With a promise like the one above from the likes of our nation’s central banker, why waste time picking through the economic flotsam in search of spoilers? Please indulge me as I lay before you a scenario that may test the efficacy of that pledge.

Annual growth in GDP is a not inconsequential economic datum. From 2006 to 2017, it averaged an anemic 1.6%, half the 3.2% rate recorded from 1970 to 2006. To avoid the influence of fluctuations in the business cycle, the preceding growth rates were calculated between years with roughly the same unemployment rate of about 5%.[1] Despite the impressive 4.2% annualized growth rate for GDP in the second quarter of this year, the prospects for future growth rates materially above the average of the last 12 years appear dim.

Such economic anemia has dire long-term consequences for society. Lower than average growth in GDP means fewer resources for education, infrastructure, and underfunded Social Security and Medicare commitments. Especially pertinent to our audience, slow growth also means lower net investment, which will in due course be a damper on corporate profits.

The principal culprits of this drama are a trio of economic developments. The first is low growth in productivity, which accounts for about 50% of the recent underperformance of GDP. Another 30% is attributable to the declining labor force participation rate, courtesy of Baby Boomer retirements and a decline in the prime-age labor force participation rate. The final 20% is traceable to the decline in population growth overall, due primarily to lower birth rates. [2]

Productivity on the Mind at the Fed

Because the latter two causes are demographic and are considered intractable without a sea change in social and political behaviors over an extended period of time, it’s not surprising that Fed chairman Jerome Powell named productivity as the necessary remedy to our current malaise during his keynote speech at this year’s Jackson Hole symposium in August. To be sure, he was circumspect. “It is difficult to say when or whether the economy will break out of its low-productivity mode of the past decade or more, as it must if incomes are to rise more meaningfully over time” (emphasis added).

He was equally guarded in wondering aloud if Okun’s law—which argues a drop in the unemployment rate creates a rise in GDP—has been compromised by low labor productivity growth. Clearly, a 3.9% unemployment rate does not square with 2% trendline GDP growth. The central question, though, is whether the recent substandard performance is temporary—or a new normal.

Powell’s presentation, “Monetary Policy in a Changing Economy,” was a pretext to plumb history for precedent. He hinted at the possibility that the history of the 1990s might repeat. In that period, then Fed chairman Alan Greenspan suspected that the economy’s productive capacity was rising due to technology-based innovations. He rightly resisted calls from his colleagues to raise interest rates so as to prevent overheating and inflation. Powell—the two-handed non-economist—then contrasted Greenspan’s success in the 1990s with the Fed’s error in the 1970s. At that time there was excessive confidence in the so-called “natural rate of unemployment,” a hypothetical rate to which joblessness can fall without sparking inflation. That supposed equilibrium exists as a natural state, should the economy be left to its own devices. It is, however, impossible to prove or calculate. Adherence to such principles helped fuel double-digit inflation by the end of that decade.

For Powell, the appeal of Greenspan’s analysis is obvious. Debates about the outlook of future U.S. growth are dominated by the speculation of optimists who herald the imminent arrival of a technology-driven Fourth Industrial Revolution.[3] They believe we will see productivity the likes of the 1990s again.

Northwestern Professor Bob Gordon, however, is not so sure. He argues that the preoccupation with future technology too narrowly defines the process of economic growth. “Productivity growth depends not only on innovation but also on the rate of increase in physical and human capital,” he writes. “Moreover, demography and inequality determine the extent to which productivity growth trickles down to individuals and households” (emphasis added). While Powell acknowledged that productivity must increase “if incomes are to rise more meaningfully over time,” Gordon reminds us that capital creation and favorable demographics are necessary preconditions for stronger productivity growth.

To be sure, how can we be anything but impressed by the frenetic pace of innovation? However, it is no contradiction in terms to, at the same time, question the strength of its impact on the growth of productivity. More on this fascinating and challenging subject in subsequent post(s).

Buybacks, Profits, and Productivity

As stated at the outset, corporate profits (to which stock prices are ultimately tethered) are themselves irrevocably tied to the economy, even if it’s with a bungee cord. These immutable truisms are frequently overlooked in today’s investment environment of instant gratification and stretched valuations.

Attempting to ameliorate the effect of subpar economic growth, many companies that make up, say, the S&P 500 index, regularly engage in various forms of financial engineering that enhance their earnings-per-share without necessitating an increase in the underlying profitability of the businesses themselves (and often at the expense of long-term financial stability). To provide added perspective, because of share buybacks and M&A activity, since 2010 the S&P 500 index’s divisor (total shares outstanding) has unprecedentedly shrunk from 312 billion to 287 billion.

Buybacks are expected to reach $1 trillion this year, but net investment in the U.S. economy (as measured as a share of the business capital stock) has shrunk, from 2010 to 2015, to 1.5%, less than half of the long-term average. This slumping investment has become a prime suspect in the slowing growth in productivity.

