This article discusses the recent turmoil in the US financial markets, the Fed’s response to inflation, the Production Function, and the Solow Model. This piece uses ChatGPT to explain the concept of Steady State. Additionally, it takes an interesting look at both the pros and cons of artificial intelligence, with a peek at behavioral finance guru Hyman Minsky.
The recent turmoil in the financial markets, caused by developments at Silicon Valley Bank, Signature Bank, and Credit Suisse, highlights risk management and compliance failures. These failures also showcase the inherent fragility within the banking sector, as epitomized by Dr. Hyman Minsky. In his landmark paper, “A Theory of Systemic Fragility,” Minsky proposed hedge financing, speculative financing, and Ponzi schemes. As banks are more akin to speculative financing, Minsky’s recommendation to look at liability structures and asset equity ratios, especially of banks, is of utmost priority. The Fed’s actions have calmed the markets and assured that the US banking system is robust. However, repeated banking crises have a high global negative externality that reinforces the fragility of the banking system. JPMorgan reported better-than-expected results, which helps the Fed’s case. Still, the asset management mismatch and the exponential effect of fractional banking reinforce the need for tighter regulation among banks.
The US inflation rate reduced to 5 percent last month. The minutes of the Federal Open Market Committee on March 21-22 discussed poor liquidity and high implied volatility due to the closure of Silicon Valley Bank and Signature Bank, but the banking crisis in the US is far from a systemic risk. According to the Bureau of Labor Statistics, the Producer Price Index fell 0.5 percent in March, seasonally adjusted. Two-thirds of the decrease in demand is due to a 1 percent decrease in prices for final demand goods, suggesting that there would be a downward movement in US inflation going forward. In March, core inflation increased by 0.4 percent, up 5.6 percent over the year, while the CPI for all urban consumers increased 0.1 percent (seasonally adjusted), rising by 5 percent over the last 12 months. Inflation in the US is showing a downward trend, which is positive for the US. The data also showed that the PCE (i.e., consumer price inflation) somewhat slowed in February. According to FOMC minutes, the gains in consumer spending in recent months are offset by the slowdown in business fixed investment and residential investment. The increase in the borrowing rate (effective fund rate at 4.83 percent as of May 1, 2023), complemented by the reduction of borrowing by banks, will further enhance the slowdown in business and residential investment. The minutes clearly note that the reduction in wage growth would translate into reducing the overall aggregate demand, lessening inflation as we move ahead. The Fed is confident that by next year, inflation would come down to 2 percent.
Consumer confidence in the US remains upbeat. The University of Michigan survey of consumers posted a 2.4 percent change month on month. The rise in year-end inflation expectations in April is due to the prevailing uncertainty in the economy. Consumer expectations are in line with the Fed’s view that inflation will be high in the short run but lower in the long run. Consumers are upbeat about the economy as current economic conditions came out stronger in April compared to last month. The unemployment rate in the US dropped to 3.5 percent on the back of a tight labor market. However, the effect of the banking crisis remains uncertain, and the FED believes that the unemployment rate could rise to 4.5 percent by this year’s end. There will be tradeoff between Inflation and Unemployment Rate. A slowdown in wage growth and an increase in the unemployment rate could lower aggregate demand curve. In the short run, shifts in aggregate demand impact employment and output but not prices. In the long run, shifts in aggregate demand affect the price level. In the short run, prices are sticky, but in the long run, the aggregate supply curve is fixed by factors of production and the level of technology. With high inflation, participants at the FOMC meeting believe that a period of below-trend real GDP growth will lead to a better balancing of aggregate demand with aggregate supply, thereby reducing inflationary pressure.
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The middle road does not see the Fed reducing interest rates anytime soon. Inflation is high but showing a downward trend. The unemployment rate in the US is expected to increase, leading to a downward shift in aggregate demand. The non-accelerating rate of unemployment, also known as NAIRU or the natural rate of unemployment, is the lowest sustainable rate of unemployment without triggering inflation. As the unemployment rate rises, the aggregate demand of the economy goes down due to a reduction in consumption and wages.
Note: This Natural Rate of Unemployment (Short Term) series is discontinued. Chart Source: U.S. Congressional Budget Office, Natural Rate of Unemployment (Short-Term) (DISCONTINUED) [NROUST], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/NROUST, May 2, 2023. Units:
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