In 2014, Andy Kessler wrote an intriguing op-ed in the WSJ, positing that beginning in the last half of the 20th century, the tech cycle had replaced the Fed cycle as the engine responsible for economic growth.
His argument went like this. Historically, the economy ran in 4 year cycles. Initially, cheap capital stimulated business investment and employment, which spurred spending, but increased spending eventually brought inflation. Inflation meant prices of goods rose and eventually tempered demand; lower demand meant inventories climbed, causing companies to slow the rate of production. Lower production forced companies to lay off workers, while the Fed raised interest rates to tame inflation which culled business investment. As inventories depleted and inflation abated, the cycle started all over again. Many interpreted this as the Fed cycle of interest rate adjustments. As it was once said, the Fed brings the punchbowl to the party before the guests arrive, and takes it away once the party heats up.
Seven years ago, Mr. Kessler pointed out that economic cycles are much longer today than they once were and attributed this to the tech cycle. His basic argument was that each new generation of tech - in his narrative (a) mainframes, (b) personal computers, (c) early internet, (d) mobile / cloud - had a greater influence on the longevity and vitality of economic performance than anything that the Fed did. The technology enabled changes in business models that made them less susceptible to traditional forces. His case study was that supply chain integration meant less inventory buildup, which meant less volatility, and subsequently longer cycles.
It’s a very intriguing proposition. I’ve wrestled with this from a few different perspectives. Yes, undoubtedly, new generations of tech have changed business models, making companies less vulnerable to the broader business (and subsequently capital) cycle. Technology has also increased worker productivity, which reduces labor intensity, which means less labor volatility when things slow down. Yet at the same time, quite a few tech firms have shown themselves to be vulnerable to the business cycle. To wit: the Fed cycle matters a great deal to tech firms dependent on benign credit conditions. Tech has no special immunity that way.
The traditional economist in me has two problems with Mr. Kessler’s argument. First, the “tech disruptor” mantra ignores financial orthodoxy - not to mention the over-abundance of other would-be disruptors - at its peril. It tends to be a self-referential argument that “tech is disruptive and is therefore ascendent.” Which is true, until the tech in question runs out of money or ends up in a bizarre stasis where a bunch of tech disruptors with overvalued equity deadlocked in internecine warfare, each simply waiting for all the others to run out of cash before they do. Second, long wave theory tends to read like narrative fallacity, something that Nassim Taleb specifically warned about. Nikolai Kondratiev was clearly onto something, but how much of a long-wave cycle is cherry-picking data points to fit a narrative rather than the data itself exposing the narrative?
That said, capital makes itself irrelevant when it is so cheap and so abundant for so long, as it has been for decades now. The traditional economist in me is an idiot for clinging to a set of parameters that have made themselves irrelevant to a broader set of trends.
That’s a long preamble to say that Mr. Kessler’s 2014 argument has contemporary relevance in light of economic performance during the COVID-19 pandemic.
The Federal Reserve’s response to the pandemic in 2020 was to apply the playbook it developed in response to the 2008 financial crisis: (a) expand the balance sheet through bond buying (this Fed page is representative of the period, look at the second and third columns); and (b) increase the money supply. Theoretically, cheap capital would mean that businesses and consumers would have no reason not to invest and spend.
But those businesses and consumers couldn’t invest or spend if they didn’t have the means of investing or spending. Traditional ways of working were analog, requiring people to conduct business in person. Fortunately, the technologies had long existed for commercial activity to continue despite people being unable to leave their homes. The existence of those technologies wasn’t just serendipitous: the fact that productivity tools enabling a remote, geographically distributed labor force to work collaboratively existed at all fits Mr. Kessler’s point that the tech cycle had far greater influence on economic performance during the pandemic than anything the Fed did. While some sectors of the economy did fall off a cliff (e.g., air travel, hospitality), most carried on. And despite the fact that the pandemic has been going on for nearly 21 months now, S&P 500 earnings are very strong. Without the technology the entire economy would have fallen off a cliff no matter how much money the Fed printed.
The pandemic also exposed winners and losers. Not created, exposed. Pre-pandemic, the tide in customer interaction, whether B2C or B2B, was already moving toward digital channels. The companies caught without viable digital channels were losers during the pandemic. The justification for digital channel development during the pandemic - and true right up to today - has less to do with beating the hurdle rate for investing capital, and more to do with simply staying in business. Sure, the decision to invest is easier to make when interest rates are meaningless, but it isn’t interest rates that make the investment in digital channels compelling. Survival makes them compelling.
The concern today - October of 2021 - is whether or not the Fed cycle has finally become inflationary. I write “finally” because Fed policy targets 2% personal consumption expenditure inflation, and PCE inflation has by and large fallen short of that target since 2008. In recent months, inflation has not only topped that 2% target but run a few laps round it. In the traditional Fed cycle, the measured policy response would be to raise interest rates, which will cool economic activity and bring an end to the cycle.
But how will this play out?
Let’s look at the drivers. Inflation, twined with a labor participation rate plumbing depths not seen since the early 1970s, is creating pressure for real wage increases. After decades of losing, labor is having a moment (link to blog). Unionized workforces are on strike. Amazon may have to increase warehouse labor comp.
Historically, the Fed response would be to increase interest rates aggressively to tame inflation. Yet markets are still pricing the Fed funds rate to rise only to about 1.20% by 2026. That might seem a huge jump from the 0.06% the Fed funds rate stands at today, but by historical standards 1.18% is ridiculously cheap capital, not the kind of rate that discourages spending. That means markets expect capital to be cheap (and therefore abundant) for the foreseeable future.
As labor costs rise, companies will look for ways to increase labor productivity so they can reduce labor intensity of operations. Labor productivity comes from increased tech density. Drones, robots, distributed ledger technology, vehicle electrification, and many more technologies will be the drivers of that labor productivity. If capital is cheap, the hurdle rate is low for productivity-enhancing investments. And even if the Fed upped interest rates much higher to tame inflation, corporate balance sheets are awash in cash. A lot of companies simply don’t need to raise capital to finance new investments.
Inflation may persist into 2022, and even beyond. But Mr. Kessler got it right in 2014: it won’t be the Fed that determines how the economy performs in this cycle, it will be tech.
