It's Beginning to Look a Lot Like Normal

Next year’s rising inflation and capex uptick could make this recovery feel “normal” at last.

With apologies to Bing Crosby and songwriter Meredith Wilson, it’s beginning to look a lot like this unusual business expansion is approaching normalcy.

As central banks rode the shock waves of the financial crisis by taking interest rates below zero and printing money, the battle lines of an economic debate were drawn.

On one side, “monetarists” predicted runaway inflation as currencies were debased. On the other, “Keynesians” argued that the shock was so great, and the fiscal response so meager, that we were doomed to disinflation and flattening yield curves regardless of what central banks threw at the economy.

An Abnormal Recovery

The history of the past decade arguably supports the Keynesians. They called it “secular stagnation” or “the new normal.” GDP growth recovered slowly and unevenly. Risky assets kept grinding upward, but inflation remained stubbornly muted and business confidence did not recover enough to support capital expenditure.

Arguably, one unusual feature of this recovery has been its uneven nature through time and across geographies. An important development this year has been the end of that uneven recovery and the emergence of globally synchronized growth for the first time since the crisis. All 45 of the economies tracked by the Organisation for Economic Co-operation and Development (OECD) are forecast to grow through 2019. But core inflation, notably in the U.S., actually declined over the summer, and capex is barely stirring.

As we move into 2018, however, we see the best chance in a long while for these two pieces of an “old normal” recovery to fall into place.

Incipient Rising Inflation

Germany recently printed year-over-year headline CPI of 1.8%, the highest since the start of 2017. Last week, U.S. core Personal Consumption Expenditures (PCE) hit a three-month annualized rate of 1.9%, within touching distance of the Federal Reserve’s target.

My colleagues Thanos Bardas and Jon Jonsson put out a paper last week analyzing some inflation dynamics and pointing to all the places where they see signs of incipient rising inflation.

The U.S. output gap has closed. China’s Producer Price Index has risen fast since 2016: As many finished goods bought by American consumers pass through China’s manufacturing sector, we would expect that to feed into U.S. CPI soon.

In addition, the low-wage sectors in the U.S., where most of the new jobs have been created, saw the biggest pay raises this year. Mario Draghi of the European Central Bank and Haruhiko Kuroda of the Bank of Japan have both urged labor unions to increase wage demands to boost inflation.

Animal Spirits

When it comes to capital expenditure, it is hard to imagine animal spirits unroused in the C-suites of multinational companies as they see every territory in which they operate expanding, their cost of capital at historic lows, and cash weighing down their balance sheets. At some point, lack of confidence yields to the fear of lost opportunity.

That point may come with U.S. tax reform, currently beginning reconciliation after passing through the Senate a week ago.

The details need to survive that process, of course, but the final bill is almost certain to allow companies to repatriate profits that currently sit, unused, overseas. Some of that will likely find its way into share buybacks, dividends and hiring, and some will simply be brought home as prudent long-term tax planning—but some is bound to be directed to new capital spending.

More crucially, the bill’s details emphasize the importance of encouraging capital expenditures by allowing for the immediate expensing of assets with a life of less than 20 years—a massive shift in incentives for businesses to invest now.

The reasons for lower capex may be structural. The new economy’s technology giants can grow without capital , and some economists observe that spending on business ideas is inherently riskier than spending on physical assets. Nonetheless, businesses in the old economy remain important, and, together with rising inflation, we believe their pent-up investments are likely to deliver something more like an “old normal” recovery as we work through 2018.

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