Inflation and markets - where to from here?
Inflation and markets - where to from here?
The greatest puzzle currently troubling economists is how the exceptionally low, and steadily falling US unemployment rate has not led to a sustained lift in inflation. In fact several economists are calling the Phillips Curve, the historical inverse relationship between the unemployment rate and inflation, dead. This is a critical issue because of the importance of US inflation to global financial markets, not just through the influence on the US Federal Reserve (Fed), the most watched and powerful central bank, but also by its impact on global inflation expectations.
Since the GFC recession, US growth has been muddling along, with the range between low and high growth a narrow 1.4% - a low of 1.3% growth in 2012 and a high of 2.7% growth in 2010. Inflation on the other hand has seen around twice the range as growth, with a low of 0.5% in 2015 and a high of 3.3% in 2011. This has been more extreme recently, with growth stuck around 2% over the last two calendar years, with a range of 0.2%, while inflation has been quite variable, with a range of 1.3%.
At each point at the extremes in the inflation range, markets have extrapolated the outcome as the future trend, seeing wild swings in inflation expectations and disappointment when inflation moved back into the range.
Recently, we have seen the powerful effect changes of inflation expectations can have on financial markets – deflation fears in 2015 hit markets for six, reflation in 2016 saw a strong recovery, and lack of follow through on reflation in 2017 seeing volatility collapse – not just at a broader market level but also on a sector level. In this note we will explore the likely direction of inflation and inflation expectations and the impact this will have on financial markets.
How did we get here?
Over the last several years, inflation expectations have fluctuated wildly. This was driven by the extreme volatility in oil prices. The plunge in oil (WTI) from around $US100pb, in 2014, to a low of $US26pb, saw US headline inflation below zero for much of 2015. With the doubling of oil prices to above $US50pb over the first half of 2016 leading to sharp rise in headline inflation, seeing a peak in February 2017 – one year after the low (inflation is measured as a 12 month rate of change). Markets responded to the move in inflation, given there is a tendency to extrapolate the recent inflation trend, by fretting about deflation in 2015 and early 2016, and moving on to the reflation theme in late 2016 as headline inflation recovered.
Watching oil prices allowed us to pre-empt the market reaction to US inflation trends, which saw us build into our multi-asset portfolios trades that benefited from reflation in the middle of 2016. Examples of these trades were: a reduction in portfolio duration, break-even trades in US TIPs, and a long Australia resource sector versus REITS in futures. We took profits on these trades in early 2017, before the lack of follow through led to disappointment.
Oil prices have been stable for over the last year, which will see its contribution to the volatility of headline inflation minimal. Pricing in the futures markets has oil prices remaining around the $US50pb level for the foreseeable future. While forecasting oil prices is a difficult endeavour, the rise of shale oil is likely to lead to less volatility in prices - its supply response is much more responsive to oil price changes than conventional oil production, suggesting the futures market outlook is not unrealistic.
Stability in oil prices will mean that to find the driver of future inflation volatility we will have to look elsewhere. This suggests that we should be focused on the outlook for core inflation.
Is the Phillip’s Curve dead?
The traditional method of forecasting core inflation is using the Phillip’s Curve: the relationship between wage / price inflation and labour market slack. The difficulty of using this relationship has been that it has been unstable over time, and more recently the Phillips curve has become flat i.e. the relationship has weakened considerably to the point that some have argued that the relationship is dead. The problem with this analysis is that it assumes that there is a stable relationship between labour slack and inflation. Research by the Fed staff suggests that it is actually non-linear – they found that the response of core inflation increased substantially when the unemployment rate fell significantly below the NAIRU during the 1960s and late 1990s. The conclusion was that it is “unwise to assume the Phillips curve remains flat at all levels of the unemployment rate.”
This can been seen in figure 1, where we plot the average rise in core inflation relative to three regimes:
– the unemployment rate above the NAIRU plus 0.5
– the unemployment rate between the NAIRU plus and minus 0.5% and
– the unemployment rate less than NAIRU minus 0.5%.
Figure 1: Unemployment rate vs NAIRU - impact on inflation
Source: Datastream, Schroders. Covers period from 1954 to 2015.
When the unemployment rate is below the NAIRU less 0.5% core inflation has risen by an average 1.7%. The CBOs current estimates of the NAIRU is 4.7%, so while the unemployment rate is at 4.4% (August 2017) it is not yet below this threshold, at the current rate of decline it will not be long before it breaks it. Though estimates of the NAIRU are problematic in real time, the 1960s showed benign inflation until the unemployment rate fell below 4%, and points to the potential risk as the unemployment rate continues to fall (see figure 2). The 90s were less dramatic, with the full impact blunted by the rise in the US dollar. With the US dollar currently elevated on real effective exchange rate measures, it suggests the full effect will be felt from the tight labour market. To the extent that inflation is a global phenomenon, the steady downward trend in unemployment rates has been replicated in the major global economies, and while there is more slack, it has closed significantly.
Figure 2: Unemployment and inflation: 1960s and now
Isn’t inflation always and everywhere a monetary phenomenon?
