In stark contrast to market expectations, US inflation is in the midst of a big downturn. Core inflation is likely to end this year close to 1 per cent, far below the Federal Reserve’s target of 2 per cent.
It is a prospect that will have significant ramifications for Fed policy, as well as the bond and equity markets.
With such low inflation at this late stage in the economic cycle, longer-term bond yields will reach further lows. In an environment in which prices and incomes are increasing more slowly relative to debt servicing obligations, record high levels of indebtedness will exert greater downward pressure on economic growth. The Fed, widely expected to raise interest rates this week, will stop raising them. Finally, lower interest rates, and hence cheaper capital, may prolong the appreciation of assets perceived as being leveraged to growth, such as technology stocks.
As we approach the end of the first half of the year, the downward pressures on inflation are building. Prices across many of the largest components of core inflation are in clear and, in several cases, accelerating downtrends. Take education. Costs rose 2 per cent in April from a year earlier, down from 4 per cent in September 2015. Or look at car prices, which fell 1.4 per cent in April from a year ago, compared with a 0.6 per cent increase in January 2016.
These downward price pressures are partly the result of structural disinflationary pressures (such as high debt levels), but they are also spurred by sector specific developments including, in the case of education, the unaffordability of college tuition and big stresses in the student lending market. Within the car industry, excess inventories and intensifying credit stresses are exerting downward pressure.
However, the most important sector-specific development is that the rate of increase in the cost of shelter — or rent — has turned down. Since the credit crisis, core inflation has only ever approached 2 per cent because the cost of shelter has been rising quickly. But over the past six months shelter price inflation has decelerated sharply. This is likely to continue.
A critically important disinflationary dynamic is paltry wage growth. Nominal wage growth has turned down this year, and real wage growth has collapsed from 2 per cent in July 2016 to 0.3 per cent in April. It is not hard to see why consumer spending growth is weak.
Wall Street economists have repeatedly called for an acceleration in wage growth, and thus inflation, over the past five years. And the argument is always the same: the slack in the labour market has gone as evidenced by the low unemployment rate, meaning wage pressures are on the cusp of boiling over.
But no one really knows how much slack remains in the labour market. The reason is that the percentage of the population either employed or seeking employment (ie the labour force participation rate) is over five percentage points lower now than it was before the credit crisis.
Although demographic shifts undoubtedly account for a large part of the decline in this rate, many have dropped out of the labour force because they simply cannot find employment or are unwilling to do so. And in cases where people will not find jobs, it is usually because wages at the low end of the income spectrum are so pitifully low.
Note, too, that the participation rate has moved sideways since 2014. This is at odds with the consensus view that the whole decline from 2008 onwards has been the result of long-term demographic shifts. It also suggests that an increase in the participation rate is entirely plausible. If it rises by just one percentage point, the labour force would expand by nearly 2m people. There would be big downward pressure on wage growth.
Two other structural dynamics are keeping wages depressed: woefully low productivity growth and globalisation. Why would companies pay American workers more when their real output is not increasing materially and when other people in other countries can make the same things more cheaply?
Other significant disinflationary forces include the lagged effect on prices of last year’s dollar appreciation and the decline in commodity prices being driven, in large part, by the tightening of economic policy in China.
The development that could push inflation higher in the near term would be the timely delivery of a big fiscal stimulus in the US. But the likelihood of this happening is diminishing by the day — given whatever stimulus materialises will be the product of an increasingly acrimonious and chaotic US political process. In the meantime, inflation and bond yields will keep falling.
Henry Hancock is the founder and head of research at Precision Macro LLC
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