- Global inflation remains low and several countries are grappling with outright deflation.
- The United States is no exception to the current disinflationary trend, but many of the traditional drivers of US inflation could soon be primed for a rebound.
- High inflation in the United States is definitely not our baseline scenario, but diversification is essential to address the ever-changing risks and opportunities that exist across the global capital markets, including the possible pick-up in inflation.
When many commentators and investors show a high conviction about something, it is perhaps a good time to explore how things could move in the opposite direction. After several trillions of quantitative easing (QE) from the major global central banks, and with trillions of QE likely ahead, the consensus appears spooked by the specter of global disinflation and deflation. The possibility of a higher inflation scenario seems to have fallen completely off the radar. Nearly six years into the recovery from the Great Recession, growth in the United States is now above-trend, while global growth remains subpar and disinflationary pressures exist across the developed world. Inflation remains well below 2% in most developed economies, with the exception of Japan; although if the consumption tax increase introduced there last year were stripped out, inflation would be below 2%. While deflation concerns have been persistent in the Eurozone, even in the United States there is a lot of uneasiness, with inflation and inflation expectations softening (though they have been improving since January).
Inflation in Most Developed Markets is Below 2%
Source: Bloomberg, as of January 31, 2015.
U.S. 5 & 10 Year Breakevens* & Core Consumer Price Index (CPI YoY)
Source: Bloomberg, as of March 17, 2015. *Note: Breakeven inflation is the difference between the nominal yield on a fixed-rate investment and the real yield (fixed spread) on an inflation-linked investment of similar maturity and credit quality.
Source: Bloomberg, as of March 31, 2015.
In 2008 as the US economy entered the Great Recession, the US Federal Reserve (Fed) cut rates aggressively, implemented a series of facilities to insure liquidity to banks and financial markets, and introduced the first round of QE. Today the size of the Fed’s balance sheet has reached about $4.51 trillion, more than quadrupling since the beginning of the Great Recession. The monetary policies adopted by the Fed since the crisis have been unorthodox and unprecedented. At the outset, and for some time during this monetary experiment, many commentators and investors believed high inflation and dollar debasement would be the eventual cost of the Fed’s aggressive balance sheet expansion. However, a very slow pace of recovery, uncertainty around the economic outlook, the health of the financial sector and the eruption of the Eurozone crisis ensured those concerns never made it into market pricing action.
Even though the US monetary base expanded, the negative outlook created by the financial crisis caused the money multiplier—also known as the “velocity” of money—to collapse. The liquidity injected into the system did not translate into credit expansion (lending), which is a fundamental driver of inflation.
Total Fed Assets and Velocity of Money
Source: FactSet, Federal Reserve. Monetary base as of 2/20/15. M2 to Monetary base ratio as of 2/13/2015.
Fast forward to today: the overwhelming consensus is that high inflation is not even remotely on the horizon and if anything, economies like Europe and Japan are flirting with deflation. Both the European Central Bank (ECB) and the Bank of Japan (BoJ) are maintaining ultra-easy monetary policies and remain in balance sheet expansion mode. In particular, the BoJ is purchasing assets at the same rate as the Fed was in an economy that is less than a third of the size as measured by nominal gross domestic product (GDP) levels. The ECB just launched an open-ended QE program which could likely be the largest the world has ever seen in terms of purchases of government bonds as a percentage of issuance.
With consensus now firmly in the no inflation camp, should we be worried about an inflation comeback? To clarify, we are not worried about inflation in the near-term, even with such elevated central bank balance sheets. But while an inflation scenario is not a high probability, we believe investors can be prepared for such a scenario through broad global diversification.
What could trigger higher inflation?
First, we need to make an important distinction between ‘bad’ and ‘good’ inflation. Think of bad inflation as inflation generated when supply cannot keep up with demand. That is sometimes the case for commodities, when supply shocks come courtesy of geopolitical events or weather. Inflation generated by supply shocks is bad as it does not necessarily accompany strengthening economic growth. On the other hand, a scenario in which economic activity accelerates to the point that aggregate demand is stronger than supply, can result in good inflation as it is often accompanied by an increase in income or household wealth. That is also the kind of inflation that central banks can attempt to tackle in their efforts to maintain price stability by tightening monetary policy conditions. Generally this has the effect of taming aggregate demand and can result in an increase in supply and an increase in economic activity overall.