The quantity theory of money, dating back to the 1500s and reinvigorated in the 1950s by Milton Friedman, is another approach to forecasting inflation. The broad concept of the theory is captioned by the saying “inflation is always and everywhere a monetary phenomenon.” This theory is based on an identity, the equation of exchange:
M . V = P . Q
– M is the total amount of money in circulation
– V is the velocity of money
– P is the price level associated with the transactions
– And, Q is an index of the real value of transactions
The quantity theory of money takes this equation of exchange and assumes three things. First, the demand for money, as reflected in its velocity, has a stable relationship based on factors like nominal income, interest rates etc. Thus velocity is relatively unchanging, seeing money supply as the key left side variable. Second, the supply of money is exogenous - not a function of other factors - and is driven solely by central bank activity. Third, production is driven by non-monetary factors such as the productivity of labour and capital, and like velocity is relatively unchanging. This sees the equation of exchange collapse to M = P, and suggests that inflation is a function of the growth rate of the money supply.
However, there are two issues with the assumptions made that suggests the relationship between money supply and inflation isn’t as simple as this theory suggests. The first problem with this theory is how do you measure money? Central banks have control over base money: notes and coins in circulation and bank reserves; but do not have direct control over broader measures of money. This relationship is driven by the money multiplier, which is driven by credit creation, which is in turn driven by the supply and demand for credit. Research generally shows that the relationship between money and inflation holds when money is measured by broad measures. The importance of the money multiplier does raise issue with the assumption that the supply of money is exogenous. Balance sheet recessions, where individuals are driven by balance sheet repair (deleveraging) rather than profit maximisation, like the Great Depression and Japan during the 1990s, would see the quantity theory of money break down.
The other issue with the theory is the assumption that the velocity of money is stable. This holds in normal conditions but breaks down at other times. A good example is what happened during the global financial crisis, where the velocity of money fell sharply. Disturbances in velocity are often the key factor in hyperinflations and severe deflationary environments. In hyperinflations the velocity of money goes up dramatically. With the value of money collapsing, sometimes on a minute by minute basis, there is a very high incentive to hold money for as short a period as possible, and this causes velocity to increase. While in deflationary environments, with prices falling, there is no incentive to purchase goods and services quickly, so the velocity of money falls. In times where money supply is relative stable, changes in velocity can provide a good lead on the inflation environment.
What does this mean for inflation?
Both the Keynesian and monetarist approaches point to a lift in core inflation – with the monetarist approach suggesting core inflation at around 2% at the end of next year, while the Keynesian approach suggesting 3.5% to 4% is not out of the question.
As with most things, the answer is more likely to be something in the middle, with mid 2% our target. However, with tax cuts expected next year, and the Fed largely only taking their foot off the accelerator, the unemployment rate is expected to remain low, suggesting the rising inflation dynamic is likely to continue into 2019 as well.
While this is largely a cyclical dynamic, the role of inflation expectations in the inflation process suggests there is the risk that this may lead to a more structural shift in inflation. This is reinforced by the fact that previous cycles have seen Fed policy at a much higher level at the same stage of the business cycle. For other developed economies, while their unemployment rates have also been falling steadily, their unemployment rates remain above estimates of their respective NAIRUs, although, not by a significant amount suggesting their Phillips curves are more in the flat area. However, rising inflation in the US will have an impact on inflation expectations in those economies.
Recent experience has shown that shifts in inflation and inflation expectations have significant impacts on markets, mainly given the potential response of central banks. With inflation expectations falling recently, due to the lack of follow through in headline inflation, this suggests significant movements in markets if our inflation outlook is correct.
Figure 4 presents a stylised look at the economic environment and asset class and market performance. The shaded area represents where we think market expectations are: modest inflation and above trend growth. If inflation and inflation expectations lift as we expect that would move the market to the right.
Initially we would expect a ‘risk off’ shock as the market moves to price in the new inflation regime, but then risk assets would be expected to recover in an environment of strong nominal growth. In a higher inflation regime, inflation proxies: breakeven trades, commodities, commodity currencies etc will do well; while bonds and bond proxies (REITs, infrastructure etc) would suffer.
Figure 4: Growth, inflation and market performance
Of course this ignores valuations which imply financial assets are stretched and that future returns will be limited. This would leave markets vulnerable to the expected shift to new higher inflation. However, as the market adjusts to positive fundamentals of strong nominal growth, this will likely keep valuations on the expensive side for risk assets but would likely see a difficult environment for bond markets.
Post the GFC recession, economic growth volatility has been generally low, while inflation volatility has been high. This has seen markets move in response to the changing inflation environment. Over the last couple of years this has been driven by the extreme volatility in oil prices. However, with oil prices expected to remain relatively stable, the inflation environment will be driven by changes in core inflation.
Economists historically have forecast core inflation using the Phillips curve relationship. However, this relationship has been weak recently with some economists arguing that it is ‘dead’. Research by the Fed and our own analysis suggests that the Phillips curve is non-linear and when the unemployment rate falls below a certain threshold this relationship will re-assert itself and core inflation will begin to rise. This is expected to start early next year. We also take a monetarist approach and find a similar story of rising core inflation next year. The bottom line is that inflation will start to accelerate next year, with core inflation likely to be around 2.5% at the end of 2018. The expected economic environment also means that inflation pressures are also likely to continue into 2019.
With markets pricing in a benign inflation environment, risk assets will initially be negatively impacted by a change in the inflation regime. However, moving past the adjustment, provided growth holds up, strong nominal growth will be positive for growth assets, inflation proxies and negative for bond and bond proxies.
 Nalewaik, Jeremy, ((2016), “Non-Linear Phillips Curves with Inflation Regime-Switching”, Finance and Economics Discussion Series 2016-078, Board of Governors of the Federal Reserve System.
 NAIRU is the non-accelerating inflation rate of unemployment and refers to the level of the unemployment rate below which inflation rises.
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