Fed Must Tune in to Changing US Economy

With each passing month, more questions are being asked about the sluggish US economic recovery. Why has growth been subdued since the recession ended in mid-2009? What's changed in the economy? How long can loose monetary policies persist before promoting more inflation or creating a new bubble?

To answer these questions, you first need to understand what is driving the US business cycle. In the initial stages of the last three US economic recoveries (1991, 2001 and 2009), the pace of growth was roughly half as fast as during recoveries from the 1960s to the 1980s (Display). In the past, it was widely believed that deep recessions were followed by sharp recoveries, while mild, short downturns were followed by weaker rebounds.

That argument doesn't hold water anymore. After the worst economic slump since the Great Depression in 2008-09, we've seen nothing but slow growth.

Part of this pattern has been created by a change in the underlying causes of recessions. The past three US downturns were driven by financial imbalances and sharp declines in asset prices. This triggered spending and investment corrections as well as a crisis in the capital markets and banking system.

But from the 1960s to the 1980s, US recessions were largely caused by imbalances from accelerating inflation of both consumer and producer prices and the subsequent tightening of monetary policy. It's much harder for an economy to extract itself from financial imbalances than from real sector imbalances.

Price patterns have also changed dramatically. During the 1960s, 1970s and the early 1980s, the consumer price index (CPI) and producer price index (PPI) rose rapidly (Display), matching the average annual increase in asset prices like real estate and equities. But since the early 1980s, the CPI and PPI rose only half as fast as in the earlier periods, while asset prices rose much faster.


These changes are extremely important. Wage trends have an affinity with CPI, while business profits are correlated with producer prices. So in good times, rising wages and business prices—and expectations that current trends will continue—encourage people and businesses to take on more debt, thereby supporting additional spending and investment.

Yet, during growth periods in the past two decades, leverage has shifted from income flows to balance sheets as asset prices fueled individual and corporate wealth. In the equity market boom of the late 1990s, many companies used their share price as a currency to invest and expand. Similarly, in the cycle that started in 2001, rising house prices allowed individuals to borrow more for additional real estate investments and to increase spending.

This shift creates the potential for more economic instability—especially since asset prices have become demonstrably more volatile over time. And since the Fed focuses primarily on consumer prices, changes to asset prices and wealth are more likely to become the “accelerator” of economic growth by driving increased use of credit and investment.

In our view, a successful monetary policy must ensure that wealth gains from rising asset prices are durable and linked to fundamental changes in the real economy—not just a temporary benefit from artificial and unsustainable liquidity flows. We don’t think that the Fed can achieve this by focusing only on the core inflation rate and the unemployment rate, which do not capture the fundamental shifts that drive the economy. Without changing the framework that underpins monetary policy, the Fed won’t be able to address the challenge posed by rising asset prices to US economic growth.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Joseph G. Carson

Director—Global Economic Research
Joseph G. Carson joined the firm in 2001. He oversees the Economic Analysis team for AllianceBernstein Fixed Income and has primary responsibility for the economic and interest-rate analysis of the US. Previously, Carson was chief economist of the Americas for UBS Warburg, where he was primarily responsible for forecasting the US economy and interest rates. From 1996 to 1999, he was chief US economist at Deutsche Bank. While there, Carson was named to the Institutional Investor All-Star Team for Fixed Income. He began his professional career in 1977 as a staff economist for the chief economist’s office in the US Department of Commerce, where he was designated the department’s representative at the Council on Wage and Price Stability during President Carter’s voluntary wage and price guidelines program. In 1979, Carson joined General Motors as an analyst. He held a variety of roles at GM, including chief forecaster for North America and chief analyst in charge of production recommendations for the Truck Group. From 1981 to 1986, Carson served as vice president and senior economist for the Capital Markets Economics Group at Merrill Lynch. In 1986, he joined Chemical Bank; he later became its chief economist. From 1992 to 1996, Carson served as chief economist at Dean Witter, where he sat on the investment-policy and stock-selection committees. He received his BA and MA from Youngstown State University and did his PhD coursework at George Washington University. Location: New York

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