I need not even mention that policymakers are frustrated, puzzled even, why inflation has not risen to the Federal Reserve's 2% target despite almost rock-bottom interest rates, low unemployment, and steady (although perhaps not robust) economic growth. I explored this conundrum in a recent column; in this follow-on piece, we'll examine why companies' pricing power faces constraints.
Price increases plus productivity gains allow for more pay raises, and when companies can't raise prices and output per worker doesn't expand, they can't increase wages by much. Otherwise, of course, it would become no longer profitable for a business to invest more, and companies would simply hire fewer people rather than hire more employees at unprofitable wages. The prevailing logic has been that companies would be able to pass through higher wages to customers in the form of higher prices, but as I explored in the aforementioned column, that doesn't seem to be happening now.
And why is that? The widely-available price discovery mechanism available to both consumers and businesses is responsible - in other words, the internet, as a primary example. However, it doesn't stop with consumers finding the best bargains online, whether they subsequently visit a bricks-and-mortar store to make a purchase they had researched, or order a book or airline ticket from a website. Technology also allows companies to optimize profits to derive their targeted price point using competitive intelligence and complex algorithms.
As a result, this can erase pricing power when consumers balk at paying higher prices and businesses know exactly what their competitors charge. As such, technology has allowed corporations to quickly assess where their supply and demand functions intersect to find a price equilibrium point where profits are maximized, whereas before, that equilibrium point may not have been immediately clear. Thus, companies know how much or how little to expand and hire on the basis of what they can charge their customers.
So, the question becomes, how much does Fed policy (or that of the European Central Bank, or the Bank of Japan, or any other central bank) really matter? Low inflation is a global phenomenon after all; it's not just limited to the U.S. As I mentioned above, companies can use complex algorithms to optimize profits based on prevailing prices and their cost structure. Their cost structure includes borrowing costs, of course, but in an environment of more-intense price competition than in previous decades, do low borrowing costs alone encourage expansion and hiring by businesses?
True, consumers can take advantage of low rates to buy a new home, car or other purchases, and residential investment has indeed rebounded following the recession. And consumer spending, generally speaking, has risen broadly as consumers have regained some comfort with taking on a bit more debt after deleveraging during and following the recession. However, this increased consumer demand has not been sufficient to provide businesses with substantially more pricing power.
Now, consider the relationship between Fed policy rates and inflation in years past versus the current environment, since about when new technologies became widespread. Inflation fell after rates had risen, and had increased after rates fell low enough once again. Now, there is no responsiveness or pass through of ultra-low rates to foster price increases.
What is especially notable is that, normally, real interest rates are positive, in that the fed funds rate is usually more than the inflation rate (the red line in the graph is typically above the blue line). Now, real interest rates are negative - which had only once been the case (but never for such a prolonged basis) in data going back to 1955 according to the Bureau of Labor Statistics and the Federal Reserve. It would appear that the lever of monetary policy has been broken.
Thus, the question becomes, which is the more important driver: interest rates (which are just part of a company's cost structure), or prevailing market prices in an era of near-instantaneous price discovery? As I alluded to earlier, competitive intelligence by companies and comparison shopping by consumers limit what companies are willing or able to charge their customers. In that sense, companies become price-takers instead of price-setters.
Similarly, companies can be equally mindful of what their competitors are paying their employees. That means that, unless their competitors offer new employees more money, companies will be unwilling to be the first mover in raising wages.
This changes the whole dynamic of how the economy might operate: if a company is a price-taker, it will hire or expand only as long as wages and capital expenditures cost less than indicated by prices. Interest rates enter the equation only as one part of the cost structure, not as a driving element.
In another changing relationship, weaker wage growth may have become a reason why unemployment has dropped, as wages are part of a business' cost structure in that profit optimization function. The reciprocal argument may then become questioned: If wages had risen faster than prices, employers may have hired fewer workers, leaving us with more unemployment. This is another long-held economic theory that could be reversed in the current environment. As such, trust in the so-called Phillips Curve, which details that falling unemployment would usually generate higher inflation via higher wages that are passed along to customers, may need to be carefully considered.
Instead, the relationship on which policymakers might focus is that of rising asset prices, not of goods or services. Recalling the graph above, note that the fed funds rate had been negative once before in recent decades; namely, the years when the housing bubble took hold. Now, with stock prices richly valued to earnings and book value as I recently wrote, and commercial real estate valuations also high, analysts and policymakers alike are taking note.
Consider the nearby graph of the tremendously wide dispersion of where individual Fed officials view their preference for interest rates in 2018 and 2019. Some policymakers are wary of igniting any dry tinder in another asset class this time around, but others are wary of lifting rates before inflation rises to and remains near the Fed's 2% target.
This is a complex topic that has drawn the attention of legions of analysts, economists and policymakers. Simple arguments may be persuasive, but may be only partially valid as other factors may influence inflation in tandem. Given that every economist may approach this issue from a different angle, it isn't surprising to have such an array of viewpoints. As such, we will need to listen to Fed speakers carefully, and thoughtfully consider their commentary and post-meeting announcements to garner clues as to which camp is winning the interest rate tug of war. But right now, with such a wide spectrum of viewpoints, investors' decisions are a bit more challenging.
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