Short and Sharp: The twisted relationship between central banks and inflation

Investors currently face the challenge of the Federal Reserve’s belief that monetary policy needs to be tightened, despite missing inflationary pressures. This is not just a U.S. phenomenon, it’s a global one. In the euro-area, core inflation remains stubbornly low, yet the European Central Bank (ECB) is likely gearing up to announce its tapering plans. In Canada, the central bank raised policy rates for the first time since 2010 despite its favored measure of inflation lingering at multi-decade lows. Central banks feel constructive about the growth outlook, but ignoring a weakening inflation trend is risky business.

One key economic theory is that unemployment can’t be continually pushed lower without sparking inflation (this is known as the Phillips Curve, which Robin Anderson explained last month). Yet in the United States, while the unemployment rate has fallen to 4.4% and is trending lower, monthly core inflation has averaged just 0.1% month-on-month for the past four months. There are a few alternative reasons why higher growth and lower unemployment rates may not be stoking inflation as quickly as they have in the past.

Structural factors are one reason for stubbornly low inflation. Overcapacity and abundant goods and commodities make passing higher costs and higher wages on to consumers a difficult proposition. Globalization and the resulting price and wage competition weigh on price pressures, while technology can also be a powerful deflationary force. These structural changes mean that even as the unemployment rate declines, higher inflation is less likely than in the past. (See Economic Insights (June 19-23, 2017) for my colleague Robin Anderson’s great discussion on this theme.)

The view favored by the Fed, ECB, and Bank of Canada, is that the recent weak inflation trend is simply transitory and down to one-off factors. They believe tighter labor markets will eventually lead to higher inflation, but the lag is long and uncertain. They probably take comfort from the fact that several U.S. business surveys point to a rise in price pressures, while producer-price inflation for services and core goods isn’t indicating any deflationary pressure in the pipeline. For this reason, the Fed is willing to look through the recent weak inflation numbers and push ahead with monetary policy tightening.

I believe that structural factors are certainly at play and, as a result, the relationship between unemployment and inflation has weakened.

Weakened, but not broken down.

Strong economic growth and falling unemployment can still trigger price pressures, but these structural factors mean  it will need  further tightening in labor markets before inflation takes off.

For that reason, I now think there’s a chance that the Fed will pause its rate-hiking cycle until it sees clear signs that inflation is picking up. Perhaps, this could even push the next rate hike into 2018.

I have not changed my view on the timing of balance sheet normalization. Recent Fed communication suggests they have linked the balance-sheet normalization decision to growth, rather than inflation. With the U.S. growth outlook continuing to look solid, I still see the Fed starting its balance sheet work later this year.

For investment purposes, this conundrum of low unemployment and low inflation is great. It ensures that monetary policy tightening will be gradual and creates a “Goldilocks” environment of positive and stable growth, which extends the equity and credit market cycles. In other words, there’s still some juice left in risk assets.


Follow Principal Global Investors on LinkedIn



Unless otherwise noted, the information in this document has been derived from sources believed to be accurate as of July 2017. Information derived from sources other than Principal Global Investors or its affiliates is believed to be reliable; however, we do not independently verify or guarantee its accuracy or validity. Past performance is not necessarily indicative or a guarantee of future performance and should not be relied upon to make an investment decision.

The information in this document contains general information only on investment matters. It does not take account of any investor’s investment objectives, particular needs or financial situation and should not be construed as specific investment advice, an opinion or recommendation or be relied on in any way as a guarantee, promise, forecast or prediction of future events regarding a particular investment or the markets in general. All expressions of opinion and predictions in this document are subject to change without notice.  Any reference to a specific investment or security does not constitute a recommendation to buy, sell, or hold such investment or security, nor an indication that Principal Global Investors or its affiliates has recommended a specific security for any client account.

Principal Financial Group, Inc.,  Its affiliates, and its officers, directors, employees, agents,  disclaim any express or implied warranty of reliability or accuracy (including by reason of negligence) arising out of any for error or omission in this document or in the information or data provided in this document. 

Third party content, such as comments to this blog, is not reviewed by Principal Global Investors before it is displayed, although we may remove, alter, edit or adapt any such comments.  Principal Global Investors does not endorse, authorize, or sponsor any third party content.  Links contained in some blog posts may take you to third-party sites and Principal Global Investors makes no guarantees to the accuracy of the information provided

​Investing involves risk, including possible loss of principal.

Insurance products and plan administrative services provided through Principal Life Insurance Co. Principal Funds, Inc. is distributed by Principal Funds Distributor, Inc. Securities offered through Principal Securities, Inc., 800-547-7754, Member SIPC and/or independent broker/dealers. Principal Life, Principal Funds Distributor, Inc. and Principal Securities are members of the Principal Financial Group®, Des Moines, IA 50392.