The Federal Reserve will meet this week to discuss their inflation targeting strategy and hopefully give us better understanding of how long and how much they plan to target inflation above 2% before they raise rates . The dual mandate of “the Federal Reserve Act are (1) promote maximum employment, which mean all Americans that want to work are gainfully employed, and (2) stable prices for goods and services we all purchase.” So the extreme situation on either side if the Federal Reserve were to fail in fulfilling their mandates would be either a depression by failing to maintain stable employment and allowing unemployment to get out of control or hyperinflation by allowing inflation to get out of hand. During the last decade we found ourselves in a sweet spot with unemployment below 4% and inflation under 2%.
After the Covid-19 pandemic struck, unemployment peaked in April at about 14.7% because most of the economy was shut down. As of August, the unemployment rate has come down to about 8.4%. As the economy continues to open and more talks of bringing workers back into offices by the final quarter of this year resound, we can expect the unemployment rate to continue its decline. The average unemployment rate post World War 2 has been about 5.6%.
If the unemployment rate continues to improve and stabilizes, then what reason does the Federal Reserve have to cause the inflation rate to increase? Inflation has been below the 2% target for most of the last decade, and this may be attributable to 2 main reasons, namely Globalization and Technology. As the world economy became more interconnected, many companies moved their operations overseas. Manufacturers moved to China because they were able to produce goods at a lower cost. U.S. call centers were moved to the Philippines or India because wages were lower. The movement of people between countries for work or travel was growing and more open. With lower labor costs came lower prices for goods. Now, politicians are promoting a nationalistic agenda and there is a lot of discussion to bring jobs back home and calls for immigrants to stay out. Although the intended goal is to lower the unemployment rate by removing competition for jobs to Americans, this would also cause more price inflation because domestic labor costs are higher than other countries. If labor input costs increase, the output costs to the end consumer must also increase.
However, the other reason that has been keeping inflation in check, which is technology, has been a stronger force and will continue to remain a strong force. Just look around you. Destruction can be very deflationary by removing industries and displacing jobs. We are surrounded by technology that has improved our standards of living and has made our lives easier. The deflationary effects that technology has had on society and our economy is numerous. For example, the smartphone, or iPhone in particular, has replaced and made so many other devices and products obsolete or near obsolete. The camera, organizer, music player or iPod, newspapers and coupons, books, calendars, watches, wallets, answering machines, maps (remember Thomas Bros Guides?), remote controls. Even many people are getting by without the need to have personal computers because you can browse the web, email, and access documents on your phones these days.
The advancement and adoption of automation, robotics, AI (artificial intelligence) and ML (machine learning) has also been growing in many industries. As corporations seek to remain competitive and reduce their operating costs, they will look to automation and robotics to manufacture goods while maintaining lower labor costs. Call centers are being replaced by Live Chat Bots that will answer basic and frequently asked questions to reduce the volume of calls that need to be sent to a live operator, thereby again reducing the cost of labor. Machine learning and AI is being used to pore through data to make decisions or alert upper management of areas that need more attention. The idea of delegation will no longer apply to delegating tasks to underlings because many tasks will now be delegated to apps and AI systems that can perform mundane and repetitive tasks as well as analyze reports.
GDP growth can be modeled by the increase of labor and capital with the application of new technologies, the so-called Total Factor Productivity. If new and future technologies will reduce the amount of labor that is required, that leaves more technological innovation and capital as the main factors that will allow GDP growth to continue. Otherwise we may expect lower GDP growth into the future. So, to increase GDP, we will need to increase capital input, and this capital will have to flow towards more advanced and efficient technology.
So, to ensure growth in GDP, does that mean more Quantitative Easing and lower rates to allow capital to be created and invested into the economy and for those investments to chase tech companies in order to achieve more technological innovation? Therefore, we may not achieve higher inflation if we do not increase GDP, and in order to increase GDP we will need more capital to invest in technology that will create more deflationary forces.