Sluggish growth in the US has led the Federal Reserve to question whether the economy is struggling with ‘economic hysteresis' - when a recession permanently damages growth potential. The issue could have huge implications for monetary policy and equity valuations. Annabelle Williams reports
The Great Recession of 2007 to 2009 left deep scars on the US economy. The recession, which followed the bursting of the housing bubble in mid-2007, saw the US suffering the largest and most sustained loss of employment since the 1920s. Five years on, the labour market is yet to fully recover.
Even though unemployment has fallen in recent years, and was at 6.2% at the end of July, Federal Reserve chair Janet Yellen admitted recently the labour market did not yet appear to be functioning normally.
In March, the central bank removed the 6.5% unemployment target it had previously given as the level at which the economy would be healthy enough to manage rate rises.
It speaks to the depth of the damage that, five years after the end of the recession, the labour market has yet to fully recover
Speaking at the Fed's annual Jackson Hole conference this summer, Yellen said while recent employment data was encouraging, "it speaks to the depth of the damage that, five years after the end of the recession, the labour market has yet to fully recover".
She highlighted the possibility that the "severe recession" had caused persistent changes in the labour market's functioning, and added apparent shifts in the structure of the labour system are complicating efforts to assess how much slack is still in the economy.
The hysteresis thesis
Yellen was making reference to a concept called ‘economic hysteresis', where a single disturbance to the economy causes wider damage to long-term growth potential.
In this case, high unemployment during the recession may have displaced or disincentivised so many workers that the labour market participation rate is now much lower. This causes a delayed return to economic growth and hinders potential GDP growth for many years to come.
Proving economic hysteresis is hugely complicated, but it is clear something strange is afoot in the labour market, and the implications of this are only just starting to appear.
The hysteresis theory was examined in a paper entitled Long-Term Damage From the Great Recession in OECD Countries, published in May by Laurence Ball at Johns Hopkins University.
Ball suggests the hysteresis effect is particularly strong in the US, as some of the hallmarks of hysteresis - including lack of corporate investment and underutilisation of labour - are evident.
Drawing on the work of other economists, Ball estimates potential growth has fallen in most countries in the OECD as a result of the most recent recession. In the US, Ball estimates the rate of potential growth has now fallen to an annual 2.2%, down from pre-crisis levels of 2.6%.
Concerns about hysteresis were also expressed in July's Federal Open Markets Committee meeting minutes, as members voted to keep interest rates on hold. Yellen indicated the hysteresis theory may be right, and admitted it is "conceivable there is some permanent damage" to economic potential.
Labour troubles
There are several metrics for assessing the state of the labour market. Traditionally, the most closely watched figure has been the unemployment rate. However, in the current environment, this figure is not proving helpful, as the Federal Reserve indicated when it said although unemployment has fallen, the overall level of participation in the labour market is down.
This has been the most troubling metric. Labour market participation was 62.8% in June 2014, down from 66.1% in January 2004. The difference may seem small, but in a population of 314 million, the smallest percentage of non-participation in labour is huge.
Robert Jukes, global strategist at Canaccord Genuity Wealth Management, said hysteresis is underway and headline figures around employment are masking the true extent of the damage.
"The tell-tale sign is lack of corporate investment, and I think we are seeing this in spades," he argued. "The other sign is falling labour market participation. The headline labour market figure is unemployment, but one of the reasons the unemployment rate is coming down is because participation is falling. It is not necessarily a sign of job creation."
Natural unemployment
Paul Dales, senior US economist at Capital Economics, explained there is a third figure involved in assessing the labour market, which is causing concern for the Federal Reserve. The natural rate of unemployment in the market is the number of people that can be out of work long term, without causing inflationary or deflationary pressures to appear. This too seems to have changed post-crisis.
"Before the crisis, the natural rate of unemployment was thought to be around 4.5% to 5%. Now it is generally thought to be between 5.5% and 6%. This may be the legacy of the financial crisis," Dales said.
The Federal Reserve was widely criticised for having dropped the 6.5% unemployment threshold, as market participants had planned for rate rises when the target was reached. But judging the state of the labour market is enormously complicated.
