Structural and cyclical influences driving focus on rising inflation

From

Steve Miller

The following are some comments from Steve Miller, an adviser at GSFM, on inflation and bond yields. He also looks at the minutes from the Federal Open Market Committee (FOMC) on inflation, and upcoming data on unemployment.

1. Inflation and bond yields

The sharp rise in bond yields and attendant yield curve steepening appear to reflect rising concerns about the potential emergence of inflation down the track. There are both structural and more “cyclical” influences at work that might explain the current focus on rising inflation.

Structural: arising from the reversal of the two great structural trends that account for the deflationary tendency of the past three decades: viz; globalisation of labour supply (as well as that for goods and services) and baby boomer workforce participation, are on the cusp of reversing. The fall of the Berlin Wall in 1989, combined with the dramatic increase in prominence of key emerging markets, particularly China, at a time when baby boomer participation in the workforce was at its highest, and female participation was secularly increasing, constituted a massive global labour supply shock. The result was a decline in wage growth and a structural deflationary trend on a global scale. That is now coming to an end. Add to that a backlash against globalisation of markets, re-regulation and supply chain constraints it may well be that structural forces are no longer as powerful in keeping inflation dormant. Of course, there are still structural inflation suppressors such as technology and demographics but certainly the structural risks now begin to look a little more two-way.

“Cyclical”: arising from concerns in some quarters that with a US budget deficit already at a peacetime record of around 15-16% of GDP, the $1.9tr Biden stimulus is “too much” and will lead to an economy that is “on fire”, according to Obama Treasury Secretary and sometime chief apostle of fiscal stimulus Larry Summers. With the economic fallout not as great as might previously have been feared and given the impressive progress on the vaccine front the shortfall in GDP as a consequence of the pandemic may be much less than previously thought. The Biden package may rapidly use up available slack in the economy and have inflationary consequences, particularly given the historically extreme levels of monetary accommodation and increased central bank tolerance of inflation. Rising commodity prices (including oil) and some upside surprise in recent inflation prints in Europe and the US (albeit of modest dimensions) underscore those concerns.

Last night’s January PPI release continued the run of upside surprises with core PPI coming in at 2.0% yoy versus 1.1% expected and 1.2% in December. Strong January retail sales at 5.3% versus 1.1% expected and -1.0% in December also potentially add fuel to Larry Summer’s warnings of an economy “on fire”! 

Quiescent inflation is pivotal to the ‘cheery narrative’ that has driven equity markets to historic highs. While ever inflation is quiescent, the more anchored are bond yields to their current levels and equity valuations remain within the realm of plausibility; if not then that cheery narrative is called into question.

Bond supply: the other issue that might be driving bond yields higher is to do with the likely issuance needed to fund those deficits, or ‘bond supply’. At 15-16% of GDP the US budget deficit is about $3tr. The Fed at the moment is buying around $1tr annually as part of its QE program which leaves a further $2tr to be financed at least in part by bond sales to the public. Given the immensity of that task it may be that higher bond yields are needed to entice the requisite number of buyers into the market. Were a Powell led Fed disposed to increase its purchases, that would limit the rise in bond yields and therefore any appreciation in the $US, but it has a lot of bonds to buy to achieve that outcome.

The latest FOMC minutes seem to downplay inflation concerns… 

2. FOMC minutes

The FOMC minutes indicate that the Fed believes that any acceleration in inflation is likely temporary noting that one-time moves in relative prices and / or base effects “could temporarily raise measured inflation but would be unlikely to have a lasting effect.”

The FOMC also  did not see the conditions for reducing their massive asset-purchase program being met for “some time”. Noting that employment and inflation goals were a long way from where the Fed would like and “[w]ith the economy still far from those goals, participants judged that it was likely to take some time for substantial further progress to be achieved.”  Such language is consistent with previous statements from FOMC members, including Chair Jerome Powell, that sought to dismiss any notion that tapering is on the Fed’s policy radar.

There have been reports that Fed Officials are looking to refine their newly adopted average of ‘flexible’ inflation target, by looking at including a suitable ‘averaging’ period and whether there is a ceiling, in order to help clarify uncertainty around the inflation outlook.

3. Coming up

Australian labour force figures are released today with the Bloomberg consensus looking at the addition of 40k jobs in January and for the unemployment rate to tick down one-tenth to 6.5% from 6.6%. Maybe a bit of upside risk in those numbers for employment and downside for the unemployment rate.

Such an outcome should be viewed positively by the market particularly given forecasts from March last year were looking at 10% unemployment rate at the end of 2020.

That said, such numbers are unlikely to move the dial for the RBA given wage growth remains moribund and the unemployment rate, even while having bettered expectations, is still some way north of the “4 point something” cited by the RBA Governor as getting close to capacity. Indeed, the Governor explicitly cited wage growth in articulating his and the Board’s expectation of no increase in the cash rate before 2024, noting that “wages growth will have to be materially higher than it is currently. This will require significant gains in employment and a return to a tight labour market.”

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