The U.S. Federal Reserve has not had to worry too much about the inflation aspect of their dual mandate for decades. Macro policy choices were mostly tilted towards the full employment aspect of their mandate.
COVID-19, the race for artificial intelligence (AI) leadership, and several geopolitical events have all been catalysts to slow globalization and increase inflationary factors. Rebalancing the world’s supply chains and shifting to more expensive production will matter.
When we consider economic growth, the biggest engine is the size of the workforce and how productive that workforce is at producing what we consume.
As the U.S. economy shifted from manufacturing to services over the decades since the Second World War and those jobs went to places in the world with lower costs of production, a disinflationary tailwind was the major driving factor. Today, demographic trends and geopolitics are reversing or at least slowing that tailwind.
The U.S. Congressional Budget Office (CBO) is responsible for forecasting what budgets may look like going forward, making assumptions based on the law.
They do not forecast recession, and they do not forecast possible changes in policy. The Fed is responsible for a more dynamic forecast that attempts to anticipate policy changes.
One currently is the concern for inflation that has mostly been a back-burner consideration for decades.
The CBO assumptions of productivity 20 years ago missed the mark by a notable margin. U.S. productivity has underperformed their expectation. There is a growing expectation that AI will create a major productivity tailwind.
It could also help the poor demographic growth outlook in terms of the labour market growth potential. The CBO alternate forecast if AI boosts productivity in the decades ahead is for the debt-to-GDP ratio to begin to level out.
While we love AI and believe it’s in its infancy in terms of the GDP impact (currently lots of spending with little productivity benefit), it could be a game changer in many ways.
The innovation effect accounts for the boost to innovation coming from an increase in the number of sciences, technology, engineering, and mathematics (STEM) workers.
That effect slowly grows over the next 10 years. The employment composition effect accounts for changes in the age, skill, educational attainment, and occupational makeup of the workforce.
New workers from the recent surge in net immigration are younger and have less education relative to the broader labour force. That puts downward pressure on TFP over the next five years.
While the market is focused on the Jerome Powell/Donald Trump dynamic this week, I’m much more interested on the changes in how the FOMC navigates these new dynamics impacting growth and inflation going forward.
We know the Trump administration wants lower rates and wants to put voters on the committee to get there.
I’m more interested in how that avoids the obvious group think that drives their decision making today and how they see inflation and growth dynamics evolving in the future.
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