Navigating an election-year maze...Policy uncertainty and the economic outlook

A sharp influx of immigration has helped to keep employment gains going and should help better balance the demand and supply of workers. That is something the Fed is counting on. It is also one of many factors on the supply side of the economy that has allowed inflation to cool to the levels we have seen without a significant rise in unemployment.

That isn’t to say rate hikes were not a factor in the cooling of inflation to date. Higher rates prompted a sharp slowdown in hiring in the most interest rate sensitive sectors. Employment growth slowed as less interest rate sensitive sectors picked up the baton to carry gains in the second of 2023. Demand for everything from homes to the stuff we fill them with cooled, while demand for services came back and remains elevated.

Some of the shifts are structural and reflect the aging of the population into retirement. Health care fits into that category along with travel and tourism. We also saw a massive healing of consumer balance sheets and still have a lot of excess savings in deposit accounts – $1.2 trillion as of December – which is now accruing interest. 

Stock ownership has picked up from 53% of households in 2019 to a record-breaking 58% in 2022 according to the Federal Reserve. Those gains, coupled with the surge in home values since 2019, have boosted wealth effects and provided a tailwind for spending.

Corporate balance sheets improved but not as much as household balance sheets. Profits slowed to a crawl in 2023, with the exception of the “Magnificent 7” - the large tech behemoths. Consumers became more discerning in how they spent and pushed back on price hikes by trading name brands for store brands.

Firms fought back by cutting costs and boosting productivity growth. They are chasing a moving target, as much of the debt issued when rates were much lower is scheduled to reset in 2024 and 2025.

A paradigm shift?

The increase in productivity growth was due to a healing of supply chains and a slowdown in quit rates, which enabled workers to learn the jobs they had. There is little evidence that investments in AI accounted for those gains; those shifts are still ahead of us.

Powell was skeptical that we were in a paradigm shift. He saw what we were seeing as more of a return to trend than a return to the 1990s, when productivity growth soared for a more prolonged period.

Recent research on full return to office mandates revealed that they backfired and hurt productivity growth. Return to office policies were more likely in firms that were struggling. The requirements reduced ratings of work-life balance and senior management. Firms which required a full return to the office lost out on diversity, notably women with young children.

Those mandates failed to improve profitability and stock performance. Fully remote work tended to hurt productivity growth, although it depended on the job. An offset was that it reduced costs and the carbon footprint of companies. Hybrid work closed the productivity gap.

Monetary policy uncertainty

The uncertainty surrounding productivity growth is compounded by the uncertainty about the speed and magnitude of rate cuts. Financial market participants are struggling to come to terms with rate cuts that are designed to normalize monetary policy rather than stimulate. The former requires more direct messaging by the Fed.

Powell used the word “normal” in one form or another in the press conference after the January meeting eight times, double the mentions in December. Add the uncertainty that accompanies election years, the polarization we are enduring, escalating geopolitical tensions, and policy uncertainty could be the greatest headwind we face in 2024 and 2025.

Chart 2 lays out the economic policy uncertainty index. The economic policy index itself is comprised of a combination of news mentions of policy uncertainty, the number of tax codes set to expire and disagreement over the outlook among forecasters.

Everything from the course of fiscal and monetary policy to the response to trade policy and geopolitical tensions are considered. It is available by country and across a broad spectrum of variables. We have highlighted the spikes in uncertainty in the US over the last decade. The result of the 2016 election, the trade war with China, the pandemic and Russia’s invasion of Ukraine stand out.

Davis did a literature review of the economic research on the effects of policy uncertainty in 2019. The degree to which they suppressed growth depended on the extent to which they moved the indices of policy uncertainty and the duration over which those shifts occurred. Even short-lived spikes in uncertainty had an impact on the economy:

• Election-related uncertainty reduces investment, discourages foreign direct investment, prompts households to pull back and save and boosts stock market volatility.
• Trade policy uncertainty suppressed investment and employment gains among firms most affected by the trade wars; stock prices were also suppressed and more volatile during trade wars, which had spillover effects to the broader economy.
• The flight-to-safety and investments in the US Treasury bond market increased during periods of geopolitical uncertainty.
• Elevated policy uncertainty took a toll on trade flows; investment in new projects were hit hardest, which undermined productivity growth.
• A smaller corner of the literature found that greater uncertainty dulls our response to changes in interest rates and taxes.

That last point is important, as it underscores how hard it was for the Fed to stimulate via ultralow rates in the wake of the global financial crisis. It could also explain why the economy has been less responsive to higher rates than many expected in 2023 and could raise the risk the Fed holds rates too high for too long in 2024.

That said, it is notable how rapidly the housing market showed signs of life once interest rates dipped below 7% late last year. This is despite high hurdles to affordability and reflects the pent-up demand for homeownership by millennials and the help they are getting from their parents.

A study that focused only on election cycles in 23 countries, including the US, found that uncertainty rose in the months leading up to and immediately following the election. Average economic policy uncertainty values were 13% higher in the month before and the month of national elections than in other months during the same election cycle.

In the US, economic policy uncertainty increases were pronounced and highest around close and highly polarized presidential elections. The election of 2000, 2016 and 2020 are the most recent examples. In those cases, uncertainty lingered after the election due to a slowdown in political appointments following the election. Political brinkmanship has been on a long-term upswing within Congress, which is further fueling the uncertainty after elections.

The authors warn that “doubts about the integrity of the election can greatly magnify the uncertainty created by close elections.” They warn that the magnitude of such uncertainty “could have large and adverse effects for the US and global economy” if left unchecked. (Sadly, that seems the case.)

Chart 3 shows the effect of a spike in uncertainty immediately before and after the election in November. We used the VIX index to shock the model. The VIX index is a measure of stock market volatility and has been nicknamed the “fear index” as it best captures shifts in uncertainty about the future by financial market participants. We found that it acted as a good proxy via our own research for many of the most important components of the economic policy index.

We boosted the VIX less and for a much shorter period than we saw during the recent surge in uncertainty surrounding Russia’s invasion of Ukraine. That shaves 0.3% from growth in the fourth quarter of 2024 and into the first quarter of 2025; the drag dissipates to 0.1% in the second half of the year but boosts unemployment slightly.

That is conservative given the spectrum of risks we currently face, from geopolitical tensions to who wins, voter turnout and the margin of victory. Shifts in the VIX also miss some of the collateral damage to households and how they shape their spending decisions during periods of high uncertainty.

A more prolonged bout of policy uncertainty in 2024 and 2025 would likely have a much larger negative impact. Investment, hiring and consumer spending could slow abruptly. Overall economic growth would dip below the economy’s potential; that would push up the unemployment rate.

Risks: The risks to the forecast when looking at the economic fundamentals alone are relatively balanced between stronger and weaker growth. Those risks move to the downside, given the spectrum of policy uncertainties that are emerging.

We beat the odds in 2023 and look poised to do so again in 2024. The economy may not even land but continue to cruise at a relatively high altitude. That does not mean we will not feel turbulence. The most likely source is policy uncertainty and political polarization.

The silver lining is how remarkably resilient the economy has been. Consumers are almost defiant in their willingness and ability to spend; the setback due to inflation and our own divisive politics is starting to fade. I am leaning into that glimmer of hope, and thinking about what binds us rather than what divides us. We all want a better future.