High inflation, in the case of the United States, can be defined as mid- to high-single digit growth in the Consumer Price Index (CPI) over one year. Inflation forecasters tend to use several variables for their models including: wage growth, unemployment rates, consumer credit growth, commodity prices and various measures of inflation expectations. Let’s take a look at how these variables are moving.
Unemployment and wage growth
Slack in labor markets has kept wage growth in check, but labor market conditions have improved more rapidly in recent months. The U.S. economy has generated a monthly average of 262k2 jobs in the past six months. The unemployment rate has been falling steadily and could soon approach what has historically been considered the structural level of unemployment of around 5%. What’s been surprising to-date is that the decline in unemployment has not triggered a sharper acceleration in wage growth which typically feeds through to inflation. Looking at history, the unemployment rate has already fallen below the average rate at which wages began to rise meaningfully during the past three business cycles. Most of the drop in the participation rate has likely been structurally driven by workers close to retirement age who have either lost their job, have not been able to return to the ranks of the employed, or have chosen to retire because they’re financially secure enough to do so.
Decline in Unemployment & Average Hourly Earnings
Source: Department of Labor, FactSet, as of January 31, 2015.
After collapsing during the Great Recession, consumer credit growth has recovered and plateaued while household balance sheets improved through debt reduction and positive wealth effects. Consumer credit is back growing in line with its long term pace and we could see an acceleration if income growth accelerates. Note that real disposable income is already growing at a rather strong 4.2%3 pace, courtesy of the recent fall in commodity prices and low inflation.
Consumer Credit Outstanding Excluding Mortgages
Source: Bloomberg, as of December 31, 2014.
Commodity prices and oil in particular experienced a considerable correction beginning in mid-2014, before rebounding a bit recently. While a low growth outlook and a worsening of the Eurozone deflationary outlook in the summer of 2014 likely contributed to the fall in oil prices, the bulk of it was likely due to a supply glut.
Oil producers have been under pressure, with costs of production above the recent low prices. Given the drop in North American rigs, oil prices have experienced a rebound. A return to $100 per barrel oil price seems unlikely; however, a further rebound could result in an uptick of inflation expectations and contribute to a perception that the Fed is getting behind the curve in terms of interest rate hikes. One last related note: the world remains geopolitically unstable and an escalation of violence in key areas in the Middle East (like Libya or Iraq) could trigger fast upward moves in energy prices and the fear premium attached to those.
West Texas Intermediate (WTI) Crude Oil Price
Source: Bloomberg, as of March 10, 2015.
Inflation expectations are of great importance for policy makers. The chart below shows the U.S. 5 year breakeven inflation expectation during Fed QE. Inflation expectations had a tendency to get a lift from the implementation of the various QE programs and then soften in between programs, as one would expect given the circumstances. As the Fed exited QE in the fourth quarter of 2014, commodity prices fell substantially; much of the world underwent deflationary pressures and U.S. inflation expectations took a hit. However, it is encouraging (including for the Fed) to see the turnaround in inflation expectations (Fig 2) since January 2015, even if they remain rather volatile. On the downside, nominal wage growth is still failing to take off, notwithstanding the fall in the unemployment rate.
Source: Bloomberg, as of February 28, 2015.
Conclusion: Fed could have some catching up to do
Falling commodity prices and inflation have definitely contributed to a rebound in consumer sentiment and real personal income. As real wages and income pick up, and labor markets continue to tighten, the Fed has been maintaining ultra-low interest rates at the short end of the yield curve. Global investors’ appetite for safe-haven US Treasuries have kept long rates low, but there is some risk that that scenario the disinflation the United States is enjoying could turn into a mild inflation scare until the Fed catches up.
1U.S. Federal Reserve
2Bureau of Labor Statistics as of 3/31/2015
3Bureau of Economic Analysis as of 1/31/2015
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