The Fed Is Fighting the Wrong War | Jim Paulsen on Why 3% Inflation Isn't the Problem

Key Concepts

• Real GDP Growth: The rate at which the economy's output of goods and services is increasing, adjusted for inflation.
• CPI (Consumer Price Index): A measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.
• PPI (Producer Price Index): A measure of the average changes in prices received by domestic producers for their output.
• Unemployment Duration: The average length of time individuals remain unemployed.
• Bull Market: A period of generally rising prices in a financial market.
• Sector Performance: The relative performance of different industries or sectors within the stock market.
• Policy Accommodation: Actions taken by central banks (like the Federal Reserve) to stimulate the economy, typically by lowering interest rates or increasing the money supply.
• Bond Yields: The rate of return an investor would receive on a bond.
• Fear-Based Assets: Investments that tend to perform well during periods of economic uncertainty or fear, such as gold, money market funds, and sometimes Bitcoin.
• Stall Speed: A level of economic growth (around 2%) where the economy becomes vulnerable to recession.
• Labor Force Growth: The rate at which the number of people available for work is increasing.
• Animal Spirits: A term coined by John Maynard Keynes to describe the psychological factors that drive economic decisions, such as confidence and optimism.
• Monetary Velocity: The rate at which money changes hands in an economy.
• D-risking Attitude: A tendency for individuals and businesses to reduce their exposure to risk, often by hoarding cash and deleveraging.
• Trade Deficit: The amount by which the value of a country's imports exceeds the value of its exports.
• Contractionary Policies: Policies aimed at slowing down economic activity, such as raising interest rates or reducing government spending.
• Total Policy Stimulus Index (TPS): A proprietary index created by the speaker to measure the combined effect of monetary, fiscal, and dollar policies.
• Market Cap Weighted vs. Equal Weighted Indices: Market cap weighted indices give more importance to larger companies, while equal weighted indices give equal importance to all companies.
• Cyclical Stocks: Stocks of companies whose performance is closely tied to the economic cycle.
• Value Stocks: Stocks that are considered to be trading below their intrinsic value.
• Tech Stocks: Stocks of companies in the technology sector.
• Price-to-Earnings (P/E) Multiple: A valuation ratio of a company's share price to its earnings per share.

Summary

This discussion delves into the current state of the U.S. economy and markets, with a particular focus on the underlying structural issues that may be hindering long-term growth, despite policymakers' current obsession with inflation. The speaker, Jim, argues that the primary problem is not runaway inflation but a significant decline in real GDP growth and other key economic indicators over the past two decades.

Current Market and Economic Observations

Jim begins by highlighting several key observations about the market and economy:

• Market Corrections and Consolidation: The market has experienced a significant 20% correction and a subsequent period of consolidation, which Jim views as a potentially healthy base for future growth.
• Broadening Market Leadership: While tech and communications sectors dominated the early part of the bull market (October 2022 to September 2024) when the Fed was not easing, there is now evidence of broadening market participation with five sectors outperforming the S&P 500 year-to-date. This is seen as a reflection of increasing policy accommodation.
• Bond Yields: The 10-year Treasury yield has broken below 4% and shows potential to decline further, possibly reaching 3.5% in 2026.
• Shifting Leadership in Fear-Based Assets: Assets traditionally seen as safe havens or "fear-based" (gold, money market funds, dollar, Bitcoin) have shown signs of unraveling, with gold struggling, money market fund ratios rolling over, the dollar declining from its highs, Bitcoin in a freefall, and tech's relative performance starting to fade. Jim suggests this indicates a potential shift away from these leadership roles.
• Tech Sector Performance: While not expecting a collapse, Jim anticipates that the technology sector may begin to underperform. Its relative performance has been flat since August, and its price highs were only slightly above those seen in June 2024.

The Core Problem: Declining Real GDP Growth

A central argument presented is that policymakers are overly focused on inflation while neglecting the more fundamental issue of declining real GDP growth.

• Real GDP Growth Decline: The chart shows that real GDP growth averaged 3.5% from 1950 to 2005. Since then, it has fallen to just over 2% annually. This represents a "huge downshift" in average growth over the last 20 years compared to the post-war era.
• Stall Speed Economy: The economy has been averaging around 2% growth for two decades, which Jim refers to as the "stall speed," a level where recession becomes a significant risk.
• Household Employment Growth: Year-on-year household employment growth has also halved, from an average of over 1.6% pre-2005 to about 0.7% currently. This slower job creation contributes to pessimism and difficulty for college graduates finding employment.
• Labor Force Growth Slowdown: Labor force growth has dramatically slowed from 3% in the 1970s to around 0.5% currently, exacerbated by slower population growth and an aging population.
• Duration of Unemployment: The average duration of unemployment has doubled from 13.5 weeks (1950-2007) to over 27 weeks currently. This indicates a significant damage to the economy's ability to generate "animal spirits" and re-employ its workforce.

