Inflation: Dead, or just forgotten?
While a number of economists and commentators believe that the global economy is on the brink of deflation, Dr. Michael Hasenstab explains why deflationary fears are misguided, and why a resurgent US economy is a key to overall global growth.
The US and global economies are six years into their post-global financial crisis (GFC) recoveries, and growth has proved resilient to a number of shocks.
Yet a widespread and deep-seated pessimism continues to characterise the economic debate and financial market dynamics.
The Secular Stagnation hypothesis recently revived by a former US Treasury Secretary and many others perhaps best encapsulates this pessimism. In a nutshell, Secular Stagnation posits that the global economy suffers from a structural lack of aggregate demand and a chronic excess of desired savings over desired investment; this results in permanently low levels of economic growth, inflation and interest rates. Indeed, a number of economists and commentators have repeatedly raised the fear that the global economy might fall into stagnation and/or deflation.
We believe global deflation fears are misguided. Inflation is running high and above target in a number of emerging markets. In many advanced economies, headline inflation has been pushed lower by the sudden collapse in commodity prices — a temporary effect — but core inflation rates have remained stable.
Our econometric analysis shows that global factors play a dominant role in driving inflation at the individual country level; our measure of the global output gap has begun to increase, and should rise further as emerging markets recover, exerting upward pressure on inflation rates.
The United States is still the largest driving force in the global economy; understanding US inflation dynamics and the implications for yields is essential to forecasting global developments. We devote the central part of our latest Global Macro Shifts paper, "Inflation: Dead, or Just Forgotten?" to a detailed analysis of wage and inflation trends in the US.
The US labour market is very close to full employment by our estimation, and remaining slack is being rapidly reabsorbed.
Growth in average wages has remained subdued, however, and this is often taken as evidence that inflation will remain extremely low. Our analysis shows that wage growth, as estimated by our composite measure of wage pressures, is beginning to accelerate; we also show that labour market indicators most closely correlated with wage growth, such as the quit rate, continue to improve.
Our models suggest that on current macroeconomic conditions, wage growth should already be trending toward a 2.7 per cent growth rate. This is important because stronger wage dynamics can continue to support private consumption and aggregate demand.
Our analysis shows that the US Phillips Curve, the relationship between unemployment and inflation, has steepened since 2006 — contrary to common perceptions. This means that the continuing decline in the unemployment rate should begin to translate into stronger inflation pressures.
This rebound in inflation should be supported by the stabilisation in commodity prices, reversing the disinflationary impulse of 2015.
We also estimate that further dollar appreciation will provide only a modest headwind, shaving off at most 0.2—0.3 percentage points from headline inflation. Our econometric model projects that headline Consumer Price Index (CPI) inflation will reach 2.2 per cent by the fourth quarter of 2016, significantly above the US Federal Reserve's (Fed's) and the market's expectations.
Our analysis also confirms that inflation expectations play a major role in the inflation process, pointing to the importance of central bank credibility.
As the Fed embarks on an unprecedented policy normalisation, we should be mindful of the magnitude of the imbalances and dislocations created by several years of zero interest rates and quantitative easing (QE).
In response to the GFC, central banks in the US, the Eurozone and Japan have massively expanded their balance sheets. At the same time, both money velocity1 and the money multiplier2 declined sharply, reflecting sudden deleveraging and a freezing up of the financial system.
If velocity and money multipliers were to revert to their pre-crisis levels, even gradually, this would imply a substantial acceleration in inflation, well into double digits. We are not suggesting that we should brace for double-digit inflation in the near future; a partial correction of velocity and money multipliers toward historical norms is plausible, however, and would put additional pressure on inflation, complicating the normalisation of monetary policy.
Referring to the pre-crisis experience is important because the catchphrases that have dominated the debate in the last few years (New Normal and Secular Stagnation) suggest that we have entered a new state of the world, where growth and inflation are destined to stagnate for the foreseeable future. And as the GFC came on the heels of the "Great Moderation," younger generations of financial market participants have never experienced higher inflation rates in advanced economies.
Forgetting the lessons of history carries risks. US inflation and inflation expectations were low and stable at around one per cent in the late 1950s through the mid-1960s; starting in 1965, both drifted upward for 15 years, with the headline inflation rate peaking near 15 per cent.
This "Great Inflation", as it is commonly known, was triggered by a combination of adverse supply shocks (notably the 1973 and 1979 oil shocks) and an accommodative monetary policy stance, which appears consistent with upward revisions of the Fed's inflation target.
Consistent with our findings on the key role of inflation expectations, the loss of Fed inflation-fighting credibility appears to have been a very important cause of the Great Inflation. It took a substantial and prolonged monetary tightening to bring inflation back under control, resulting in a two per cent recession in 1982.
The Great Inflation episode underscores the dangers of believing that a structural shift has taken inflation risks off the table. We believe a combination of adverse shocks and policy mistakes comparable to those of the late 1960s and 1970s are very unlikely.
A moderate version of it, however, is not implausible. Many influential voices are urging the Fed to tighten extremely slowly, and recent Federal Open Market Committee (FOMC) statements indicate that the Fed wants to see a significant pickup in inflation before it steps up the pace of rate hikes.
Meanwhile, rock-bottom commodity prices pose the risk of adverse shocks, however moderate. This flags a clear risk that monetary policy may fall behind the curve and suggests that risks to inflation will tilt to the upside in 2016.
The Fed has signaled a very gradual monetary tightening ahead: the median FOMC expectation envisions four 25-basis-point (BP) hikes in 2016, and a fed funds rate rising to 3.3 per cent by end-2018.
This path is predicated on the assumption that even as the labour market reaches full employment, the pace of economic growth will remain moderate, and inflation will not reach the Fed's two per cent target before end-2017.
Financial markets are pricing in an even more gradual tightening. Our models, however, suggest that inflation will outpace the Fed's expectations by late-2016. This should either trigger a faster policy response, or raise concerns that the Fed is falling behind the curve; both scenarios should result in a rise in market interest rates.
Our analysis shows that long-term Treasury yields are 130 BPs below the "normal" levels implied by their historical relationship with nominal gross domestic product (GDP) growth.
This gap has been caused by monetary policy through both QE and through forward guidance, which has reduced volatility in short rates. Our model indicates that going forward, long-term yields will likely be subject to three upward pressures:
1) Our forecasted increase in inflation will boost nominal GDP growth;
2) As forward guidance is replaced by a data-dependent monetary tightening, volatility in short rates will increase; and
3) As the impact of QE on the Treasury market fades, long-term yields will trend back to their historical link with nominal GDP growth. Over the medium term, based on the Congressional Budget Office's estimates of potential growth, long-term yields should trend toward a five per cent level.
During the last Fed tightening cycle, long-term yields were held down by what former Fed Chair, Ben Bernanke, dubbed a "Global Savings Glut" — a substantial excess of desired savings over desired investment.
The key drivers of the Savings Glut, however, have weakened or reversed: China's growth is rebalancing toward domestic consumption, and its stock of foreign exchange (FX) reserves has declined; other Asian emerging markets have already accumulated sufficient FX reserves and no longer need to accumulate assets; and the plunge in oil prices is forcing a number of oil exporters to reduce savings to delay or smooth the adjustment in expenditures. It seems therefore unlikely that global trends will once again cap US long-term yields.
FOOTNOTES
1. Money velocity measures the ratio of nominal GDP to broad money.
2. The money multiplier is the ratio of broad money to the monetary base.
Dr. Michael Hasenstab is the chief investment officer of Templeton Global Macro.
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