It helps to have a framework for thinking through the different events that might come along and surprise us. Some things are just lumps and bumps along the way, while others are genuinely forks in the path ahead.
The past few weeks have been big ones for news. An assassination attempt, a Presidential withdrawal and a global cyber-botch. Not to mention a string of elections in other countries in prior weeks. Aside from the salutary reminder that we should never attribute to conspiracy something that could as easily be a stuff-up, recent events have highlighted that unexpected events can occur, and that even things that were well-anticipated can have surprising consequences. As former UK Prime Minister Harold Macmillan famously said, the biggest issues he needed to deal with were ‘Events, my dear boy, events’.
It helps to have a framework for thinking through the events that might come along and surprise us. Some years ago, in another life, I tried to develop one, dividing things up into lumps, bumps and waves.
Lumps, bumps, waves …
Perhaps easiest to understand are the lumps and bumps. The ‘lumps’ are the single factors that are big enough to shift the total even though they are not representative. You can see the role they play when forming a view about very near-term outcomes. In the broader scheme of things, inflation is driven by macro-level factors, the balance of aggregate demand and aggregate supply. But in working out what you expect the next CPI result to print, you need to allow for all the individual components that could shift the total. This is why Westpac Economics Senior Economist Justin Smirk’s preview of next week’s CPI release covered specific factors such as electricity rebates and the timing of end of financial year sales. In ‘now-casting’, a ‘bottom-up’ view can be very helpful.
The ‘bumps’ are temporary special factors like cyclones or other disruptions. In a world where supply shocks are more prominent, thinking through the effects of these bumps will be something we all need to do more often.
Bumps are not always short-lived. A good example of a bump that is playing out over several years is the drop and then surge in population growth resulting from the closure of Australia’s international borders during the pandemic and subsequent reopening. The peak in population growth was last year, partly because China’s borders had just reopened. It will take a couple of years before population growth reverts to its pre-pandemic norm. In the meantime, the housing market is under pressure. Even allowing for some increase in average household size back to its pre-pandemic level, rental vacancy rates will remain low for a while, and rent growth in the CPI elevated.
A challenge for policy in all of this is that one needs to recognise where the aggregate numbers are being pushed around by one-offs and unrepresentative influences. At the same time, one cannot dismiss these effects entirely. Simply excluding all the one-off things that are boosting inflation, for example, can mean one ends up with an inappropriately sanguine view of the underlying trend.
We also need to pay attention to the ‘waves’ – the big shifts that can change the underlying structure of the economy. Typically these stem from demographic shifts or regulatory or technological developments.
Sometimes these waves are transitions to a new normal. The process of urbanisation underway in China is a good example of such a transition. The end of a transition can be especially challenging to navigate. People get used to the way things work during the transition phase, and do not anticipate that it will not last forever. This is especially so for the leveraging phase that typically follows deregulation of the financial sector. The crises and near-crises in Japan, Scandinavia and Australia in the early 1990s and in Asia in the late 1990s are all examples of how that can play out badly. It can also be hard to stick the landing when converging to a higher standard of living, as Ireland and Spain found after joining the Euro Area and converging to Euro Area living standards.
Another challenge with the truly important waves is that even when we recognise a wave is occurring, we might misread its broader implications. As I pointed out in that speech in 2019, it is often assumed that the ageing of the population means that participation in the labour force will decline and the workforces of advanced economies will shrink. In fact, with the notable exception of the United States, the reverse is happening. (This trend, and the US exception to it, is a topic for a future note.) Similarly, it is often assumed that technological change boosting productivity in one sector more than others will result in that sector expanding. That may be true for output, but the history of agricultural and manufacturing employment shows the opposite.
…and forks
With the benefit of a few more years, it has become clear that some events are best understood not as lumps, bumps or waves, but as forks in the road. A particular threshold event occurs with two or more possible future outcomes. Once it occurs, it closes off some potential futures, and sets us on one path. While this is not the superposition of possible states of a Schrödinger’s cat, we know that, for example, come November the cat will either be red or blue. The reunification of Germany was another good example.
Resolution of this kind of event uncertainty can shift market pricing considerably. Before the event pricing needs to cover a range of possible futures. Once some paths are closed off, the chance they might occur is no longer priced in.
We must remember, though, that not every big event is a lasting wave or a fork. Sometimes they are just big bumps, and things return to where they were before. And even if something is genuinely a fork, some aspects of the scenery along the path will be similar. For example, regardless of whether the November cat is red or blue, the United States will still be running enormous fiscal deficits in some form. That has implications for the global structure of interest rates. And in time, decisionmakers in that country may well face another fork in the road as a consequence.