Could it be, though, that causation runs the other way—namely, that slowing GDP leads to declining investment? After all, it’s been a central tenet of growth theory the capital-output ratio is constantly at equilibrium. Therefore, the long-term decline in GDP growth due to slower growth in population and hours worked per person would lead inexorably to a decline in the growth rate of capital and hence a decline in net investment. Essentially, the role of net investment is a dependent variable. While it is a prerequisite for the growth rate of productivity to increase, investment does not lead GDP growth. It follows it. Whether CEOs are being rational spending shareholder cash without regard to price on financial engineering is debatable. What does seem to be unquestionably rational is their reluctance to spend more on capital assets.

Central Banking in the Era of Slowing Growth

The global central banks, to which most conversations about economics eventually return, have been the lifeblood of halting post-crisis recoveries, especially in the U.S. and European Union. Center stage has been the Fed. Chairman Powell opened his Jackson Hole speech by paying homage to Alan Greenspan. Powell’s copycat title plays on Greenspan’s presentation, “Adapting to a Changing Economy,” delivered at the 2003 symposium, in what turned out to be the twilight years of the Great Moderation.

Powell quoted the then-chairman’s famous declaration that “uncertainty is not just an important feature of the monetary policy landscape; it is the defining characteristic of that landscape.” Perhaps Powell’s use of Greenspan’s phrase “… Changing Economy” is a fitting descriptor after all.

Parenthetically, the “uncertainty as the defining characteristic” warning should appear on all Fed pronouncements and forecasts, not unlike the labels prominently displayed on packs of cigarettes. Greenspan’s obfuscating observation was unintentionally prescient. Powell admitted in his speech, “on the doorstep of…the Financial Crisis, surely few, if any…would have imagined [what lay ahead].” [4]

Despite both Powell’s and the maestro Greenspan’s deference to uncertainty, the folly of forecasting, not the comparative certainty of preparedness, will continue to rule the day.

But forecasting, irrespective of its failures, will never be abandoned. It is an inbred necessity of human nature. The more we can anticipate the course of events in the world in which we live, the better prepared we are to react to those events in a manner that can improve our lives. Introspectively, we know that we have a limited capability to see much beyond our immediate horizon. … Today, both fortunetellers and stock pickers continue to make a passable living. [And the clincher, emphasis added …] Even repeated forecasting failure will not deter the unachievable pursuit of prescience, because our nature demands it.[5]

Let’s hope this confession from the frequently-wrong-but-never-in-doubt serial forecasters agitates you to think skeptically of Fed pronouncements. While ostensibly on the horns of a dilemma, “moving too fast and needlessly shortening the expansion, verses moving too slowly and risking a destablizing overheating,” Powell seems unnervingly confident in his outlook for various economic trends. Inflation has so far been quiescent. Powell acknowledges that it recently has approached 2%, but he sees no clear signs of it accelerating beyond that, nor does he sense an elevated risk of the economy overheating. Assuming the 1990s as precedent, Powell sees present circumstances continuing when he notes that in the run-up to the past two recessions destablizing excesses appeared mainly in financial markets rather than inflation numbers.

Differing with Powell, we value investors believe past and current Fed policy has been the catalyst for massive asset prices inflation that is precisely the kind of destabilizing excess about which investors (and the Fed) should be concerned. Overvaluation currently persists throughout almost every class of financial assets. We find no solace in Powell’s blanket assurance at the end of his speech: “I am confident that the FOMC [Federal Open Market Committee] would resolutely do ‘whatever it takes’ should inflation expectations drift materially up or down or should crisis again threaten.”

The powers of the Fed, however, are limited. By Powell’s own admission, taking actions intended to increase the growth rate in productivity is well outside the Fed’s mandate, to say nothing of its capability. And as we will argue in subsequent posts, the drag of low productivity growth casts a pall over economic prospects in general.

Thus, Powell’s pledge—the title of this post—is the equivalent of putting a Band-Aid on an arterial hemorrhage.

[1] The unemployment rate was 5% in 1970, and 4.6% in 2006. Since the business cycle expansion phase is still intact, we chose to use the latest unemployment rate of 3.9% in August 2018.

[2] “Why Has Economic Growth Slowed When Innovation Appears to Be Accelerating?” White paper. Robert Gordon. April 2018.

[3] To provide context, the Third (digital) Industrial Revolution generated a productivity boost of only a decade, roughly between 1996 and 2006, as contrasted to the five-decade (1920–70) interval of rapid productivity growth during part of the Second Industrial Revolution, because the earlier inventions had a more profound effect on virtually every aspect of human existence.

[4] Powell, Jackson Hole.

[5] Greenspan, Alan. The Map and the Territory: Risk, Human Nature, and the Future of Forecasting (Kindle Locations 70–77). Penguin Group (USA). Kindle Edition.



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