 2018, when the quality relative embarked on a sustained rise in February but a fall in Treasury yields was delayed until November. This year’s quality rally also started in February, suggesting a resolution of the current disconnect with yields by year-end.
Pessimistic commentators argue that the Chinese economy has entered a “liquidity trap” and faces Japan-style deflation. This assessment is not shared here: a recent monetary slowdown can be explained by misguided policy tightening around end-2022, which is now being reversed, while broad money growth would need to fall much further to suggest a sustained decline in prices.
A review of monetary policy in recent years is helpful in understanding current conditions. An important consideration is that – like the Fed decades ago – the PBoC does not announce changes in its policy stance, which often become apparent only after the event in movements in money market rates and credit / monetary trends.
The PBoC eased policy between late 2020 and summer 2022 to cushion covid-related economic weakness. Three-month SHIBOR fell from over 3% to 1.5%, while six-month growth rates of money and credit began to pick up from mid-2021 – see charts 1 and 2.
Chart 1
Chart 2
Narrow and broad money measures continued to accelerate in H1 2022, laying the foundations for a solid post-reopening economic recovery in H1 2023 – real GDP grew by 6.1% annualised between Q4 2022 and Q2 2023.
The PBoC, however, blotted its copy book in late 2022, tightening policy on misplaced concern about a reopening-driven inflation pick-up, although narrow money and credit growth were by then cooling and the ratio of broad money to nominal GDP was close to trend (in contrast to the US / Europe, where a large monetary overhang fuelled strong price pressures).
Three-month SHIBOR rebounded from 1.7% in September to 2.4% by year-end, rising further to 2.5% in March. The consensus view at the time – not shared here – was that the rise in money rates reflected stronger money demand due to reopening, i.e. the increase was “endogenous” rather than policy-driven and would not threaten economic prospects.
Policy tightening has resulted in six-month narrow and broad money growth falling to late 2021 levels, although credit expansion has declined by less (despite a very weak July flow number) – chart 2. The monetary slowdown suggests a loss of economic momentum through late 2023.
The PBoC has, at least, been swift to recognise its error, resuming easing in early Q2. Three-month SHIBOR has retraced half of its August-March rise but may need to return to the low to offset recent monetary damage.
Chart 3 illustrates the inverse leading relationship between changes in interest rates (in this case the two-year government yield) and narrow money momentum. The reversal in rates suggests a bottoming out and revival in money momentum, although timing is uncertain.
Chart 3
Why did Japan enter a sustained deflation in the early 1990 and are there parallels with current Chinese conditions?
From a monetary perspective, a deflationary environment requires (broad) money growth to fall below the sum of trend real GDP growth and the trend rise in the money / nominal GDP ratio.
The ratio of Japanese broad money M3 to nominal GDP has risen by 1.8% pa on average over the long run – chart 4. Trend real GDP growth was running at about 2% in the early 1990s, so broad money needed to expand by about 4% pa to maintain stable prices. Annual growth fell below this level in 1991 on the way to zero in 1992, averaging 2.7% over 1991-2000.
Chart 4
China’s broad money to nominal GDP ratio has risen at a similar trend rate of 1.7% pa – chart 5. If trend real GDP growth is assumed to be about 5%, broad money expansion needs to stay above about 7% to avoid a deflationary scenario. Annual growth is currently 11.6%, with the six-month rate of increase at 10.4% pa.
Chart 5
A recovery in global economic momentum into the spring has gone into reverse, with monetary trends suggesting that weakness will intensify during H2.
The global composite PMI new orders index fell sharply again in July and has now retraced half of its December-May rise – see chart 1. The relapse was foreshadowed by a decline in global six-month real narrow money momentum from a local peak in December 2022. Real money momentum retested its June 2022 low in April and has since moved sideways, suggesting a further slide in the PMI index into early Q4 followed by stabilisation.
Chart 1
The December-May recovery in global PMI new orders was boosted by several non-monetary factors, including release of pent-up demand for services, China’s reopening and gas price relief in Europe. With similar tailwinds unlikely during H2, the orders index may retest or break the December 2022 low.
