“I’ve always been suspicious of collective truths.”
We live in a subversion age. A wrecking ball of new technologies, a gargantuan financial economy and invasive central banks are laying waste to once-granitic market principles. Consider, for example, equity markets and how their single-minded assault on the stratosphere has rendered volatility all but extinct. Or take the finding, reported last month in the CFA Institute’s Financial Analysts Journal, that the benefits of stock-picking models based on earnings growth are less effective than those led by such subjective variables as a company’s relative strategic advantage.
It makes one wonder what other market verities are poised to go the way of the Palm Pilot. Trading pits and the people who man them? How about the globalized economy or the annual general meeting?
For my money, given the headline events of last month, I’d wager on the fundamentals of inflation. It seems only yesterday that inflation was a pretty basic concept: wages amplify with job growth, which increases consumption and bids up prices. As retailers achieve pricing power, manufacturers expand capacity which creates more jobs. Inflation expectations rise until – presto!- the Federal Reserve raises interest rates and the cycle repeats itself.
Economics 101, sophomore year.
And yet here we are in the midst of the longest economic recovery in history and inflation, like a skittish colt at a steeplechase, refuses to make the decisive leap past the Fed’s 2% target rate. According to the Labor Department’s consumer price index, inflation is trundling along at 1.9% while the Department of Commerce’s personal consumption expenditures, which the Fed closely tracks, calculates it at a mere 1.4%, the slowest level in a year. Small wonder that the defining moment of the third quarter, if not the year, was Fed Chair Janet Yellen’s observation last month that inflation had become “mysterious.”
Yellen, who may soon be replaced by President Trump’s own hire, is in a tight corner, policy-wise. She wants to raise interest rates by December, having already done so twice this year, but renewed tightening in the face of muted inflation seems precipitous. At the same time, having created along with her predecessor one of history’s greatest liquidity bubbles in the form of a $4.5 trillion bond-buying program, she will soon reverse that trade for the sake of monetary policy normalization. Yellen confirmed last month that the Fed would begin liquidating its balance sheet, a process that will take many years to exhaust but one with bearish implications for bond prices. As there is no precedent for such a massive stimulus program it is impossible to anticipate the consequences of its diminution.
While we are sympathetic to Yellen’s plight we couldn’t help but notice the New York and Atlanta Fed’s roll-out last month of something called the Underlying Inflation Gauge, an obscure price-tracker that registered inflation at a head-spinning 2.64% in July and 2.74% in August, the highest rate since November 2007.
This came as little surprise as the UIG incorporates dozens of additional variables outside of prices, including the unemployment rate, stock prices, bond yields and purchasing managers’ indexes. What we found puzzling was the Fed’s decision to include the UIG alongside the Departments of Labor and Commerce’s benchmarks, given their contrasting metrics. As ZeroHedge chided in a blog post last month, “the Fed should be figuring out why and how it is calculating inflation incorrectly before continuing to blow the world’s biggest asset bubble.”
Despite full employment – indeed evidence of labor shortages – it turns out that falling trend inflation may be a secular, rather than cyclical, reality. An article in the Wall Street Journal pointed out late last month that following every recession since 1982, core inflation trended lower than it did in the previous business cycle. At the same time, a senior Fed official noted that inflation has dropped 0.25-0.75% in the past decade, a deflationary trend that can only be reversed by driving the unemployment rate below its natural rate until it meets inflation targets – that is if we believe the Phillips curve and NAIRU framework still hold.
So why is inflation so stubbornly docile? For one thing, the current long-but-shallow recovery may be the new reality, in part due to languishing productivity rates as economist Robert Gordon argued persuasively in a book last year. Though the labor market is tightening, the overall size of the workforce peaked in the early 1990s and has been dwindling ever since. Wage growth, meanwhile, continues to disappoint and consumer spending has underwhelmed in kind. Then add a generous dose of technology and shake well.
There are also political factors to consider, at least looking forward. Like it or not, we have reached an inflection point in Washington where thoughtful deliberation is no more likely when one party controls government than when it is shared. The possibility of a third party evolving from such an ossified system can no longer be comfortably ruled out along with the legislative havoc that such an array of forces implies.
Unlike investors, whose world is defined by the globe’s $300 trillion in financial assets – plus the lily-gilding properties of unlimited liquidity – businessmen and consumers know a leaky ship when they smell one. There may come a time when 2% inflation will be the welcomed drumbeat of a particularly rigorous economy.