James Bevan: Inflation pressures and the risks
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James Bevan
Last week, the UK’s Office for National Statistics announced an important change in how it publishes inflation numbers – from March next year, the key measure will be CPIH which includes a measure of owner-occupier housing costs.
The latest standard CPI (consumer prices index) data, out today (15 November), are expected to show that the rate of inflation has reached a two-year high of 1.1%, with the weakness of the pound delivering higher import prices and CPI remains the Bank of England’s Monetary Policy Committee reference point.
CPI has largely replaced RPI (retail prices index) as the UK’s most accepted measure of inflation, and is the basis of CCLA’s real asset return assessments, and CPIH was primarily designed for macroeconomic purposes, not giving the public a price index which measures the actual impact of inflation on households to replace RPI.
However, the Office for National Statistics apparently regard CPIH as the best measure of inflation for households because it includes housing costs, but not changes in house prices, which reflect asset prices not goods and services prices.
Rising
Whichever measure is preferred by the ONS, it’s clear that in the near term inflation is rising. Looking ahead we have clear inflation pressures from the weaker pound and yet there remains an ongoing deflation challenge from global over-capacity.
A new influence will be US policy under Mr Trump, which is expected to include both demand-side and supply-side measures. The former tend to be inflationary, while the latter tend to be disinflationary. Thus, on the demand side, Mr Trump proposes to spend $1tn on infrastructure over the next 10 years and on the supply side, he proposes to cut corporate and personal income taxes, which can have both inflationary demand-side and disinflationary supply-side effects.
Perhaps on balance, the disinflationary supply-side effects will offset some, but not all, of the inflationary demand-side effects and that should reduce the risk and fears of deflation. If so, then the 35-year bull market in US$ Treasury bonds might have ended on 8th July this year when the 10-year yield hit a record low of 1.37%. It is already back up to 2.23%.
Stimulus
Much of that backup was attributable to the perception that no matter who won the presidency, there would be more fiscal stimulus and Mr Trump’s victory increases that chance.
Looking at Trump policies more broadly, globalization has been and is inherently disinflationary and the political backdrop looks negative for globalisation. With globalisation seemingly in retreat, and inflation and protectionism likely more prominent, financial assets do not get the support they have had from QE and deflation.
Protectionism can be inflationary, as long as it doesn’t trigger a depression, which would be deflationary. Looking back, the Smoot-Hawley Tariff of June 1930 caused a depression and a collapse in commodity and consumer prices but the Reagan administration pursued policies that seemed protectionist — with the US’ major trading partners pressed to adopt fairer trade practices in exchange for free trade with the US — and the US economy continued to grow, and inflation remained subdued. This may well be the outcome of the current protectionist wave and we can expect globalisation to survive the latest challenges.
But we could see higher wage inflation. Early in November, Fed vice chairman Stanley Fischer said that in his view “the labor market is close to full employment” adding that it wouldn’t take much by way of job gains to maintain the unemployment rate near 5%.
That’s because he expects that the labour force participation rate will continue to decline due to the “likely drag from demographics” and specifically, he said that job gains of as low as 65,000 to 115,000 would be “sufficient to maintain full employment.”
Even if participation rates were to remain unchanged, Mr Fischer said a range of 125,000 to 175,000 job gains would prevent “unemployment from creeping up.”
Non-farm private payroll employment gains averaged 210,200 per month over the past five months through October. The unemployment rate has been around 5% since last autumn. Strong jobs market indicators were also evident in the latest Job Openings and Labor Turnover Survey (JOLTS) and National Federation of Independent Business (NFIB) reports through September and October, respectively.
According to both surveys, the rate of job openings exceeds levels during two of the past three cyclical peaks. Layoffs fell to the lowest on record, while quits were near a record high during September. Not surprisingly, quits are highly correlated with the Consumer Confidence Index, which has been lagging but could move up now that the elections are over.
Rising wages
These factors point to higher US wage inflation and the Atlanta Fed’s median wage growth tracker shows that “job switchers” achieved wage increases of 4.2% year-on-year (yoy) during September versus 3.3% for “job stayers”.
Average hourly earnings for all private industry workers rose 2.8%yoy during October, the highest since June 2009. Mr Trump’s policies could put more upward pressure on wages given that most indicators suggest that the economy is at full employment with a shortage of construction workers.
The US inflation outlook benefits from dollar strength, and falling oil prices should also help to moderate inflationary pressures. The JPMorgan trade-weighted dollar is now up 24% from its low on 1st July 2014 and that, along with OPEC’s inability to agree on production cuts, is depressing the price of oil.
Mr Trump’s commitment to “lift the restriction” on the US energy industry can only feed supply. But against that, the Commodity Research Bureau (CRB) raw industrials spot price index is soaring and doing so, as the dollar surges, is unprecedented. And inflation expectations have jumped since the election, even though the strong dollar will put downward pressure on non-petroleum import prices.
Stagflation risk
Over the past couple of years, there has been a widening consensus that secular stagnation is here to stay and Keynesian economists, like Larry Summers and Stanley Fischer, have argued that the only way out is more fiscal spending. Supply-siders have championed less government and tax cuts as the only sure way to revive growth.
Mr Trump is in effect backing both camps. If he succeeds in boosting real economic growth, it might not be inflationary, if it is based on productivity.
Productivity has a demand side as well as a supply side given that inadequate demand may leave even the most efficient factories under-producing and therefore unable to deliver productivity improvements in practice.
Better economic growth could very well prove that the supply side of productivity can deliver more output, thus limiting inflation.
These are the same challenges facing the UK post the Brexit vote: we need better growth and investment to drive productivity, and the risk is that we end up with stagflation.
Neither environment can be construed as good news for bond markets with yields at current levels. The former outlook is potentially good for equities, the latter outcome is not good for equities – but quality growth can survive and deliver decent real returns to patient investors. Real assets can prosper with both scenarios.
James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla
*CCLA is a supporter of Room151