The July orders decline was paced by a slowdown in services new business, although manufacturing demand also weakened further – chart 2. The services-manufacturing gap remains wide and is expected to close via the former moving into contraction, with manufacturing possibly stabilising as the stockbuilding cycle bottoms.
Chart 2
The July PMI orders decline was broadly based across sectors. Within manufacturing, consumer goods joined investment and intermediate goods in contraction – chart 3. Services demand slowed across consumer, financial and business segments – chart 4.
Chart 3
Chart 4
Six-month real narrow money momentum remains weakest in Europe and has slowed in China and India – chart 5. With policy tightening still feeding through, and recent oil price strength acting to slow a decline in six-month CPI momentum, global real money momentum may fail to recover during Q3.
Chart 5
Eurozone CPI numbers for July were deemed disappointing because annual core inflation – excluding energy, food, alcohol and tobacco – stalled at 5.5%.
Or did it? The annual rise in the ECB’s seasonally adjusted core series slowed to 5.3%, below the consensus forecast of 5.4% for the Eurostat unadjusted measure. The two gauges rarely diverge to this extent (they both recorded 5.5% inflation in June).
The six-month rate of increase of the ECB series eased to 4.7% annualised in July, the slowest since June 2022 and down from a December peak of 6.2%. Six-month headline momentum was lower at 3.4%.
As in the UK, six-month headline inflation is tracking a simplistic “monetarist” forecast based on the profile of broad money momentum two years earlier – see chart 1. This relationship suggests that six-month CPI momentum will be back at about 2% in spring 2024, with the annual rate following during H2.
Chart 1
The projected return to 2% next spring is a reflection of a fall in six-month broad money momentum below 5% annualised in spring 2022. A subsequent decline in money momentum to zero suggests an inflation undershoot or even falling prices in 2025.
The shocking implication is that monetary trends were already consistent with a return of inflation to target before the ECB started hiking rates in July 2022. The 425 bp rise since then represents grotesque overkill, confirmed by recent monetary stagnation / contraction.
The corollary is that a huge and embarrassing policy reversal is likely to be necessary over the next 12-24 months, unless some other factor causes broad money momentum to recover to a target-consistent pace.
That seems a remote possibility, based on consideration of the “credit counterparts”. Loan demand balances in the latest ECB bank lending survey were less negative but still suggestive of negligible private credit expansion – chart 2.
Chart 2
Credit to government may contract given QT, withdrawal of TLTRO funding and inverted yield curves. (Banks previously used cheap TLTRO finance to buy higher-yielding government securities.) Redemptions of public sector debt held under the ECB’s Asset Purchase Programme amount to €262 billion over the next 12 months, equivalent to 1.6% of M3.
Broad money momentum has been supported recently by an increase in banks’ net external assets, reflecting a strengthening basic balance of payments (current account plus non-bank capital flows) – chart 3. This could accelerate as a Eurozone recession swells the current account surplus but is unlikely to outweigh domestic credit weakness.
Chart 3
A bottoming out of the global stockbuilding cycle could be associated with a near-term recovery in manufacturing survey indicators. Money trends suggest that any revival will be modest / temporary and offset by wider economic weakness.
Economic news has been unusually mixed since end-2021, with GDP weakness contrasting with labour market strength and manufacturing deterioration offset by services resilience. Confusing signals have contributed to market hopes of a “soft landing”.
Sectoral and regional divergences may persist in H2 2023. The expectation here is that manufacturing survey weakness will abate but labour market data will worsen significantly. Money trends continue to cast strong doubt on soft landing hopes. Europe is likely to underperform the US.
The US ISM manufacturing new orders index – a widely watched indicator of industrial momentum – hit a low of 42.5 in January and retested this level in May before recovering to 45.6 in June.
Reasons for expecting a further rise include:
The index has been in the 40s since September 2022 and the mean duration of sub-50 periods historically was eight months (ignoring episodes of three months or less).
The global stockbuilding cycle remains on track to bottom out during H2 2023 and lows historically were usually preceded by a recovery in US / global manufacturing new orders.
Recent price falls for raw materials and other production inputs may further incentivise firms to step up purchasing to maintain or replenish inventories.
Korean manufacturing is a bellwether of US / global trends and the latest Federation of Korean Industries survey reported a marked improvement in optimism, consistent with ISM new orders moving back above 50 – see chart 1.
