Signs point to inflation, but will it last?

With inflation edging up recently, investors ponder the road ahead. Is this the start of a more sustainable upward movement in prices, or just another uptick in an inflation rate that has been in a holding pattern below 2%?

A more durable upturn in inflation with a backdrop of slow growth can complicate the implementation of monetary policy and may lead to financial market volatility. While stagflation, such as was seen in the 1970s, seems unlikely, a more populist U.S. administration, which is focused on protectionism and trade tariffs more than pro-growth policies, could push prices higher just as investor confidence fades or the U.S. Federal Reserve tightens more aggressively.

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Inflation tends to follow a low unemployment rate

Chart 1. Inflation tends to follow a low unemployment rate

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Note: Shaded regions indicate recession

Core PCE: Core personal consumption expenditures price index, excluding food and energy

U rate: Unemployment rate

Fed target: Federal Reserve’s target inflation rate

CBO NROU: Congressional Budget Office’s natural rate of unemployment

Source: Bureau of Economic Analysis, Bureau of Labor Statistics, Federal Reserve, and Congressional Budget Office

Two views of the uptick

Inflation has recently moved upward globally. In the United States, the Consumer Price Index (CPI), which measures what is known as headline inflation, rose 0.3% for December 2016 and 2.1% for the year. The core personal consumption expenditures (PCE) price index (excluding volatile food and energy prices) rose 1.6% from a year earlier (source: U.S. Commerce Department). We view this recent uptick in inflation in a twofold manner.

First, from a cyclical perspective, inflation tends to pick up late in the cycle when unemployment falls below the natural rate of unemployment (NROU), a measure that includes aspects such as workers' looking for better jobs, and is considered by economists to be close to full employment. In fact, the U.S. unemployment rate has been trending downward, with the U.S. Bureau of Labor Statistics reporting a 4.8% jobless rate in February.

The Fed and the markets also remain focused on wage growth as evidence of diminishing excess capacity in labor markets, and proof of a more sustainable pickup in inflation. However, we caution that wage growth has been lagging the recovery in core inflation, remaining 1.0%–1.5% below pre-global financial crisis levels. Additionally, as we have highlighted in a prior Insight, the correlation between wages and inflation seems to have broken down.

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Wage growth remains muted

Chart 2. Wage growth remains muted

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Source: Bureau of Labor Statistics

Second, we view this recent rise in inflation as largely representing a fading of the effects of earlier declines in energy prices and nonenergy import prices. This has driven a reflation of prices globally, led by a rally in oil prices starting in late 2016. China’s producer prices — known as “inflation at the factory” — are a good example because they relate largely to the extensive industrial engine in China’s economy. The Chinese Producer Price Index (PPI) jumped 5.5% year over year in December 2016, following a 3.3% year-over-year increase in November, after being negative every month in the first half of 2016 (source: National Bureau of Statistics of China). There has been a similar recent increase in inflation in the euro area.

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Inflation picking up globally

Chart 3. Inflation picking up globally

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Source: Bureau of Economic Analysis, Eurostat, Bureau of Labor Statistics, National Bureau of Statistics of China, and Bloomberg (for oil prices)

Will oil be the wild card?

Assuming stable oil prices and relatively minimum foreign exchange fluctuation in the dollar, our view is that inflation is likely to move to 2% over the next couple of years, provided that wages maintain the recent uptrend. The Fed also holds this view. However, unexpected moves could counter those assumptions.

A number of aspects regarding oil and energy remain uncertain. One is the recent rise in oil prices. The price for a barrel of Brent crude oil was in the mid-$50s range in early February 2017, compared with its low of $27 a barrel in February 2016. This rally has been attributed to production cuts announced recently by the Organization of the Petroleum Exporting Countries (OPEC), but it is unclear how compliant other oil-producing countries such as Iran and Russia will be with these kinds of production decreases. Higher U.S. energy production in shale oil and gas — which the U.S. seems better poised to achieve in a more energy-friendly Trump administration — could offset attempts to control oil production elsewhere, and U.S. oil rig counts have increased (substantially?) from previous lows. Additionally, as shown in the chart below, oil supply and production can be expected to come “online” as prices approach $60.

