Watch out for rising inflation

October’s lift in hourly earnings number confirmed that wages are on the rise. The Philips Curve has been slow to operate in this cycle but there seems little doubt that with unemployment below 5% now for more than 2 years, and down at 3.7% currently, the labour market is finally responding as expected. The Fed’s task is set to become much more complicated if wage growth continues to accelerate because stopping at ‘neutral’, assuming they can find it, won’t be enough. They might need to exceed neutral, to actually slow growth below trend.

Falling unemployment (in red) points to rising wages (blue)

So here is the way the Late Upswing of the cycle usually plays out. The Fed raises rates to neutral and then above, hoping to achieve a ‘soft landing’ or mild recession, enough to take the economy off the boil, perhaps push up unemployment a little and cool the labour market. But calibrating it just right to slow the economy without precipitating a recession is hard to achieve.

That said, there are a few things that could help over the next year or two. First, the current growth surge is unlikely to continue because it is fuelled by government fiscal stimulus – tax cuts and spending - and supported by the stellar rise in stocks during 2017. The fiscal stimulus effect will dwindle in 2019 and, at best, stocks are likely to rise only slowly from here. So, we won’t see a repeat of the wealth effect from the 30% rise in stocks we saw after President Trump’s election. In effect some of the Fed’s work is going to be done for it.

Secondly, there is a decent chance of a cyclical rise in productivity growth which would offset rising wages to some extent. Investment, an important driver of productivity growth, has picked up in the last couple of years while higher wages themselves tend to encourage productivity gains. If labour is becoming more expensive you look for ways to economise on it or find a way to automate something. Rising capacity utilisation also tends to support higher productivity. So far in this cycle capacity use has not gone as high as it typically does (see chart). That is something to watch out for, though it will also be a red warning signal for the Fed.

Thirdly, growth is slowing in Europe and China which will keep the downward pressure on commodity prices, again holding down inflation. The outlook for oil prices has shifted markedly in just the last few weeks as a surplus of oil production has emerged. Well into October the markets were nervous about the effects of the economic collapse in Venezuela as well as the effect of sanctions on Iran but these fears have evaporated. Instead it seems that the 2mbd increase in US oil production in just the last two years, coupled with increases from Russia and the Gulf (despite the earlier agreement to curtail production) have left the market oversupplied. That said, lower oil prices will boost real incomes keeping growth going strong for a bit longer.

But, and there is always a but in economics, there is one major new inflationary force – the rise in tariffs. The US has just imposed tariffs of 10% on many goods from China and in January that is set to rise to 25% and on a greater range of goods. This will raise the prices of many goods in the US, both consumer imports and locally produced goods relying on imported parts. Perhaps President Trump will be able to secure a deal with China before long and take the tariffs down again but there is room for doubt on this. Trump wants to do a deal that he can crow about, while China’s leaders will not want to lose any face. Whatever the details of any deal, the optics are going to be hard to manage for both sides. One hope for the near term is that there could be a pause for negotiations with the 25% tariffs put in abeyance for now. But even at a 10% tariff rate there will be increased prices for some goods.

It is possible of course that the Fed could tolerate inflation somewhat higher than the 2% target for a while. There are good arguments for this approach. For one thing inflation has been below the 2% target for most of the last 10 years. Another, often mentioned, is that even if wage growth moves up to 4% and inflation to 2.5-3%, they might not continue to accelerate. Why not? Partly because business and labour groups may be anchored to 2% inflation and partly because international competitive pressures could help keep the lid on.

In my view this latter view will prove wrong. It is true that wages for some workers are constrained by the potential for outsourcing or imports. But a great deal of the economy, from food and hospitality service workers to transportation to health workers is essentially immune to foreign competition so I expect that the tight labour market will continue to take wages higher. So, if the Fed does take risks on this the move will backfire in the end because inflation will keep accelerating. But they may be tempted to give it a try, so as to avoid being criticised for unnecessarily ending the expansion.

It is difficult to get away from the fact that the mini-economic boom of 2018, driven by badly timed fiscal expansion, risks shortening this economic upswing because it will lift inflation and put the Fed in a tough pace. That said, I still think the upswing has further to go because the inflation response is likely to stay rather sluggish. Given a bit of economic slowdown and some acceleration in productivity growth we should be able to get to 2020 at least and 2021 if we are lucky.