Chart 1
Sustained recoveries in ISM new orders from the mid 40s into expansionary territory historically occurred against a backdrop of positive and / or rising six-month real narrow money* momentum. Current trends are unfavourable, with momentum still significantly negative and moving sideways – chart 2.
Chart 2
Examples of recoveries to above 50 without a supportive monetary backdrop include 1970 and 1989-90. In both cases the rise was modest (peaking below 55), short-lived and followed by a decline to a lower low. The recovery in 1970 occurred within an NBER-defined recession and in 1989-90 just before one.
An ISM rebound might not be mirrored by much if any revival in European manufacturing surveys. Money trends are even weaker than in the US, while the stockbuilding adjustment started later in the Eurozone and probably has further to run – charts 3 and 4.
Chart 3
Chart 4
*Narrow money definition used here = M1A = currency + demand deposits.
While we are always operating in uncertain times when making investment decisions, some periods, like 2022, are much more daunting than others. This article shares five essential guidelines to help investment committees manage uncertainty and limit negative influences in the decision-making process.
Understanding uncertainty
In the book, Thinking in Bets by Annie Duke, she addresses the topic of uncertainty. Duke has a PhD in psychology and was a professional poker player and past world poker champion. Drawing on her poker-playing experience, she highlights how good poker players and good decision-makers have comfort with the world being uncertain. Instead of focusing on trying to be sure about a decision, they try to determine how unsure they are, which Duke suggests can make for better decisions.
Risk and uncertainty go together. The international risk management consultant, Dr. David Hillson, describes the relationship as, “All risks are uncertain, but not all uncertainties are risks.” For example, if the weather forecast suggests the potential for rain, it implies an uncertainty rather than a risk, which could be addressed by simply bringing an umbrella.
Hillson suggests risk is uncertainty that matters. This naturally leads to the question: how does one know what matters? The key is to understand both the probability of the risk occurring and how material the consequences could be if things do not go as expected. If an event has a high probability of occurring and the risk is material, then it would certainly matter and need to be addressed.
Managing uncertainty
So, what can be done to manage uncertainty? The first guideline is to recognize uncertainty exists, while the other guidelines layout a clear approach for effectively steering through it.
Guideline 1: Decisions are best made with everyone’s eyes open.
This is crucial and depends on acknowledging the unpredictable nature of decisions for which there are risks that can – and can’t – be controlled. It is also necessary to assess the level and likelihood of the risk. For example, if a risk associated with an investment portfolio is expected to have a minimal impact and low probability of occurring, then a committee may decide it is an acceptable risk to bear. However, for risks identified as material and with a higher probability of occurring, a committee would want to mitigate the risk, such as by improving portfolio diversification.
Guideline 2: Deconstruct the problem into more manageable elements.
This guideline draws on the idea of the “uncertainty onion” by breaking down a problem into smaller, more manageable elements. Like peeling back an onion, assessing the various layers of a situation can provide useful insights that may not have been evident on the surface.
One such element is framing, which recognizes there are distinct types of uncertainty that are sometimes labelled the same. For example, limited knowledge could be due to the unpredictability of an outcome, such as the impact of equity market volatility. Alternatively, limited knowledge could be due to a committee having little information on a new topic, such as the role of private markets. The response would be different for each one.
Another layer of the onion is to appreciate the various individuals, groups and organizations connected to the decision and identify the stakeholders who hold influence over the decision, those with the expertise that can support it and those who will be impacted by it.
It is also important to distinguish between fact and assumption. For example, an assumption for an annualized 7% return over the long term is simply the best estimate of the expected return and not necessarily the return that will be achieved.
Guideline 3: Realize the benefits and limitation of models.
Managing uncertainty can include appreciating the advantages and constraints of models that are used to help make decisions. The British statistician, George Box, points out:
“All models are wrong; some models are useful.”
One of the most useful benefits of models is they can foster better understanding. In the construction of a new building, a small-scale architectural model serves as a visual representation of the final building design. Providing a clearer picture and overall feel of the project can help identify and rectify potential design flaws, ultimately saving material costs during the actual construction phase.
