#MacroMemo: July 24 – 28, 2017

Understanding low wage growth:

• In the quest for evidence that the U.S. now occupies a “late” stage of the business cycle, one indicator that has failed to jibe with the rest has been the sluggish rate of wage growth. This has picked up, but remains well short of a normal late-cycle reading. Wage growth is important not just for workers but also because it is a theoretical precursor for higher inflation.
• We believe – aided by a recent Bank of Canada study on wage behavior – that the slow wage story is less mysterious than it first looks.
• Once one has accounted for the present era of sluggish productivity growth and the lingering effect of prior economic slack, wage growth in the vicinity of 2-3% per year is not such a surprise for the U.S.
• Crucially, however, wage growth could pick up now that economic slack is nearly gone. There is a limited relationship between the two variables for most of the cycle, but the effect puts on considerable muscle once an economy hits its full potential. The U.S. is now reaching such a point.
• Although many cite the preponderance of discouraged job seekers and involuntary part-time workers as an argument that more labour market slack remains than is reflected in the official unemployment rate, we note that the broad U6 measure captures these labour market distortions and yet is already within a few tenths of the previous cyclical low. Things are getting tight.
• Furthermore, because of the aforementioned low rate of productivity growth, the necessary wage signal to endorse further Fed tightening is somewhat lower than it once was. In other words, the Fed is arguably right to be raising rates despite an otherwise lackluster rate of wage growth.
• From a Canadian-specific perspective, the residual effects of the oil shock have constrained Canadian wages (which have been notably softer than in the U.S.), but this depressant is rapidly vanishing. Canadian economic slack is also quickly vanishing. 

U.S. NAFTA demands:

• With the release of an 18-page report detailing key U.S. objectives for upcoming NAFTA negotiations with Canada and Mexico, a certain amount of light has been cast on a previously shadowy subject.
• The good news is that U.S. plans do not involve unilaterally tearing up NAFTA, imposing blanket tariffs or conjuring a border adjustable tax, as was feared in the early stages of the Trump presidency.
• However, there is still reason for concern on all sides of the relevant borders, and we found the aims to be slightly greater than anticipated.
• Most worrying, in our opinion, are the plans to eliminate trade resolution panels and to secure the primacy of U.S. law over NAFTA law. If successful on the first front, this would oblige any grievance to be dealt with by the courts of the country that is misbehaving, in contrast to the neutral tribunals currently in effect. The odds of a fair outcome might be significantly reduced. And, on the second front, if the U.S. manages to elevate its own laws above NAFTA rules, this would permit a theoretically unlimited number of tariffs to be imposed in the future, under the guise of anti-dumping, countervailing duties and safeguard exclusions. The last of these essentially means that the U.S. could impose a tariff if any American parties were hurt by another country’s exports. Some party is almost always hurt by free trade, opening up a Pandora’s Box of potential tariffs. To put a fine point on this, these proposed changes could defang NAFTA so significantly that it isn’t clear you could call what remained “NAFTA.”
• A central goal articulated in the plan is to reduce the size of the U.S. trade deficit. This is not an unreasonable aspiration by itself, but there are limits to what a government can achieve by decree. Arguably, the goal may even be intellectually incoherent given that aiming for a smaller trade deficit is more or less the same as targeting a higher national savings rate – conceivably achievable in isolation, but arguably in conflict with the White House’s simultaneous aim to increase business investment (dissaving) and to deliver fiscal stimulus (further dissaving).
• From a Canadian perspective, it is difficult to know how seriously to take the desire to eliminate restrictions limiting U.S. firms’ access to Canadian telecom, financial and other service sectors. This has been a longstanding desire of U.S. trade policy, but never pushed for all that hard. The question going forward is how aggressively will it be pursued? If done forcefully, this could be disruptive to many Canadian corporate champions, though of course it would represent a theoretical economic positive: the dismantling of trade barriers as opposed to constructing new ones.
• Other proposals were largely expected, including tighter rules of origin requirements, a bigger cross-border shopping limit, freer agricultural trade (a dig at Canada’s supply management, and another illustration that the U.S. proposals are as often as not to tear down barriers rather than to build them up), and aligning intellectual property laws.
• Of course, all of this is just a wish list. Canada and Mexico will have goals of their own, and any eventual deal will have to land somewhere in the middle. That said, the stakes seem higher than usual given several proposals to defang important NAFTA foundations, what could be a more aggressive American negotiating strategy, and a greater tolerance for the unthinkable – walking away from NAFTA altogether. 

Central banking huddle:

• ECB recap: The European Central Bank failed to signal any further tapering at its latest decision, in alignment with our expectations. The “easing bias” toward quantitative easing persisted, though it is important to understand that this has more to do with retaining some optionality and preventing markets from getting even more revved up than an actual plan to increase bond-buying from here. It looks as though the early-September meeting could reveal more about any plan to scale-back quantitative easing flows in 2018. The timing simply wasn’t right to provide such a signal yet, in part because of the desire to see more economic growth, in part because the euro and European yields have already increased significantly, effectively tightening financial conditions.
• BoJ recap: Unlike many central banks, the Bank of Japan remains firmly in stimulus-delivery mode. This has less to do with the state of the economy – Japan’s economic slack has all but vanished – and more to do with reluctant wages and inflation. Reflecting this, the BoJ reduced its inflation forecast for each of the next two years. Governor Kuroda is up for renewal and is likely to be reappointed in 2018. This renewed mandate could unleash another wave of stimulus as he seeks to send inflation higher through force of will despite profound disinflationary pressures from demographics and adaptive expectations.
• Fed ahead: The Fed set off fireworks in June with a fourth rate hike, but is unlikely to follow that up with more action in the coming week. It would be very aggressive to raise rates at two consecutive meetings. The overall economic backdrop seems similar to six weeks ago, with a weaker U.S. dollar providing a slightly hawkish tilt (more growth, more inflation). The key debate concerns whether the Fed will raise rates in September, use that opportunity to articulate a clear starting point for balance sheet reduction, or both. We are inclined to think “both” at this juncture. 

Data run:

• Canadian inflation: Canadian headline CPI was soft, falling from 1.3% YoY to just 1.0%. This was a bit weaker than expected, and continues a string of inflation misses across a fair chunk of the developed world. Core inflation was more middling, with two of the three Canadian measures rising by 0.1% on a YoY basis. Their central tendency is now a tame 1.4% YoY. As we have been saying since the late winter, the period of accelerating inflation has ended for the time being, though we expect it to reassert itself later in the year. And yet this does not appear to impede central banks since central banks are presently a) less data dependent than usual; and b) anticipating higher inflation in the future given ongoing economic progress.

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Published July 21, 2017