Contributing Factors to Slowing Growth

Jim identifies several factors contributing to this secular slowdown:

• Slower Population Growth and Aging: Delayed family formation and lower birth rates, coupled with an aging population, are key drivers of slower labor force growth.
• Decreased Productivity Growth: Average productivity growth has fallen from 2.5% annually (1950-2005) to 1.6% annually (since 2006). While measurement issues exist, the trend is undeniable.
• D-risking Attitude and Hoarding Cash: Since the 2008 crisis, there has been a shift towards deleveraging balance sheets and hoarding cash rather than borrowing and investing. This is reflected in the declining monetary velocity.
• Increased Trade Deficits: The average annual trade deficit has nearly tripled since 2006 (3.2% of GDP) compared to the pre-2005 period (1.2% of GDP), indicating more spending is leaking abroad.
• Contractionary Policies: The prescription for slowing growth has often been contractionary policies, which Jim argues are counterproductive.
• Innovation and Productivity: While acknowledging significant technological innovations like AI, Jim questions their broad economic impact on productivity. He suggests that some innovations may lead to distraction or be concentrated in specific sectors, not broadly benefiting the entire economy. He also notes that past innovations like the mainframe computer had a more discernible impact on productivity.

Inflation Concerns vs. Reality

Jim argues that the current focus on inflation is misplaced and that the economy is more prone to deflation than inflation.

• Below-Average Inflation Metrics: Both CPI (3%) and PPI (less than 2%) are currently below their historical averages (nearly 4% and 3.5% respectively since 1965).
• Supply-Side vs. Demand-Driven Inflation: The inflation burst in 2020-2022 was primarily supply-side driven and has long since subsided. Jim sees no evidence of demand-driven inflation that would lead to a 1970s-style scenario.
• Misplaced Fear of Inflation: The obsession with the Fed's arbitrary 2% inflation target and the lessons learned from the 1970s are leading policymakers to fight inflation too aggressively, potentially harming economic growth.
• Real Wage Growth: Despite public perception, real wages have been climbing for much of the last several years and are near all-time highs. Real profits have also continued to climb.

Policy Responses and Their Impact

The discussion highlights how current policies are acting as contractionary forces:

• Money Growth: While money growth has improved recently, it remains below its historical average. A period of negative M2 money supply growth for 16 consecutive months was a significant contractionary force.
• Real Funds Rate: The real funds rate (currently around 1.13%) is significantly higher than the average of -1% seen over the last 20 years, which was necessary to achieve even 2% GDP growth. This tighter policy is not suited for the current low-growth economy.
• Inverted Yield Curve: The prolonged inversion of the yield curve has been a significant contractionary force.
• Strong US Dollar: A rising dollar makes U.S. exports less competitive globally. The dollar's significant appreciation over the last decade has acted as a contractionary force, impacting domestic manufacturers. Jim suggests a weaker dollar policy could be a more effective way to boost competitiveness than tariffs.
• Aggregate Tax Rate: The aggregate tax rate as a percentage of GDP has increased slightly since 2005, despite slower economic growth, adding to the burden on the economy.
• Tariffs: Tariffs are viewed as a tax on the economy, acting as a disinflationary force rather than inflationary, as commonly perceived. They indirectly affect service businesses by reducing overall economic activity.

The Total Policy Stimulus (TPS) Index and Market Implications

Jim introduces his proprietary Total Policy Stimulus (TPS) Index, which combines monetary, fiscal, and dollar policies.

• Low Stimulus Environment: The bull market since October 2022 has been characterized by historically low policy stimulus, averaging around 0.3 on a percentile ranking, a level typically associated with recessionary conditions.
• Impact on Market Segments:
  • Equal-Weighted S&P 500: This index performs significantly better when TPS rises and underperforms when it falls.
  • Small Cap Stocks: These are highly sensitive to policy stimulus, showing the most dramatic outperformance when TPS rises and underperformance when it falls.
  • Cyclical Stocks: These also show a strong correlation with policy stimulus, with their performance lagging behind the rise in TPS by about 18 months.
  • Value Stocks: This segment appears to be the least sensitive to TPS, with a less pronounced difference in performance based on stimulus levels.
  • International Stocks: Their performance is heavily influenced by the real value of the US dollar. A weaker dollar leads to significant outperformance.
• Shift Towards Blue (Stimulus): Jim believes the market is transitioning from a "red" (low stimulus) environment to a "blue" (increasing stimulus) environment, which could lead to a different market leadership than seen previously.

Technology Sector Outlook and Valuations

• Underperformance, Not Collapse: Jim anticipates that tech stocks will likely underperform the broader market rather than collapse, similar to the 2021-2022 period when policy stimulus was introduced.
• Valuations: While tech valuations (P/E multiple of 45) appear high, they are not as extreme as during the dot-com bubble (P/E of 65).
• Broader Market Participation: Unlike the dot-com bubble where most stocks performed well alongside tech, the current bull market has seen the rest of the market lag significantly. This suggests that a tech downturn might not necessarily lead to a broad market collapse.
• Fed Response: The Fed's current proactive easing stance, even before tech's relative performance peaks, is a key difference from the dot-com era, where the Fed was playing catch-up. This proactive approach may prevent a severe tech collapse.
• Comparison to Dot-Com: The current bull market for tech has been a more gradual, "steady eddy" process over 10 years, unlike the "faddish, emotional, irrational" run of the dot-com bubble, which was concentrated in its final two years.

Conclusion and Outlook for 2026

Jim suggests that 2026 will likely be more focused on promoting growth than fighting inflation. He anticipates a potential for surprisingly strong returns (around 17%) if policy stimulus is effectively implemented and leads to broader market participation. He emphasizes that the primary challenge is overcoming chronic pessimism by fostering a leadership that prioritizes growth and opportunity. The key takeaway is that the economy's underlying growth engine is sputtering, and a shift in policy focus from inflation control to growth stimulation is crucial.