The phrase fairy tale economics is usually used to describe economic policies that do not add up or bear no relation to reality.
But the current reality we find ourselves in does resemble an economic fairy tale of sorts: that of the so-called Goldilocks economy.
The term Goldilocks economy — derived from the well-known 19th Century fairy tale Goldilocks and the Three Bears — refers to a benign set of market conditions characterized by strengthening economic activity, subdued inflation and accommodative monetary policy. These conditions translate into high equity valuations, low bond yields and narrow credit spreads. And as with the fairy tale, there are three “bears” in this real-life scenario that the Goldilocks economy needs to keep at bay.
As the Goldilocks economy has gathered steam in the aftermath of, and recovery from, the 2008 financial crisis, the fear of an imminent economic catastrophe has correspondingly subsided. This prompted former Fed President Janet Yellen to reassuringly predict last year that there will be no new financial crisis in our lifetimes.
“Would I say there will never, ever be another financial crisis? You know probably that would be going too far but I do think we’re much safer and I hope that it will not be in our lifetimes and I don’t believe it will be,” Yellen said in June 2017.
Does Yellen’s optimistic outlook hold true a year later?
The current environment serves up a well-balanced economic cocktail that supports the notion of the self-reinforcing, Goldilocks economy – economic growth, moderate-to-low levels of inflation and post-crisis monetary stimulus. This set of dynamics has helped fuel synchronised global growth in both developed and developing economies, in turn supporting asset prices and keeping volatility at record lows.
Economists point to several drivers that could further sustain and extend this global growth momentum. Broader and structural long-term trends including technology, automation and globalization are levers for both increased labour productivity (on the output side) and falling rates of inflation (at least outside the US). And muted inflation means central banks will approach quantitative tightening gradually and carefully, favouring a prolonged low rate environment.
A continued benign outlook for inflation is undoubtedly a positive for markets. But concern about rising inflation came to a head earlier this year during February’s dramatic market correction when the value of the VIX more than doubled in a single session for the first time ever. Was this the first sign of market nervousness and an indication that the Goldilocks era is nearing an end?
Indeed, current market conditions point to several potential weaknesses and downside risks. And there are three main risks, or three bears to keep with the fairy tale analogy, that could upset the economic applecart. These bears — represented by higher inflation, protectionism/trade wars and financial instability — pose a danger to the Goldilocks economy.
The risk presented by the first bear, higher inflation, was something highlighted by Ravi Menon, managing director of the Monetary Authority of Singapore. “Inflation will return when tightening cyclical factors outweigh the structural disinflationary forces,” Menon said at the start of the year.
While globalisation and technology are the main deflationary drivers, the inflationary forces of output and declining unemployment are acting as a counterweight on the economic seesaw.
The famous Phillips Curve, which remains a subject of debate among economists, depicts an inverse relationship between inflation and unemployment. In essence, a higher employment rate means workers can demand higher wages, translating into higher inflation.
And unemployment rates are falling, especially in the US where the rate fell to an 18-year low of 3.8% in May. Along with the decline in unemployment, average earnings in the US increased by 2.7% year-over-year in May, up from 2.6% in April.
It should be noted that nominal US wage growth has been far below target in the aftermath of the financial crisis — meaning there is downward pressure on wages. However this wage gap (2.7% in May 2018 vs. an average of 3.5% in the pre-crisis period) will eventually be closed as unemployment rates continue to fall.
Perhaps a greater threat to the Goldilocks economy comes from the output side and namely the output gap. The output gap – the difference between actual and potential economic output — is considered a key measure of inflationary pressures. And with the US output gap now closing, there is not much slack left in the economy, paving the way for price pressures to rise in the months and years ahead.
The second bear, trade wars and protectionist policies, have certainly become more prominent recently. Donald Trump’s decision to impose tariffs on steel and aluminium producers on May 31 was met with a swift and sharp response from leaders in the EU, Canada and Mexico who have warned of the risk of imminent trade wars.
Protectionist policies have also been fuelled by wider political currents including populism and anti-globalism as well as events such as the 2016 US election and the Brexit vote in the UK. International trade is no longer confined to goods and services and now entails capital and investment flows as well as immigration.
This second bear may not directly impact the Goldilocks momentum in 2018 but will surely shape it in the years ahead.
The third bear encompasses the broader sphere of financial instability. This includes risk factors such as global economic and financial weaknesses, geopolitical threats and the role of central banks.
Contractionary monetary policies are already underway in the US and beginning to take shape in the UK and Europe. Such central bank action, and the market’s reaction to it, is closely connected to inflation, output and the employment trends mentioned above. But these tightening policies over time will also serve to reverse the momentum of the Goldilocks economy.
Other key variables to monitor on the economic radar include growth in the US and China. In the US, which is in the late stage of the economic cycle, we are seeing a flattening yield curve — considered an indication of a looming recession. And any economic slowdown, or “hard landing,” in China will add to downside risk.
So while the Goldilocks economy is unlikely to completely lose steam this year, the three bears are waiting ominously in the wings and – just as in the fairy tale — will likely spoil the Goldilocks party sooner or later.