The shape of things to come – is the era of G7 zero rates over?

• The current economic cycle is much shallower than the V-shaped GFC and Covid recessions.
• Structural G7 labour shortages and mild slowdowns jeopardise 2% inflation targets, particularly in the UK.
• Inflation Targeting Dilemma: Relaxing 2% targets during a significant overshoot is difficult. 
• Central banks may be more cautious about easing rates, after the recent inflation shock.
• Return to "Old” Normal Rates and Yield Curve Insight. Without higher targets, a return to the pre-GFC, “old” normal of 3-6% policy rates becomes more plausible. Today’s inverted yield curves are reminiscent of Greenspan’s “conundrum”.

Ever since G7 central banks began tightening policy in 2022, markets have been pre-occupied by talk of “soft and hard landings” for growth and inflation. There has been less focus on what implications the type of economic cycle, and its causes, may have for the shape of the economic recovery, policy rates and the performance of different asset classes.

More specifically, does the policy-induced slowdown in GDP growth to date, with tight labour markets, mean a weak recovery, when it comes, and are labour shortages structural, not just cyclical? Do slow, gradual and shallow recessions and sticky inflation mean central bank easing will be slow and gradual as a result, and the era of zero interest rate policy (ZIRP) is effectively over?

In assessing these issues, both G7 labour markets and the causes of the slowdown are key. Despite weakness in manufacturing and interest rate sensitive sectors, there is little evidence of labour shedding to date. Fears of difficulty in hiring workers during an upturn may explain labour hoarding in the current slowdown phase.

Post-Covid, the so-called “great resignation”, and ageing labour forces have created a structural shortage in US labour supply. Chart 1 shows excess demand for US workers, measured by employment and job openings, actually emerged modestly before Covid, and is now just under 4 million workers, versus the available labour force. Note that this labour shortage developed pre-Covid, but was largely concealed by the Covid recession, before becoming more acute in 2021/22.

Tightness in labour markets is not confined to the US- it is evident in most G7 countries. As well as an ageing labour force, the UK labour market has been subject to a perfect storm of Brexit, the great resignation following Covid, and a surge in long-term disability claims^[1] of 500,000 between 2019 and 2022. Chart 2 shows this has meant wage inflation has accelerated despite the economic slowdown, in 2022/23, and that wage inflation has almost doubled at about the same levels of unemployment since 2019.

Structural labour market shortages in the G7 suggest “cost-push “pressures on inflation may persist, though the pattern is not uniform, as Chart 3 shows, with varying employment rates relative to population. Increased labour supply elasticity could pull more workers back into some labour forces, most notably in the US, where labour force activity, and participation rates, are still low. The failure of the UK activity rate to recover since Covid, plus increased healthcare waiting lists, and labour militancy suggests more acute UK labour supply issues than the rest of the G7. In contrast, higher activity rates in Japan and Eurozone show improved labour supply elasticity, after market reforms, most notably in Japan. This may dampen wage pressure.

Labour shortages have important implications for the shape of the business cycle. Reduced labour shedding in a downturn, due to shortages, may prevent a spike in unemployment, collapse in demand and deeper recession, while also dampening the demand for labour during the upswing. This tends to make the economic contraction more modest, and the cycle shallower. In addition, structurally, reduced labour supply constrains potential, non-inflationary GDP growth, unless offset by faster technological progress^[2].

Other key drivers of the current cycle have been an exogenous energy shock, and policy tightening by central banks’, to reduce inflation. These are very different drivers from the global financial crisis (GFC) recession and Covid business cycles, which were exogenous and severe deflationary shocks; one a major credit crunch in the financial system, and the other a pandemic driven enforced Lockdown of activity.

Chart 4 shows these deflationary shocks drove rapid, V-shaped recessions and recoveries in the US and UK, characterised by severe contractions in economic activity, spikes in unemployment, and damage to global supply-chains. Policymakers responded quickly with zero rates, and substantial Quantitative Easing, and fiscal support, driving significant rebounds in demand, and economic activity (also boosted by base effects).

The Chart shows both the profile, and speed of the economic cycles were very different from the current and earlier cycles. As a result, inferences drawn from recent fast-moving, V-shaped cycles for monetary and fiscal policy, interest rates and asset valuations may be inappropriate for a slow-motion, shallow economic cycle.

The reaction function of central banks may have changed also. Covid and the recent inflation rebound raised questions about the appropriateness of using GFC policies of zero rates, and QE to revive growth, and whether the stimulus was left in place too long? Enforced Lockdown recessions were very different from the GFC credit crunch and fiscal policy also supported employment via furlough schemes during Covid.

So perhaps it is unsurprising that, as Chart 5 shows, inflation expectations rose steadily after central bank QE in March 2020, and did not stabilise until they finally began raising rates in early-2022. Given this history, greater reluctance to ease rates quickly can be expected from central banks, and particularly the Bank of England, given the scale of the UK inflation overshoot (currently 6.8% y/y versus the 2% target).

It would be difficult to introduce higher inflation targets now, even if more appropriate, because inflation is well above target and doing so risks de-stabilising inflation expectations.

So, if higher inflation targets are not feasible, and labour shortages delay disinflation, the prospect of a new “old” normal of 3-6% on policy rates becomes more plausible. Also note that flat, or inverted yield curves were typical of the pre-GFC period: a phenomenon described as a conundrum by Fed Chairman Greenspan^[3], in 2005.

[1] Source: UK ONS data, July 2023

[2] In neo-classical growth models, beginning with Solow et al, from 1956.

[3] Alan Greenspan, Fed Chairman’s Congressional testimony, February 2005.