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Global oil and natural gas liquids production cost curve, 2016

Chart 4. Global oil and natural gas liquids production cost curve, 2016

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Chart 4. Global oil and natural gas liquids production cost curve, 2016

Global oil and natural gas liquids production cost curve, 2016

Data: Bureau of Labor Statistics, via Federal Reserve Bank of St. Louis. Calculated as percentage change from year ago, seasonally adjusted. Monthly observations.

We see the possibility that the tailwind of headline inflation, especially with oil’s recovery, could mean some higher inflation rates passing through to core inflation. However, this is a slow and timely process, as the chart below illustrates.

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Headline inflation can pass through to other measures

Chart 5. Headline inflation can pass through to other measures

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Source: Bureau of Economic Analysis

It is also important to highlight that in a critically important sector of the economy — the services-only sector — shelter costs are trending upward. Primary-residence rent and owner-equivalent rent are both running close to 4% year over year, while core service inflation excluding rent remains weak.

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Cost of shelter is on an upward trend

Chart 6. Cost of shelter is on an upward trend

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Data: Bureau of Labor Statistics, via Federal Reserve Bank of St. Louis. Calculated as percentage change from one year earlier, seasonally adjusted. Monthly observations.

Would central banks react?

If the inflation rate picks up within the core measure, it can be important to consider how central banks might react, especially if wage growth tops 3%.

Generally, an increase in inflation causes central banks to tighten monetary policy to try to put the inflation genie back in the bottle. In the low growth–low inflation environment that has persisted since the global financial crisis, many central banks have continued pursuing ultraloose monetary policies — although the Fed has cautiously moved toward raising interest rates. The Fed raised rates once in 2016, in December, but has signaled the possibility of more rate hikes through 2019. Further, the Fed has set an inflation target of 2% as part of its trigger to tighten. If core inflation moves above that target, it could tip the scales.

Whether or not the Fed follows its rate-hiking potential through rhetoric or action, another consideration is the divergence of monetary policy globally. For example, even though much of Europe has seen inflation increase, the European Central Bank (ECB) has viewed this as only transitory and has indicated intentions to continue its highly accommodative policy.

This dichotomy of one central bank going in one direction and interest rates in another part of the world heading in a different direction can help push the U.S. dollar into a key position. The dollar has been generally stronger since the fourth quarter of 2016, and rising interest rates would help strengthen it further, as would some improvement in gross domestic product (GDP) growth. It’s important to watch how this will play out, because we believe a stronger dollar continues to be a big disinflationary force.

Real inflation versus expectations — but will it last?

With Donald Trump as U.S. president, his proposed policy plans have the potential to help stimulate economic growth. A common view has been that inflation could also increase as a result. But these are still only expectations that Trump’s policies could reflate the economy, whereas the cyclical uptick has been real inflation. That is different from the stock market rallies and higher bond yields that developed after the November election, which reflected expectations of tax cuts and stimulus-driven inflation under a Trump administration.

While the current ratcheting up of inflation reflects real numbers, it still poses the question of whether this inflation is sustainable. We are not seeing any evidence to convince us to move away from our thesis of a continued low-inflation world.

On a long-term secular basis, the data are not supporting sustained, growing inflation. We don’t see any increase in the current low velocity, or low circulation, of money, which would be an indicator of inflation. As we’ve discussed in The Great Risk Rebalance series on the debt supercycle, economies are still burdened with a great deal of debt. Another important factor is the demographic effect on economies of aging populations (more saving and less investment and growth).

To us, any significant upturn in inflation would be tied to economic growth. That’s because the basic framework for inflation is the excess demand that exists over supply. As long as demand — that is, economic growth — continues to be tepid, inflation is likely to be lukewarm as well.

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Growth and inflation continue to be muted

Chart 7. Growth and inflation continue to be muted

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Source: International Monetary Fund, Bureau of Economic Analysis, and Bloomberg


All charts shown throughout are for illustrative purposes only.

The views expressed represent the Manager's assessment of the market environment as of February 2017 and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.

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