June 24, 2022 | 13:03
Mind over Model: How Behaviour Shaped the Outlook
Mind over Model: How Behaviour Shaped the Outlook
If the pandemic episode has left you bearish on MMT, it should leave you bullish on Behavioural Economics. Quick changes in psychology and household behaviour seriously complicated the forecasting process and contributed to policymakers falling well behind the curve. In some cases, these behaviour changes have been small and temporary; but in others, they could have long-lasting and seriously important implications for the broader economy.
Spending and Work Patterns
“Wouldn’t economics make a lot more sense if it were based on how people actually behave, instead of how they should behave?” — Dan Ariely, Predictably Irrational.
We’ve long argued that the supply-shortage narrative has been as much the result of demand excesses, especially for physical goods. Real personal spending on goods in the U.S. is still roughly 15% above pre-COVID levels (Chart 1). The initial burst was the result of lockdowns and closing of services, but we’ve argued all along that it was that burst in demand that drove much of the initial inflation process. And, remember the early-pandemic hoarding of things like toilet paper and flour? Now, goods demand has levelled off, but there hasn’t been a major pullback (yet) despite increased service spending. This is helping inflation pressure linger in the goods sector. Looking ahead, the acute pressure on goods prices will likely fade (there are already signs that inventories are building in some areas), but the pressure on services prices will remain a challenge.
Meantime, the research consensus says that it takes 66 days for a change in behaviour to become a habit, and this pandemic is now pushing toward 800 days! That has helped cement new work patterns across a large swath of the economy, not because of new technology (we always had it), but because of a change in behaviour. Tellingly, activity in areas like restaurants, travel and sporting events is effectively back to pre-COVID levels in the U.S., but office occupancy is running at just 44%, according to data from Kastle (Chart 2). Suffice it to say that the way many industries operate has changed permanently, and the implication in areas like commercial real estate is still being worked out, likely through gradual repricing and rescaling of space.
Speculation, Housing and the FOMO Effect
"If we do not understand the epidemics of popular narratives, we do not fully understand changes in the economy and in economic behavior.” Robert Shiller, Narrative Economics.
From tulips to tech stocks to Bitcoin, rising prices have a way of feeding on themselves if left unchecked. The housing market strength in Canada has been well documented and debated, and we argued well over a year ago that “the action needed today is one that immediately breaks market psychology and the belief that prices will only rise further”, with higher interest rates the main recommendation. Since then, prices ballooned, driven by a fear of getting priced out, and outright speculation that prices would keep running—this is psychology, not a supply problem. But, beginning with the Bank’s first nudge in interest rates, those market expectations began crumbling (Chart 3). According to weekly survey data from Nanos, just over 40% now expect higher prices in the year ahead, down from near-record highs above 64% early in the year. At the same time, 26% now expect lower prices, up from less than 6% (i.e., nobody) early in the year (the pre-COVID norm was around 15%). Tighter monetary policy is starting to clean out a lot of froth in asset markets, and it is not exclusive to housing.
Inflation Expectations and Labour Unrest
“One of the factors in our deciding to move ahead with 75 basis points today was what we saw in inflation expectations. We’re absolutely determined to keep them anchored at 2 percent” — Fed Chair Powell, FOMC press conference, June 15, 2022.
Early this year, consumer inflation expectations, as measured by the Conference Board, hit the highest level on record going back to 1987; and results from the University of Michigan have hit the highest since 1982. According to the latter, inflation over the next year is expected at 5.3%, a tick off the highest since 1981, while 3.1% for the next five years is a notable departure from recent decades in the 2%-to-3% range (Chart 4). That clearly caught the attention of the Federal Reserve. Why do central bankers consider expectations a really big deal? If inflation gets rooted into consumer psychology, expectations of higher prices can pull forward demand and further contribute to higher prices. At the same time, those expectations lead to firmer wage demands and, once achieved, will compress profit margins and force further price increases. And the wheel keeps turning.
That might be where the economy is now at, and central bankers realize the importance. There is an extremely tight job market in North America, with near record-low unemployment rates and record-high job vacancies in both Canada and the U.S. The combination of firming consumer inflation expectations and an uber-tight job market is filtering into wage demands, and many firms will be forced to pay up given the conditions. Based on the Atlanta Fed’s measure, wage growth has broken out to the highest since the mid-1980s. Gains are widespread across hourly and full-time workers, across industries, and among job switchers and those staying put. In Canada, while headline wage gains look light, industry detail shows that many areas of the economy are already offering sizeable pay increases. Based on the Job Vacancy and Wage Survey, almost half of industries offered wage gains in excess of year-over-year inflation in Q1. Most of those gains have been in private-sector industries like trade, construction and finance. Public sector-heavy areas like health care and education have lagged, but with labour unrest now making the news often, provincial/local governments should be on alert.
Indeed, there is a real risk that labour disputes become more common and disrupt the supply side of the economy when it absolutely can not afford it. While the official count of job action is still low coming out of the pandemic (Chart 5), there is a direct correlation between inflation and labour unrest, and we’ve begun to see anecdotes of such in recent months—rail workers, construction trades, aerospace and retail, among others.
Self-Fulfilling Recession Worries
“The relentless strength of inflation, and the policy response needed to address it, is ramping up the risks of a hard landing for the North American economy” — BMO Economics, June 17, 2022.
That sentiment has broadened well beyond Bay Street, with recession chatter spreading around Main Street too. Google searches for “recession” have surged to relative levels above those seen during the 2008/09 financial crisis, and in the early stages of the pandemic (Chart 6). There are two reasons to take this seriously. First, this has historically been coincident or slightly leading to actual swings in the economy. It caught the first negative U.S. real GDP print in 2008Q1, and then the much deeper dive in the economy later in the year. Canadian trends also picked up the 2015 downturn—lighter volume because the recession was contained to oil-producing provinces. Second, concerns about recession could influence actual behaviour. One might spend less or move out of riskier assets, exacerbating a slowdown.
Bottom Line: Central banks were much too slow off the mark with tightening in this cycle. Perhaps they were lulled to sleep after a decade of deflationary conditions following a credit event; but traditional economic modelling also missed major behavioural shifts in the economy. That leaves the economy at a critical juncture, where an acute burst of inflation has persisted to the point of rooting itself into the psychology of households and businesses. Central bankers now know it, and they probably won’t relent until they break it.