Markets are starting to fret: it is a close call, but we are slightly more sanguine.
Inflation is now back on many minds. And this matters because, as go inflation expectations, so go bond yields, and thence asset prices, exposed leveraged entities, official interest rates, and more.
Inflation expectations however are difficult to forecast, not least because they are driven by a range of factors, none of which is certain. But there are two broad strands of thought:
- Budget deficits and money growth. There is concern, especially in, though not limited to, the financial community that budget deficits and/or recent money growth presage faster inflation, if not immediately then in due course. We shall write about that shortly.
- The pressure of demand. During the post-2008 and then the COVID-19 recessions this potential driver has been quiescent; but it has recently reared its head, in the US at least, with concern that President Biden’s proposed $1.9 tr fiscal stimulus 1 is potentially riskily large in relation to the admittedly uncertain margin of extant spare capacity.
The pressure of demand argument
The issue here is whether pressure on capacity – by itself or in conjunction with a price spike 2 would lead not just to a one-off increase in the aggregate price level, but to the sort of sustained price-wage-price spiral that defines ‘true’ inflation.
The notions of spare capacity, and hence productive potential, are useful pedagogic devices; and at the extreme they can be operationally useful: egregious excess demand will almost always be inflationary. But whether estimated measures of spare capacity, or productive potential, are good enough to support ex ante judgements, and to calibrate policy settings appropriately, is moot. 3
In practice, much would be revealed by whether unit labour costs were to pick up; and in turn that would depend inter alia on wage developments; 4 the evolution of productivity; and to some extent the exchange rate of the dollar.
Wage developments. Many factors stand to be at work, but important could be that a falling US participation rate over the past 20 years suggests that there is considerable additional labour potentially available. 5 Furthermore, compared with earlier epochs, union membership in the US, at 11.9%, is at its lowest for more than 70 years: 6 the US labour market today is highly atomistic.
Productivity developments. US productivity growth (output per person employed basis) has been slowing for decades. 7 Typically however productivity is procyclical – Verdoorn’s law – and would likely accelerate somewhat with stronger growth. Over the longer term, however, productivity is determined importantly by the pace of net investment, and the extent to which this brings the new technologies into the workplace. But the likely extent of any such pickup is inescapably uncertain.
Investors are clearly on the lookout for an acceleration of inflation, and indeed are already changing their expectations 8 – even if the implied acceleration is mild by past standards. 9
We doubt that the stage is being set for a material, sustained, increase in US inflation, 10 at least this year and quite probably next. Moreover, were excess demand to start to eventuate, we suspect that it would manifest itself primarily not as faster inflation but as a widening current account deficit. 11 Perhaps most importantly, while the Fed has reiterated its ‘lower for longer’ mantra, 12 if there were to be a need to cool the economy, that would probably require only a small rise in official interest rates, given that leverage in the economy is almost certainly high.
To assess the evolving risk, watch for:
- The extent to which the proposed US package gets whittled down in the political negotiations.
- The composition of the package – how much it merely supports aggregate demand or, alternatively, promotes investment spending.
- The rate of growth of nominal GDP, and its split between its real and price elements.13◼
Early thoughts on an initial draft of this Global Letter were discussed with a range of people, and particularly useful comments were offered by Saul Eslake, Gerald Holtham, Han de Jong, Russell Jones, Philip Turner, and Dimitri Zenghelis. However, none has responsibility for this final version: that owes solely to the author.
Macro series – Rising US inflation concerns – February 2021