Day by day, a plethora of official economic statistics is released, building into a vast data set. In just one month, from mid-October to mid-November, Bloomberg recorded 585 major data releases for G8 economies, with a further 175 revisions to previous data. Extending this to the G20 produces nearly 1,000 separate data points.
We believe that one specific sub-set will be by far the most important to monitor during 2018: figures for the US, EU and UK inflation rates. While other data may have a tangential impact on worldwide or UK inflation and sometimes be used as a leading indicator, this relationship can vary. There is little substitute for the inflation numbers themselves, even if we accept that the statistics may not be a full reflection of price pressures in an economy. Their impact will be magnified during 2018.
The importance of monitoring the inflation forecast
Financial assets and equity markets have enjoyed strong performance for two main reasons. The first is the global economic recovery, which gathered strength during 2017. The second is that the world’s leading central banks have continued to underwrite financial markets by extending emergency monetary support measures. ‘Peak stimulus’ has already been seen and the US, EU and UK are all reducing the scope of their support. Depending on how worldwide and UK inflation responds moving forward, the support which many financial assets have enjoyed would be at risk if central banks feel the need to remove their policy support more quickly than expected.
What do policymakers think about the inflation figures?
Policymakers are confused about why higher inflation has not already reared its head, given the underlying strength of the global economy and low levels of unemployment.
As Janet Yellen commented in September, “we should be wary of moving too gradually (on raising interest rates) … potentially creating an inflationary problem down the road that might be difficult to overcome without triggering a recession.”
Why haven’t inflation rates risen already?
The reasons why US, EU and UK inflation rates haven’t already increased has been the subject of intense debate, with questions asked about whether the inflation-dampening forces are structural or cyclical. If structural, inflation could be expected to remain relatively subdued. However, if it’s because of temporary forces, such as spare capacity in the economy (the under-utilisation of labour and capital that could be put to work to boost output), we may be set for a period of higher worldwide and UK inflation as this slack has now been depleted. This mindset has implications for how quickly and aggressively central banks will feel they need to move.
It appears that Consumer Price Inflation (CPI) bottomed in 2015, although core-CPI (excluding food and energy) has flatlined in the US and EU over the past three years. Only the core measure of UK inflation has registered any acceleration.
Schools of thought: the hawks
Those who believe that price pressures may increase, and that the inflation-dampening forces are temporary, often argue that the low jobless rate and steady increase in employment will feed through to wages which, in turn, will put pressure on inflation rates. US unemployment stands at 4.1% – a rate not seen since 1999/2000 – and initial unemployment claims have been on a firm downtrend since the end of the global financial crisis. Meanwhile spare labour capacity has been cut, as shown by the diminishing number of people marginally attached to the labour force, or who are working part time but are available for full-time work.
Wage momentum is rising in most sectors and, with corporate profitability increasing, it is only a matter of time before average hourly earnings accelerate further. Companies are finding it hard to fill job openings, which is a precursor to higher wage growth. Proponents also argue that core inflation lags the economic cycle, so the subdued inflation readings in 2017 may still be a legacy of 2015/2016’s deflation scare. As far as the US is concerned, the impact of previous dollar strength and lower energy prices will also begin to diminish.
… and the doves
The opposing view centres on the impact of globalisation and technology, which has ensured that inflation rates are less sensitive to domestic macro conditions. It is the global output gap (the difference between actual economic activity and the maximum output if the economy were operating at peak capacity) which is of most importance and, globally, there is still significant slack. The IMF has highlighted technology as being the primary force behind a decline in wages as a percentage of costs; even at low levels of unemployment, firms may not need to increase wages. In the absence of wage inflation, broader price pressures will remain subdued.
The supposed closing of domestic output gaps is also viewed sceptically; these figures are notoriously inaccurate and consequently there is likely to be more slack in domestic economies than currently assumed. By way of evidence, US labour force participation is extremely low by historical standards and consequently there is potential for greater numbers to re-enter the workforce.
Has the Phillips curve changed?
The Phillips curve plots the relationship between rates of unemployment and the inflation rate within an economy. From an economic perspective, it might well have changed. Low unemployment is no longer inflationary, due to factors such as outsourcing, global value chains and higher levels of automation. Demographic forces – the replacing of older, higher paid workers with younger, cheaper alternatives – may also be restraining wage growth and by extension inflation.
A balanced view of inflation
Our conclusion is that while there may be a temporary increase in inflationary pressures, structural forces will ensure they do not build significantly. Although interest rates are unlikely to reach previous ‘normal’ peak levels, inflation will also remain subdued relative to history, ensuring that central banks can remove their unorthodox monetary support gradually.
However, there are many unknowns, and the potential for a central bank policy mistake has risen. We will watch inflation rate figures and the UK inflation forecast closely over the coming year. We feel that investors should do the same.
