Prospects for the Global Economy

This is an edited version of the speech given by Randall S. Kroszner, Norman R. Bobins Professor of Economics, at Chicago Booth’s Economic Outlook forum on January 15 in Chicago.

If we look back to my forecast from last year, it said that I was going to upgrade from a “sideways slide” to a more rapid recovery, with GDP growth finally getting into the threes [3 percent range], with a continued gradual decline in the unemployment rate, and still little inflation pressure. The unemployment rate did move down, and inflation stayed quite low, but GDP growth stayed in the twos, where it has been most of the recovery. Well, two out of three ain’t bad!

We didn’t quite get into the threes for the year, largely due to the frigid first quarter of last year. But then spring sprung, and we've had reasonably good growth since then.

Looking forward to 2015, we are on a trajectory to grow in the threes again, and continue to have a gradual decline in the unemployment rate. We’ve had pretty strong growth for the last three quarters, but there are still a lot of fragilities out there. Can we finally graduate from the “terrible twos” at least to the “fragile threes”? That’s going to be the theme for this year: the fragilities that might take us away from that kind of growth.

Let’s look at the labor market, for example. We’ve got the unemployment rate down to 5.6 percent. We used to think of that as a pretty good level, and a level where traditionally you might start to see some wage pressure. But even as the unemployment rate has declined, we’re not seeing any.

How can this be? Consider a broad measure of labor-market utilization that the Fed often mentions. The so-called U6 takes into account not just the traditional definition of those who are unemployed. In the United States, to be considered part of the labor force, you have to either be working or actively looking for work. There are about 2 million people who looked sometime in the last year or so but have given up recently. Fewer people are being counted as looking for work, so you don’t have to generate as many jobs to have the unemployment rate go down. But you might want to take those people into account, because potentially, they will be entering the labor force.

Also, there are about 7 million people who report that they have part-time employment but would prefer to be employed full time.

When you include those two pieces of the labor market, you have this broader U6 measure, and that gives you an unemployment rate of 11.2 percent, double the 5.6 [percent] [for the commonly cited rate]. I think looking at those broader measures is very important for thinking about the state of the labor market, for thinking about wage pressures, and especially for thinking about Federal Reserve policy.

I don’t believe anyone who was sitting around the Federal Open Market Committee table with me at the end of 2008, when we brought rates effectively to zero, thought that six years hence we would be debating whether next year we’re going to raise rates or whether it’s going to be the year after. One of the reasons for that has been a “twos” type of recovery; but also, a very important reason is we’ve had very low inflation. There are many people who were very concerned about the potential for inflation as the Fed undertook large-scale asset purchases. The Fed’s balance sheet for the last three or four months that I was there [as a governor of the Federal Reserve System, from 2006 to 2009] went from $800 billion to $2.4 trillion. It’s now more than $4.5 trillion.

Yet inflation’s low, not high. And if you look at inflation expectations, especially intermediate to longer-term expectations, they’re moving toward levels back in the bad old days, when we were concerned that we were facing deflation, in late 2008.

This is not unique to the US. It’s also happening with greater force in many parts of the world, particularly in Europe, and this is one of the concerns the Fed has. I think they’re going to be patient in raising rates, not only because of a lack of inflation pressures in the US, but because of some of these fragilities internationally.

What we see is the European Central Bank (ECB) taking bold actions early on. They bought a lot of assets, much like we did in the US. They brought their balance sheet to about 30 percent of euro-area GDP. But they’ve allowed it to drop by roughly a trillion euros to 20 percent of euro-area GDP over the last 18 months. In the US, we’ve kept it at about 25 [percent], or 20 [percent] moving up to about 25 percent of GDP.

And what’s happened in Europe? We’re getting close to deflation. The most recent monthly report would suggest that prices have actually fallen over the last year. There’s been an enormous debate in Europe over what they can do and what they should do. The Germans have always taken a very strong stance against inflation. I hope this isn’t too much of a central banker’s joke, but the Germans count ein, zwei, drei, one, two, three, but they count inflation one, two, three, 1 million. If they see inflation moving up just slightly, they worry that it could quickly turn into hyperinflation. Given their history, this is understandable; but it is important also not to ignore the challenges of deflation.

But if inflation expectations start to move down, it can be very difficult to pull out of that. Why is that so bad? Two key reasons. First, if you’re going to be buying a car and you know there’s going to be a sale on that car in six months, what are you going to do? You might wait a little while. More broadly, if the prices of a lot of different types of goods are going to fall, demand may go down.

Second, consider how you’re going to repay your debts. Let’s say you have $1 million worth of debt outstanding, and you were planning to sell a million and a half of some particular product at a dollar each. You receive $1.5 million in revenues and can easily pay your debt.

In deflationary times, let’s even say you’re not losing demand, but the price level comes down. Now you’re getting 75 cents for the products you sell, so then you don’t generate enough revenue to repay your debt. That’s the heart of the “debt deflation spiral” when firms go bankrupt, asset prices fall, unemployment increases, demand falls, and prices fall further. That was really pernicious in the 1930s in the US, and Japan had a more mild case of this over the last couple of decades.

I wanted to note a few anniversaries that are relevant for thinking about Europe and the challenges it faces. It’s the 200th anniversary of the defeat of Napoleon and the Congress of Vienna, which ushered in 40 years of stability in Europe, much as had been the hope with the European Union and the euro. But then, roughly 160 years ago, stability unraveled and they hit a crisis: the Crimean War. Hmmm, maybe sometimes history does repeat itself!

One of the most famous episodes from the Crimean crisis was the Charge of the Light Brigade. I don’t know if you remember, perhaps from grammar school, the Tennyson poem about the valor of this ill-fated British light brigade that mistakenly was sent against a very strong, fortified Russian position.

Now the Europeans are facing a major challenge for how they are going to contend with the forces of deflation. Will they be sending just the light brigade, as some want them to do, or will they realize that deflation is an extremely potent enemy, not to be taken lightly?

My good friend and coauthor Raghuram Rajan, [Distinguished Service Professor of Finance at Chicago Booth,] who became the head of the Reserve Bank of India almost 18 months ago, established his bona fides as a strong inflation fighter, raising interest rates even though growth was just OK in India, because inflation was starting to move up. But inflation has started to move down and inflation expectations have moved down very significantly. Just yesterday, Rajan did a surprise rate cut.

Now, if we can avoid the fragilities I’ve touched upon and don't experience negative shocks, the US will go along fine and have stronger growth than we have had since the recovery began. If so, by the fall the Fed will be in a trajectory to raise rates.

In the December statement, the Fed included a discussion of not only inflation but inflation expectations, emphasizing the role that expectations will play in their decisions. As we see inflation expectations starting to move down, as we see interest rates starting to move down, the 10-year rate in the US is now under 2 percent. In Germany, it's about 40 basis points. In Japan, it's 25 basis points, all suggesting that people are seeing very low inflation outcomes. Let us all hope that central banks around the globe don’t send in the light brigade to fight the forces of deflation.