Inflation creeping back into the global economy?
Sunday, July 6th 2014, 4:19PM
by Andrew Hunt
Slightly to the financial markets’ consternation, the latest data for the US consumer price index has shown headline inflation accelerating quite sharply towards a 2.5% annualised rate over the last three months or so. In a purely mechanistic sense, the primary drivers of this surge in prices were food and medical care prices, although transport costs and some other services also contributed to the faster rate of inflation. In some respects, the acceleration within the CPI was perhaps to have been expected; the previously released producer price index data had already begun to signal higher price pressures in some parts of the economy and particularly within the food-related sectors following the poor weather, which has apparently led to a depletion of animal feeds and rise in meat prices.
The producer price data had also highlighted the rise in heating fuel prices that occurred during the first quarter’s abysmal weather in the northern hemisphere, the effects of which may still be working its way through the supply chain. Meanwhile, the recent trend towards slightly higher import prices into the USA were also arguing for an upward bias to at least some parts of the CPI data. Overall, it seems to us that the rise in the rate of inflation should not have been overly unexpected and it was, we suspect, predominantly weather-related rather than particularly “fundamental” in nature.
For some market participants, though, the advent of the higher reported headline rate of CPI inflation, on top of their continued belief that the US economy is somehow booming, initially at least appeared to represent reason enough to expect the now rather new-look Federal Reserve Board (it now has no fewer than five new members) to continue the central bank’s previous tightening bias and to even be considering advancing its rate hike agenda. We must admit that we still find it strange even now just how convinced markets are that the US is “booming” despite the message suggested by the recent very weak GDP figures (which are now conveniently thought by many simply to be “wrong”, despite their consistency with the previously published income data and much of the incoming consumer data – and, we might argue, peoples’ perceptions of the state of the economy out in the real world away from Wall Street). Many portfolio managers, though, simply “assume” that the economy is expanding rapidly and the reported higher inflation – despite its probably temporary, weather-related causes – was viewed as further evidence to support their view that nominal GDP growth is rising and that the FRB will be tightening “soon”.
In fact, it could also be argued that, inasmuch as the rise in the CPI has tended to be a function of rising subsistence and import costs against a background of slowing, rather than accelerating, nominal wage growth (note that despite rumours to the contrary, the three month moving average rate of growth of average hourly earnings has slowed to below 2% annualised from 3% at the beginning of the year – thereby potentially implying negative real wage growth), recent consumer price index trends could actually be considered as being deflationary for economic growth.
In fact, it all seems to be rather “neat” and notionally consistent to us: nominal wage growth is currently only running at circa 2% while CPI inflation is over 2%, with the result that real wages are falling once again and overall consumer spending growth has weakened, despite more households apparently being obliged to turn to unsecured forms of credit to make ends meet. In this seemingly “alternative” world, the weak GDP figures seem to make perfect sense and one could argue on this basis at least that the latest wage/CPI data points actually provided a reason for the Federal Reserve not to tighten – as perhaps Ms Yellen was aware when pressured on the subject at a recent press conference.
Certainly, in her recent press comments, Ms Yellen has appeared to suggest that she believed that the recent rise in inflation was largely transitory and presumably the result of the after-effects of the cold weather earlier this year. As we have already noted, at a superficial level we certainly have some sympathy with this view but we are also aware that the structure of the US economy and its “sustainable trend rate of growth” have probably changed over recent years and this does make it doubly difficult for anyone – the Fed included - to discern just what might be occurring with regard to underlying inflationary pressures within the economy.
In an effort to solve this particular conundrum, we have attempted to go back to what we regard as being “inflation first principles” by attempting to look at what we believe to be the true state of US capacity utilisation, or as we prefer to call it, demand pressure. Rather alarmingly, in the course of this exercise, we have found evidence to suggest that despite the weak GDP data of late, underlying capacity utilisation in the US may be slightly above trend at present and therefore signalling that the economy may notionally already be operating in potentially inflationary territory, despite its recent weak headline growth rates.
Unfortunately, our index of demand pressure suggests that the US is currently already working with a slightly above average level of capacity utilisation (that is, above the neutral “zero line”). Very worryingly, this situation seems to have arisen not only despite the weak first quarter data that we noted above, but more importantly, despite the fact that over the last five years of the recovery since the GFC real GDP growth has only averaged around 1.9% per annum. In fact, real GDP growth has only averaged 0.7% YoY since 2007 and we would infer from this that US sustainable GDP growth must now be in the region of only 1.5%. This is in line with much of the productivity and value-added data that we have quoted in other reviews but which (significantly) we did not use within the construction of our demand pressure index. Moreover, we find further corroboration for our findings from not only the behaviour of the CPI itself but also the country’s current account balance data, which seems to have ceased improving. A static current account balance is usually an indicator of an economy working at around its sustainable/full employment level.
If our findings are in any way correct – and we have some confidence that they are, then we can argue that a number of things naturally follow. Firstly, we can suggest that US trend GDP growth is now firmly below 2% and that the natural rate of unemployment must therefore have moved up substantially. This would seem likely to have deep political implications and we would also argue that it is hardly a positive factor for long-term corporate earnings estimates. Moreover, if the economy is already within seemingly close proximity to its new full employment level, then perhaps the FRB should already be considering some form of tightening, despite Yellen’s comments to the contrary. Unfortunately, we would argue that none of these conclusions or inferences can be considered as being positive factors for the asset markets – either bonds or equities.
Andrew Hunt International Economist London
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