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The writer is publisher of The Overshoot research service and co-author of ‘Trade Wars are Class Wars’
Markets are currently pricing in the most benign possible outcome: that US inflation continues to decelerate even as real output keeps growing briskly. While this is certainly possible, it is at least as likely that inflation will stabilise at a rate roughly 2 percentage points faster than the Federal Reserve’s 2 per cent yearly goal. In that scenario, shorter-term interest rates would remain at their current levels for some time, if not go even higher, which in turn would pull up longer-term yields and push down valuation multiples. That could spell trouble for asset prices.
At first glance, this seems like an odd time to be expressing concern. US inflation has already slowed from roughly 10 per cent a year in the first half of 2022 to about 3 per cent a year. This slowdown has coincided with robust growth in real consumer spending and millions of extra jobs. Having made it this far, it feels churlish to suggest that inflation will not decelerate painlessly to 2 per cent from here.
But the slowdown in inflation reflects the unwinding of temporary disruptions associated with the coronavirus pandemic and Russia’s full-scale invasion of Ukraine. These events reduced the supply of goods and services, pushing up prices. As conditions have normalised, many prices have stopped rising or even dropped outright.
These swings have masked the modest but persistent acceleration in underlying price pressures. Just as investors and policymakers were right to look through the “transitory” inflation of 2021-2022, they should also strip out the “transitory” disinflation of 2022-2023 to get a handle on where such pressures will settle in the years ahead. Since inflation is just the difference between changes in nominal spending and real production, that means focusing on wage trends: the largest and most reliable source of financing for consumer spending.
Since 1929, the average American worker’s hourly wage has grown about 1.6 percentage points faster than the PCE price index each year. Wages have grown at least 3 percentage points faster than prices in only 17 of the past 92 years for which we have data, of which only five occurred after 1956. Between 2000 and 2019, average hourly wages consistently grew just 1 percentage point faster than prices each year. Wages have grown 4 or more percentage points faster than prices only a handful of times: at the beginning of the Great Depression, during the rationing and price controls of the second world war and the Korean war, in the late 1990s productivity boom, and during the first year of the pandemic.
Now, however, the best data suggests that US wages are rising at a yearly rate of about 5 per cent. Moreover, persistent wage growth means that interest rates may stay “higher for longer”— unless consumers start spending a much lower share of their incremental earnings, real output per worker rises sharply, or both.
Federal Reserve boss Jay Powell agrees. At his recent press conference, he said: “we want wages to be going up at a level that’s consistent with 2 per cent inflation over time” and that “wages are probably an important issue going forward”. This explains Fed officials’ continued focus on “softening” the job market via higher interest rates. That presents a risk that interest rates may not come down as quickly as implied by market prices, which in turn could affect other asset valuations.
Futures in Sofr, the floating interest rate benchmark, currently imply that short-term interest rates will drop to 3.5 per cent by the end of 2025, while break-even inflation rates imply that prices will rise almost exactly 2 per cent a year from now for the next three decades. Meanwhile, credit spreads are tighter than they were in 2019 and earnings multiples on stocks have jumped. By some measures, the prospective returns on stocks relative to bonds are lower than at any point since mid-2007, implying extreme optimism about future profit growth. This combination only makes sense if inflation returns to 2 per cent — and wage growth decelerates commensurately — without any hit to real output.
Many Fed officials would be unwilling to force the economy into a downturn just because inflation stabilised around 4 per cent a year, instead of 2 per cent. It was not long ago that many leading economists were recommending 4 per cent inflation targets, or, in what amounts to roughly the same thing, a 5 to 6 per cent yearly nominal income growth target. But while a policy of benign neglect might make sense, it is not currently priced in.
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