Statistical models are frequently used to review investors’ long-term policy asset mix. The role of these models is to foster a better understanding of the relative merits of different potential asset mixes before committing any real money to them. While these types of statistical models are helpful in aggregating much complex information to assist in decision-making, they are only tools and provide no guarantee of the actual outcome.
Guideline 4: Do not be fooled by behavioural biases.
When making decisions, it is important to be aware of behavioural biases that can subconsciously influence our choices. These biases often pose challenges for investment committees.
Common decision-making biases
Assessing odds Too focused on outcomes
Narrow framing Do not consider all options
Anchoring Biased to initial information
Confirmation bias Favour information that confirms viewpoint
Decision fatigue Deteriorating quality of decisions
Short-term emotion Emotions can impact decisions
Memory recall Benefit from past experiences
Overconfidence Tendency to place too much believe in an outcome
In their book, Decisive, Chip and Dan Heath refer to four of these common biases as the “Four Villains,” shedding light on how they can influence decisions and ways to minimize their impact.
Narrow framing: This bias limits our perspective by focusing our attention on a specific area, like a spotlight illuminating one part of a stage while leaving everything else in the dark. Narrow framing can cause us to overlook potential options and important considerations. To overcome this bias, it’s important to widen our outlook, moving the spotlight to different areas of the stage to uncover new ideas and possibilities.
Confirmation bias: This bias leads us to seek and favour information that confirms our existing beliefs. It can result in gathering self-serving information underestimating the risks associated with the decision. To combat confirmation bias, it’s helpful to reality test our assumptions. One way to do this is by having someone play the role of devil’s advocate, challenging our ideas and providing constructive criticism before finalizing the decision.
Short-term emotion: This bias refers to the influence of immediate emotions on decision-making. It can lead us to make impulsive choices without fully considering the long-term consequences. To mitigate the impact of short-term emotion, it can be beneficial to conceptualize the implications of our decisions in a future timeframe. By imagining how we might feel about the decision six months down the line, we can reduce the sway of immediate emotions.
Overconfidence: This bias involves placing too much confidence in the likely future outcome of our decisions. We tend to believe our judgements and predictions are more accurate than they are. To address overconfidence, acknowledge the inherent uncertainty in decision-making. Be prepared to accept that you may be wrong and understand the potential downside risks associated with your choices.
Being mindful of these biases and implementing strategies to avoid them can aid in making more informed and rational decisions.
Guideline 5: Bring all involved along.
The final guideline to manage uncertainty emphasizes the importance of involving all stakeholders in the decision-making process. When a new idea is presented at a meeting, it is common to not immediately welcome the idea and instead resist what is being proposed. New ideas are often met with push back no matter how well the information is presented.
It is helpful to identify when resistance is present and to allow stakeholders to express their concerns, and by doing so build trust with the various stakeholders. Communication is also integral to bring about change. Making sure there is discussion at each step of the review can help avoid a situation where, at end of the review process, it is discovered key decision-makers got lost along the way.
How to be a more effective decision-maker
As daunting as it can sometimes be, it is necessary to make investment decisions in uncertain times. Following a disciplined process and being aware of the influences that can derail it can help you be a more effective decision-maker.
Thriving in the face of the unknown
Be comfortable with the uncertainty associated with investing.
Prioritize the risks that are most relevant to your desired goals.
Recognize and accept the unpredictable nature of decisions.
Deconstruct complex decisions into manageable elements for easier analysis.
Use models as tools to gain a better understanding of available options while being aware that they do not guarantee an actual outcome.
Be mindful of behavioural biases that can impact decision-making and take steps to manage their influence.
Foster effective communication to facilitate change and ensure informed decision-making.
As an investment decision-maker, navigating uncertainty with a steady hand, disciplined strategies, open communication and by managing biases can empower you to make informed choices and thrive amidst complexity.
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UK headline CPI momentum continues to track a simplistic “monetarist” forecast based on the profile of broad money momentum two years earlier.
Six-month growth of headline prices, seasonally adjusted, peaked at 12.7% annualised in July 2022 and had halved to 6.5% as of June. This mirrors a halving of six-month broad money momentum from a peak of 20.5% annualised in July 2020 to 10.5% in June 2021 – see chart 1.
