Benjamin Tal, Deputy Chief Economist at CIBC joins Avery Shenfeld to discuss Fed policy and where the US economy is heading, pointing to the fact that the current situation in the US is very similar to the soft landing of 1995.
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Introduction: Welcome to Eyes on the Economy by CIBC Capital Markets. A podcast series dedicated to addressing current issues in a concise format, helping to make sense of the evolving economic complexities, so that you can take action.
Avery Shenfeld: Thanks for joining us today. I’m Avery Shenfeld, Chief Economist of CIBC, and it’s my pleasure to be joined by our Deputy Chief Economist, Benjamin Tal, for a look at some insights into where Fed policy might be headed and where the US economy might be headed, drawing on some past periods which looked similar to what we are facing today. So Ben, your latest research, which is on CIBC’s economic websites, takes a particular look at the 1994-1995 episode. How does what happened in that tightening cycle that began in 94 and the easing cycle in 95 and beyond, how did that stack up in terms of what we’re seeing now in terms of economic growth and rate hikes?
Benjamin Tal: Yes, you know, it’s very interesting. As we know, it seems that the Fed is becoming more and more confident that the soft lending scenario is actually happening. Well, as far as history goes, we really don’t have much to play with. Yes, you can make the point every that they following the 2017-19 hiking by the Fed, maybe 2020 could have been a good candidate for a soft lending scenario, but of course, then COVID happened. So when it comes to a real soft lending, we really have a sample of one, the mid 1990s. And there are some interesting similarities, quite frankly. Back then, the economy was recovering from the savings and loan crisis, as people remember. And of course, from the 1991 recession, the capacity utilization was rising very rapidly and the unemployment rate was sinking to below 6%. That was perceived back then to be the neutral rate. Now, very important to note here that back then inflation was actually trending downward. So Greenspan back then was chasing the fear of inflation. Today, as we all know, Powell is chasing actual real inflation. Regardless, the Fed back then moved by 300 basis points during the course of 94-95 versus 500 basis points today. So in both cases, we have seen a significant correction in the bond market ahead of the hike. Now, what’s important here, Avery, is that the Fed hardly touched rates in 1995, which means this is actually the closest we can get to the first experience of higher for longer. Now, as far as the economy is concerned, it of course reacted to higher rates. It went down, but it was not recessionary by any stretch of the imagination. In fact, when you adjust for population growth, the economic performance following the two hikes were basically identical, telling you that 300 and 500 basis points were the same. So the point that I’m making here is that the impact of higher interest rates is similar in both cycles.
Avery Shenfeld: And what explains the fact that we had many more hikes this time around with about the same response in the economy given that in both cases the Fed is aiming at a soft landing and trying to avoid an out-rate recession?
Benjamin Tal: Well, that’s an important question. We are discussing it all the time, as you know, Avery. We often discuss the fact that Canada is more sensitive to higher rates than the U S due to higher leverage here. We all know that. Basically what I’m saying here is that the tiny Bank of Canada is more powerful than the mighty Fed when it comes to the effectiveness of monetary policy. This is true, but the reality is, Avery, that the Fed is more effective relative to itself in the past. What I’m saying here is that as we all know, the sensitivity of the US economy to higher rates has been going down for many well-known factors such as increased reliance on services. We know that. We know that the Phillips curve, which is the relationship between price movement and the slack in the economy, has been flattening. But in the case of 95 versus today, there is more. There is a significant difference. Back then, the level of net interest payments paid by corporations as a show of GDP was about 5-6%. Today it’s about 2%. So clearly more sensitive to higher rates back then. Same goes by the way for household credit. The debt service ratio back then was much higher because the US went through the mud of all the leveraging in 2008. But there is more every year. In the years before the hike of 1994, no less than 27% of mortgages were variable rate mortgages. Today it’s 10%. Again, more sensitivity back then. The point that I’m making here is that de facto impact of 300 basis points back then is not very different than the 500 basis point today.
Avery Shenfeld: One of the things that is of course helping to keep the US economy a little slower than it might otherwise be is the fact that outside the US, the global economy is quite sluggish and so that’s shown up in US exports and US manufacturing. Was that also true in the 95 case?
Benjamin Tal: Absolutely, that’s another similarity and that’s why it makes the situation so interesting. We know that the US is the only game in town at this point, quite frankly, when it comes to economic growth. Japan just escaped a recession, Germany is in a recession, basically, the UK in a recession, China is underperforming relative to expectations. So really, the US is the only thing moving. Canada is in a per capita recession, as unfortunately we all know. And that exactly was the case in 95, in the mid 90s. The US was going and the rest of the G7 was basically in recessionary territory. So clearly back then, by the way, this led to a situation in which the US dollar went relatively strongly up, appreciated significantly and led to put a cap on commodity prices. We are not sure whether or not the history will repeat itself here because back then the dollar was very weak before it went up. But it’s interesting.
Avery Shenfeld: So, of course, markets and the investors who are listening to this podcast are probably more interested in what comes next. And the biggest positive of the 95 story wasn’t just that the economy saw a soft landing, avoided a recession and got some interest rate cuts, but how well the US economy actually did following that soft landing. We had a big surge in productivity and the last half of the 95 to 2000 period was actually a very strong period for GDP gains as a result in the US. And the productivity surge also helped keep inflation at bay while the economy saw that very strong recovery. Do you see conditions as being ripe for something similar in the wake of this tightening cycle? Could we come out of this with productivity-led growth that keeps inflation at bay?
Benjamin Tal: I think yes to an extent, and I’ll tell you why. Because I think that profit in North America, Canada, the US over the past 20, 30 years was easy. We had the globalization good for business. We had the just-in-time inventories good for business. The labor market was giving, the bargaining power was not there. So profit was easy. Profit margins went up dramatically. Today, the opposite is the case. We have de-globalization or if you wish de-risking. We have just in case inventories replacing just in time inventories. The labor market is not as giving, it’s tight, will continue to be tight, demographically speaking. And all those great initiatives, let’s face it, they are not good for business at least in the short term. So you have a lot of forces putting downward pressure on profitability. So you’re a CEO, you have two options. One is do nothing, which is not an option. The other is do something. And this something is to replace labor with capital. And that’s exactly what we have seen in the 1990s. We have seen a significant increase in productivity. And that’s why wages went up without inflation because of the dot-com revolution. Today we have what? The AI revolution. So I think yes, I think investing in Canada and in the US is no longer a nice drive but it will be a necessity which will lead to some increase in low inflation, higher productivity trajectory.
Avery Shenfeld: Well, that all sounds great as long as AI doesn’t replace economists with computer programs, and we hope not. And we hope that those who listen to this podcast will find some insights into where we might be headed given the soft landing we had in 95. And I invite you to join the future episodes of Eyes on the Economy for further insights into both the US and Canada. Thanks for joining us today.
Outro: Please join us next time on the Eyes on the Economy where we will share our latest perspectives and outlook for the Canadian and US economy.
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