Policy Challenges in the World of Faltering Phillips Curve

Global equity markets have done remarkably well over the last few months aided by ultra loose monetary conditions, low interest rates and more recently good macros and earnings growth. However, valuations are elevated and therefore investors are worried about potential risks ranging from political uncertainty to policy mistakes.  One of the biggest concerns is that it will probably not be long before worldwide money creation starts being reduced. G4 central bank balance sheets currently stand at a staggering US$14 trillion. This has more than doubled from 2009 and compares with US$100 trillion in investable global bond and equity outstanding. 

The big question that arises is whether the economic conditions that had led to this massive balance sheet expansion in the first place have turned favourable enough to justify a withdrawal of QE.  While there is no denying that growth currently is at its strongest level it has ever been in this cycle, what seems to be still missing in action is inflation (Chart 1). Thus, despite eight years of the “Grand Monetary Policy Experiment”, G-20 inflation remains at is lowest levels since the Great Financial Crisis.

                                       Chart 1: Global Inflation continues to remain absent

                                     Source: OECD

Global excess capacities, debt and deleveraging as well as the sharp decline in oil prices are some of the well discussed reasons for the current low inflation environment. However, a less talked about factor is the complete absence of wage inflation despite a tightening labour market. The Phillips curve, named after the 20^th-century economist A.W. Phillips conjectures an inverse relationship between the unemployment rate and inflation, that is, a tighter labour market (lower unemployment) should be consistent with higher inflation (or wage inflation). In general, this relationship has withstood the test of time.

However, since the Great Financial Crisis, we have seen the US unemployment rate from drop from nearly 10% at its peak to just 4.4% today, yet core PCE inflation has failed to break above 2.0% - the Fed’s price stability goal. This is true not only for the US but other developed economies as well. The consistent downside miss amid continuously dropping unemployment rate and tightening labour market has now led many investors to question the validity of the Phillips curve concept.

So why does the relationship appear to be breaking down? Our best guess is that technological disruption is thwarting the war on deflation, that is, technological disruption is proving to be deflationary. For instance, in 2015, a spot-welder working in the US automotive industry was paid about US$25 per hour. A spot-welding robot can now do the same job for US$8 per hour (all in), and the difference is only likely to get bigger in the years to come (Source: BofAML).

In other words, the acceleration of robots and AI (the number of global robots is forecast to rise from 1 million in 2010 to 2.5 million in 2020) seems to be exerting downward pressure on wage expectations. A basic principle of economics is that when you face more competition, you are less inclined to put your price, or as a worker, your wage, up. Perhaps as a consequence of this extra competition from robots, many workers in advanced economies now feel less inclined to take a risk by seeking larger wage increases.

If the above is indeed true then it poses some serious challenge for central banks. It means that the Phillips Curve is now much flatter than it once was and thus inflation is now likely to be much harder to generate. This probably explains the utter failure of QE to help central banks achieve their inflation mandate. However, while QE has failed to generate what we call consumer price inflation, it has definitely led to inflation of a different kind. The liquidity bazooka provided by the central banks in recent years has resulted in an environment where prices of financial assets are high across the board – almost nothing can be bought below its perceived intrinsic value while risk aversion (volatility) is at lowest levels on record.And it is precisely this asset price inflation along with the threat it poses to long-term financial stability which is pushing central banks towards unwinding their “Great Monetary Policy Experiment” rather than any threat of real life inflation.

Coming to the India, the Indian economy too has been facing a similar situation where inflation has consistently surprised to the downside in the last couple of years. Thanks to a combination of global and domestic factors, inflation has come down sharply from a peak of 10% in 2012 to close to 2% today (much below RBI’s target of 4%). In fact, it now appears that the economy is undergoing a structural shift in the inflationary process towards low inflation.

It is important to note that being a current account deficit economy, India has always been a net importer of price trends from the rest of the world. Thus, if global inflation is on a structural downtrend thanks to the long lasting decline in oil prices and a flattening Phillips curve, then India no longer needs to worry about imported inflation. More importantly, domestic factors are also pointing to a paradigm shift towards lower inflation. Supply side pressures are far lesser now than it was in the past (e.g. power, coal, telecom, etc) while recent reforms (including GST, demonetisation) are on balance deflationary in nature.

However, despite these favourable developments, both the Government and the RBI have adopted a policy consolidation approach. It is perhaps the trauma of the past inflationary episodes and the serious dent it had caused on their credibility that is forcing policy makers to adopt such an approach. Clearly, by adopting an inflation target framework, their main objective is to reduce medium term inflation and inflationary expectations. However, if both local and global factors are firmly in favour of structurally lower inflation then purely for the sake of preserving credibility, policy makers may inadvertently do more harm by being too adamant in sticking to their ambitious inflation targeting framework.

Looking beyond the narrow discussion of near term policy response, a flattening Phillip’s curve globally represents a major challenge for the Indian economy. This is because labour is the only factor of production which India possesses in abundance and that factor of production is now losing pricing power. In fact, the rent on labour that India receives from the rest of the world (as a proportion of GDP) has already begun to fall (Chart 2). Going forward, if incremental growth will require lesser and lesser labour, then it becomes imperative for India to adopt the right policies and pursue higher growth with a single-minded focus. The entire “India story” is predicated on its demographic dividend and if that under delivers, then it will not only have economic repercussions but serious social and political implications as well.