In a bid to gain a fuller understanding of labour dynamics - and whether the hysteresis thesis is correct - Yellen is now consulting a table of 19 key indicators.
The recently developed Labour Market Conditions index is building a more detailed picture of the labour market using data points around job creation in public, private, and temporary roles, alongside figures on average hours worked per week.
Underperforming economy
In the meantime, evidence for the hysteresis effect is mounting, particularly with the poor economic growth the US has shown this year. Even though five years have passed since the end of the great recession in 2009, GDP growth for the first quarter of 2014 came in at a worrying annual rate of -2.9%.
This figure was blamed on exceptionally bad weather, when a ‘polar vortex' grounded flights and emptied the high street of shoppers. But it is difficult to separate the weather effect from the real lag in the economy, and even though growth rebounded to 4.2% in the second quarter, some experts believe the overall picture is of an economy falling well short of its potential.
"Compared to the size of the US economy and what we know about its potential, the economy is underperforming," Jukes said.
Both GDP growth and unemployment figures fly in the face of positive trends which should be pushing the US economy ahead of other developed markets, such as the reshoring of manufacturing jobs and the spurt of activity in shale gas.
"The US has been growing at a rate slower than its potential," Dales said. "Before the crisis, the US could grow at 2.25%-2.5% without generating inflation. But this figure has been closer to 1.8%-2.2%."
This could indicate an economy in the throes of long-term damage from the recession.
Policy implications
Although the hysteresis theory remains unproven, the current lower levels of productivity and labour participation are having significant ramifications for the economy and the setting of monetary policy.
Lack of wage growth is considered the main barrier to higher consumer spending. But wage growth is unlikely to appear so long as unemployment levels remain elevated.
"Many participants continued to attribute the subdued rise in wages to the remaining slack in the labour market; it was noted the elevated level of relatively low-paid part-time workers was holding down overall wage increases," the FOMC's July meeting minutes stated.
The labour market situation is also having an impact on the Federal Reserve's assessment of the inflation which has appeared. Overall consumer price inflation has risen 2.1% over 12 months to the end of June, and is predicted to rise further over the coming months.
Jason Vaillancourt, co-manager of the CF Canlife Total Return fund, explained the Federal Reserve is allowing inflation to rise while keeping rates low because unemployment is still too high.
"While the Federal Reserve is tasked with promoting full employment and price stability, the objective of reaching full employment has not yet been achieved," Vaillancourt said.
"Under its framework of optimal control, the Federal Reserve will be more tolerant of adverse moves in one objective if it is still far from achieving the second objective. This means it is willing to tolerate a little bit of inflation because it believes there is still slack in the labour market."
But inflation is placing upward pressure on interest rates, making it harder for the Federal Reserve to justify keeping rates at record lows, argued Canaccord's Jukes.
"The effects of this hysteresis may bring forward the timing of policy normalisation, possibly baking in the lower level of potential growth," he added.
"I think policymakers in the US are well aware of what is going on, and are worried about it. They do not know quite how to approach this. It is a straw in the wind that seems to show that this time it is different."
Market impact
Nevertheless, the S&P 500 has risen around 200% since its lowest level in March 2009 and recently touched an all-time high of 2,002. This has led many managers to question whether the US is overvalued at current levels.
Laith Khalaf, senior analyst at Hargreaves Lansdown, argued that, on a backward-looking cyclically adjusted basis, the S&P 500 is overvalued at a P/E of 19x. He said this is a rich valuation, both in historical terms and relative to other markets.
"If you look at the prism of cyclically adjusted P/E ratios, then you would probably come to the conclusion that the US market is above average in terms of how expensive it is," he said.
However, even though this is ostensibly a backward looking calculation, in practise, equity valuations take in to account the prospects for future growth.
Valuations
Jukes has begun adjusting his valuation models in light of the potential lower economic growth brought on by hysteresis.
"Permanently lower levels of economic expansion will lower corporate earnings potential and therefore equity valuations on most discount models. Assuming everything else is equal, the US equity market should be 10% lower on our models," he explained.
So far, investors have shrugged off any concerns over the health of the US. But with the Federal Reserve remaining so cautious five years after the crisis, investors would be wise to watch for straws in the wind.
