Less than a year ago, the St Louis Fed declared with a great deal of fatalism that the economic regime in the US had reached a new equilibrium which could be defined as follows: low growth, low interest rates, low inflation (see ‘The Genius of the And’ – June 26, 2016). Instead of being on its way to the formerly assumed steady state of higher growth, rates and inflation, it was there to stay for the foreseeable future. ‘Secular stagnation’ had become the best way to describe the macro situation. Larry Summers wrote close to twenty articles about it over the 2014-2016 period. Paul Krugman has been a believer in secular stagnation too, and only argued with Mr. Summers about its causes. There was no way out. All economic participants had better get used to the new regime.
Today, the outlook has brightened. Perhaps not sufficiently to celebrate a victory yet, but it has (just check the stellar Flash Eurozone PMI from Friday). The change in circumstances came in fast and unexpected. How will economists, central banks and other decision makers react to this surprising evolution should it persist? The straightforward answer would be to refer to the common ‘data dependency’ policy: Any change in data should drive a change in policy.
It may not be as simple as that. First, the current mood is largely driven by survey data (including PMIs) rather than real data. Until the real data converges towards the survey data, there is no real challenge to the secular stagnators (and Q1 may actually be soft in the US).
Second, if the real data were to catch up, it would create a state of cognitive dissonance for many, i.e. a situation where conflicting bits of knowledge or information co-exist:(1) the firm and widely-spread conviction until recently that the global economy was doomed versus concrete evidence to the contrary.
Both sources of knowledge will need to be reconciled. It would require nothing short of a change of mind from policymakers, decision makers and influencers, which is notoriously difficult to engineer, even for the best. In fact, the primary reaction from individuals in the face of conflicting evidence is instead to ‘double down’ as part of a set of behaviors known in the psychology literature as ‘motivated reasoning’. They do so by ignoring or devaluing disturbing pieces of new information, to the point where they get even more convinced that they were right about their initial views.
The strong power of motivated reasoning is well illustrated in politics. An International Society of Political Psychology paper (2010) presents evidence that ‘voters ignore significant amounts of negative information about positively evaluated candidates. In fact, voters may become even more positive about a candidate they like after learning something negative about that candidate.’ Negative campaigning therefore tends to create an environment which fosters tribalism as it pushes all potential voters further into their own camp. That broad political trend has driven up partisanship in the US (check the charts here) and beyond.
Applying this potent concept to central banks’ policies supports the following postulate: The Fed and the ECB are far from turning hawkish and will stay behind the curve. Should the new, actual data conflicts with their latest models, central bankers will have a hard time admitting that they were wrong in their assessment of economic trends. They will instead persevere in their current tracks for some time. It would thus be hazardous to read too much into the Fed’s tactical March hike and into the ECB’s latest press conference. Psychological forces should ensure that interest rates remain low for longer.