                              Chart 2: India's rent on labour from overseas has started to decline

                                Source: CMIE Economic Outlook

Bridging the Income Gap: A Delicate Balancing Act

The world currently seems to be experiencing a “Piketty moment”. Thomas Piketty’s magnum opus, the controversial, surprise bestseller, “Capital in the Twenty-First Century” perhaps very adequately captures the events which have unfolded in 2016. In his book, Piketty derives a simple theory of capital and inequality. According to him, wealth grows faster than economic output if r>g (where “r” is the rate of return to wealth and “g” is the economic growth rate). Other things being equal, faster economic growth will diminish the importance of wealth in a society, whereas slower growth will significantly increase it. However, there are no natural forces pushing against the steady concentration of wealth. Only a burst of rapid growth (from technological progress or rising population) or government intervention can be counted on to keep economies from returning to the “partrimonial capitalism” that worried Karl Max. Piketty closes the book by recommending that governments step in now, by adopting a global tax to wealth, to prevent soaring inequality which could result in economic or political instability down the road. 

While Piketty’s thesis and recommendations are debatable, there is no denying that income inequality is leading to political upheaval across the world. The unprecedented rise of Donald Trump as well as the British vote to leave the Eurozone bears testimony to the fact. Post the Global Financial Crisis, anemic global growth combined with the extreme expansionary stance of central banks has had the effect of increasing wealth disparity by benefiting foremost the wealthy. This is well reflected in the sharp divergence in performance of financial assets (Wall Street) vs. wage growth (Main Street) in recent years. It comes as a no surprise then that electorates all over the world are now demanding a new “War on Inequality” by policy makers, requiring less taxpayer’s money being spent on bonds and more money on people via fiscal stimulus to boost wage growth. If 2016 is anything to go by, then 2017 could prove to be even more interesting given the election heavy political calendar globally.

          Chart 1: US wealth inequality - Top 0.1% hold the same amount of wealth as the bottom 90%

                                       Source: Deutsche Bank Research

No discussion on income inequality can be complete without a mention of India. This is because as per a recently released Credit Suisse report, India is the second-most unequal country in the world with the top 1% owning 58.4% of the economy’s wealth. The gap is not only large but rising. A long dated history of corruption and crony capitalism has been one of the biggest factors contributing to the rising gap between the rich and poor. This ever increasing gap has finally started to impact the political landscape of the economy through the emergence of anti-establishment politics. This probably also explains the historic rise of Modi – a "chaiwala" who promised greater transparency, breaking of oligarchic structures and “ache din for all”.

 Chart 2: Inequality is rising rapidly in India

                                        Source: International Monetary Fund (IMF)

With almost three years in power, Modi’s policies can be distinctly divided into two parts. The first part focused on the upliftment of the poor through productivity enhancing techniques – Jan Dhan Accounts, Direct Benefit Transfer, Skill India, Mudra Bank, etc. These schemes had the dual effect of curbing leakages in the system (thereby preventing the corrupt from getting richer) as well as providing adequate resources to the poor for a better life. It is important to note that none of these measures had any element of populism via direct dole out to the poor. Instead, it focused on a more sustainable upliftment of the underprivileged without hurting the “private sector”.

The second part of Modi’s tenure on the other hand seems to be in stark contrast to his first. It now seems that Prime Minister is determined to position himself as the “Indian Robinhood” – i.e. taking away from the rich and giving to the poor. A clear example of this is the recent demonetisation exercise. What the exercise aims to do is generate a “negative wealth effect” where the richer section of the society is left feeling poorer and then use the bounty to redistribute to the less privileged. In fact, last year’s Economic Survey had a special section called “Piketty in India: Growing Concentration of Incomes at the Top”. One of the suggestions it gave to reduce the income disparity included: reducing bounties for the rich and taxing the well-off regardless of the source of income. In a recent speech, Mr. Modi proclaimed “those who profit from financial markets (rich) must make a fair contribution to nation-building through taxes. For various reasons, the contribution of tax from those who make money on the markets has been low. I call upon you to think about the contribution of market participants to the exchequer”.

 

All the above indicate a very clear change in stance – helping the poor even if it inadvertently hurts the “private sector”.

 

There is no denying that a more equitable distribution of wealth is desirable and the need of the hour. However, the method to achieve this seems to be a complex issue. Neither Trump’s rhetoric against globalization/immigration appears to be the right solution nor Modi’s growth impacting demonetisation program. The key thing to remember is that higher inequality goes along with lower economic growth, especially in Emerging Economies. Therefore, the right matrix perhaps is to have a more conducive and compliant growth environment rather than one where the private sector feels threatened. The upcoming Central government budget is most likely to have a social upliftment agenda. However, to increase the size of the overall cake, the government has to acknowledge and act in favour of investments and job enhancing policies. Thus, infrastructure spending and tax rationalization has to meaningfully surprise positively to achieve sustainable growth driven income equality. Good intent alone is not enough, balanced policies are needed.