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.
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