Chart 1
Broad money continued to slow sharply during H2 2021, with six-month momentum down to 2.7% by December, suggesting a fall in six-month CPI momentum to 2% annualised or lower by late 2023 / early 2024.
A 2% rate of increase of prices during H2 2023 could be achieved by the following combination:
The energy price cap falling by a further 10% in October, in line with current estimates based on wholesale prices, following the 17% July reduction.
Food, alcohol and tobacco prices slowing to an 8% annual inflation rate by December from 14.9% in June.
Core prices rising at a 4% seasonally adjusted annualised rate during H2 2023, down from 7.7% in H1.
The latter two possibilities are supported by producer output price developments – annual inflation of food products is already down from a 16.8% peak to 8.7%, while core output prices flatlined during H1, following a 6.4% annualised rise during H2 2022.
A 2% annualised CPI increase during H2 2023 would imply a headline annual rate of about 4% by year-end, well with PM Sunak’s target of a halving from 10%+ levels, although he will have made no contribution to the “success”.
Why has UK CPI inflation exceeded US / Eurozone levels, both recently and cumulatively since end-2019?
The assessment here is that the divergence reflects relatively weak UK supply-side economic performance and a larger negative terms of trade effect, rather than more egregious monetary excess.
Charts 2 and 3 show that UK / Eurozone broad money expansion since end-2019 has been similar and less than in the US, with the relative movements mirrored in nominal GDP outcomes.
Chart 2
Chart 3
The UK has, however, underperformed the US and Eurozone in terms of the division of nominal GDP expansion between real GDP and domestically-generated inflation, as measured by the GDP deflator – charts 4 and 5.
Chart 4
Chart 5
UK consumer prices were additionally boosted relative to the US by opposite movements in the terms of trade (i.e. the ratio of export to import prices), reflecting different exposures to energy prices as well as currency movements (i.e. a strong dollar through last autumn) – chart 6.
Chart 6
UK supply-side weakness may be structural but monetary and terms of trade considerations suggest an improvement in UK relative inflation performance – annual broad money growth is now similar to the US and below the Eurozone level, while sterling appreciation since late 2022 may extend a recent recovery in the terms of trade.
The Sahm rule states that the (US) economy is likely to be in recession if a three-month moving average of the unemployment rate is 0.5 pp or more above its minimum in the prior 12 months.
The rule identified all 12 US recessions since 1950 but gave two false positive signals based on current (i.e., revised) unemployment rate data (1959 and 2003) and four based on real-time data (additionally 1967 and 1976).
The signal occurred after the start date of the recession in all 12 cases, with a maximum delay of seven months* (in the 1973-75 recession).
The Sahm condition hasn’t yet been met in the US – the unemployment rate three-month average was 3.6% in June versus a 12-month minimum of 3.5%.
The rule has, however, triggered a warning in the UK, where the jobless rate averaged 4.0% over March-May, up from 3.5% over June-August 2022.
UK Sahm rule warnings occurred on nine previous occasions since 1965, six of which were associated with GDP contractions.
The Sahm signal is another indication that the UK economy is already in recession – see previous post – but a stronger message is that earnings growth is about to slow.
Annual growth of average earnings fell after the Sahm signal in eight of the nine cases, the exception being the 2020 covid recession, when earnings numbers were heavily distorted by composition effects – see chart 1.
Chart 1
Previous generations of monetary policy-makers understood the dangers of basing decisions on the latest inflation and / or earnings data, which reflect monetary conditions 18 months or more ago.
The current reactive approach, apparently endorsed by the economics consensus, may partly reflect mythology about a 1970s “wage / price spiral”. Rather than causing each other, high wage growth and inflation were dual symptoms of sustained double-digit broad money expansion.
The monetarist case is summarised by chart 2, showing that earnings growth is almost coincident with core inflation whereas broad money expansion displays a long lead. (The correlations with core inflation are maximised with lags of four months for earnings growth and 24 months for money growth.)
Chart 2
Recent monetary weakness argues that core inflation and wage growth will be much lower by late 2024; the Sahm rule signals that the decline is about to start.
*Eight months taking into account a one-month reporting lag.
