As short-term rates rise, inflation slips away
- The inflation expected by critics of quantitative easing and advocates of Phillips curve theory has failed to materialize.
- We believe that structural forces, including demographics in the labor force, continue to exert disinflationary pressure in the United States.
- The combination of weak inflation and a lower normal rate of growth means that the Fed may be past the midpoint of rate increases for this cycle.
Stimulus effects are a fading concernAs major central banks around the world responded to the 2008 financial crisis by massively increasing the size of their balance sheets in an effort to flood the financial system with liquidity, one popular critical refrain from the sceptics of this policy was that, down the road, developed market economies would be at risk of hyperinflation. This liquidity, skeptics claimed, would eventually find its way into the real economy, and a positive feedback loop of accelerating velocity in the money supply would cause prices of everything to spiral out of control.
Yet here we sit, a full eight years into the third-longest economic expansion in the post-War era, and the Federal Reserve's (Fed) preferred inflation metric — core personal consumption expenditures, or PCE — has met or exceeded the Fed's 2% target in a grand total of only four months, all of them in early 2012. It is thus no surprise that the hyperinflation alarmists have gone into hiding.
A tight labor market should lift wagesWith fears of policy-induced inflation put to rest, attention shifted to more traditional wage-driven inflation sparked by a tighter labor market. By most accounts, the U.S. labor market is certainly tight. Given the steady descent of the unemployment rate and the steady ascent of job openings, on the surface it seems like the right question is whether the Fed is behind the curve in setting the federal funds rate in the 1.00%–1.25% range. This level would seem to be too low for today's unemployment rate of 4.3% if the Fed truly believes in its models, which are built in part on faith in the Phillips curve. The Federal Open Market Committee (FOMC) made it clear in its June meeting statement that it believes a return to inflation levels above 2% is just around the corner. What's more, many pundits have been quick to point out that a Taylor rule model (which calls for rates to rise faster than inflation) with traditional default inputs would put the current federal funds target rate at 3% or higher.
Demographics provide the most revealing cluesIn our view, it makes more sense to be asking if the Fed is now ahead of the curve. Let's review what we know for certain, beginning with a discussion of the "neutral rate," or the policy rate that is neither expansionary nor contractionary for the real economy. Through their speeches and research, Fed members have told us that this rate has declined over time and has likely been close to zero recently. If that is indeed the case, then the current upper bound of the target policy rate, since it is above zero, is, by definition, contractionary.
We also know that the United States and most developed markets have aging populations, which has profound impacts on wages and, therefore, on inflation generally. According to the U.S. Census Bureau, between 2000 and 2010 the U.S. age cohort of workers 18–44 years old grew just 0.6%, while the population older than 65 increased by 15.1%. These trends have continued in the seven years since the last census.
For some time after the recession, it was expected that older workers would return to the labor market. As a St. Louis Fed staff paper observed in late 2013, "If a large portion of the workers who are currently out of the labor force is out because of cyclical influences, then the unemployment rate might not be fully capturing the slack in the labor market." However, in her press conference following the June FOMC meeting, Chair Janet Yellen noted the recent stability in the labor force participation rate, indicating that people have already re-entered the workforce in the face of those demographic headwinds, and so there is likely even less slack now. Households headed by people between the ages of 50 and 65 are the highest paid. As these people retire, their income falls, and in the workforce they are being replaced by younger people, who are paid less. This trend helps to hold down inflation.
Innovation is a deflationary forceAnother interesting tidbit in Chair Yellen's press conference was her mention of the impact of wireless telephone services on overall inflation, which she described as "appear[ing] to be one-off." We would not describe the impact of this component of inflation as one-off, for obvious reasons.
However, nitpicking aside, this specific item highlights a bigger problem for the inflation bulls, namely, that prices in the traded goods segment have flatlined. Prices in the technology sector have almost always been in deflation, and because we use more technology and services than ever before, their weights in PCE have increased over time. It is the hedonic quality control adjustments to these prices that drive their deflation. Put another way, consider how much wireless data you "consume" via your smartphone now versus 10 years ago. If the price of your wireless plan goes unchanged from one contract to the next, but your new plan includes more data than your old plan, this "quality" change must be accounted for in the inflation statistics. More data for the same price equals deflation. Real estate offers a parallel: From 2005 to 2014, the Case-Shiller U.S. National Home Price Index was unchanged, yet the size of the median home increased from just over 2,100 square feet to more than 2,600 square feet. Deflation is all but built in to some key items in the inflation statistics by virtue of the way they are calculated.
The Fed may be just a few hikes from the cycle peakWith so much changing in consumer behavior, demographics, and labor market dynamics, it is hardly surprising that the Fed and the central banks of other developed markets are focusing on hard questions about the future path of inflation. In fact, if we tweak the aforementioned Taylor rule to include a lower NAIRU (non-accelerating inflation rate of unemployment) to account for the substitution of cheaper, younger workers for more expensive older workers, Fed policy begins to look too tight.
The implication for financial markets, we believe, is that it will prove difficult in the short term for companies to gain pricing power, which could dampen earnings growth. The policy framework is also likely to constrain the rise of long-term bond yields around the world. At the same time, inflation is unlikely to rise dramatically or slip back into outright deflation, so we can expect that inflation-sensitive assets will move sideways. As we write, the slope of the U.S. yield curve measured by the difference between the 10-year Treasury yield and T-bills sits just above 110 basis points. That level coincides with where it stood at approximately the midpoint of the Fed's last tightening cycle in 2005. From that point in the 2005 cycle, the Fed made five more hikes. Today, inflationary pressure and the neutral rate are lower, and so it seems likely that there will be fewer than five hikes ahead before short-term rates peak.